Read the case given below and answer the questions given at
the end.
Krutika Designers Ltd is an Indian company engaged in
designing shirts for an international shirt manufacturer.
Its operations are currently restricted to designing shirts
for the Indian market. The firm is interested in extending
its operations to the European markets, but is restricted
by its lack of knowledge about the latest fashions and
trends prevailing there. Hence, the firm has decided to
open an office in Finland for establishing a network in
Europe that will give the firm access to the needed
information. The firm feels that its does not have the
capability of sustaining itself in the foreign markets in
the long-term, and will be able to generate additional
revenue from these activities only for the next 5 years.
After that, the Finnish office will have to be closed down.
The firm anticipates an initial investment of Rs.14
million. The project is expected to generate the following
cash flows over the 5 years period.
Year Cash flow (Finnish Marks)
1
2
3
4
5 10,00,000
20,00,000
50,00,000
50,00,000
30,00,000
These cash flows are expressed in terms of today’s money.
The firm can claim depreciation in India according to the
Straight Line Method. The salvage value from the project
is expected to be nil.
The Finnish Government does not provide any incentives for
foreign investments. However, currently it is making an
attempt to have better economic ties with India. Hence, it
has decided to extend a loan of 50,000 marks to Krutika
Designers. The loan will be at a concessional interest
rate of 7%. The loan is to be repaid in 5 equal annual
installments which will include the interest payments.
The project will generate additional borrowing capacity of
Rs.5 million for the firm. However, as the firm does not
have any firm contract with the international shirt
manufacturer, its domestic revenues are expected to be very
volatile. Therefore, there is no surely that the firm will
be able to absorb the tax benefits arising out of
depreciation and additional borrowing capacity.
The firm does not intend to indulge in any illegal money
transfers.
The current spot rate for the Finnish Mark is Rs.7.25/FM.
The inflation rates in India and Finland for the next 5
years are expected to be 8% and 3% respectively. The
exchange rate is expected to move in tandem with the
inflation rates.
Indian tax rate is 35% while Finnish tax rate is 40%.
India and Finland have entered into a tax treaty whereby
the earnings of the residents of one country are taxable in
that country only.
In India, the nominal risk-free interest rate is 11%. The
same is 6% in Finland. The Indian nominal interest rate
(including risk-premium) is 15%, while that in Finland is
9%. The nominal all-equity rate in India is 18%.
1. Comment on the financial viability of the project.
2. What are the different circumstances in which
nominal all-equity discount rate and real all equity
discount rate should be used for discounting the cash
flows? Explain the rationale behind it.
3. Comment on the financial viability of the project
if the firm is sure about being able to absorb the tax
benefits arising out of depreciation and increased
borrowing capacity.
4. Explain the concept of exchange risk and how it
affects an international project.
5. How can the financial structure of a project be
used to overcome repatriation restrictions? What are the
additional benefits of such maneuvers?
Sean Alicandri, a sophisticated investor who is both
willing and able to take risk, has just noticed that Mid-
West Airlines has become the target of a hostile takeover.
Prior to the announcement of the offer to purchase the
stock for $72 a share, the stock had been selling for $59.
Immediately after the offer, the offer the stock rose to
$75, a premium over the offer price. Such premiums are
often indicative that investors expect a higher price could
occur if a bidding was erupts for the company or if
management buyout of the firm. Of course, if neither of
these scenarios occurs, the price of the stock could fall
back to the $72 offer price. In addition, if the offer
were to be withdrawn or defeated by management, the price
of the stock could fall below the original stock price.
Alicandri has no reason to anticipate that any of these
possibilities will be the final outcome, but the realizes
that the price of the stock will not remain at $75. If a
bidding war erupts, the price could easily exceed$100.
Conversely, if the takeover fails, he expects the price to
decline below $55 a share, since he previously believed
that the price of the stock was overvalued at $59. With
such uncertainty, Alicandri does not want to own the stock
but is intrigued with the possibility of earning a profit
from a price movement that he is certain must occur.
Currently there are several three months put and all
options traded on the stock. Their strike and market
prices are as follows:
Strike Price Market Price of Call Market Price of Put
$50 $26.00 $0.125
55 21.50 0.50
60 17.00 1.00
65 13.25 1.75
70 8.00 3.50
75 4.25 6.00
80 1.00 9.75
Alicandri decides the best strategy is to purchase both a
put and a call option (to establish a straddle). Deciding
on a strategy is one thing; determining the best way to
execute it is quite another. For example, he could buy the
options with the extreme strike price (i.e. the call at $80
and the put at $50). Or he could buy the options with the
strike price closest to the original $72 offer price (i.e.
buy the put and the call at $70).
To help determine the potential profits and losses from
various positions, Alicandri developed profit profiles at
various stock prices by filling in the following chart for
each position:
Price of the stock Intrinsic Value of the Call
Profit on the Call Intrinsic Value of the Put
Profit on the Put Net Profit
$50
55
60
65
70
75
80
85
To limit the number of calculations, he decided to make
three comparisons: (1) the purchase of two inexpensive
options-buy the call with the $80 strike price and the put
with the $60 strike price, (2) the purchase of the options
with the $70 strike price, and (3) the purchase of the
options with the price closest to the original stock price
(i.e., the options with the $60 strike price).
Construct Alicandri’s profit profiles and answer the
following questions.
1) Which strategy works best if a bidding war erupts?
2) Which strategy works best if the hostile takeover
is defeated?
3) Which strategy works best if the original offer
price becomes the final price?
4) Which of the three positions produces the worst
result and under what condition does it occur?
5) If you were Alipcandri’s financial advisor, which
strategy would you advise he establish? Or would you argue
that he not speculate on this takeover?
Read the case carefully and answer the questions given at
the end:
CALLS PUT
A B
C
Months of expiration 3 9
3
Continuous yearly risk-free
Rate (Rf) 10% 10%
10%
Discrete yearly Rf 10.52%
10.52% 10.52%
Standard deviation of
Stock returns 40% 40%
40%
Exercise price Rs.55
Rs.55 Rs.55
Option price Rs.2.56 -
Rs.6.20
Stock price Rs.50
Rs.50 Rs.50
Cash Dividend Re.0 Re.0
Re.0
1) Why should call B sell for more than call A?
2) Is the put call parity model working for options
A&C?
3) Calculate the Black Scholes values of call A & Call
B?
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