1. XYZ Inc. is a start-up biotech firm. It has a beta of 2.3. Last year is had $17 million in total earnings and 6 million shares outstanding. The company anticipates that its start-up phase will last 3 years. During this period it will have ROE of 29% and a plowback ratio of 100%. In year 4 XYZ enters into a transitional period lasting 4 years, during which it expects to launch many of the products it is developing. ROE is expected to fall to 23% and the dividend payout ratio to 20%. In Year 8 the company plans to enter its mature phase. It anticipates constant growth of ROE of 19% and the dividend payout ratio increases to 80%. The return on the market is 11% and the risk free rate is 3%.
What is the intrinsic value of XYZ?
High Tech Mutual is a mutual fund that invests in biotech stocks, including XYZ. In two months High Tech anticipates needing a large amount of cash, but the fund does not want to sell any shares today. The fund decides to protect this position by purchasing put options on many of the shares in the portfolio. The premium on puts with a strike price $5 lower than the price you found in part (a) is $4. However, the puts are expensive. The mutual fund therefore decides to also write calls on XYZ shares to cover the cost of the puts. Those calls have a strike price equal to the price in (a) plus $7 and a premium of $3. What is this strategy called? Explain what the name means.
Graph the payoffs and profits from this strategy as a function of Pt=market price of XYZ when the options expire.