A Simple Application of the Standard Model

We have shown how the Standard Model of Finance came into existence, as each of its pillars appeared and achieved widespread success. Now we can look at a business decision and see how the Standard Model guides corporate financial managers to the correct decision.

Suppose there is a petrochemical company that processes crude oil and makes it into several different plastics. The company is known for the high quality of its products and is successful. It sells to more than 175 different customers, and no customer accounts for more than 2 percent of its annual sales, so in that sense it is stable. It does not rise or fall with any industry sector because its customers are in many different industries.

The petrochemical company’s capital structure is optimal. Its management confers frequently with investment bankers, and as market sentiment changes, the company tailors each new issue of securities to stay in step with what the market wants. The company sometimes buys back its common shares and sometimes uses the shares it has bought back to pay for an acquisition.

Despite the quality of its products and its other advantages, the petrochemical company’s share price is not very high. Its earnings are too volatile, and its capacity to pay dividends is too low. The company operates in a mature industry, and investors see that it should have the capacity to generate steady earnings. They also see that it does not deliver stable performance, so they buy its shares only at times when the shares are relatively cheap. The company’s earnings are unstable because the price of crude oil fluctuates, and the company is not able to raise the prices of the plastics it sells every time the price of crude rises. The company tries to hedge its exposure to the fluctuations in the price of crude, but its hedging is not very successful. The company is underhedged, so its earnings fluctuate too much.

Now suppose there is an opportunity to buy a company that has oil wells. These are good wells, with many years of reserves, and they are located near the company’s petrochemical plants. From a strategic point of view, buying the oil company looks like a good decision. The petrochemical company would integrate vertically, and its cost of crude oil would no longer fluctuate. The petrochemical company would buy 100 percent of the shares of the oil company and then consolidate the oil company’s accounts into its own. The petrochemical company’s balance sheet would then show its original assets and liabilities together with the assets and liabilities of the oil company.

The acquisition might be a bad idea from a financial point of view. To see how financial considerations could block this acquisition that sounds so logical from a strategic point of view, suppose the oil company owed $900 million. Also suppose that its equity is worth only $100 million. To complete the beginning assumptions, suppose the petrochemical company owed $500 million, and its equity was worth $500 million. Also suppose the petrochemical company would issue new shares in exchange for 100 percent of the shares of the oil company. Before the merger, the petrochemical company has 10 million shares issued and outstanding, and its shares are trading at $50 a share. It would issue 2 million new shares and give those to the owners of the oil company, so after the merger there would be 12 million shares outstanding.

The petrochemical company’s stock price would probably go down as soon as it announced the transaction. This is normal because investors would be able to see that 2 million new shares are going to come into existence, so they would be wary of buying until they have seen whether the owners of the oil company decide to keep the shares of the oil company or sell them.

The big question the Standard Model can answer is whether the shares of the petrochemical company would rise in the weeks and months following the merger.

In this case the shares probably would not rise back to $50; instead, they might fall. The reason is that after the merger the petrochemical company would owe too much money. It would owe the $500 million it owed before the merger, and it would also owe the $900 million the oil company owed. To complete the merger, the petrochemical company would have had to assume the oil company’s debt. Its consolidated debt position would be $1.4 billion. If market participants considered that amount of debt prudent for the consolidated company, the market value of its equity would be $600 million. If market participants felt the consolidated company would be safer and more profitable after the merger, the market value of its equity could be greater than $600 million. Its stock price could rise above $50 a share in the months following the merger.

The more likely outcome, however, is that market participants would feel $1.4 billion is too much debt for the consolidated company to bear prudently. In that case they would be wary of buying the shares, so the shares would fall on the announcement of the merger and not rise later. They might fall to $40 a share and not rise until the consolidated company had paid back enough of the debt that its debt burden once again looked prudent.

The calculations to determine ahead of time whether the merger would raise the petrochemical company’s stock price or lower it are quite simple. The data inputs needed are also simple to obtain. Any junior analyst can quickly get the data and do these calculations.

What does the Standard Model suggest the petrochemical company should do if the merger would lower its stock price? The answer is the petrochemical company should improve its hedging. It can purchase a cap. This is a contract that puts a ceiling on the price the petrochemical company pays for crude oil. For example, if the petrochemical company buys a five-year cap with a price ceiling of $25 a barrel, and the price of crude oil rises above $25 a barrel, the counterparty that issued the cap will have to pay the excess over $25 a barrel to the petrochemical company. If the price of crude oil rises to $28 a barrel, the counterparty would have to pay $3 a barrel to the petrochemical company. Caps are now easy to buy, and there are several major financial houses that offer them.

This example shows that financial considerations now influence whether deals are done, and it shows that the main consideration is the effect of the deal on stock prices. The example also shows that new risk management products have appeared in the market. These new products meet the needs for hedging that are now greater because old-fashioned strategies, such as vertical integration, are not always helpful, since shareholders do not tolerate volatility.

Tags: Principles

The Fourth Principle: Pricing Options

In the period 1972-73 there was a fateful coincidence. Three developments happened in a short span of time, and together they spawned a revolution in corporate finance. The pressures on corporate financial managers until that time were intensifying, but the events of 1972-73 ratcheted up the intensity.

The events began when Black and Scholes published a formula for valuing the price of an option. This formula used more advanced mathematics than the three breakthroughs that preceded it. Time might have elapsed before the formula would have come into widespread use, but the other two events put the formula to work almost immediately.

Hewlett Packard began marketing a high-end hand-held calculator that could find solutions to the formula quickly. The calculator was expensive, and many scientists did not buy it because they could solve formulas on their mainframe computers. But the third event was that the Chicago Board of Trade launched a new category of product, options on common stocks. These were different from futures contracts, which were what the Board of Trade had offered before. These options on common stocks were difficult to value, and the young traders who acted as market makers knew that. Some of them found the Black-Scholes formula and the new Hewlett Packard calculators, and as soon as they had those two tools, they were able to buy options that were underpriced and sell options that were overpriced.

Other market makers who did not use those two tools were trying to do the same thing, and their methods were less accurate. Option trading is a fast-moving game, and a market maker can make hundreds or thousands of trades a week. The people who used the formula and the calculator had an advantage, making fewer errors and higher average profits on each trade. In a very short time the formula and the calculator were absolute requirements for survival.

Trading volume in options grew rapidly. Portfolio managers and individual investors found ways of using the Chicago Board of Trade options. The options allowed them to alter the risk characteristics of their portfolios and to stabilize the rates of return their portfolios delivered. By using the options correctly, a sophisticated investor could buy risky securities with high expected yields but high volatility and convert them into a portfolio that was quite stable. The options added stability to portfolios that had already been made as stable as Markowitz’s and Sharpe’s techniques could make them.

Corporate treasurers saw what was happening, and some of them began to investigate ways of applying the new options to improve the financial stability of their companies. For them, the new options were another kind of hedging product. There had been hedging products before the new options came along. For example, foreign exchange hedging products had existed for centuries, and corporate treasurers had used them extensively. There had also been a wide range of insurance policies, and corporate treasurers had bought those to protect their companies.

Corporate treasurers as a group were slow to take advantage of the new options. They faced restrictions and had to wait until new hedging products appeared. The success of the Chicago Board of Trade options showed that there is demand for new hedging products, and financial institutions began to offer innovative products. The result has been called the Derivatives Revolution.

The term derivative is a catch-all that includes options, futures contracts, and swaps. All these products have some common elements, despite having evolved separately. They all protect against one risk or another. In that sense they are all like specialized insurance policies that pay off when some specific event occurs. A company can buy them individually or in combinations, or it can sell one and use the proceeds to buy another. As these products began to appear in large numbers and variations, corporate treasurers had a complicated but potentially rewarding task. They had to choose which ones to use, and they had to keep reviewing the ones they were using, and replacing some of the ones that expired. The name of the task is risk management.

Companies that are good at risk management show steady growth despite the volatility of the industry sectors they operate in. They use risk management products to smooth the ups and downs of the underlying commodity cycles. In that fashion they deliver stable, growing returns to shareholders. Among investors there is always a strong demand for shares that do not fluctuate violently, but instead rise steadily, with few bumps along the way. The companies that are able to deliver that performance succeed, and their shares rise in the market. The companies quickly gain leadership status and often are able to raise enough capital to buy their competitors. Stock market performance gives them the advantage they need to acquire dominance in their industry sector.

Tags: Principles