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 [...]... 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? •... 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... 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... 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... 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? 24- 27 End of Chapter 24- 28 ... 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... 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... 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... 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)... 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 . 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. 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. 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