Chapter 24 options and corporate finance

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 • Unde

Chapter 24 Options and Corporate Finance

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

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

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

– Call options with strikes greater than the current price

are worth less than the corresponding puts

Option Payoffs – Calls

• The value of the call

Option Payoffs - Puts

• The value of a put at

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

Call Option Bounds

• If either of these bounds are violated,

there is an arbitrage opportunity

Figure 24.2

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

– C0 = S0 – PV(E)

• If the call is worth something other than

this, then there is an arbitrage opportunity

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

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

Table 24.2

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

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

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

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

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

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

• 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

• 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

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

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

• 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?

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?

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?

End of Chapter