1. 14-0 Week 12 Lecture 12 Ross, Westerfield and Jordan 7e Chapter 14 Options and Corporate Finance

2. 14-1 Last Week.. Dividends matter Chronology of dividend payment Ex-dividend Date Dividend Policy doesn’t matter (in theory..) Homemade dividends Clientele effect In real life – policy matters (low/high payouts) Information content effect – signalling to the market Types of dividend policies Stock repurchases, splits, reverse splits

3. 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

4. 14-3 Option Terminology Call option Right without the obligation to buy a specified asset at a specified price on or before a specified date. Put option Right without the obligation to sell a specified asset at a specified price on or before a specified date. Option premium The price paid by the buyer for the right to buy or sell an asset. Strike or Exercise price The contracted price at which the underlying asset can be bought (call) or sold (put).

5. 14-4 Option Terminology Option contract counterparties: buyer and seller An investor who sells the option – the option writer, holds a short position in the contract An investor who buys the option – holds a long position in the contract Expiration date The date at which an option expires. European option An option that can only be exercised on a particular date (on expiry). American option An option that can be exercised at any time up to its expiry date. Exercising the option The act of buying or selling the underlying asset via the option contract.

6. 14-5 Option Contract Characteristics Expiration month Every month is coded A-L for calls and M-X for puts Option type Call or Put Contract size 1 contract is for 100 shares of stock Exercise price Coded multiple prices that increases by $5 Open Interest The number of contracts outstanding

7. 14-6 Option Quote - Intel Corp. (INTC)

8. 14-7 Option Valuation S T = share price at expiration S 0 = share price today C or P= value of call/put option on expiration C 0 or P 0 = value of call/put option today E = exercise price on the option

9. 14-8 Value of Option At the money: stock price equals exercise price Out-of-the-money option has no intrinsic value In-the-money option has intrinsic value Intrinsic value the value of the option if exercised it immediately - Call: stock price – exercise price > 0 - Put: exercise price – stock price > 0 The time premium or time value component the difference between the option premium and the intrinsic value

10. 14-9 Share price (S 0 ) Call option value (C 0 ) S 0  E Out of the money S 0 > E In the money Exercise price (E) S 0 = E At the money 45 ° Value of Call Option (C 0 ) Value of Call Intrinsic Value Time value

11. 14-10 Value of Call and Put Option at Expiry (C & P) At time T: If the call is in-the-money, it is worth: C = S T – E. If the call is out-of-the-money, it is worthless: C = 0 If the put is in-the-money, it is worth: P = E – S T. If the put is out-of-the-money, it is worthless: P = 0 Where S T is the value of the stock at expiry (time T) E is the exercise price. C is the value of the call option at expiry P is the value of put option at expiry

12. 14-11 Call Option Payoffs – for Buyer –20 120 204060 80 100 –40 20 40 60 Stock price ($) Call payoff ($) Buy a call Exercise price: E = $50 If share at expiration: S T = $80, S T = $20 Buyer payoff: S T – E = 80 – 50 = $30 S T – E = 20 – 50 = -$30 50

13. 14-12 Call Option Payoffs - for Seller –20 120 204060 80 100 –40 20 40 60 Stock price ($) Option Payoff ($) Sell a call 50 Exercise price: E = $50 If share at expiration: S T = $80, S T = $20 Seller payoff: 50 – 80 = -$30 50 – 20 = $30

14. 14-13 Call Option Profits/Losses Exercise price: E =$50 Option premium: C 0 = $10 If S T = $80 Sell a call Loss = +10 +50-80 = -20 Buy a call Profit = -10 -50 + 80 = 20 –20 120 204060 80 100 –40 20 40 60 Stock price ($) Option payoffs ($) 50 –10 10

15. 14-14 Put Option Payoffs - for Buyer –20 0204060 80 100 –40 20 0 40 60 Stock price ($) Option payoffs ($) Buy a put 50 Exercise price: E = $50 If share at expiration: S T = $20, S T = $80 Buyer payoff: E - S T = 50 – 20 = $30 E - S T = 50 – 80 = -$30

16. 14-15 Put Option Payoffs - for Seller –20 0204060 80 100 –40 20 0 40 –50 Stock price ($) Option payoffs ($) Sell a put 50 Exercise price: E = $50 If share at expiration: S T = $20, S T = $80 Seller payoff: 20 – 50 = -$30 50 – 20 = $30

17. 14-16 Put Option Profits –20 204060 80 100 –40 20 40 60 Stock price ($) Option payoffs ($) Buy a put Profit = -10 - 20 + 50 = 20 Exercise price: E = $50 Option premium: P 0 = $10 If S T = $20 –10 10 Sell a put Loss = +10 + 20 – 50 = -20 50

18. 14-17 Valuing a Call (1) If a call option is sure to finish in-the-money (S T -E)>0, the option value today would be: C 0 = S 0 – PV(E) C 1 = S T - E C 0 = Stock value – Present value of Exercise Price Example: S 0 = $100 E = $105 Rf = 20% S 1 = $110 or $130 C 1 = $5 or $25 C 0 = ???? C0C0 S0EStStS0EStSt 100105110130 C0C0 S0EStStS0EStSt

19. 14-18 Valuing a Call (2) In one year the payoff of owning the stock must equal the payoff of taking the option Stock value = Call Value + Exercise Price S 1 = C 1 + E $110 = $5 +$105 $130 = $25+$105 Today, the same relationship must hold: S 0 = C 0 +E/(1+Rf) t $100 = C 0 + $105/(1.20) $100 = C 0 + $87.50 C 0 = $12.50

20. 14-19 Valuing a Call (3) If a call option can finish out of the money (S T – E) ≤ 0, what would be the value of the option today? Example: S U = $130 S 0 = $100 S 1 S D = $110 R f = 20% C U = $10 (130-120) E = $120 C 1 C D = 0 (110-120) C0 = ??? C0C0 S 0 S D E S U 100 110 120 130

21. 14-20 Valuing a Call (4) Payoff of owning the stock = payoff of taking the option and investing some money at the risk free rate out of the money in the money S 1D = S D + C D S 1U = S D + 2*C U 110 = 110 + 0 130 = 110 + 2*10 Same relationship must hold today: The value of stock today = value of calls today +PV of lowest price 100 = n c *C 0 +110/1.2 n c = (130-110)/(10-0) = 2 100 = 2*C 0 + 110/1.2 100 = 2*C 0 + 91.67 C 0 = $4.17

22. 14-21 Factors that Determine Option Value

23. 14-22 Employee Stock Options (ESO) Call options that give employees the right to buy stock in the company Given as part of their benefits package and are used as a bonus or incentive Designed to align employee interests with stockholder interests and reduce agency problems Cannot be traded Cannot be exercised before a certain date

24. 14-23 If the firm Value (Assets) = Debt + Equity The exercise price of the call option is the loan amount to be repaid (like E) and the value of the firm is the underlying asset (like S T ) Treat shareholders as having bought a call option on the value of the firm If the assets > debt, equivalent to S T > E Call is in-the-money, option will be exercised Shareholders retain ownership. Treat bondholders as having written a call option on the value of the firm If the assets < debt, equivalent to S T < E Call is out-of-the-money, the shareholders let the option expire Assets will belong to the bondholders. Equity: A Call Option

25. 14-24 Equity as Call Option: Example (1) Suppose firm has debt with face value $1000 due in 1 year. Value of firm now is $950, and in 1 yr will be either $800 or $1200. Risk-free rate is 12.5%. What is the value of equity and (risky) debt? Value of firm now = S 0 = $950R f = 12.5% Value of debt in 1yr = E = $1000 S U = $1200 Value of firm in 1 year or S D = $800 C U = $200 (1200 -1000) Value of Call in 1 year = Equity or C D = 0 (800 -1000) C 0 = ?? Equity today = ? Debt today = ?

26. 14-25 Equity as Call Option: Example (2) At expiry in year 1: 1200 = n c *200 + 800 Today in year 0: $950 = 2*C 0 + 800/1.125 C 0 = $119.44 C 0 = $119.44 means that value of equity today is $119.44. If Value of firm today = $950 Value of Equity today = $119.44 Value of Debt today = $950 - $119.44 = $830.56

27. 14-26 Capital Budgeting Options Almost all capital budgeting scenarios contain implicit options A proposed project = A real option Such options are valuable Make the capital budgeting project worth more than it may appear Failure to account for these options can cause firms to reject good projects Examples: Timing Options Options to Expand Options to Abandon

28. 14-27 Timing Options With standard NPV we normally assume that a project must be taken today or forgone completely Option to wait = the fact that we don’t have to take the project now 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 Value of Option to wait = NPV future – NPV now

29. 14-28 Options to Expand/Abandon Managers often have options even after a project has been implemented Contingency planning – looking ahead to determine what will cause the options to be exercised 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 reduce operations Strategic options – look at how taking this project opens up other opportunities that would be otherwise unavailable

30. 14-29 Warrants Warrants are similar to call options and give the holder the right, but not the obligation, to buy shares of common stock directly from a company at a fixed price for a given period of time. Warrants tend to have longer maturity periods than exchange traded options Warrants are generally issued attached to privately placed bonds as an “equity kicker” or “sweeteners”.

31. 14-30 The Difference Between Warrants and Call Options Call options are written by individuals whereas warrants are issued by firms. When a call option is exercised, one investor buys from another investor. When a warrant is exercised, the firm must issue new shares of stock. This can have the effect of diluting the claims of existing shareholders.

32. 14-31 Conclusion Options are valuable financial instruments Increases upside potential Reduces or limits the downside Provide greater flexibility in capital budgeting decisions

33. 14-32 End Chapter 14