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Options and Corporate Finance

Chapter 24

Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

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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

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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

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Option TerminologyCallPutStrike or Exercise priceExpiration dateOption premiumOption writerAmerican OptionEuropean Option

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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

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Stock Option Quotations

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

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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

Option Payoffs – Calls

The value of the call at expiration is the intrinsic valueMax(0, S-E)If S<E, then the

payoff is 0If S>E, then the

payoff is S – E(Assume that the exercise price is $30)

Call Option Payoff Di-

agram

Stock Price

Cal

l Val

ue

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Option Payoffs - Puts

The value of a put at expiration is the intrinsic valueMax(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)

Payoff Dia-gram for Put

Options

Stock Price

Opt

ion

Val

ue

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Work the Web

•Where can we find option prices?•On the Internet, of course! •One site that provides option prices is www.Finance.Yahoo.com•Click on the web surfer to go to Yahoo Finance

Enter a ticker symbol to get a basic quoteFollow the options linkCheck out “symbology” to see how the ticker symbols are formed

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Call Option BoundsUpper bound

Call price must be less than or equal to the stock price

Lower boundCall 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

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Call Option Bounds

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A Simple ModelAn 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:

C0 = S0 – PV(E)If the call is worth something other than this, then there is an arbitrage opportunity

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What Determines Option Values?

Stock priceAs the stock price increases, the call price increases and the put price decreases

Exercise priceAs the exercise price increases, the call price decreases and the put price increases

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What Determines Option Values?

Time to expirationGenerally, as the time to expiration increases, both the call and the put prices increase

Risk-free rateAs the risk-free rate increases, the call price increases and the put price decreases

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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

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What about Variance?The greater the variance, the more the call and the put are worthIf 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 doesn’t lose any more from volatility on the downside

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Factors of InfluenceFactor Direction of

Influence Calls Puts

Current value of the underlying asset

+ -

Exercise price on the option - +

Time to expiration on the option + +

Risk-free rate + -

Variance of return on the underlying asset

+ +

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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

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Employee Stock Options

ESO’s are options that are given to employees as part of their benefits packages

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Employee Stock Options

Often used as a bonus or incentiveDesigned to align employee interests with stockholder interests and reduce agency problemsEmpirical evidence suggests that they don’t work as well as anticipated due to the lack of diversification introduced into the employees’ portfolios

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Employee Stock Options

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

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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

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Equity: A Call OptionEquity 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

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Equity: A Call OptionIf the assets are worth more than the debt when it comes due, the option will be exercised and the stockholders retain ownership

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Equity: A Call OptionIf the assets are worth less than the debt, the stockholders will let the option expire and the assets will belong to the bondholders

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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

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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

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Timing OptionsWe normally assume that a

project must be taken today or forgone completely

Almost all projects have the embedded option to waitA 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

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Timing Options

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

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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 =

$384.62NPV waiting one year = (-5,500 +

800/.13)/(1.13) = $578.62It is a good project either way, but we

should wait until next year

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Managerial OptionsManagers 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

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Managerial Option Examples

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

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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

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Warrants Definition: A warrant is a call option issued by corporations in conjunction with other securities to reduce the yield required on the other securities

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Warrant Uniqueness

Differences between warrants and traditional call options:Warrants are generally very long termThey 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”

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Convertibles

Convertible bonds (or preferred stock) may be converted into a specified number of common shares at the option of the bondholder

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ConvertiblesThe 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

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Valuing ConvertiblesSuppose you have a 10% bond that pays semi-annual 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 = $1,081.44Conversion ratio = 1,000/100 =

10Conversion value = 10*110 =

$1,100Minimum price = $1,100

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Other OptionsCall provision on a bondAllows 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

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Other OptionsPut bond

Allows the bondholder to require the company to repurchase the bond prior to maturity at a fixed price

Insurance and Loan GuaranteesThese are essentially put options

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Ethics Issues

It has been reported that during the internet boom in the late 1990s, technology firms were increasing their earnings by selling put options on their own stock.When is this practice beneficial for the firm?

Why do you think this practice was significantly reduced in the year 2000?

Is there any ethical implication of this practice?

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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?

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Comprehensive Problem

A convertible bond has a straight bond value of $1,050. The conversion ratio is 24, and the stock price is $49 per share. What is the value of the option to convert?

What is the intrinsic value of a call and a put, each with an exercise price of $40, if the stock price is currently $50?

What if the stock price is $20?

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Terminology

•Bond•Par value (face value)•Coupon rate•Coupon payment•Maturity date•Yield or Yield to Maturity (YTM)

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Formulas

C0 = S0 – PV(E)

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Key Concepts and Skills

•Differentiate between put and call options.•Determine option payoffs and pricing bounds•Explain how options are valued•Describe why companies offer stock options to new employees

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Key Concepts and Skills

• Describe how a firm’s equity can be viewed as a call option on the firm’s assets.• Explain how option valuation

can be used in capital budgeting• Identify the determinants of warrant and convertible valuation.

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1.Put and Call options are contracts to sell or buy something at a fixed price in the future.

2.Options may happen (exercised) or they may not (expired) based on the value at some specific time.

What are the most important topics of this chapter?

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3. Warrants provide for the purchase of shares of stock at a fixed price in the future.

4. Convertible bonds may become shares of common stock instead of paying the maturity value.

What are the most important topics of this chapter?

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Questions?