McGraw-Hill/IrwinMcGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

1414Options and

Corporate Finance

14-2

Key Concepts and SkillsKey Concepts and Skills

Understand the options terminology Be able to determine option payoffs and pricing

bounds Understand the five major determinants of option

value Understand employee stock options Understand the various managerial options Understand the differences between warrants and

traditional call options Understand convertible securities and how to

determine their value

14-3

Chapter OutlineChapter 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

14-4

Option TerminologyOption Terminology

Call Put Strike or Exercise price Expiration date Option premium Option writer American Option European Option

14-5

Stock Option QuotationsStock Option Quotations

Look at Table 14.1 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

14-6

Option Payoffs – CallsOption 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

Call Option Payoff Diagram

05

10152025

0 10 20 30 40 50 60

Stock Price

Cal

l Val

ue

14-7

Option Payoffs - PutsOption 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

Payoff Diagram for Put Options

05

101520253035

0 10 20 30 40 50 60

Stock Price

Opt

ion

Val

ue

14-8

Work the Web ExampleWork 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

14-9

Call Option BoundsCall 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

If either of these bounds are violated, there is an arbitrage opportunity

14-10

Figure 14.2Figure 14.2

14-11

A Simple ModelA 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 C0 = S0 – PV(E)

If the call is worth something other than this, then there is an arbitrage opportunity

14-12

What Determines Option Values?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

14-13

What about Variance?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 anymore from volatility on the downside

14-14

Table 14.2Table 14.2

14-15

Employee Stock OptionsEmployee Stock Options

Options that are given to employees as part of their benefits package

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

14-16

Equity: A Call OptionEquity: 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

14-17

Capital Budgeting OptionsCapital 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

14-18

Timing OptionsTiming 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

14-19

Example: Timing OptionsExample: 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

14-20

Managerial OptionsManagerial Options Managers often have options after a project has

been implemented that can add value 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

14-21

WarrantsWarrants 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”

14-22

ConvertiblesConvertibles

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 the straight bond value or the conversion value, whichever is greater

14-23

Valuing ConvertiblesValuing 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

14-24

Other OptionsOther 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

14-25

Quick QuizQuick 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?

McGraw-Hill/IrwinMcGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

1414End of Chapter

14-27

Comprehensive ProblemComprehensive 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 exercise 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?