Category Archives: Paid Content

Solution to Management Science Series #185: Options and Capital Budgeting

Options and Capital Budgeting

Arkham Games is a game studio creating video games for console manufacturers. The following information is shared for the firm.

Calculate the market value of equity and debt for Arkham Games.

Additionally, the firm has two mutually exclusive investments under consideration. The projects will impact both the market value of the firm’s assets and standard deviation of the return on firm’s assets as was shared.

Calculate the market value of equity and debt if Arkham Games chooses Project A? What if it were to choose Project B? Which project would benefit the stockholders the most?

On investment decision rules in finance and why using payback period method misleads you

On investment decision rules in finance ⚠️

⬇️

There are many decision and investment rules in finance.

Although there is only one rule that trumps every other, inferior methods are still being used by many companies, even by the most successful ones.

Granted, regardless of whatever investment rule your company is using, estimating future cash flows is an uncertainty for each method.

However, this reality does not change the fact that there is still only one superior investment rule through which you can make sound decisions.

For example, which project would you choose if you were to use payback period method?

Project A requiring an initial investment of $100MM is projected to yield $20MM, $30MM, $50MM, and $35MM for the next four years.

Project B requiring an initial investment of $100MM is projected to yield $50MM, $30MM, $20MM, and $35MM for the next four years.

While solving the question above, I will also demonstrate why payback period may not be reliable in assessing financial viability of projects and what method you should have used given these inherent problems of the payback period.

Solution to Management Science Series #184: Using options in assessing feasibility of mergers and acquisitions 🧠

Using options in assessing feasibility of mergers and acquisitions 🧠

There are two toy companies whose products fundamentally differ and cater to very different segments and targets. One is called Robotformers producing and marketing robots to boys within the 12-15 age group. And the other is called Cindy producing and marketing figures to girls within the 9-11 age group.

Toy industry is known to have risky cash flows exposed to very different factors. If the two companies were to merge, the combined company would have a much more stable cash flow and diversify away some of the risk, making the bankruptcy of both companies less likely.

So, the operations of both firms are very different and the proposed merger is a purely financial merger in which there are no synergies and other value-creating possibilities. Only gain from this merger would be the reduction of the default risk. The premerger information is being shared.

Using Black-Scholes option pricing model and the appropriate risk-free rate, calculate the market value of equity and debt for both companies before the merger.

Assuming that the merger will lead to diversification effect and the post-merger asset return standard deviation is estimated to be 48% and utilizing Black-Scholes again, calculate the market value of equity and debt for the combined firm.

Between stockholders and bondholders, who would benefit the most from this merger? Quantify the benefit/loss to each party.

How too much reliance on sales promotions can upend long-established brands and companies: With lessons from video games industry

Designing a profitable sales promotion campaign is difficult, yet generally, sales promos make up big part of any company’s marketing budget.

You may think that even a poorly designed sales promo will lift your company’s gross revenues in the short-term, perhaps for a period of 2-3 months.

Having said that, a supposedly very well thought out, at least on paper, sales promotion can hurt your company’s both short- and long-term profitability, brand loyalty, and brand equity, as well as long-term overall gross revenues.

So, be careful with promotions; your company may have started its life as a differentiator but after so many promotions your company will become a commodity supplier that cannot command any price premium and dwindle, waging promotion and price wars.

I will briefly investigate and provide examples from my childhood heroes, namely Sega and Nintendo.

Solution to Management Science Series #183: Stocks and Bonds as Options 🧮 Banzai Toy Company

You found a new toy company called Banzai that would produce and market state-of-the-art action figures with high articulation. Luckily, you won a contract through which Banzai was trusted the license to produce and market toys for the video game ‘The Legend of Sarah’.

Banzai could sell these toys for a single year, i.e. the next year, after which Banzai will cease operations and be disbanded. Banzai has issued debt to help finance this venture. Interest and principal due on the debt next year will be $450M, at which time the debt will be paid off in full.

Banzai’s cash flows next year are being shared.

Each scenario is equally likely to occur. Plot the payoff table for both the bondholders and stockholders!

Assess the position of both parties in terms of options; who are the option holders and writers and what kind of an option do they possess or have they written/sold?

Deciphering financial ratios that could lead to bad management and investment decisions

Test your finance and accounting skills! 💹
This time through a story!
⬇️

You are a buy-side equity analyst.

You are poring over financial statements of different companies.

You are looking for a company that has showed strong growth potential in the last 5 years although you are aware that past-performance may not always be a good indicator for future performance.

After weeks of hard work, you think you found one: Ace Chemicals.

Its net revenues have been growing so have its net earnings.

Then, you remembered what your fellow classmate, who is also working as a buy-side equity analyst at a competitor firm and with whom you discuss financial markets superficially, had said about this company a few weeks ago: “I went to their factory. The place was falling apart…”

So, “How was that possible?”, you asked yourself.

“The company has been growing, at least based on the metrics that I think are important.

I also looked at the ratio, according to which the company was in a good position regarding its investments in physical assets”
—
Yes, it is possible and in reality, this company is not growing.

It escaped your notice as you did not look at the most important metric revealing a company’s operational performance clearly.

What is it?

What was the ratio tricking you into believing that the company was investing in physical assets (and in fact, it was not)?

Solution to Management Science Series #182: Checking the reliability of Black-Scholes through a real-world example #2🧠Walmart Example

Value the call option ‘WMT250620C00046670’, by using Black-Scholes as of the 10th of January 2025.

Will a rational investor buy this option?

In order to duplicate the call, how much of a share of stock do you need to purchase and how much do you need to borrow?

Digitization and Fixed Costs: Transformation that happened in Retail and Video Games

Digitization has reduced fixed costs for many businesses.
However, companies that were and are still being hurt most by this reality are those for which fixed costs were working as barriers to entry.
Furthermore, mediocre efforts to digitize, poor execution, and false beliefs that digitization are not possible for “them” exacerbated their situation.
The higher the fixed costs, the more skyscraping barriers to entry were.
Digitization has partially changed this situation, lowering fixed costs and helping challengers compete against incumbents.

In this article, I provide examples from the retail and video game industries regarding how digitization has been a game changer for both incumbents and new entrants.

Solution to Management Science Series #181: Checking the reliability of Black-Scholes through a real-world example 🧠Ebay Example

Checking the reliability of Black-Scholes through a real-world example 🧠

Value the call option ‘EBAY250919C00045000’, by using Black-Scholes as of the 10th of January 2025.

Will a rational investor buy this option?

In order to duplicate the call, how much of a share of stock do you need to purchase and how much do you need to borrow?

Solution to Management Science Series #180: Combinations of Options 🧮Tesla Example

Combinations of Options 🧮

You wanted to invest in Tesla stock and also follow a protective put strategy.

Your advisors recommend that you buy the contract ‘TSLA241129P00285000’.

Plot the payoff to the combination of buying the put contract and buying the underlying stock.

Note: Solution of this question, as well as those of all the questions asked so far, is shared on my website.