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