Chapter 14
•Options and Corporate
Finance
McGraw-Hill/Irwin
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
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
14-1
Chapter Outline
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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
14-2
Option Terminology
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Call
Put
Strike or Exercise price
Expiration date
Option premium
Option writer
American Option
European Option
14-3
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
14-4
Option Payoffs – Calls
• The value of the call
at expiration is the
intrinsic value
• Assume that the
exercise price is $30
25
Call Value
• Max(0, S-E)
• If S<E, then the payoff
is 0
• If S>E, then the payoff
is S – E
Call Option Payoff
Diagram
20
15
10
5
0
0 10 20 30 40 50 60
Stock Price
14-5
Option Payoffs - Puts
• The value of a put at
expiration is the
intrinsic value
• Assume that the
exercise price is $30
Option Value
• Max(0, E-S)
• If S<E, then the payoff
is E-S
• If S>E, then the payoff
is 0
Payoff Diagram for Put
Options
35
30
25
20
15
10
5
0
0 10 20 30 40 50 60
Stock Price
14-6
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
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 minus the exercise price or zero, whichever is
greater
• If either of these bounds are violated, there is an
arbitrage opportunity
14-8
Figure 14.2
14-9
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-themoney, the option value would be
• C0 = S0 – PV(E)
• If the call is worth something other than
this, then there is an arbitrage opportunity
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
• Risk-free rate
• As the risk-free rate increases, the call price increases
and the put price decreases
14-11
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
• The owner of the option gains from volatility on the
upside, but don’t lose anymore from volatility on the
downside
14-12
Table 14.2
14-13
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 isn’t worth as much to the employee as it is
to an outside investor because of the lack of
diversification – this suggests that options may work in
limited amounts, but not as a large part of the
compensation package
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 face 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
14-15
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
14-16
Timing Options
• We normally assume that a project must be
taken today or forgone completely
• Almost all projects have the embedded option to
wait
• A good project may be worth more if we wait
• A seemingly 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 the project produces the
highest NPV
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 will
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 = 384.62
• 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
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
• Strategic options – look at how taking this project
opens up other opportunities that would be otherwise
unavailable
14-19
Warrants
• A call option issued by corporations in conjunction
with other securities to reduce the yield required on
the other securities
• 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, generates
cash for the firm and alters the capital structure
• Warrants can normally be detached from the original
securities and sold separately
• Exercise of warrants reduces EPS, so warrants are
included when a firm reports “diluted EPS”
14-20
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
14-21
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?
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Straight bond value = 1081.44
Conversion ratio = 1000/100 = 10
Conversion value = 10*110 = 1100
Minimum price = $1100
14-22
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
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?
• How would you value a convertible bond?
14-24
Chapter 14
•End of Chapter
McGraw-Hill/Irwin
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.