22-1 CHAPTER 22 Options and Corporate Finance: Basic Concepts McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 22-2 Chapter Outline 22.1 Options 22.2 Call Options 22.3 Put Options 22.4 Selling Options 22.5 Reading The Wall Street Journal 22.6 Combinations of Options 22.7 Valuing Options 22.8 An Option‑Pricing Formula 22.9 Stocks and Bonds as Options 22.10 Capital-Structure Policy and Options 22.11 Mergers and Options 22.12 Investment in Real Projects and Options 22.13 Summary and Conclusions McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 22-3 22.1 Options Many corporate securities are similar to the stock options that are traded on organized exchanges Almost every issue of corporate stocks and bonds has option features In addition, capital structure and capital budgeting decisions can be viewed in terms of options McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 22-4 22.1 Options Contracts: Preliminaries An option gives the holder the right, but not the obligation, to buy or sell a given quantity of an asset on (or perhaps before) a given date, at prices agreed upon today Calls versus Puts Call options gives the holder the right, but not the obligation, to buy a given quantity of some asset at some time in the future, at prices agreed upon today When exercising a call option, you “call in” the asset Put options gives the holder the right, but not the obligation, to sell a given quantity of an asset at some time in the future, at prices agreed upon today When exercising a put, you “put” the asset to someone McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 22-5 22.1 Options Contracts: Preliminaries Exercising the Option The act of buying or selling the underlying asset through the option contract Strike Price or Exercise Price Refers to the fixed price in the option contract at which the holder can buy or sell the underlying asset Expiry The maturity date of the option is referred to as the expiration date, or the expiry European versus American options European options can be exercised only at expiry American options can be exercised at any time up to expiry McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 22-6 Options Contracts: Preliminaries In-the-Money The exercise price is less than the spot price of the underlying asset At-the-Money The exercise price is equal to the spot price of the underlying asset Out-of-the-Money The exercise price is more than the spot price of the underlying asset McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 22-7 Options Contracts: Preliminaries Intrinsic Value The difference between the exercise price of the option and the spot price of the underlying asset Speculative Value The difference between the option premium and the intrinsic value of the option Option Premium McGraw-Hill/Irwin Corporate Finance, 7/e = Intrinsic Value Speculative + Value © 2005 The McGraw-Hill Companies, Inc All Rights 22-8 22.2 Call Options Call options gives the holder the right, but not the obligation, to buy a given quantity of some asset on or before some time in the future, at prices agreed upon today When exercising a call option, you “call in” the asset McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 22-9 Basic Call Option Pricing Relationships at Expiry At expiry, an American call option is worth the same as a European option with the same characteristics If the call is in-the-money, it is worth ST – E If the call is out-of-the-money, it is worthless: C = Max[STT – E, 0] Where ST is the value of the stock at expiry (time T) E is the exercise price C is the value of the call option at expiry McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 2210 ac al l Call Option Payoffs Bu y Option payoffs ($) 60 40 20 20 40 50 60 80 100 120 Stock price ($) –20 –40 McGraw-Hill/Irwin Corporate Finance, 7/e Exercise price = $50 © 2005 The McGraw-Hill Companies, Inc All Rights 2261 22.9 Stocks and Bonds as Options Levered Equity is a Call Option The underlying asset comprise the assets of the firm The strike price is the payoff of the bond If at the maturity of their debt, the assets of the firm are greater in value than the debt, the shareholders have an in-the-money call, they will pay the bondholders and “call in” the assets of the firm If at the maturity of the debt the shareholders have an out-of-the-money call, they will not pay the bondholders (i.e the shareholders will declare bankruptcy) and let the call expire McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 2262 22.9 Stocks and Bonds as Options Levered Equity is a Put Option The underlying asset comprise the assets of the firm The strike price is the payoff of the bond If at the maturity of their debt, the assets of the firm are less in value than the debt, shareholders have an in-the-money put They will put the firm to the bondholders If at the maturity of the debt the shareholders have an out-of-the-money put, they will not exercise the option (i.e NOT declare bankruptcy) and let the put expire McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 2263 22.9 Stocks and Bonds as Options It all comes down to put-call parity E c0 = S0 + p0 – (1+ r)T Value of a call on the firm Value of a Value of = the firm + put on the – firm Stockholder’s position in terms of call options McGraw-Hill/Irwin Corporate Finance, 7/e Value of a risk-free bond Stockholder’s position in terms of put options © 2005 The McGraw-Hill Companies, Inc All Rights 2264 22.10 Capital-Structure Policy and Options Recall some of the agency costs of debt: they can all be seen in terms of options For example, recall the incentive shareholders in a levered firm have to take large risks McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 2265 Balance Sheet for a Company in Distress Assets BVMVLiabilities Cash $200$200LT bonds Fixed Asset $400$0Equity $300 Total $600$200Total $600 BVMV $300 $200 $200 $0 What happens if the firm is liquidated today? The bondholders get $200; the shareholders get nothing McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 2266 Selfish Strategy 1: Take Large Risks The Gamble Win Big Lose Big Probability 10% 90% Payoff $1,000 $0 Cost of investment is $200 (all the firm’s cash) Required return is 50% Expected CF from the Gamble = $1000 × 0.10 + $0 = $100 $100 NPV = –$200 + (1.10) NPV = –$133 McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 2267 Selfish Stockholders Accept Negative NPV Project with Large Risks Expected CF from the Gamble To Bondholders = $300 × 0.10 + $0 = $30 To Stockholders = ($1000 – $300) × 0.10 + $0 = $70 PV of Bonds Without the Gamble = $200 PV of Stocks Without the Gamble = $0 $30 PV of Bonds With the Gamble: $20 = (1.50) $70 PV of Stocks With the Gamble: $47 = (1.50) The stocks are worth more with the high risk project because the call option that the shareholders of the levered firm hold is worth more when the volatility of the firm is increased McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 2268 22.11 Mergers and Options This is an area rich with optionality, both in the structuring of the deals and in their execution In the first half of 2000, General Mills was attempting to acquire the Pillsbury division of Diageo PLC The structure of the deal was Diageo’s stockholders received 141 million shares of General Mills stock (then valued at $42.55) plus contingent value rights of $4.55 per share McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 2269 22.11 Mergers and Options Cash payment to newly issued shares The contingent value rights paid the difference between $42.55 and General Mills’ stock price in one year up to a maximum of $4.55 $4.55 $0 $38 $42.55 McGraw-Hill/Irwin Corporate Finance, 7/e Value of General Mills in year © 2005 The McGraw-Hill Companies, Inc All Rights 2270 22.11 Mergers and Options The contingent value plan can be viewed in terms of puts: Each newly issued share of General Mills given to Diageo’s shareholders came with a put option with an exercise price of $42.55 But the shareholders of Diageo sold a put with an exercise price of $38 McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 2271 22.11 Mergers and Options Cash payment to newly issued shares Own a put Strike $42.55 $42.55 $42.55 – $38.00 $4.55 $0 $38 $42.55 –$38 McGraw-Hill/Irwin Corporate Finance, 7/e Value of General Mills in year Sell a put Strike $38 © 2005 The McGraw-Hill Companies, Inc All Rights 2272 22.11 Mergers and Options Value of General Mills in year Value of a share plus cash payment Value of a share $42.55 $4.55 $0 $38 $42.55 McGraw-Hill/Irwin Corporate Finance, 7/e Value of General Mills in year © 2005 The McGraw-Hill Companies, Inc All Rights 2273 22.12 Investment in Real Projects & Options Classic NPV calculations typically ignore the flexibility that real-world firms typically have The next chapter will take up this point McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 2274 22.13 Summary and Conclusions The most familiar options are puts and calls Put options give the holder the right to sell stock at a set price for a given amount of time Call options give the holder the right to buy stock at a set price for a given amount of time Put-Call parity E c0– T = S0 + p0 (1+ r) McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 2275 22.13 Summary and Conclusions The value of a stock option depends on six factors: Current price of underlying stock Dividend yield of the underlying stock Strike price specified in the option contract Risk-free interest rate over the life of the contract Time remaining until the option contract expires Price volatility of the underlying stock • Much of corporate financial theory can be presented in terms of options Common stock in a levered firm can be viewed as a call option on the assets of the firm Real projects often have hidden option that enhance value McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights ... 22.13 Summary and Conclusions McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 22-3 22.1 Options Many corporate securities are similar to the stock options... issue of corporate stocks and bonds has option features In addition, capital structure and capital budgeting decisions can be viewed in terms of options McGraw-Hill/Irwin Corporate Finance, 7/e... agreed upon today When exercising a put, you “put” the asset to someone McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 22-5 22.1 Options Contracts: