Case Problem 14.1: The Franciscos' Investment Options

Hector Francisco is a successful businessman in Atlanta. The box-manufacturing firm he and his wife, Judy, founded several years ago has prospered. Because he is self-employed, Hector is building his own retirement fund. So far, he has accumulated a substantial sum in his investment account, mostly by following an aggressive investment posture. He does this because, as he puts it, "In this business, you never know when the bottom will fall out." Hector has been following the stock of Rembrandt Paper Products (RPP), and after conducting extensive analysis, he feels the stock is about ready to move. Specifically, he believes that within the next six months, RPP could go to about $80 per share, from its current level of $57.50. The stock pays annual dividends of $2.40 per share. Hector figures he would receive two quarterly dividend payments over his six-month investment horizon.

In studying RPP, Hector has learned that the company has six-month call options (with $50 and $60 strike prices) listed on the CBOE. The CBOE calls are quoted at $8 for the options with $50 strike prices and at $5 for the $60 options.

Questions:

a.How many alternative investments does Hector have if he wants to invest in RPP for no more than six months? What if he has a two-year investment horizon?

b.Using a six-month holding period and assuming the stock does indeed rise to $80 over this time frame:

1.Find the value of both calls, given that at the end of the holding period neither contains any investment premium.

2.Determine the holding period return for each of the three investment alternatives open to Hector Francisco.

c.Which course of action would you recommend if Hector simply wants to maximize profit? Would your answer change if other factors (e.g., comparative risk exposure) were considered along with return? Explain.