SRWP- IPO Valuation

IPO Valuation: An Analysis

Sampling Research White Paper Series

13th Feb 07

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SRWP- IPO Valuation

Content
1 Information about Initial Public Offer (IPO) 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 1.10 1.11 1.12 1.13 1.14 1.15 1.16 1.17 2 What is an Initial Public Offer? Who decides the price of an issue? What does price discovery through Book Building Process mean? What is the main difference between offer of shares through book building and offer of shares through normal public issue? What is Cut-Off Price? What is the floor price in case of book building? What is a Price Band in a book built IPO? Who decides the Price Band? What is minimum number of days for which a bid should remain open during book building? Can open outcry system be used for book building? Can the individual investor use the book building facility to make an application? How does one know if shares are allotted in an IPO/offer for sale? How long does it take to get the shares listed after issue? What is the role of a Registrar to an issue? Does NSE provide any facility for IPO? What is SEBIs Role in an Issue? What is the Obligation which company has to comply? 4 4 4 4 4 5 5 5 5 5 5 6 6 6 6 6 7 7 7 8 8 9 9 9 10

Valuation Model Used in IPO 2.1 Dividend Discount Model 2.1.1 2.1.2 2.1.3 2.1.4 2.2 The Gorden Growth Model The Two- Stage Dividend Discount Model The H-Model The Three- Stage Dividend Model

Discounting Case Flow Based Model

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2.2.1

The Free Cash Flow to Equity (FCFE Discount Model ) 2.2.1.1 2.2.1.2 2.2.1.3 The Constant Growth Model The Two-Stage FCFE Model The E Model-The Three-Stage FCFE Model

11 12 12 12 13 13 14 14 14 15 15 16 16 17 17 18 18 19 19 19 20 21

2.2.2

The Free Cash Flow to Firm (FCFE Discount Model) 2.2.2.1 2.2.2.2 Stable Growth Firm General Version of FCFF-Two and Three Stage Versions of The FCFF Model

2.3

Balance Sheet Based Model 2.3.1 2.3.2 Adjusted Book Value liquidation Value

2.4

Income Statement Based Methods 2.4.1 2.4.2 2.4.3 2.4.4 Value of Earnings (PER) Value of the Dividends Sales Multiples Other Multiples

2.5 2.6

Valuation Using Multiple Value Creation Methods 2.6.1 2.6.2 2.6.3 2.6.4 Economic Value Added (EVA) Economic Profit (EP ) Market Value Added (MVA ) Cash Value Added (CVA )

2.7

Option Pricing Model

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1.) Information about Initial Public Offer (IPO) 1.1) What is an Initial Public Offer? An Initial Public Offer (IPO) is the selling of securities to the public in the primary market. It is when an unlisted company makes either a fresh issue of securities or an offer for sale of its existing securities or both for the first time to the public. This paves way for listing and trading of the issuers securities. The sale of securities can be either through book building or through normal public issue. 1.2) Who decides the price of an issue? Indian primary market ushered in an era of free pricing in 1992. Following this, the guidelines have provided that the issuer in consultation with Merchant Banker shall decide the price. There is no price formula stipulated by SEBI. SEBI does not play any role in price fixation. The company and merchant banker are however required to give full disclosures of the parameters which they had considered while deciding the issue price. There are two types of issues, one where company and Lead Merchant Banker fix a price (called fixed price) and other, where the company and the Lead Manager (LM) stipulate a floor price or a price band and leave it to market forces to determine the final price (price discovery through book building process). 1.3) What does price discovery through Book Building Process mean? Book Building is basically a process used in IPOs for efficient price discovery. It is a mechanism where, during the period for which the IPO is open, bids are collected from investors at various prices, which are above or equal to the floor price. The offer price is determined after the bid closing date. 1.4) What is the main difference between offer of shares through book building and offer of shares through normal public issue? Price at which securities will be allotted is not known in case of offer of shares through Book Building while in case of offer of shares through normal public issue, price is known in advance to investor. Under Book Building, investors bid for shares at the floor price or above and after the closure of the book building process the price is determined for allotment of shares. In case of Book Building, the demand can be known everyday as the book is being built. But in case of the public issue the demand is known at the close of the issue.

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1.5) What is Cut-Off Price? In a Book building issue, the issuer is required to indicate either the price band or a floor price in the prospectus. The actual discovered issue price can be any price in the price band or any price above the floor price. This issue price is called Cut-Off Price. The issuer and lead manager decides this after considering the book and the investors appetite for the stock. 1.6) What is the floor price in case of book building? Floor price is the minimum price at which bids can be made. 1.7) What is a Price Band in a book built IPO? The prospectus may contain either the floor price for the securities or a price band within which the investors can bid. The spread between the floor and the cap of the price band shall not be more than 20%. In other words, it means that the cap should not be more than 120% of the floor price. The price band can have a revision and such a revision in the price band shall be widely disseminated by informing the stock exchanges, by issuing a press release and also indicating the change on the relevant website and the terminals of the trading members participating in the book building process. In case the price band is revised, the bidding period shall be extended for a further period of three days, subject to the total bidding period not exceeding ten days. 1.8) Who decides the Price Band? It may be understood that the regulatory mechanism does not play a role insetting the price for issues. It is up to the company to decide on the price or the price band, in consultation with Merchant Bankers. 1.9) What is minimum number of days for which a bid should remain open during book building? The Book should remain open for a minimum of 3 days. 1.10) Can open outcry system be used for book building? No. As per SEBI, only electronically linked transparent facility is allowed to be used in case of book building.

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1.11) Can the individual investor use the book building facility to make an application? Yes. 1.12) How does one know if shares are allotted in an IPO/offer for sale? What is the timeframe for getting refund if shares not allotted? As per SEBI guidelines, the Basis of Allotment should be completed with 15 days from the issue close date. As soon as the basis of allotment is completed, within 2 working days the details of credit to demat account / allotment advice and dispatch of refund order needs to be completed. So an investor should know in about 15 days time from the closure of issue, whether shares are allotted to him or not. 1.13) How long does it take to get the shares listed after issue? It would take around 3 weeks after the closure of the book built issue. 1.14) What is the role of a Registrar to an issue? The Registrar finalizes the list of eligible allottees after deleting the invalid applications and ensures that the corporate action for crediting of shares to the demat accounts of the applicants is done and the dispatch of refund orders to those applicable are sent. The Lead Manager coordinates with the Registrar to ensure follow up so that that the flow of applications from collecting bank branches, processing of the applications and other matters till the basis of allotment is finalized, dispatch security certificates and refund orders completed and securities listed. 1.15) Does NSE provide any facility for IPO? Yes. NSEs electronic trading network spans across the country providing access to investors in remote areas. NSE decided to offer this infrastructure for conducting online IPOs through the Book Building process. NSE operates a fully automated screen based bidding system called NEAT IPO that enables trading members to enter bids directly from their offices through a sophisticated telecommunication network. Book Building through the NSE system offers several advantages: The NSE system offers a nation wide bidding facility in securities It provide a fair, efficient & transparent method for collecting bids using the latest electronic trading systems

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Costs involved in the issue are far less than those in a normal IPO The system reduces the time taken for completion of the issue process

The IPO market timings are from 10.00 a.m. to 3.00 p.m. On the last day of the IPO, the session timings can be further extended on specific request by the Book Running Lead Manager. 1.16) What is SEBIs Role in an Issue? Any company making a public issue or a listed company making a rights issue of value of more than Rs 50 lakh is required to file a draft offer document with SEBI for its observations. The company can proceed further on the issue only after getting observations from SEBI. The validity period of SEBIs observation letter is three months only i.e. the company has to open its issue within three months period. 1.17) What is the Obligation which company has to comply? Annual listing fees: - each company has to pay annual listing fees on or before 30th of April for the each financial year to all stock exchanges where the securities of the company are listed. Notice of Board Meetings: - Details and the agenda of any board meeting at which the company is going to consider quarterly results , yearly results, dividend, bonus issue or any such matters which are pre sensitive and have and effect on the market piece must be informed at least 7 days prior to the date of the board meeting. Publishing of Quarterly Results: - the company must prepare half yearly results in the same Performa and the same must be approved by the board of directors and must be subjected to a limited review by the exchanges within 2 month after the close of the half yearly. 2.) Valuation Model Used in IPO

For anyone involved in the field of corporate finance, understanding the mechanism of company valuation is very important not only because of valuation of mergers and acquisitions, in choosing investment for a portfolio, in deciding on the appropriate price to pay or receive in takeover, but also in restructuring the corporation. The process of determining the present value of a company is called valuations.

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There are different methods and techniques which can be used for valuation. These are:

1) Dividend Discount Model 2) Discounting Cash Flow Based Model 3) Balance Sheet Based Model 4) Income Statement Based Model ( Relative valuation) 5) Valuation Using Multiples 6) Value Creation Methods 7) Option Pricing Methods

2.1) Dividend Discount Model

The Dividend Discount Model for valuing equity is the present value of expected dividends on the value of stock. When investors buy stock they generally expect to get two types of cash flows:

Dividends during the period of the stock An expected price at the end of the holding period

Type of this Model 1.1) The Gordon Growth Model 1.2) The Two-Stage Dividend Discount Model 1.3) The H Model 1.4) The Three-Stage Dividend Discount model 2.1.1) The Gorden Growth Model: THE MODEL: Value of Stock = DPS1 r-g Where, DPS1 = Expected Dividends one year from now

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r = Required rate of return for equity investors

g = Annual Growth rate in dividends forever 2.1.2) The Two- Stage Dividend Discount Model The Model is based upon two stages of growth: an extraordinary growth phase that last for n years and a stable growth phase that lasts forever after that. Where, Extraordinary growth rate: g% each year for n years Stable growth: gn forever Value of the stock = PV of individuals during extraordinary phase + PV of terminal price

(1 + g )n DPS 0 (1 + g ) 1 (1 + r )n Value of the stock (P0) = rg

Where, DPS = Expected dividends per share r = Required rate of return 2.1.3) The H-Model

(r g n )(1 + r )n

DPS n +1

The model is based upon the assumption that the earnings growth rate starts at a high initial rate (ga ) and declines linearly over the extra ordinary growth period ( which is assumed to last 2H periods ) to a stable growth rate (gn). It also assumes that the dividend payout is constant over time, and is not affected by the shifting growth rates.

Value of stock (P0) =

DPS 0 (1 + g n ) DPS 0 H ( g a g n ) + r gn (r g n )

Where, H = Mid-point of high growth period

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2.1.4) The Three- Stage Dividend Model

The three stage dividend discount model allows for an initial period of high growth, a transitional period in which growth declines and a final stable growth phase. It is most general of the model because it does not impose any restriction on the payout ratio. The three stage dividend discount model is applicable where the firm shows an extraordinary growth rate at present and are expected to maintain this rate for an initial period, after which the differential advantage of the firm is expected to deplete, leading to gradual declines in the growth rate to a stable growth rate.

t = n1

Value of Stock P0 =

t =1

EPS 0 (1 + g a )

(1 + r )

t = n1+1

(1 + r )

t =n

DPS t

EPS n 2 (1 + g n ) n

(r g n )(1 + r )n

High growth

Transition

Stable growth phase

Where , EPS = Earnings per share DPSt = Dividends per share in year t ga= Growth rate in high growth phase (lasts n1 periods) gn= Growth rate in stable phase a= Payout ratio in high growth phase n= Payout ratio in stable growth phase r = Required rate of return on equity

2.2) Discounting Case Flow Based Model

These methods seek to determine the companys value by estimating the cash flows it will generate in the future and then discounting them at a discount rate matched to the flows risk. Cash flow discounting methods are based on the detailed, careful forecast, for each period , of each of the financial items related with the generation of the cash flows corresponding to the companies operations, such as, collection of sales, personnel, raw materials, administrative, sales, expense, loan repayments, etc..

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In cash flow discounting based valuations, a suitable discount rate is determined for each type of cash flow. Determining the discount rate is one of the most important tasks and takes into account the risk and historic volatilities.

General Method for Cash Flow Discounting

A valuation method used to estimate the attractiveness of an investment opportunity. Discounted cash flow (DCF) analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive at a present value, which is used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one

There are many variations when it comes to what you can use for your cash flows and discount rate in a DCF analysis. Despite the complexity of the calculations involved, the purpose of DCF analysis is just to estimate the money you'd receive from an investment and to adjust for the time value of money.

DCF models are powerful, but they do have shortcomings. DCF is merely a mechanical valuation tool, which makes it subject to the axiom "garbage in, garbage out". Small changes in inputs can result in large changes in the value of a company. Instead of trying to project the cash flows to infinity, a terminal value approach is often used. A simple annuity is used to estimate the terminal value past 10 years, for example. This is done because it is harder to come to a realistic estimate of the cash flows as time goes on.

Types of This Model:

1.5) 1.6)

The Free Cash Flow To Equity (FCFE) Discount Model The Free Cash Flow To Firm (FCFF) Discount Model

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2.2.1) The Free Cash Flow to Equity (FCFE) Discount Model

The Free Cash Flow to Equity (FCFE) is the cash flows leftover after meeting all financial obligations, including debt payments, and after covering capital expenditure and working capital needs. The FCFE is measured as follows:

FCFE = Net income + Depreciation Capital spending Principal repayments + New debt issues

Working Capital

Different Models of FCFE:

2.1.1) The Constant Growth Model 2.1.2) The two stage FCFE Model 2.1.3) The E Model The three stage FCFE Model

2.2.1.1) The Constant Growth Model

The value of equity, under the constant growth model, is a function of the expected FCFE in the next period, the stable growth rate and the required rate of return. This model can be applied when growth rate in firms earnings is stable and the leverage is stable. And this model can be applied where the dividends are different from FCFE or dividends not available (private firms).

Value of Equity (P0) =

FCFE1 r gn

Where, gn = Growth rate in FCFE for the firm forever 2.2.1.2) The Two-Stage FCFE Model

The value of any stock is the present value of the FCFE per year for the extraordinary growth period plus the present value of the terminal price at the end of the period. This model is applicable when the growth rate in the firm is moderate and leverage is stable. This model is applicable where dividends are very different from FCFE or dividends are not available (private firms).

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Value of equity = PV of FCFE + PV of terminal price

Value of equity (P0) = where,

(1 + r )

FCFEt
t

(r g n )(1 + r )n

FCFE n +1

gn = Growth rate after the terminal year forever. 2.2.1.3) The E Model-The Three-Stage FCFE Model

The E Model is designed to value such firms that are expected to go through three stages of growth. We will apply this model when the growth rate in firms earnings is high and leverage is stable. This model can be applied where the dividends are very different from FCFE or dividends are not available (private firms).

t = n1

Value of equity (P0) =

(1 + r )
t =1

FCFEt
t

t =n2

t = n1+1

(1 + r )

FCFEt
t

Pn 2 (1 + r )n

Where,

P0= Value of the stock today FCFEt = FCFE in year t r = Cost of equity Pn2 = Terminal price at the end of transitional period = FCFEn2+1/(r-gn) n1 = End of initial high growth period n2= End of transition period

2.2.2) The Free Cash Flow to Firm (FCFE) Discount Model

The free cash flow to the firm is the sum of the cash flows to all claim holders in the firm including stock holders, bond holders and preferred stock holders. The FCFF develops the approach to valuation where the entire firm is valued by discounting the cumulated cash flows to all claim holders in the firm by the weighted average cost of capital, and examines its limitations and applications.

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There are two ways of measuring Free Cash Flow to the Firm (FCFF). One is to add up the cash flows to the claim holders:

FCFF = FCFE + interest expenses (1 tax rate) + principal payments new debt issues + preferred dividends

The other way is to use Earning Before Interest and Taxes (EBIT) as a base for the calculation:

FCFF = EBIT (1 tax rate) + Depreciation Capital Expenditure - Working capital

Different Models Of FCFF:

2.2.1) Stable Growth Firm 2.2.2) General Version of FCFF-Two and Three Stage Versions of The FCFF Model

2.2.2.1) Stable Growth Firm

The firm in steady state with cash flows growing at a stable growth rate can be valued using a variant of the infinite growth model.

Value of the firm =

FCFF1

(WACC - gn) where,

FCFFt = Free Cash flow to firm in year t WACC = Weighted average cost of capital gn = Growth rate in the FCFF forever 2.2.2.2) General Version of FCFF-Two and Three Stage Versions of The FCFF Model

The value of the firm, in the most general case can be written as the present value of expected free cash flows to the firm. If the firm reaches steady state after n years, and starts growing at a stable growth rate gn. The general version of the model can be used to value any firm, where sufficient information exists to forecast FCFF.

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Value of the firm =

(1 + WACC )
t =1

t =n

FCFFt

[FCFFn+1 (WACC g n )] (1 + WACC )n

2.3) Balance Sheet Based Model

Balance Sheet based valuation methods are traditionally used to consider a companys value lies basically in its balance sheet. These methods are based on static view point. Therefore, it doesnt take into account the companys possible future evolution, moneys temporary value and other factors that also affect the value such as the industrys current situation, human source, organizational problem and other economic issues.

Types of This Model

3.1) Adjusted Book Value 3.2) Liquidation Value

2.3.1) Adjusted Book Value

A companys book value, or net worth, is the value of the shareholders equity stated in the balance sheet (capital and reserve). This quantity or the value of the firm is the difference between total assets and liabilities, that is, the surplus of the companys total goods and rights over its total debt with third parties. When the values of assets and liabilities match their market value the adjusted net worth is obtained.

2.3.2) Liquidation Value

Liquidation literally means turning the assets of a company into readily available cash. The liquidation value of an asset or a company is the estimated amount of money that it could be sold for quickly. This value is calculated by deducting the business liquidation expenses (redundancy payments to employees, tax expenses and other liquidation expenses) from the adjusted net worth. Such as if it is to go bankrupt. In a normal growing profitable industry, a companys liquidation value is usually much less than the current share price. In a dying industry, the liquidation value may exceed the current share price. This usually means the company should end its business.

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This methods usefulness is limited to situation when the company is bought with the purpose of liquidating it at a later date.

2.4) Income Statement Based Methods Income-based methods determine probable future income of the business and capitalize this income stream to determine the businesss value. The adjusted or normalized income stream can be determined by adjusting each revenue and expense item on the income statement. Capitalizing the income stream means determining an appropriate discount rate to apply to the income stream to arrive at its present value. The present value of the income stream in a profitable business is what gives the business its highest and best value. In a profitable, closely held business, income-based methods are usually the best to use. They seek to determine the companys value through the size of its earnings, sales, or other indicators. Types of This Model:

4.1) Value of Earnings (PER) 4.2) Value of the Dividends 4.3) Sales Multiples 4.4) Other Multiples

2.4.1) Value of Earnings (PER)

The PER of a share indicates the multiples of the earnings per share that is paid on the stock market. It is the shares price divided by the earning per share. The PER is the most commonly used ratio in valuation, particularly for listed companies.

According to this method, the equitys value is obtained by multiplying the annual net income by PER as it believes that share price is a multiple of the earnings of the firm.

Equity Value =

Pr icePerShares NetIncome EarningPerShare

Equity Value = PER * Net Income

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2.4.2) Value of the Dividends

Dividends are the part of earnings effectively paid out to the share -holder and the impact of dividend policies on equity value shows that the companies that pay more dividends as a percentage of their earnings do not obtain a growth in their share price as a result. This is because if a company distributes more dividends, normally it reduces its growth because it distributes the money to its share holders instead of plowing back into new investments.

If we expect constant dividends every year, the value can be

Equity Value =

DPS Ke

Where, DPS = Dividend distributed by the company in the last year Ke = required return to equity

If the dividend is expected to grow at a constant annual rate g

Equity Value =

DPS1 (K e g )

Where, DPS1 = Dividend per share for the next year Ke = required return to equity 2.4.3) Sales Multiples

This valuation method is used in such industries with a certain frequency, consists of calculating a companys value by multiplying its sales by a number. The Sales Multiples method is used for the FMCG, Pharmaceutical, IT and various service industries. The sales multiples or price/sales ratio can be broken down into a further 2 ratios:

Equity Value =

Pr icePerShares Sales

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Equity Value =

PER

EarningPerShares Sales

Equity Value = PER X Return on Sales

2.4.4) Other Multiples

In addition to the PER and the price / sales ratio, some of the frequently used multiples are:

4.4.1) Value of the company/earnings before interest and taxes (EBIT) 4.4.2) Value of the company / earnings before interests, tax, depreciation, and amortization (EBITDA) 4.4.3) Value of the company/operating cash flow 4.4.4) Value of the equity / book val

Enterprise Value to EBITDA is one of the most widely used multiple by analysts in chemicals industry, metal and mining industry, capital good industry, FMCG, Telecom industry, Hotel industry, media industry, real estate, retail industry.

2.5) Valuation Using Multiple

Multiples may be helpful for comparing two companies. We look at estimated earnings and estimate what "fair" multiple someone might pay for the stock When we project fair multiples for a company based on forward earnings estimates, we start to make a heck of a lot of assumptions about what is going to happen in the future. Although one can do enough research to make the risk of being wrong as marginal as possible, it will always still exist. If one of your assumptions turn out to be incorrect, the stock will probably not go where we expect it to go. Most of the investors and companies using this approach, making their own assumptions as well.

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SRWP- IPO Valuation

P/E, PER P/CE P/S P/LFCF P/BV P/AV P/Consumer P/Units P/output

Price Earnings Ratio Price to Cash Earnings Price to Sales Price to Levered Free Cash Flow Price to Book Value Price to Asset Value Price to Consumer Price to Units Price to output

EV/EBITDA Enterprise Value to EBITDA EV/S EV/FCF EV/BV PEG EV/EG Enterprise Value to Sales Enterprise Value to Unlevered Free Cash Flow Enterprise Value to Book Value Price Earnings (PER) to Growth Enterprise Value to EBITDA Growth

2.6) Value Creation Methods

In this part we will cover a series of parameters that have been proposed for measuring a firms value creation for its shareholders. These can be:

6.1) Economic Value Added (EVA); 6.2) Economic Profit (EP); 6.3) Market Value Added (MVA); 6.4) Cash Value Added (CVA);

Many firms use EVA, EP, or CVA, instead of the book profit, to asses the performance of the managers or business units and as a reference parameter for executive compensation.

The advantage of EVA, EP and CVA over earnings is that they take into account the capital used to obtain the earnings and its risk. The present value of EVA, EP and CVA is similar to the MVA.

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2.6.1) Economic Value Added (EVA)

A measure of a company's financial performance based on the residual wealth calculated by deducting cost of capital from its operating profit (adjusted for taxes on a cash basis).

EVA = Capital book value (Return on assets Average cost of liabilities)

EVAt = (Dt-1 + Ebvt-1) (ROA - WACC) It is the earnings before interest less the firms book value multiplied by the average cost of capital. 2.6.2) Economic Profit (EP)

Economic profit (EP)is the profit after tax (PAT) less equity book value (Ebvt-1)

EPt = PATt Ke Ebvt-1 EP (Economic Profit) =

Profit after tax Equity book value cost of equity

It is the book profit less the equitys book value multiplied by required return on equity. 2.6.3) Market Value Added (MVA)

The difference between the market value of a company and the capital contributed by investors (both bondholders and shareholders) is known as market value added. In other words, it is the sum of all capital claims held against the company plus the market value of debt and equity.

The higher the MVA, the better. A high MVA indicates the company has created substantial wealth for the shareholders. A negative MVA means that the value of the actions and investments of management is less than the value of the capital contributed to the company by the capital markets, meaning wealth or value has been destroyed.

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MVA (Market Value Added) = Equity market value (price) Equity Book Value

MVA0 = E0 Ebv0 It seeks to measure a firms value creation, which is understood as the difference between the market value of the firms equity and the equitys book value (or initial investment) 2.6.4) Vash Value Added (CVA)

A measure of the amount of cash generated by a company through its operations. It is computed by subtracting the 'operating cash flow demand' from the 'operating cash flow' from the cash flow statement.

Cash value added is similar to economic value added but takes into consideration only cash generation as a opposed to economic wealth generation. This measure helps give investors an idea of the ability of a company to generate cash from one period to another. Generally speaking, the higher the CVA the better it is for the company and for investors.

It is earnings before interest plus amortization less economic depreciation less the cost of capital employed. CVA = NOPAT + Depreciation ED (D0 + Ebv0) WACC ED is the annuity that, when capitalized at the cost of capital, the assets value will accrue at the end of their service life. The problem with EVA, EP, CVA start when it is wished to give these parameters a meaning (that of value creation) that they do not have. Value always depends on expectations. 2.7) Option Pricing Model

Options are derivative securities- they are securities that derive their value from an underlying asset. An Option provides the holder with the right to buy or sell a specified quantity of an underlying asset at a fixed price ( called a strike price or an exercise price ) at or before the expiration date of the option. Since it is the right and not an obligation, the holder can choose not to exercise the right and allow the option to expire.

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There are two type of options:

1) Call Options 2) Put Options

Call option gives the buyer of the option the right to buy the underlying asset at a fixed price at any time prior to the expiration date of the option. The buyer pays a price for this right. Or he can wait till expiration and if the asset value is greater than strike price, buyer earns a profit equal to the difference between asset value and the sum of strike price and call price.

Put option gives the buyer of the option the right to sell the underlying asset at a fixed price at any time prior to the expiration date of the option. The buyer pays a price for this right. or he can hold the asset till expiration and if the asset value is less then the strike price, he earns a profit equal to the difference between strike price and sum of asset value and put price.

The Black-Scholes Model :

This model is best suitable where Equity is in a troubled firm (i.e. a firm with high leverage, negative earnings and a significant chance of bankruptcy) can be viewed as a call option, which is the option to liquidate the firm. Natural resource companies, where the undeveloped reserves can be viewed as options on the natural resource and Start-up firms or high growth firms which derive the bulk of their value from the rights to a product or a service (eg. a patent) Value of call = SN(d1) k e-rt N(d2) Where, d1 = ln(S/K) + (r + 2 / 2)t t d2 = d1 - t

S = Current value of the underlying asset K = Strike price of the option t = Life to expiration of the option r = Riskless interest rate corresponding to the life of the option = Variance in the ln(value) of the underlying asset
2

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