Corporate finance principles and practices

Corporate Finance

As explained by Professor Watkins at San Jose State University, the binomial option pricing model is when a stock price over some period is presumed to go up by a certain percent or down by a certain percent. This leads to a formula whereby the current stock price is multiplied times one plus the percentage it could go down and then the same formula is done for the percentage it could go up. If a call option is in play or if the stock has interest that is risk-free, then the formula gets a little more complex (Watkins, 2014). Risk-neutral option pricing relies on something known as arbitrage. In this instance, all future outcomes are adjusted for risk and the expected asset values that results are calculated thusly. Once that is done, every asset can be priced accordingly. This is not the same thing as true real-world risk but it is commonly and pervasively used throughout the option pricing sphere. The key part about this method and arbitrage is that there is assumed to be none, with arbitrage the intentional act of purchasing and selling an option for a quick buck. It is extremely hard to pull off but people attempt it all of the time (Investopedia, 2014).

Investopedia. (2014, July 31). Investopedia - Educating the world about finance. Investopedia.

Retrieved July 31, 2014, from http://www.investopedia.com/

Watkins, T. (2014, July 31). The Binomial Model for Pricing Options. The Binomial Model for Pricing Options. Retrieved July 31, 2014, from http://www.sjsu.edu/faculty/watkins/binomial.htm

Question Two

As with other parts of doing business and the wants of all the stakeholders and investors involved, the agency problem is when the differing objectives and desired outcomes of the stakeholders and investors lead to business decisions that fail to properly and sufficiently maximize value. Not unlike situations where money is tugged between dividend payments and more investing in the business, an agency problem creates issues with mergers as the price a business is sold or bought for has a major effect on the motives and perspectives of the people involved. One academic theory that relates to this subject points out that perceived or stated value up front before a merger is approved and executed can differ greatly from the verifiable or perceived value found after the fact. Further, it is shown that managerial behavior by bidding companies is promoting of mergers that are excessive and managerial behavior in target firms tends to manifest in the opposite way. In short, the collusion and behavior of buying and selling firms leads to an improper price being paid for a firm and this can be either a boon or a bust for the buying firm (Caves, 1989).