CHAPTERS 23, PART III AND 24:
OPTIONS IN CORPORATE FINANCE
Topics:
• 23.9
Stocks and Bonds as Options
(Robert Merton, 1974)
• 23.10
Capital Structure Policy and Options
• 24.1
Executive Stock Options
• 24.2, 24.3 Introduction to Real Options
1
Firm expressed in terms of call options
• Consider a firm with a single outstanding debt issue on
which there is one remaining payment B at T
• Payoff to stockholders:
Value to shareholder
Stockholders own call on firm
with
1) the underlying asset:
2) exercise price B
• If cash flow < B:
B
Firm Cashflow
• If cash flow > B:
2
Firm as a call cont’d
• If stock can be viewed as a call option on the firm’s assets
with a strike price of B,
– Bondholders own firm and have written a call option against it
with a strike of B (Bondholders: long in firm, short a call.)
• Payoff to bondholders:
3
Firm expressed in terms of put option
• Use the put-call parity to interpret the firm in terms of put
options.
• For stockholders: C = V + P – risk free bond
– the stockholders own the firm,
– have sold a risk free bond
– own a put option with a strike price of B
• From
V-C = Riskfree bond – P
– B/H have sold a put option on the firm to the s/h with an
exercise price of $B and are owed $B
– In principle, we can value risky debt as safe debt less the value
of a put option (however, in practice this is quite complicated
since coupon payments effectively create a whole series of
options)
4
Value
Firm as put option: Bondholder payoff
B
Firm Cashflow
• If cash flow < B:
• If cash flow > B:
5
Loan Guarantees
Value to bondholder
• Government sometime provides guarantees that loans will be
repaid
• Value of the loan before and after loan guarantee:
• A government guarantee
converts a risky bond into a
risk-free bond
• Option:
B
Firm Cashflow
• Value of the government guarantee?
6
Loan Guarantee
• An important application of loan guarantees is deposit insurance
– Deposit insurance is a government guarantee that depositors in financial
institutions will receive their money back (up to a specified limit)
• The intention is to prevent “bank runs”
• Research indicates that the Canadian government has significantly
undercharged banks for this insurance. Moreover, the premiums were
not risk-adjusted, leading some to argue that this gives banks the
incentive to take too many risks
• A similar situation in the U.S. led to the S&L scandal in the early 1990s
which ended up costing taxpayers several hundred billion dollars
• Another example is the ongoing Subprime Crisis
– Wachovia, WaMu, IndyMac, CIBC
7
Options and Bondholder-Stockholder Conflicts
• Incentives for stockholders to select high-risk projects
– Recall the interpretation of stocks and bonds in terms of call
options
– stockholders: C; Bondholders: V – C.
– A rise in the volatility of the firm increases the value of the
call
• Value to stockholders (value of stock) is higher if riskier projects
are selected.
– This incentive is strongest when the value of C is relatively
low (i.e. when firm value is low)
8
Incentives for milking the firm
• Recall the interpretation of stocks and bonds in terms of put
options
– Bondholders: safe bond – P;
– stockholders: V – safe bond + P
– Value of put increases as value of asset falls
• Stockholders can increase the value of the put by paying out
dividends to themselves (thereby reducing V)
9
Executive stock options
• Stock options can be a significant component of
compensation for high-ranking executives and other
employees
• Executive Stock Options are call options (technically
warrants—see Ch. 25) on the employer’s shares.
–
–
–
–
Inalienable: unseparatable from employee him/herself
Typical maturity is 10 years.
Typical vesting period is three years.
Many include implicit reset provision to preserve incentive
compatibility.
• Resetting (repricing): If stock price is (well) below X
(option deep out of the money), adjust X to new price.
• Firms need to expense ESOP after 2004 (usually using B-S
formula)
10
Example: Larry Ellison (Oracle CEO & Founder)
• From 1999 to 2003, Ellison’s salary was $1
• Yet he is among the most highly paid CEOs world wide.
• Trick: ESOP
• Ellison’s 2005 fiscal year options granted: 2.5m, on 8/27/2004
• Key features of Ellison’s package:
• Exercise price: 10.23, at-the-market when granted
• Expiry Time: 10 years.
• Vesting clause: 25% per year (Meaning: ¼ of the granted
options are exercisable per year.
• Assuming r = 5%, σ = 20%. S = X = 10.23, T-t = 10, d = 0, the
call option value = $4.62.
• This gives a total pay of over $10 million.
11
Oracle 2005 Executive Stock Option Granting (with some accounting)
12
Why (not) ESOP?
• Advantages
–
–
–
–
Aligning managerial incentive with S/H interests
Incorporating uncertainty regarding managerial quality
Non-cash substitute for part of wage compensation
Tax advantage for executives: grants of at-the-money options
are not considered to be taxable income (taxes are due if the
option is exercised)
• Disadvantages
– Can be costly to S/H: Economic value of a long-lived call
option is enormous
– Resetting exercise price adds to the costs.
13
Problems/Issues with B-S for valuing ESOP
• While using Black-Scholes to value executive stock options
is definitely better than nothing, it is not without problems:
– how to adjust for dividends with long term options
– early exercise/vesting/time to expiry (key point: the executive
is not allowed to sell the option, so it may be best to exercise
before expiry, even in the no-dividend case)
– dilution
– ignores strike resets and other contractual provisions such as
reload features
– ignores the ability of the executive to change parameters
(σ,dividends)
• In 2004, Time Warner reduced its estimate of σ, thereby cutting
its options expense by $72 million, a 28% drop
• In 2004 alone, roughly 200 companies in the Russell 1000 cut
their volatility estimates by an average of 17%
14
Introduction to Real Options
•
•
•
The traditional NPV approach to capital budgeting has been
criticized because it typically ignores the ability of
management to adapt strategically to changing conditions.
When management has a strategic choice to do this, it is
referred to as a real option
In many cases it is possible to use option valuation
techniques to incorporate these types of effects
• Quoting Judy Lewent, CFO, Merck & Co. (Harvard Business
Review, 1994):
Financial theory, properly applied, is critical to managing
in an increasingly complex and risky business climate
. . . Option analysis provides a more flexible approach to
valuing our investments . . .To me all kinds of business
decisions are options.
15
Some Common Examples
• option to defer (e.g. resource extraction)
• time-to-build option (e.g. staged investments in R&D intensive
industries such as pharmaceuticals)
– “Canadian Telecom commits to producing digital switching equipment that is
specially designed for the European market. Although the project has a negative
NPV, management believes that it will position the firm in a rapidly growing,
potentially very profitable market.”
• option to change operating scale (expand, contract, temporarily shut
down)
• option to abandon (permanently shut down and sell off assets)
• option to switch outputs (product flexibility, e.g. Honda builds more
expensive plants but these offer the ability to quickly change the models
being produced)
• option to switch inputs (process flexibility, e.g. in chemical refineries)
16
24.2 Valuing an option to expand using the Black-Scholes model
“Strategic” NPV = Original NPV + Follow-On Call Option
• The underlying asset is the present value of the future cashflows after
expansion
• The strike price is the required future investment
Expected Cashflows
0
Original project w/o
expansion has a NPV
at t 0
t
Exercise the follow-up
opportunity at price X
How to determine S?
Discount the expected cash inflows from follow up investment to time 0 to
obtain the current value (S) of the follow-up opportunity.
17
Example: Option to expand
A firm has considered a 2 year project in a promising area, but
its current NPV = -$45 M. If it takes the project, it will get a
jump on the competition, and will be able to easily proceed
to the next generation of the product in two years.
The NPV of this contingent project in two years is $60M, with
PV of cash inflows of $800 M, and an investment of $740 M
at that time (T=2).
Additional Information:
R f = 9%, σ = 10%, Div = 0, Cost of Capital = 20%.
18
Cont’d
Show using the BS-OPM that the call value = $6.72 m
“Strategic” NPV = Original NPV + Follow-On Call Option
Show using the BS-OPM that if σ = 32%, the call value =
$67.35 M
“Strategic” NPV = Original NPV + Follow-On Call Option =
19
Option to Abandon (Put option)
A firm is making a new investment in a new division that is expected
to have a NPV=+1M. If cash inflows are low at the end of the
first year, the firm plans to abandon the project for an after-tax
cash inflow of $5 M (=X). The present value (at T=0) of the cash
flows expected after year 1 is $6.5M (=S).
Additional Information:
R f = 12%, σ = 55%, Div = 0
Show using the BS-OPM that
“Strategic” NPV = Original NPV + Abandonment Option
20
24.3 Valuing a real option using the binomial option
pricing model
Anthony Meyer is a heating oil distributor. Today, September
1, heating oil sells for $1.00 per gallon. CECO, a large
electric utility, approaches him with the following
proposition. The utility would like to be able to buy a call
option for 6 million gallons of oil from him at $1.05 per
gallon on December 1. CECO will pay $500,000 up front for
the option.
Assume a one-period model. In the period ending Dec 1, the
oil price will be either $1.25 or $0.80. The annual risk-free
interest rate is 8%. Would Anthony accept CECO’s offer?
21
22
Review Question
Retractable bonds allow the investor to redeem the bond at par or
allow the bond to remain outstanding until maturity.
a. These bonds are called puttable bonds, why?
b. What is the underlying asset? What is the exercise price?
c. When will the option be exercised?
d. How about extendables (which give the bond issuer right to
extend the bond)?
23
• Assigned Problems # 23.34—36,
24.1, 5, 6, 7
24
Source: Oracle 2005 proxy statement.
25