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Re: [sharechat] Option Adjustment


From: "Brent Wheeler" <brentw@bwcl.co.nz>
Date: Fri, 5 Nov 1999 06:16:35 +1300


<!DOCTYPE HTML PUBLIC "-//W3C//DTD HTML 4.0 Transitional//EN"> <HTML><HEAD> <META content="text/html; charset=unicode" http-equiv=Content-Type> <META content="MSHTML 5.00.2721.2900" name=GENERATOR> <STYLE></STYLE> </HEAD> <BODY bgColor=#ffffff> <DIV><FONT size=2>To speed things up I have had a go at re-writing the formula for adjusting the CAPM in a form which should Email OK.</FONT></DIV> <DIV>&nbsp;</DIV> <DIV><FONT size=2>It goes like this:</FONT></DIV> <DIV>&nbsp;</DIV> <DIV><FONT size=2>&nbsp;&nbsp;&nbsp; Ce! = Bo / ( Bo - 1 ) * Ce</FONT></DIV> <DIV>&nbsp;</DIV> <DIV><FONT size=2>Where:</FONT></DIV> <DIV>&nbsp;</DIV> <DIV><FONT size=2>&nbsp;&nbsp;&nbsp; Ce! = cost of equity adjusted to incorporate option value</FONT></DIV> <DIV>&nbsp;</DIV> <DIV><FONT size=2>&nbsp;&nbsp;&nbsp; Ce = cost of equity as estimated by the CAPM</FONT></DIV> <DIV>&nbsp;</DIV> <DIV><FONT size=2>&nbsp;&nbsp;&nbsp; Bo = 0.5 * [ 1 + SQRT of ( 8 * Ce / V SQUARED ) ]</FONT></DIV> <DIV>&nbsp;</DIV> <DIV><FONT size=2>&nbsp;&nbsp;&nbsp; V = std deviation of expected future cashflows</FONT></DIV> <DIV>&nbsp;</DIV> <DIV><FONT size=2>Forgive the slightly unconventional notation.&nbsp; Also note that this is a "ready reckoner" given various sources of noise arising from measurement errors and problems in estimating parameters such as V.</FONT></DIV> <DIV>&nbsp;</DIV> <DIV><FONT size=2>We generally use standard deviation of share price (with n = at least 20) as a proxy for V because it is often hard to get reliable estimates of expected future cashflows.</FONT></DIV> <DIV>&nbsp;</DIV> <DIV><FONT size=2>Ce! can obviously be incorporated into WACC in the normal manner.</FONT></DIV> <DIV>&nbsp;</DIV> <DIV><FONT size=2>Hope all this gives some food for thought to those of us who use discount rates in trying to value shares.&nbsp; I note that the theory applies well in the current activity of GPG in respect of WRI.&nbsp; A premium was paid reflecting demands (implicit) of WRI shareholders to compensate for the "option value" associated with "waiting" to see if incumbent management could turn the company around.</FONT></DIV> <DIV><FONT size=2><BR>Dr Brent Wheeler<BR>Director<BR>Brent Wheeler &amp; Co. Limited<BR>AUCKLAND</FONT></DIV></BODY></HTML>

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