© 2003 The McGraw-Hill Companies, Inc. All rights reserved. Options and Corporate Finance Chapter Fourteen

McGraw-Hill/Irwin © 2003 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

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved Chapter Outline Options: The Basics Fundamentals of Option Valuation Valuing a Call Option Employee Stock Options Equity as a Call Option on the Firms Assets Options and Capital Budgeting Options and Corporate Securities

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

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved 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 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 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 dont lose anymore from volatility on the downside

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

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved 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 dont work as well as anticipated due to the lack of diversification introduced into the employees portfolios –The stock just isnt 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 Equity: A Call Option Equity can be viewed as a call option on the companys 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 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 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 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 = /.13 = –NPV waiting one year = ( /.13)/(1.13) = –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 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 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 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 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 = –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 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 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?