© 2003 The McGraw-Hill Companies, Inc. All rights reserved.

14.1
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
McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved.

14.2
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
McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved.

14.3
Option Terminology
• Call
• Put
• Strike or Exercise price
• Expiration date
• Option premium
• Option writer
• American Option
• European Option
McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved.

14.4
Stock Option Quotations
• Look at Table 14.1 in the book
– Price and volume information for calls and puts with the same strike and expiration is provided on the same line
• Things to notice
– Prices are higher for options with the same strike price but longer expirations
– Call options with strikes less than the current price are worth more than the corresponding puts
– Call options with strikes greater than the current price are worth less than the corresponding puts
McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved.

14.5
Option Payoffs – Calls
• The value of the call at expiration is the intrinsic value
– Max(0, S-E)
– If S<E, then the payoff is
0
– If S>E, then the payoff is
S – E
• Assume that the exercise price is $35
McGraw-Hill/Irwin
Call Option Payoff
Diagram
20
15
10
5
0
0 10 20 30 40 50 60
Stock Price
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.

14.6
Option Payoffs - Puts
• The value of a put at expiration is the intrinsic value
– Max(0, E-S)
– If S<E, then the payoff is
E-S
– If S>E, then the payoff is
0
• Assume that the exercise price is $35
McGraw-Hill/Irwin
Payoff Diagram for Put
Options
40
30
20
10
0
0 10 20 30 40 50 60
Stock Price
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.

14.7
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
McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved.

14.8
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 minus the exercise price or zero, whichever is greater
• If either of these bounds are violated, there is an arbitrage opportunity
McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved.

14.9
Figure 14.2
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14.10
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
– C
0
= S
0
– PV(E)
• If the call is worth something other than this, then there is an arbitrage opportunity
McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved.

14.11
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
• Risk-free rate
– As the risk-free rate increases, the call price increases and the put price decreases
McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved.

14.12
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
– You gain from volatility on the upside, but don’t lose anymore from volatility on the downside
McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved.

14.13
Table 14.2
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14.14
Employee Stock Options
• Options that are given to employees as part of their 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
McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved.

14.15
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
• If the assets are worth less than the debt, the stockholders will let the option expire and the assets will belong to the bondholders
McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved.

14.16
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
McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved.

14.17
Timing Options
• We normally assume that a project must be taken today or foregone completely
• Almost all projects have the embedded option to wait
– A good project may be worth more if we wait
– A seemly 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 produces the highest NPV
McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved.

14.18
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 $750. 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
McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved.

14.19
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
– Strategic options – look at how taking this project opens up other opportunities that would be otherwise unavailable
McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved.

14.20
Warrants
• A call option issued by corporations in conjunction with other securities to reduce the yield
• 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
– Warrants can be detached from the original securities and sold separately
McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved.

14.21
Convertibles
• 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 as much as the straight bond value or the conversion value, whichever is greater
McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved.

14.22
Valuing Convertibles
• Suppose you have a 10% bond that pays semiannual coupons and will mature in 15 years. The face value is $1000 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 = 1081.44
– Conversion ratio = 1000/100 = 10
– Conversion value = 10*110 = 1100
– Minimum price = $1100
McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved.

14.23
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
McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved.

14.24
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?
• How would you value a convertible bond?
McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved.