Financial Options and Weighted Average Cost of Capital (WACC)

Financial Options and Weighted Average Cost of Capital (WACC)

Determine two to three (2-3) methods of using stocks and options to create a risk-free hedge portfolio can be created. Support your answer with examples of these methods being used to create a risk-free hedge portfolio.

Hedging is mainly a type of transaction that tends to lower risk of damage in consideration to a particular organization. These damages may be as a result of fluctuating commodities prices, exchange rate and also interest rates. Hedging which can either be in a portfolio, anywhere also or even in business involves decreasing or even transferring of risk in general. In this case, it can be considered as a valid strategy that will significantly help an individual to protect the business, a home, and also a portfolio from uncertainty.

In this regard, one and a conventional method that involves the use of stocks and different options with a primary aim of creating a risk-free hedge portfolio is mainly through call options. A call option, in this case, is primarily an agreement that will significantly provide investors with sufficient rights but not necessarily obligations to easily buy stocks, commodities, bond, and any other instrument at prices that are specified and most importantly within a specified period. In this case, it helps an individual to be effective remember that a call option provides one with the right to call in which involves buying an asset or assets in general. To get profit on a call, then the underlying assets will have to increase particularly in its prices.  In this case, a call offer will provide an investor with an effective way to leverage capital that they own for a more significant investment return.

The second method involves put option. A put option can be considered as an option contract. In this case, it will provide to the owner the right and not an obligation to sell specified amounts of underlying securities. This case will be regarded as mainly with a determined price and also term. It is thus more valuable as prices of underlying stocks tend to depreciate relative to the strike price in general. In this case, it allows a particular user to effectively hedge an investment they mainly owe even in some instances speculate in other investment that they do not have ownership in general.

From the scenario, create a unique hypothetical weighted average cost of capital (WACC) and rate of return. Recommend whether or not the company should expand, and defend your position.

Weighted Average Cost of Capital (WACC) is calculated by:

= ((E/V) * Re) + [((D/V) * Rd)*(1-T)]

E = (Market value of the company’s equity)

= $600,000

D = Market value of the company’s debt

= $400,000

V = Total Market Value of the company (E + D)

= (600,000 + 400,000)

= 1,000,000

Re = Cost of Equity

= .06

Rd = Cost of Debt

= .05T=

Tax Rate = 35%

As a result; we can be able to effectively calculate TFCs weighted average cost of capital (WACC).


WACC = ((600,000/$1,000,000) x.06) + [(($400,000/$1,000,000) x .05) * (1-0.35))]

= 0.049

= 4.9%

As the weighted average cost of capital for TFCis 4.9 percent, it means that for every $1 TFC that an investor raises, it is required to pay its investors approximately $0.05 in return leaving TFC with $0.95 of each dollar in general.


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