Plekhanov Russian Economic Academy

Traditional options have been dealt in for over 200 years, and are usually written for a date three month’ hence, when either the shares are exchanged, or the option lapses. The disadvantage of the traditional option is that it cannot be traded before the exercise date, and it was because of this inflexibility that the traded options market was created in the UK in

1978.

Equity options were first traded on LIFFE in 1992, and currently

(1997), options are available on 73 large companies’ shares. Because traded options cost much less then the underlying shares, an investor is able to back an investment opinion without risking too much money.

II. Dividend Policy and Share Valuation

Dividends as a Residual Profit Decision

It would seem sensible for a company to continue to reinvest profit as long as projects can be found that yield returns higher than its cost of capital. In this way, the company can earn a higher return for shareholders than they can earn for themselves by reinvesting dividends. Such a policy can be optimal, however, only if the company maintains its target-gearing ratio by adding an appropriate proportion of borrowed funds to the retained earnings. If not, the company’s coast of capital would increase because of its disproportionate volume of higher-cost equity capital; this would be reflected share price.

Activity:

The LTD Company has the chance to invest in the five projects listed below:

|Projects |Capital outlay, ? |Yield rate, % |

|A |70.000 |18 |

|B |100.000 |17 |

|C |130.000 |16 |

|D |50.000 |15 |

|E |100.000 |14 |

The company cost of capital is 16% its optimal debt to net assets ratio is 30% and the current year’s profit available to equity shareholders is ?350.000.

Required:. State which projects would be accepted, and what is the total finance requires for those projects.

. Assuming that the company wishes to maintain its gearing ratio, how much of the required finance will be borrowed?

. How much of this year’s profit can be distributed?

The answers:

. A, B and C, with yield greater than or equal to the company’s cost of capital; total finance required ?300.000.

. Amount to be borrowed: 30% of ?300.000=?90.000.

. This year’s profit: ?350.000 less amount to be reinvested ?300.000-?90.000:

210.000