23-1 CHAPTER 23 Options and Corporate Finance: Extensions & Applications McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 23-2 Executive Summary This chapter extends the analysis of options contained in Chapter 22 We describe four types of options found in common corporate finance decisions Executive stock options The option to expand embedded in a start-up The options in simple business contracts The option to shut down and reopen a project McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 23-3 Chapter Outline 23.1 Executive Stock Options 23.2 Valuing a Start Up 23.3 More on the Binomial Model 23.4 Shutdown and Reopening Decisions 23.5 Summary and Conclusions McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 23-4 23.1 Executive Stock Options Executive Stock Options exist to align the interests of shareholders and managers Executive Stock Options are call options (technically warrants) on the employer’s shares Inalienable Typical maturity is 10 years Typical vesting period is years Most include implicit reset provision to preserve incentive compatibility Executive Stock Options give executives an important tax break: grants of at-the-money options are not considered taxable income (Taxes are due if the option is exercised.) McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 23-5 Valuing Executive Compensation FASB allows firms to record zero expense for grants of at-themoney executive stock options However the economic value of a long-lived call option is enormous, especially given the propensity of firms to reset the exercise price after drops in the price of the stock Due to the inalienability, the options are worth less to the executive than they cost the company The executive can only exercise, not sell his options Thus he can never capture the speculative value—only the intrinsic value This “dead weight loss” is overcome by the incentive compatibility for the grantor McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 23-6 Top Stock Option Grants Company CEO Stock Option Value (Black-Scholes) Cisco Systems, Inc Chambers $140,000,000 AOL Time Warner Levin 135,000,000 SBC Communications Whiacre 67,000,000 Qwest Communications Nacchio 111,000,000 Sprint Corporation Esrey 74,000,000 McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 23-7 23.2 Valuing a Start-Up An important option is the option to expand Imagine a start-up firm, Campusteria, Inc which plans to open private dining clubs on college campuses The test market will be your campus, and if the concept proves successful, expansion will follow nationwide Nationwide expansion will occur in year four The start-up cost of the test dining club is only $30,000 (this covers leaseholder improvements and other expenses for a vacant restaurant near campus) McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 23-8 Campusteria pro forma income statement Investment Year Years 1-4 Revenues $60,000 Variable Costs ($42,000) Fixed Costs ($18,000) Depreciation ($7,500) Pretax profit ($7,500) Tax shield 34% $2,550 Net Profit –$4,950 Cash Flow –$30,000 $2,550 We plan to sell 25 meal plans at $200 per month with a 12-month contract Variable costs are projected to be $3,500 per month Fixed costs (lease payment) are projected to be $1,500 per month We can depreciate our capitalized leaseholder improvements NPV $30,000 McGraw-Hill/Irwin Corporate Finance, 7/e $2,550 $21,916.84 t t 1 (1.10) © 2005 The McGraw-Hill Companies, Inc All Rights 23-9 23.2 Valuing a Start-Up Note that while the Campusteria test site has a negative NPV, we are close to our break-even level of sales If we expand, we project opening 20 Capusterias in year four The value of the project is in the option to expand We will use the Black-Scholes option pricing model to value this option McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 10 23.2 Valuing a Start-Up with Black-Scholes The Black-Scholes Model is rT C0 S N(d1 ) Ee N(d2 ) Where C0 = the value of a European option at time t = r = the risk-free interest rate σ N(d) = Probability that a ln(S / E ) ( r )T standardized, normally d1 distributed, random T d2 d1 T variable will be less than or equal to d The Black-Scholes Model allows us to value options in the real world just as we have done in the 2-state world McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 18 Three Period Binomial Process: Call Option Prices C3 (U ,U ,U ) max[$38.02 $25,0] C1 (U ) $13.02 (1 3) $3.10 C2 (U , U ) (1.05) $9.25 (1 3) $1.97 (1.05) 28.75 2/3 6.50 C1 ( D) $25 4.52 1/3 33.06 2/3 9.25 1.25 2/3 C3 (U , D, U ) C3 (U , U , D) 1/3 $3.10 (1 3) $0 2/3 (1.05) 1/3 24.44 1.97 C ( D, D ) 1/3 18.06 McGraw-Hill/Irwin Corporate Finance, 7/e max[$28.10 $25,0] 28.10 3.10 C3 (U , D, D) C3 ( D, U , D) C3 ( D, D, U ) $0 (1 3) $0 2/3 (1.05) 1/3 $6.50 (1 3) $1.25 C0 (1.05) 13.02 C3 ( D , U , U ) C2 (U , D ) C2 ( D, U ) $1.97 (1 3) $0 2/3 (1.05) 21.25 38.02 max[$20.77 $25,0] 20.77 C3 ( D , D , D ) max[$15.35 $25,0] 1/3 15.35 © 2005 The McGraw-Hill Companies, Inc All Rights 19 Valuation of a Lookback Option When the stock price falls due to the stock market as a whole falling, the board of directors tends to reset the exercise price of executive stock options To see how this reset provision adds value, let’s price that same three-period call option (exercise price initially $25) with a reset provision Notice that the exercise price of the call will be the smallest value of the stock price depending upon the path followed by the stock price to get there McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 20 Three Period Binomial Process: Lookback Call Option Prices 38.02 33.06 28.10 28.75 28.10 24.44 20.77 $25 28.10 24.44 20.77 21.25 20.77 18.06 15.35 McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 21 Three Period Binomial Process: Lookback Call Option Prices C3 (U ,U ,U ) max[$38.02 $25,0] C (U , U , D) max[$28.10 $25,0] 3.10 28.75 38.02 13.02 28.10 $3.10 33.06 C (U , D, U ) max[$28.10 $24.44,0] 3.66 28.10 $3.66 20.77 28.10 $6.85 20.77 24.44 $25 C (U , D, D) max[$20.77 $24.44,0] 0 C ( D,U , U ) max[$28.10 $21.25,0] 6.85 24.44 21.25 C ( D, U , D) max[$20.77 $21.25,0] 0 C ( D, D,U ) max[$20.77 $18.06,0] 2.71 McGraw-Hill/Irwin Corporate Finance, 7/e 20.77 2.71 15.35 18.06 C ( D, D, D ) max[$15.36 18.06,0] © 2005 The McGraw-Hill Companies, Inc All Rights 22 Three Period Binomial Process: Lookback Call Option Prices C2 (U , U ) 38.02 13.02 28.10 $3.10 $3.66 (1 3) $0 C (U , D) (1.05) 28.10 $3.66 $13.02 (1 3) $3.10 (1.05) 28.75 33.06 9.25 24.44 2.33 $25 C ( D, U ) $6.85 (1 3) $0 (1.05) 20.77 28.10 $6.85 20.77 20.77 2.71 15.35 24.44 4.35 21.25 $2.71 (1 3) $0 C ( D, D ) (1.05) McGraw-Hill/Irwin Corporate Finance, 7/e 18.06 1.72 © 2005 The McGraw-Hill Companies, Inc All Rights 23 Three Period Binomial Process: Lookback Call Option Prices C1 (U ) 33.06 $9.25 (1 3) $2.33 (1.05) 28.75 9.25 6.61 38.02 13.02 28.10 $3.10 28.10 $3.66 20.77 28.10 $6.85 20.77 20.77 2.71 15.35 24.44 2.33 $25 5.25 C1 ( D) $4.35 (1 3) $1.72 (1.05) 24.44 4.35 21.25 3.31 $6.50 (1 3) $1.25 C0 (1.05) McGraw-Hill/Irwin Corporate Finance, 7/e 18.06 1.72 © 2005 The McGraw-Hill Companies, Inc All Rights 24 23.4 Shutdown and Reopening Decisions Can easily be seen as options The “Woe is Me” gold mine is currently closed The firm is publicly held and trades under the ticker WOE The firm has no debt and has assets of around $30 million The market capitalization is well over $1 billion What could possibly explain why a firm with $30 million in assets and a closed gold mine that is producing no cash flow at all has this kind of market capitalization? Options This firm has them in spades McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 25 Discounted Cash Flows and Options We can calculate the market value of a project as the sum of the NPV of the project without options and the value of the managerial options implicit in the project M = NPV + OPT A good example would be comparing the desirability of a specialized machine versus a more versatile machine If they both cost about the same and last the same amount of time the more versatile machine is more valuable because it comes with options McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 26 The Option to Abandon: Example Suppose that we are drilling an oil well The drilling rig costs $300 today and in one year the well is either a success or a failure The outcomes are equally likely The discount rate is 10% The PV of the successful payoff at time one is $575 The PV of the unsuccessful payoff at time one is $0 McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 27 The Option to Abandon: Example Traditional NPV analysis would indicate rejection of the project Prob Expected Prob Payoff Payoff payoff sucess given success failure given failure Expected 0.5 $575 0.5 0 $287.5 payoff NPV $300 McGraw-Hill/Irwin Corporate Finance, 7/e $287.50 $38.64 t (1.10) © 2005 The McGraw-Hill Companies, Inc All Rights 28 The Option to Abandon: Example Traditional NPV analysis overlooks the option to abandon Success: PV = $500 Sit on rig; stare at empty hole: PV = $0 Drill $500 Failure Sell the rig; NPV $0 salvage value = $250 The firm has two decisions to make: drill or not, abandon or stay Do not drill McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 29 The Option to Abandon: Example When we include the value of the option to abandon, the drilling project should proceed: Prob Expected Prob Payoff Payoff payoff success given success failure given failure Expected 0.5 $575 0.5 250 $412.50 payoff NPV $300 McGraw-Hill/Irwin Corporate Finance, 7/e $412.50 $75.00 t (1.10) © 2005 The McGraw-Hill Companies, Inc All Rights 30 Valuation of the Option to Abandon Recall that we can calculate the market value of a project as the sum of the NPV of the project without options and the value of the managerial options implicit in the project M = NPV + OPT $75.00 = –$38.60 + OPT OPT = $113.64 McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 31 Enron’s Inefficient Plants In 1999 Enron planned to open gas-fired power plants in Mississippi and Tennessee These plants were expected to sit idle most of the year, and, when operated to produce electricity at a cost of at least 50 percent higher than the most efficient state-ofthe-art facility Enron was buying a put option on electricity They could sell electricity when electricity prices spike Typical price is around $40 per megawatt-hour, but occasionally the price is several thousand dollars Having a plant that was only economic to operate a few weeks a year was a positive NPV investment—when you include the value of that option Brealey, Myers, and Marcus Fundamentals of Corporate Finance, 3e And “Exploiting Uncertainty: The “Real Options” Revolution in Decision Making” Business Week, June 7, 1999 McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 32 23.5 Summary and Conclusions Options appear in a variety of corporate settings We describe four types of options found in common corporate finance decisions Executive stock options The option to expand embedded in a start-up The option in simple business contracts The option to shut down and reopen a project We have the methodology to value them McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights ... Marcus Fundamentals of Corporate Finance, 3e And “Exploiting Uncertainty: The “Real Options” Revolution in Decision Making” Business Week, June 7, 1999 McGraw-Hill/Irwin Corporate Finance, 7/e © 2005... in simple business contracts The option to shut down and reopen a project McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 23-3 Chapter Outline 23.1 Executive... Model 23.4 Shutdown and Reopening Decisions 23.5 Summary and Conclusions McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 23-4 23.1 Executive Stock Options