Question

Financial Options and Weighted Average Cost of Capital (WACC). Determine two to three methods of using stock and options to create a risk free hedge portfolio can be created. Support your answer with examples of these methods being used to create a risk-free hedge portfolio. Create a unique hypothetical weighted average cost of Capital WACC and rate return. Recommend whether or not the company should expand, and defend your position.

Answer 1

The first part of the questions is based on option strategies. There are multiple option trading strategies that are aimed at exploiting the market structure to generate a risk free profit. Some of these strategies are as below-

Protective put-

This is strategy where you buy the underlying the stock and also buy a put option at a strike price A. the put option insures the minimum sell price. However, higher the strike price, higher the price of the option and lower the profit. This is best strategy when you already own a stock which has an unrealized gain but cant sell it now to realize the gains.

Collar-

This is a combination of covered call and protective put. The position is – buy the underlying stock, buy a put option at a lower strike price A and sell a call option on higher strike price B. Buying a put option limits the downside on the stock movement. Selling a call option lowers the cost of put option but also limits the upside since it creates an obligation to sell.

Long straddle-

This strategy involves buying a call option and a put option at same strike price A. the only cost involved is the cost of option premiums. If the stock moves in either direction, at least one of the option would be profitable (stock moves up- call option in the money; stock moves down- put option in the money). This strategy is profitable if the trader expects large stock movements i.e. volatility of the price.

Short strangle-

This strategy involves selling a put option at a lower strike price A and selling a call option at a higher strike price B. the returns from this strategy is equal to the premiums of the two options. This strategy is profitable if the trader expects no large movements in the stock. If the stock moves up or down beyond the strike prices of the two options, the trader has an obligation to sell or buy the stock (sell if up movement where call option is exercised; buy if down movement where put option is exercised).

WACC-
Cost of debt (pre-tax)	10%
Tax rate	30%
Cost of debt (post-tax)	7%
Cost of equity	15%
% of debt	50%
% of equity	50%
WACC	=50%*7%+50%*15%
	11.00%

Consider a projects with cash flows as below-

(-ve cashflow is investment)

Year	0	1	2	3	4 onwards
Cash flow	-50000	25000	20000	20000	0
PV	-50000	22523	16232	14624	0
NPV	3379
IRR	15.02%

Conclusion-

Undertake the project to expand the company

It is seen that the IRR or rate of return of these project is 15% which is more than the WACC of the company. Hence, the company should undertake the project if it can raise the capital for this new project as per current capital structure i.e. 50% debt and 50% equity. Ideally, the company should undertake every project which has a rate of return higher than the WACC, assuming the projects are mutually exclusive, investible and the cost structure (WACC) remains unchanged.

The NPV of the project, considering 11% WACC is +ve.