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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> </DIV> <DIV><FONT size=2>It goes like this:</FONT></DIV> <DIV> </DIV> <DIV><FONT size=2>    Ce! = Bo / ( Bo - 1 ) * Ce</FONT></DIV> <DIV> </DIV> <DIV><FONT size=2>Where:</FONT></DIV> <DIV> </DIV> <DIV><FONT size=2>    Ce! = cost of equity adjusted to incorporate option value</FONT></DIV> <DIV> </DIV> <DIV><FONT size=2>    Ce = cost of equity as estimated by the CAPM</FONT></DIV> <DIV> </DIV> <DIV><FONT size=2>    Bo = 0.5 * [ 1 + SQRT of ( 8 * Ce / V SQUARED ) ]</FONT></DIV> <DIV> </DIV> <DIV><FONT size=2>    V = std deviation of expected future cashflows</FONT></DIV> <DIV> </DIV> <DIV><FONT size=2>Forgive the slightly unconventional notation.  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> </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> </DIV> <DIV><FONT size=2>Ce! can obviously be incorporated into WACC in the normal manner.</FONT></DIV> <DIV> </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.  I note that the theory applies well in the current activity of GPG in respect of WRI.  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 & Co. Limited<BR>AUCKLAND</FONT></DIV></BODY></HTML>

References

[sharechat] Back to basics Brian Brakenridge

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