The other way to do this is to note that in this question the rate of return
on equity is the Earnings/Price (remember from Ch 4 that r=E/P if earnings
are constant in perpetuity). So in this case, when the return on equity
becomes 15%, then 15%=E/P and the P/E ratio becomes 1/.15=6.67. And since
15%=E/P, then E=.15P. Before E=.1P when the P/E ratio was 10, so the E has
increased by 50%. I don't recommend thinking about it this way though. The
first way I did it let's you see more clearly what is really happening, and
it is safer in situations in which you are paying a dividend rather than
repurchasing shares.
Ch 20
As I wrote before, for position diagrams the safest and easiest method is to
just plot points. Always plot points like zero, the exercise prices, a
point above and a point below. Then connect the dots - they are always
connected with straight lines. Take your second case. When you lend
someone money today, they will repay you 100 at the end, so that payoff is
always +100. Plot some points. When S=0, the loan payoff is 100, the two
calls are both zero. When S=100, the loan payoff is 100, and both calls are
zero. When S=200, the loan payoff is 100, the call you sold has a payoff
of -100 (negative because you sold the option so someone else has the right
to buy it from you for 100 and it is worth 200), the call you bought has a
payoff of zero, for a net payoff of zero. When S=210, loan payoff is 100,
the call you sold payoff is -110, the call you bought payoff is 10, for a
net of 0. Now connect the dots and you have the diagram you provided in
your original e-mail.
Hope this helps.
----- Original Message -----
From: <Shenaz_Keshwani@mercer.com>
To: <studygroup5b@lists.casact.org> Goldfarb; Richard
<Goldfarb@WESTPORT.MSMAIL.AIGFPC.COM>
Sent: Monday, April 19, 1999 3:55 PM
Subject: 5B, ch 17-4c and Fall 94, #28
> Richard:
>
> Thank you for your all your tips in the past. Here is the question I
> had asked about earlier this morning.
>
>
>
> First problem: chapter 17 Quiz # 4c
>
> Company C is financed entirely by common stock and has a beta of 1.0.
> The stock has a P/E multiple of 10 and is priced to offer a 10%
> expected return. The company decides to repurchase half the common
> stock and substitute an equal value of debt. Assume that the debt
> yields a risk free 5%
>
> (After some calculations we find that the rate of return on the
common
> stock after refinancing is 15% and Beta of equity after refinancing
is
> 2.0)
>
>
> C) Assume that the operating profit of firm C is expected to remain
> constant. Give:
>
> i) The percentage increase in earnings per share
> ii) The new price-earnings multiple.
>
>
> Second Problem Fall 94 #28.
>
> Fall 94 # 28 is from Chapter 20. It has to do w the position
diagrams
> and I tried to create them by using the drawing tools in excel.
> However when I attach the file the drawing is not coming through. I
> could fax you the problem and perhaps you may be able to shed some
> light.
>
> Basically, I am having trouble combining the different position
> diagrams into one diagram. For example how would I represent the
> following:
>
> borrowing the present value of 100 at the risk free rate, buying two
> shares of stock, and selling one call with an exercise price of $100
>
> lending the PV of 100 at the risk free rate, selling a call with an
> exercise price of 100 and buying a call with excercice price of
$200.
>
>
>
>
> ______________________________ Reply Separator
_________________________________
> Subject: RE: 5B, Fall 94, #28
> Author: "Goldfarb; Richard" <Goldfarb@WESTPORT.MSMAIL.AIGFPC.COM> at uucp
> Date: 4/19/99 2:26 PM
>
>
> While I await the full question from you, here's what I think will clear
> things up for you.
>
> In all questions like this, there is rarely any subtle meaning behind it
> all. Simply plot a few points and connect the dots. Take Figure E for
> example. If the stock price is zero, then you have to repay the 100
> that you borrowed, that's -100. The 2 shares of stock are worth zero
> and the call option you sold is zero, so the total is -100. If the
> stock price is 100, then the borrowing is again -100, the two shares are
> 200 and the option payoff is zero, for a total of 100. Then if stock is
> 101, then borrowing is -100, stock is 202 and the option is -1, so
> that's 101. Connect the three dots and you are done.
>
> The only thing to be careful about in these cases is to plot points at,
> above and below the exercise prices of the options. That's where all
> the action will be. So if there are several options involved in a
> particular strategy, be sure to plot points at each exercise price and
> at points in between.
>
> The search for additional meaning is pointless. After a bit of practice
> though, you should be able to start to see some patterns.
>
> > -----Original Message-----
> > From: Shenaz_Keshwani@mercer.com [SMTP:Shenaz_Keshwani@mercer.com]
> > Sent: Monday, April 19, 1999 2:58 PM
> > To: studygroup5b@lists.casact.org; Richard Goldfarb
> > Subject: 5B, Fall 94, #28
> >
> >
> > Chapter 20/21
> >
> > What do figures B and E represent. I have tried to draw the figures
> > in the
> > attached file.
> >
> > Thanks
> >
> >
> > Shenaz << File: MS Excel spreadsheet >>
>