British Petroleum Company, Ltd. Essay Example

British Petroleum Company, Ltd. Essay Example British Petroleum Company, Ltd. Essay British Petroleum Company, Ltd. Essay Formed in 1909, British Petroleum (BP) was the world’s seventh largest industrial company and the third largest oil company based on 1986 sales figures. As a part of its decentralization plan which prepares for the privatization of the nationalized industries, the British Government initiated a sale of BP’s stock in March 1987. Later on BP announced an offering of new stock in conjunction with the government sale in July 1987. Underwriting agreement was made between BP and both the domestic and international underwriters on 15 Oct 1987.The offering date was set for 30 Oct 1987. The price for both the fixed-price offer and the international offer was set at ? 3. 30 payable in three installments. While the first installment of ? 1. 20 was due immediately upon sale, the second and third installment of ? 1. 05 were due on 30 Aug 1988 and 27 April 1989 respectively. Right after the underwriting agreement was made, the stock market suffered its largest decline in history. The underwriters of the BP issue faced substantial losses as a result of the drop in BP price.Refusing to rescind the deal, the British government announced on 29 Oct 1987 that the offering would proceed as planned, and the Bank of England would offer a repurchase plan for the underwriters. The bank would buy for ? 0. 7 any and all partly paid BP shares that would begin trading the following day. Those who sold their shares to the bank would then be relieved of the second and third installments. The offer to repurchase shares would expire on 6 Jan 1988. Case ObjectivesWith the drop of BP’s stock value and the Bank of England’s offer of the repurchase plan, the objectives of this case study is to 1) Evaluate from the point of view of the U. S. underwriters the value of the repurchase plan, so as to help decide if they should sell their partly paid BP stock to the Bank of England instead of holding on it to sell it to the individual investors after the offering date; 2) To compare the value for the repurchase plan with the total change in equity value of the U. S. underwriters, so as to have an extra reference on the value of the repurchase plan. Discussion The Repurchase Plan as a Put Option According to the case, anyone who owned partly paid BP shares could sell them at any time to the Bank of England for ? 0. 7 regardless of the then prevailing market price. We have concluded that this offers the equivalent of the Bank of England writing a put option with the strike price of ? 0. 7 plus the present value of the remaining two installments of the price of the BP shares. To be more specific, since the option could be exercised anytime during the life of the offer, it should be treated as an American option. Â ¦ Methodology The Black-Scholes ModelAfter the identification of the repurchase plan as a put option, it comes to the vital part of the case study- valuation of the option. As stated earlier, the repurchase offer resembles an American put option which means the Binomial model would be more appropriate for the calculation of the option price. We are aware that the a major limitation with the Black-Scholes model is its incompetence in pricing an American option due to the fact that it only calculates the option price at expiration. However, the statistics given are not sufficient enough for us to precisely compute the price of an American option.Furthermore, the main objective of this report is to estimate the value of the repurchase offer as a whole rather than calculating the exact price of the option at a specific date. That being said, we would treat the option as a European option for the sake of simplicity. For European options, the binomial model tends to converge with the Black-Scholes formula as the number of steps increases. Since the statistics of days after the announcement of the repurchase plan are fairly limited, we have decided that the Black-Scholes Model would perform better for this case scenario. Assumptions Limitations Term Structure As the period between the announcement and expiration date of the repurchase plan is a little bit more than 2 months (From 29 Oct 1987 to 6 Jan 1988), we have chosen to use the term structure of 3 months (Exhibit 8), which is closest to this period, for the pu rpose of our calculation. Volatility In selecting the data to calculate for the volatility, we did recognize that using the daily stock prices from 16 to 19 Oct 1987 (Exhibit 7) should be problematic with the stock market crash.As the Black-Scholes model assumes a lognormal distribution of volatility, using the Black-Scholes model to process this set of extreme data would lead us to the assumption risk, which is the risk that the Black-Scholes is inappropriate to be used to value options for the period. Alternatively, we considered about avoiding the crash period by only using the data before or after the crash (i. e. from beginning of Oct to 16th or from 19th to the end of the month). However, as we only have one month data on hand, further cutting half of it would leave us too little data for a fair calculation.However, if we do have data of a longer period, we would choose to use the data after the crash as it would be better matched with the case. Â ¦ Stock Price As we see a he althy financial status of BP according to its income statements and balance sheets (Exhibit 1-3), it is assumed that the stock price of BP will never drop to zero in the period. To support this, we have calculated the book value per share of BP, which is USD3. 73. (Please refer to the work sheet Book Value of BP in the Excel file for calculation details. Â ¦ Trading Days The number of trading days in a year is assumed to be 252 according to the usual practice for the calculation of volatility. Â ¦ Calculation Results With the help of the Black-Scholes model, we come up with the answer of USD0. 38 as the value of the put option, which is equivalent to the value of the repurchase plan to the U. S. underwriters at the end of 30 Oct 1987. (For details on the calculations, please refer to the work sheets of Black-Scholes Model and Volatility in the Excel file. )Apart from using the Black-Scholes model, we also calculated the implied put option/repurchase plan value by calculating the c hange in equity value of the publicly traded U. S. underwriters between 29 Oct 1987 and 30 Oct 1987 for comparison (Please refer to the work sheets of Equity Value Change and Black-Scholes Model for the calculation details). Before the results were being worked out and compared, we have assumed the two values to be close to each other, as we assumed a semi-strong form of market efficiency, with which stock prices are believed to reflect all publicly available information.In this case, as the announcement of the repurchase plan was made to the public on 29 Oct 1987 after the close of the London and New York markets, we believed the change in stock prices of the U. S. underwriters should reflect the value of the repurchase plan on the next trading date (i. e. 30 Oct 1987), with the assumption of the repurchase plan being the only factor influence the stock prices on that day. However, the two values that we got turned out to be more inconsistent with each other than we thought, with U SD0. 8 as the value from Black-Scholes model and USD1. 02 as the implied value from the equity value change. Assuming the market participants are rational, the change in the equity price of the US listed underwriters should correctly reflected the true price of the repurchase plan (i. e. the put option). If the put option was USD1. 02, the volatility of the stock price of BP should be 145. 49% under the Black-Scholes model (calculated by trial and error) instead of 60. 11% (Please refer to the work sheets of Volatility for the calculation details).The great difference between the two volatilities may be due to insufficient of data (especially the price change after the market crash) as provided by the case and the Black-Scholes Model may not be applicable in the time when the stock market is fragile. Apart from using Black-Scholes model and market reaction to the stock price of the US listed underwriters, we use another way to evaluate the put option. We estimated that the book valu e per BP share as of 30 Oct 1987 was USD 3. 73. Normally, the stock price should not below the book value per share.Otherwise, it would provide an incentive for the major shareholder to privatize the company. As of 30 Oct 1987, the share price of BP was USD4. 56 (? 2. 65 X 1. 722 (the exchange rate of USD to GBP). The difference of the share price and book value per share as of 30 Oct 1987 was USD0. 83. If the estimated book value per share was correct, the room for the drop of BP would be USD0. 83. When we compared the put option price implied by the market (i. e. USD1. 02) with USD0. 83, we see that there is a premium of USD0. 19.The premium may be the reward for the insurance protection factor and time value of the put option. The premium may also reveal the market overreacted to the information of repurchase plan. Conclusion BP’s stock offering was an important part of the British Government’s decentralization plan back then. The repurchase plan had not only succes sfully prevented a political setback, it had also worked well as a protective arrangement of the British Government to ease the nerve of the panicking domestic and international investors amidst the aftermath of the largest stock market decline in history.The limitations discussed above may have inevitably caused some error in the computation of the implied volatility of the stock price of BP after the announcement of the repurchase plan. However, from the prevailing up movement of the stock prices of the four US investment banks and BP, we could see that the response to the plan from the financial market was excellent.