Chapter 24 options and corporate finance

Chapter 24
Options and
Corporate Finance
McGraw-Hill/Irwin
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

Key Concepts and Skills
•
Understand the basics of call and put options
•
Be able to determine option payoffs and pricing
bounds
•
Understand the major determinants of option
value
•
Understand employee stock options
•
Understand how a firm’s equity can be viewed as
a call option on the firm’s assets
•
Understand how option valuation can be used to
further evaluate capital budgeting projects
•
Understand warrants and convertible securities
and how to determine their value
24-2

Chapter Outline
•

Options: The Basics
•
Fundamentals of Option Valuation
•
Valuing a Call Option
•
Employee Stock Options
•
Equity as a Call Option on the Firm’s
Assets
•
Options and Capital Budgeting
•
Options and Corporate Securities
24-3

Option Terminology
•
Call
•
Put
•
Strike or Exercise price
•
Expiration date
•
Option premium
•
Option writer
•

American Option
•
European Option
24-4

Stock Option Quotations
•
Look at Table 24.1 in the book
–
Price and volume information for calls and puts with
the same strike and expiration is provided on the same
line
•
Things to notice
–
Prices are higher for options with the same strike price
but longer expirations
–
Call options with strikes less than the current price are
worth more than the corresponding puts
–
Call options with strikes greater than the current price
are worth less than the corresponding puts
24-5

Option Payoffs – Calls
•
The value of the call
at expiration is the
intrinsic value

–
Max(0, S-E)
–
If S<E, then the payoff
is 0
–
If S>E, then the payoff
is S – E
•
Assume that the
exercise price is $30
24-6

Option Payoffs - Puts
•
The value of a put at
expiration is the
intrinsic value
–
Max(0, E-S)
–
If S<E, then the payoff
is E-S
–
If S>E, then the payoff
is 0
•
Assume that the
exercise price is $30
24-7

Work the Web Example
•
Where can we find option prices?
•
On the Internet, of course. One site that provides
option prices is Yahoo Finance
•
Click on the web surfer to go to Yahoo Finance
–
Enter a ticker symbol to get a basic quote
–
Follow the options link
–
Check out “symbology” to see how the ticker symbols
are formed
24-8

Call Option Bounds
•
Upper bound
–
Call price must be less than or equal to the
stock price
•
Lower bound
–
Call price must be greater than or equal to the
stock price minus the exercise price or zero,
whichever is greater (i.e., the option’s intrinsic

value)
•
If either of these bounds are violated,
there is an arbitrage opportunity
24-9

Figure 24.2
24-10

A Simple Model
•
An option is “in-the-money” if the payoff is
greater than zero
•
If a call option is sure to finish in-the-
money, the option value would be
–
C
0
= S
0
– PV(E)
•
If the call is worth something other than
this, then there is an arbitrage opportunity

24-11

What Determines Option
Values?

•
Stock price
–
As the stock price increases, the call price increases
and the put price decreases
•
Exercise price
–
As the exercise price increases, the call price
decreases and the put price increases
•
Time to expiration
–
Generally, as the time to expiration increases, both the
call and the put prices increase
•
Risk-free rate
–
As the risk-free rate increases, the call price increases
and the put price decreases
24-12

What about Variance?
•
When an option may finish out-of-the-money (expire
without being exercised), there is another factor that
helps determine price
•
The variance in underlying asset returns is a less
obvious, but important, determinant of option values

•
The greater the variance, the more the call and the put
are worth
–
If an option finishes out-of-the-money, the most you can
lose is your premium, no matter how far out it is
–
The more an option is in-the-money, the greater the gain
–
The owner of the option gains from volatility on the
upside, but don’t lose any more from volatility on the
downside
24-13

Table 24.2
24-14

Employee Stock Options
•
Options that are given to employees as part of
their benefits packages
•
Often used as a bonus or incentive
–
Designed to align employee interests with stockholder
interests and reduce agency problems
–
Empirical evidence suggests that they don’t work as
well as anticipated due to the lack of diversification
introduced into the employees’ portfolios

–
The stock isn’t worth as much to the employee as it is
to an outside investor because of the lack of
diversification – this suggests that options may work in
limited amounts, but not as a large part of the
compensation package
24-15

Equity: A Call Option
•
Equity can be viewed as a call option on the
company’s assets when the firm is leveraged
•
The exercise price is the face value of the debt
•
If the assets are worth more than the debt when
it comes due, the option will be exercised and
the stockholders retain ownership
•
If the assets are worth less than the debt, the
stockholders will let the option expire and the
assets will belong to the bondholders
24-16

Capital Budgeting Options
•
Almost all capital budgeting scenarios
contain implicit options
•
Because options are valuable, they make

the capital budgeting project worth more
than it may appear
•
Failure to account for these options can
cause firms to reject good projects
24-17

Timing Options
•
We normally assume that a project must be
taken today or forgone completely
•
Almost all projects have the embedded option to
wait
–
A good project may be worth more if we wait
–
A seemingly bad project may actually have a positive
NPV if we wait due to changing economic conditions
•
We should examine the NPV of taking an
investment now, or in future years, and plan to
invest at the time that the project produces the
highest NPV
24-18

Example: Timing Options
•
Consider a project that costs $5,000 and has an
expected future cash flow of $700 per year

forever. If we wait one year, the cost will
increase to $5,500 and the expected future cash
flow will increase to $800. If the required return is
13%, should we accept the project? If so, when
should we begin?
–
NPV starting today = -5,000 + 700/.13 = 384.62
–
NPV waiting one year = (-5,500 + 800/.13)/(1.13) =
578.62
–
It is a good project either way, but we should wait until
next year
24-19

Managerial Options
•
Managers often have options that can add
value after a project has been implemented
•
It is important to do some contingency
planning ahead of time to determine what
will cause the options to be exercised
•
Some examples include
–
The option to expand a project if it goes well
–
The option to abandon a project if it goes poorly
–

The option to suspend or contract operations
particularly in the manufacturing industries
–
Strategic options – look at how taking this
project opens up other opportunities that would
be otherwise unavailable
24-20

Warrants
•
A call option issued by corporations in conjunction with
other securities to reduce the yield required on the other
securities
•
Differences between warrants and traditional call
options
–
Warrants are generally very long term
–
They are written by the company, and warrant exercise
results in additional shares outstanding
–
The exercise price is paid to the company, generates
cash for the firm, and alters the capital structure
–
Warrants can normally be detached from the original
securities and sold separately
–
Exercise of warrants reduces EPS, so warrants are
included when a firm reports “diluted EPS”

24-21

Convertibles
•
Convertible bonds (or preferred stock) may be
converted into a specified number of common
shares at the option of the bondholder
•
The conversion price is the effective price paid
for the stock
•
The conversion ratio is the number of shares
received when the bond is converted
•
Convertible bonds will be worth at least the
straight bond value or the conversion value,
whichever is greater
24-22

Valuing Convertibles
•
Suppose you have a 10% bond that pays
semiannual coupons and will mature in 15 years.
The face value is $1,000, and the yield to
maturity on similar bonds is 9%. The bond is also
convertible with a conversion price of $100. The
stock is currently selling for $110. What is the
minimum price of the bond?
–
Straight bond value = 1,081.44

–
Conversion ratio = 1,000/100 = 10
–
Conversion value = 10*110 = 1,100
–
Minimum price = $1,100
24-23

Other Options
•
Call provision on a bond
–
Allows the company to repurchase the bond prior to
maturity at a specified price that is generally higher than
the face value
–
Increases the required yield on the bond – this is
effectively how the company pays for the option
•
Put bond
–
Allows the bondholder to require the company to
repurchase the bond prior to maturity at a fixed price
•
Insurance and Loan Guarantees
–
These are essentially put options
24-24

Quick Quiz

•
What is the difference between a call option and
a put option?
•
What is the intrinsic value of call and put options,
and what do the payoff diagrams look like?
•
What are the five major determinants of option
prices and their relationships to option prices?
•
What are some of the major capital budgeting
options?
•
How would you value a convertible bond?
24-25