Question

Buffelhead's stock price is $227 and could halve or double in each six-month period. Assume that you own a one-year American out option on Buffelhead stock with an exercise price of $227. The interest rate is 18% a year. a. Would you ever want to exercise an American put early? Yes No b. Calculate the value of the Buffelhead American put. (Do not round intermediate calculations. Round your answer to 2 decimal places.) c. Calculate the value of the put if it had been European-style. (Do not round intermediate calculations. Round your answer to 2 decimal places.) Not

Answer 1

Investors use discounted cash flow (DCF) to calculate the present value of expected dividends from stocks, like the shares of Babble, Inc. The price an investor would pay for a share is determined by discounting the future profits to their present value and dividing by the total number of shares.

Step-by-step explanation:

When investing in stocks, particularly in a company set to be disbanded like Babble, Inc., investors aim to determine the present value of future dividends. This requires discounting the future profits based on an appropriate discount rate to their present value. In the case of Babble, Inc., investors would calculate the present value of the $15 million expected immediately, the $20 million after one year, and the $25 million after two years. As each profit will be paid out as dividends and accordingly becomes a part of the stock's value, dividing the total present value by the number of shares will give the price per share.

To calculate this for Babble, Inc., one might employ the discounted cash flow (DCF) method. The DCF method requires selecting a discount rate, which could be the prevailing market rate of return for similar investments. Once the total present value is calculated, it would be divided by 200 shares to find the price per share that an investor would be willing to pay. This kind of valuation technique is fundamental for financial analysis and making investment decisions.