Future Venture company\'s dividend per share for the next year is of $15. The co
ID: 2719828 • Letter: F
Question
Future Venture company's dividend per share for the next year is of $15. The company has 200 shares outstanding. The growth rate of dividends is 2%. Due to it's risky operations the company beta is 1.2. Risk-free rate is 3% and stock market risk premium is 8%. To reduce risks and hopefully improve the beta, the management decides to buy some hedging instruments (such as options and swaps). As a result of these hedging activities, company beta drops from 1.2 to 0.5. What is the market value of the hedging instrument?Explanation / Answer
(a) Without Hedging
Cost of equity, ke = Risk free rate + Beta x Market risk premium
= 3% + 1.2 x 8% = 3% + 9.6% = 12.6%
Stock price = Next dividend / (ke - Dividend growth rate) = $15 / (0.126 - 0.02) = $15 / 0.106 = $141.51
Company value = $141.51 x 200 = $28,302
(b) With hedging
ke = 3% + 0.5 x 8% = 3% + 4% = 7%
Stock price = $15 / (0.07 - 0.02) = $15 / 0.05 = $300
Company value = $300 x 200 = $60,000
Therefore,
Market value of hedging instrument = $(60,000 - 28,302) = $31,698
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