Lecture Fundamentals of corporate finance: Lecture 14 - Ross, Westerfield, Jordan

Chapter 14, options and corporate finance. After studying this chapter you will be able to: Give the definitions for a put option and a call option, be familiar with common stock option quotations, illustrate the payoffs from a put and call option at maturity, explain how to determine the upper and lower bounds on a call option''s value, compute the value of a call option based on the assumption that it is certain that the option will finish in the money,...

Chapter Fourteen Options and Corporate Finance © 2003 The McGraw­Hill Companies, Inc. All rights reserved 14.2 Key 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 McGrawưHill/Irwin â2003TheMcGrawưHillCompanies,Inc.Allrightsreserved 14.3 Chapter Outline ã ã ã ã ã • • 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 McGraw­Hill/Irwin © 2003 The McGraw­Hill Companies, Inc. All rights reserved 14.4 Option Terminology • • • • • • • • Call Put Strike or Exercise price Expiration date Option premium Option writer American Option European Option McGrawưHill/Irwin â2003TheMcGrawưHillCompanies,Inc.Allrightsreserved 14.5 Option Payoffs Calls ã Thevalueofthecallat expirationisthe intrinsic value • Assume that the  exercise price is $35 20 Call Value – Max(0, S­E) – If SE, then the payoff  is S – E Call Option Payoff  Diagram 15 10 0 10 20 30 40 50 60 Stock Price McGraw­Hill/Irwin © 2003 The McGraw­Hill Companies, Inc. All rights reserved 14.6 Option Payoffs - Puts • The value of a put at  expiration is the  intrinsic value • Assume that the  exercise price is $35 40 Option Value – Max(0, E­S) – If SE, then the payoff  is 0 Payoff Diagram for Put  Options 30 20 10 0 10 20 30 40 50 60 Stock Price McGraw­Hill/Irwin © 2003 The McGraw­Hill Companies, Inc. All rights reserved 14.7 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  minustheexercisepriceorzero,whicheverisgreater ã Ifeitheroftheseboundsareviolated,thereisan arbitrageopportunity McGrawưHill/Irwin â2003TheMcGrawưHillCompanies,Inc.Allrightsreserved 14.8 Figure 14.2 McGrawưHill/Irwin © 2003 The McGraw­Hill Companies, Inc. All rights reserved 14.9 A Simple Model • An option is “in­the­money” if the payoff is  greater than zero • If a call option is sure to finish in­the­money,  theoptionvaluewouldbe C0=S0PV(E) ã Ifthecallisworthsomethingotherthanthis, thenthereisanarbitrageopportunity McGrawưHill/Irwin â2003TheMcGrawưHillCompanies,Inc.Allrightsreserved 14.10 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 • Risk­free rate Astheriskưfreerateincreases,thecallpriceincreasesand theputpricedecreases McGrawưHill/Irwin â2003TheMcGrawưHillCompanies,Inc.Allrightsreserved 14.11 What about Variance? ã When an option may finish out­of­the­money (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 out­of­the­money, the most you can  lose is your premium, no matter how far out it is – The more an option is in­the­money, the greater the gain – You gain from volatility on the upside, but don’t lose  anymore from volatility on the downside McGraw­Hill/Irwin © 2003 The McGraw­Hill Companies, Inc. All rights reserved 14.12 Table 14.2 McGrawưHill/Irwin â2003TheMcGrawưHillCompanies,Inc.Allrightsreserved 14.13 Employee Stock Options ã Optionsthataregiventoemployeesaspartoftheir 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 just isn’t worth as much to the employee as it is  to an outside investor McGraw­Hill/Irwin © 2003 The McGraw­Hill Companies, Inc. All rights reserved 14.14 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 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 • Iftheassetsareworthlessthanthedebt,the stockholderswilllettheoptionexpireandtheassets willbelongtothebondholders McGrawưHill/Irwin â2003TheMcGrawưHillCompanies,Inc.Allrightsreserved 14.15 Capital Budgeting Options ã 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 McGraw­Hill/Irwin © 2003 The McGraw­Hill Companies, Inc. All rights reserved 14.16 Timing Options • We normally assume that a project must be taken  today or foregone completely • Almost all projects have the embedded option to wait – Agoodprojectmaybeworthmoreifwewait AseemlybadprojectmayactuallyhaveapositiveNPVif wewaitduetochangingeconomicconditions ã WeshouldexaminetheNPVoftakinganinvestment now,orinfutureyears,andplantoinvestatthetime thatproducesthehighestNPV McGrawưHill/Irwin â2003TheMcGrawưHillCompanies,Inc.Allrightsreserved 14.17 Example: Timing Options • Consider a project that costs $5000 and has an  expected future cash flow of $700 per year forever. If  we wait one year, the cost will increase to $5500 and  the expected future cash flow increase to $800. If the  required return is 13%, should we accept the project?  If so, when should we begin? – NPV starting today = ­5000 + 700/.13 = 384.16 – NPV waiting one year = (­5500 + 800/.13)/(1.13) = 578.62 – It is a good project either way, but we should wait until  next year McGraw­Hill/Irwin © 2003 The McGraw­Hill Companies, Inc. All rights reserved 14.18 Managerial 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 – Strategicoptionslookathowtakingthisprojectopensup otheropportunitiesthatwouldbeotherwiseunavailable McGrawưHill/Irwin â2003TheMcGrawưHillCompanies,Inc.Allrightsreserved 14.19 Warrants ã Acalloptionissuedbycorporationsinconjunction withothersecuritiestoreducetheyield ã Differences between warrants and traditional call  options – Warrants are generally very long term – They are written by the company and exercise results in  additional shares outstanding – The exercise price is paid to the company and generates  cash for the firm Warrantscanbedetachedfromtheoriginalsecuritiesand soldseparately McGrawưHill/Irwin â2003TheMcGrawưHillCompanies,Inc.Allrightsreserved 14.20 Convertibles ã Convertiblebonds(orpreferredstock)maybe convertedintoaspecifiednumberofcommonshares 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 as much as  the straight bond value or the conversion value,  whicheverisgreater McGrawưHill/Irwin â2003TheMcGrawưHillCompanies,Inc.Allrightsreserved 14.21 Valuing Convertibles ã Supposeyouhavea10%bondthatpayssemiannual couponsandwillmaturein15years.Thefacevalue is$1000andtheyieldtomaturityonsimilarbondsis 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 = 1081.44 Conversion ratio = 1000/100 = 10 Conversion value = 10*110 = 1100 Minimumprice=$1100 McGrawưHill/Irwin â2003TheMcGrawưHillCompanies,Inc.Allrightsreserved 14.22 Other Options ã Callprovisiononabond Allowsthecompanytorepurchasethebondpriorto 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 McGraw­Hill/Irwin © 2003 The McGraw­Hill Companies, Inc. All rights reserved 14.23 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? ã Howwouldyouvalueaconvertiblebond? McGrawưHill/Irwin â2003TheMcGrawưHillCompanies,Inc.Allrightsreserved  ... If S>E, then the payoff  is S – E Call Option Payoff  Diagram 15 10 0 10 20 30 40 50 60 StockPrice McGrawưHill/Irwin â2003TheMcGrawưHillCompanies,Inc.Allrightsreserved 14. 6 Option Payoffs - Puts ã Thevalueofaputat... © 2003 The McGraw­Hill Companies, Inc. All rights reserved 14. 5 Option Payoffs – Calls • The value? ?of? ?the call at  expiration is the  intrinsic value • Assume that the  exercise price is $35 20 Call Value – Max(0, S­E) – If S