Chapter 24

Options and Corporate Finance

McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

Key Concepts and Skills

• Understand the basics of call and put options• Be able to determine option payoffs and pricing

bounds• Understand the major determinants of option

value• Understand employee stock options• Understand how a firm’s equity can be viewed as

a call option on the firm’s assets• Understand how option valuation can be used to

further evaluate capital budgeting projects• Understand warrants and convertible securities

and how to determine their value

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Option Terminology

• Call• Put• Strike or Exercise price• Expiration date• Option premium• Option writer• American Option• European Option

24-3

Stock Option Quotations

• Look at Table 24.1 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

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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 $30

Call Option Payoff Diagram

0

5

10

15

20

25

0 10 20 30 40 50 60

Stock PriceC

all V

alue

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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 $30

Payoff Diagram for Put Options

05

101520253035

0 10 20 30 40 50 60

Stock PriceO

ptio

n V

alue

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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 (i.e., the option’s intrinsic value)

• If either of these bounds are violated, there is an arbitrage opportunity

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Figure 24.2

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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– C0 = S0 – PV(E)

• If the call is worth something other than this, then there is an arbitrage opportunity

24-9

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

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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 any more from volatility on the downside

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Table 24.2

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Employee Stock Options

• Options that are given to employees as part of their benefits packages

• 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

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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

24-14

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

24-15

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

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Example: Timing Options

• Consider a project that costs $5,000 and has an expected future cash flow of $700 per year forever. If we wait one year, the cost will increase to $5,500 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 = -5,000 + 700/.13 = 384.62– NPV waiting one year = (-5,500 + 800/.13)/(1.13) =

578.62– It is a good project either way, but we should wait until

next year

24-17

Managerial Options• Managers often have options that can add

value after a project has been implemented• 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

24-18

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 warrant 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”

24-19

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 the straight bond value or the conversion value, whichever is greater

24-20

Valuing Convertibles

• Suppose you have a 10% bond that pays semiannual coupons and will mature in 15 years. The face value is $1,000, 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 = 1,081.44– Conversion ratio = 1,000/100 = 10– Conversion value = 10*110 = 1,100– Minimum price = $1,100

24-21

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

24-22

Ethics Issues

• It has been reported that during the internet boom in the late 1990s, technology firms were increasing their earnings by selling put options on their own stock.– When is this practice beneficial for the

firm?– Why do you think this practice was

significantly reduced in the year 2000?– Is there any ethical implication of this

practice?24-23

Comprehensive Problem

• A convertible bond has a straight bond value of $1,050. The conversion ratio is 24, and the stock price is $49 per share. What is the value of the option to convert?

• What is the intrinsic value of a call and a put, each with an exercise price of $40, if the stock price is currently $50?

• What if the stock price is $20?

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End of Chapter

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