Instituto Superior de Economia e Gestão
Gestão Financeira II
Ano letivo 2019/2020
Problem Set 3
Realizado por:
Inês Carreira Paulo (nº50388)
Maria Leonor Borges (nº48928)
Maria Margarida Areia (nº50673)
Maria João Rodrigues (nº50711)
Chapter 19 – Financing and Valuation & Chapter 20 – Understanding Option
J-O&G Corp. is a company specialised in oil and gas drilling headquartered in Amman, Jordan.
The company has currently a debt capacity of $US 25bn, fully used. To fund a new project in
the Dead Sea area, the company needs CAPEX of $US 4.2 bn during 2020 (depreciated in 15
years), allowing a long-run growth of 1.75% for the whole company from 2023 onwards and
+35 bps for shareholders. The new investment should be funded with a 10% increase in the
current debt level at the end of 2019 and by raising equity during 2020. Issuance costs of 4.00%
will be incurred.
No dividends are expected to be paid in the foreseeable future, and J-O&G’s debt strategy is
to maintain the new debt capacity.
Your consulting team was hired to value J-O&G Corp equity at the beginning of 2020.
1) Considering the information above, explain which valuation methods are more
appropriate to value J-O&G Corp as well as which ones are not valid. Explain.
The valuation methods which are more appropriate to value J-O&G Corp are the WACC and
the FTE because, considering the information above, the company’s debt strategy is to maintain
the new debt capacity and the WACC & FTE work better when the capital structure is expected
to remain stable (ratio D/V).
So, if J-O&G’s debt strategy is to maintain the new debt capacity, the method which is not
valid is the APV because in this method the level of debt is expected to change over time.
Following the first meeting, the CFO disclosed the following figures for the company:
Net Working Capital is 22% of sales and J-O&G’s marginal tax rate is 25.0%. The yield on
longterm default-free bonds is 1.2%, and the expected market return is 7.5%. The average
beta for comparable companies is 1.475 with D/E of 0.75 and a similar tax structure. The
nature of J-O&G Corp. business and its capital structure yields a debt spread of 325 bps. The
number of shares outstanding is 1,500. The industry is trading at 1.2x Market/Book and the
company closely follows industry multiples.
The other tasks assigned to your team are as follows:
2) Estimate the FCFF for each period.
𝑭𝑪𝑭𝑭 = 𝑬𝑩𝑰𝑻 × (𝟏 − 𝑻𝒄) + 𝑫&𝑨 − ∆𝑵𝑾𝑪 − 𝑪𝑨𝑷𝑬𝑿
𝑵𝑾𝑪 = 𝟐𝟎% × 𝑹𝒆𝒗𝒆𝒏𝒖𝒆𝒔
Period 0 1 2 3 4
Year 2019 2020 2021 2022 2023
Revenues 34,125 34,808 60,913 62,010 62,878
𝑵𝑾𝑪 7507.5 7657.76 13400.86 13642.2 13833.16
∆𝑵𝑾𝑪 0 -150.26 -5743.1 -241.34 -190.96
Tc = 25%
CAPEX year 1 = 3063 + 4200
Period 0 1 2 3 4
Year 2019 2020 2021 2022 2023
EBIT (1-Tc) 3645.75 3334.5 8364 7848 8001
D&A 2750 3230 3230 3230 3230
∆𝑵𝑾𝑪 0 -150.26 -5743.1 -241.34 -190.96
CAPEX -3003 -7263 -5360 -5457 -5533
FCFF 3392.75 -848.76 490.9 5379.66 5507.04
3) Estimate the FCFE for each period.
𝑭𝑪𝑭𝑬 = 𝑵𝒆𝒕 𝑰𝒏𝒄𝒐𝒎𝒆 + 𝑫&𝑨 − ∆𝑵𝑾𝑪 − 𝑪𝑨𝑷𝑬𝑿 − 𝑵𝒆𝒕 𝒃𝒐𝒓𝒓𝒐𝒘𝒊𝒏𝒈
𝑵𝒆𝒕 𝒃𝒐𝒓𝒓𝒐𝒘𝒊𝒏𝒈 = 𝟎
Period 0 1 2 3 4
Year 2019 2020 2021 2022 2023
Net Income 2950 2500 7530 7013 7167
D&A 2750 3230 3230 3230 3230
∆𝑵𝑾𝑪 0 -150.26 -5743.1 -241.34 -190.96
CAPEX -3003 -7263 -5360 -5457 -5533
Net borrowing 0 0 0 0 0
FCFE 2697 -1683.26 -343.1 4544.66 4673.04
4) Estimate J-O&G Corp.’s WACC for 2020 and the corresponding cost of capital for an
all equity-financed company.
Equity in the beginning of the year 60000
Debt (book) in the beginning of the year 20833 × 1.1 = 22916,3
Equity (market) in the beginning of the year 60000 ×1.2 + (4200-0.1*20833*1.2)= 73700
Debt (market) in the beginning of the year 22916,3 × 1.2 = 27499.56
Value of the company = D +E 27499.56 + 737000 = $ US 101199.6 bn
27499.56
D/V= 101199.6 =0.272
73700
E/V=101199.6 =0. 728
0.272
D/E = 0.728 = 0.374
The cost of debt can be obtained as follows:
Rd= 3.25% + 1.2% = 4.45%
The cost of equity can be calculated like so:
Ra = Rf + 𝛽a (Rm – Rf) = 0,012 + 1,475 (0,075 – 0,012) = 10,49%
𝐷
Re = Ra + × (Ra – Rd) × (1 – Tc) = 10,49% + 0.374 × (10,49% – 4.45%) = 12. 75 %
𝐸
WACC =Re × (E/V) + Rd × (D/V) × (1 – tc) = 12. 75% × 0. 728+ 4.45% × 0.272 × (1 –
0.25) = 10.87%
When a company is all equity financed, it means that the company has a capital structure of
100% equity and no debt. Therefore, our cost of capital for an all equity financed company is
equal to the Re ,since we do not have debt.
Re = Ra= Rf + βa (Rm-Rf) = 1.2% + 1. 475 × (7.5% – 1.2%) = 10.49%
5) Estimate the equity value of J-O&G Corp.’s using the APV method.
In this method we discount the unlevered cash flow (UCF) using an unlevered cost of capital
(Ru) – as an all-equity financed company, and the present value of the financing side effects
should be added.
APV = Base case NPV + PV (interest tax shields) – Issue costs
Ra = 10,49%
The PV of the financing side effects considers the tax shield in perpetuity. Since the debt is
stable, we can assume a tax shield in perpetuity.
PV (interest tax shields) = Debt × T = (0.1×20833×1.2) × 25% = 624.99
Issue costs = 4% × 1700.04 = 68.00
g = 1.75%
−848.76 490.9 5379.66 5507.04
PV 𝐴𝑃𝑉 = + (1+0,1049)2 + + (1+0,1049)4 = 7317.32
(1+0,1049) (1+0,1049)3
𝐹𝐶𝐹𝐻+1 1 5507.04×1.0175 1
PV Terminal =
𝑅𝑎−𝑔
× (1+𝑅𝑎)𝐻
= × (1+10.49%)4
= 43017.9
10.49%−1.75%
APV Method
PV APV 0-4 7317.32
PV Terminal 43017.9
NPV (base case) 50335.2
PV(Int. Tax Shield & Issue costs) 556.99
Net Debt 27499.56
Equity 23392.6
Number of shares 1500
Value per share 15.5951
6) Estimate the equity value of J-O&G Corp.’s using the FTE method.
In this method we need to discount the previously calculated FCFE using Re (equity holders’
cost of capital) estimating the Equity Value
Re = 12.75% (Calculated in exercise 4)
−1683.26 343.1 4544.66 4673.04
PV 𝐹𝐶𝐹𝐸 = + + + = 4299.4
(1+12.75%) (1+12.75%)2 (1+12.75%)3 (1+12.75%)4
𝐹𝐶𝐹𝐻+1 1 4673,04× 1.0175 1
PV Terminal = × = × = 26747
𝑅𝑒−𝑔 (1+𝑅𝑒)𝐻 12.75−1.75% (1+12.75%)4
FTE Method
PV FCFE 0-4 4299.4
PV Terminal 26747
Equity 31046.4
Number of shares 1500
Value per share 20.6976
Mr J. Faria, an investor, also contacted your team for financial advisory. He expects
very low volatility for oil prices within the next six months, which is based on his view
on the outlook for oil prices worldwide. There is an active market for both call and put
options on oil prices:
7) Explain two strategies that can be implemented by Mr J. Faria to profit from his view
on the market. Show the profit diagram, the breakeven points and the maximum gain
and loss for each strategy.
Mr. J Faria expects very low volatility for oil prices. So, the two strategies that he can
implement are: the Butterfly strategy and the Short Straddle strategy.
For the butterfly strategy:
To maximize cost of premium he needs to buy a call in a low X (A), then he sells 2 calls
in a medium X (B) and buys a call in a high X (C). This strategy implies that all calls have
the same expiration date, and the exercise prices of the higher and lower options are
equidistant.
Mr J. Faria can also use put long butterfly strategy, because he’ll have the same
outcome. He buys one put in a high X, he sells 2 puts in a medium X and he buys one put
in a low X.
In the end, the profit diagram will be:
The maximum profit is attained when the underlying stock price remains unchanged at
expiration. At this price, only the lower striking call expires in the money. So, we have:
o Max Profit = Strike Price of Short Call (B) - Strike Price of Lower Strike Long Call
(A)
So, the max profit will be when the stock price is equal to the strike price of the short
call (B) at expiration.
The maximum loss will be the premium, because if the stock price is below the lowest
exercise price at expiration, then all calls expire worthless and the full cost of the
strategy is lost. Also, if the stock price is above the highest exercise price at expiration,
then all calls are in the money and the butterfly spread position has a net value of zero
at expiration.
There are 2 breakeven points for the butterfly spread position. We can use these
formulas to calculate it:
o Upper Breakeven Point = Strike Price of Higher Exercise Long Call - Premium
o Lower Breakeven Point = Strike Price of Lower Exercise Long Call + Premium
For the Short Straddle strategy:
This strategy can only be used when the market is expected to have a very low or no
volatility at all. So, as Mr J. Faria expects this to happen, this is the best time to use this
strategy.
The short straddle strategy consists on selling a put and a call option at the same
underlying stock, striking price and expiration date.
If the price remains stable, both the call and put options will expire worthlessly and Mr
J. Faria will have both premiums as max profit. So, the max profit will be achieved when
price of underlying = strike price of short call/put.
The maximum loss is unlimited. Large losses for the short straddle can be incurred when
the underlying stock price makes a strong move either upwards or downwards at
expiration, causing the short call or the short put to expire deep in the money. The
premiums received are not enough to cover for the losses in most cases.
There are 2 breakeven points for the short straddle position. We can use these formulas
to calculate it:
o Upper Breakeven Point = Strike Price of Short Call + Premium received
o Lower Breakeven Point = Strike Price of Short Put - Premium received
In the end, the profit diagram will be:
As we can see, Mr J. Faria will only make a profit if in the future there’s low volatility in
the market, as he expects that to happen, we advise him to use either one of the
strategies.