1. OPTIONS AND CORPORATE SECURITIES Chapter 25

2. Chapter Outline Options: The Basics Option Payoffs Employee Stock Options Equity as a Call Option on the Firm’s Assets Warrants Convertible Bonds Reasons For Issuing Warrants and Convertibles Other Options 1

3. Options: The Basics Put option – the right to sell some asset Call option – the right to buy some asset American vs. European options 2 Option – a contract that gives its owner the right to buy or sell some asset at a fixed price on or before a given date

4. Option Payoffs – Calls The value of the call at expiration is the intrinsic value ◦ C 1 = Max(0, S 1 - E) ◦ If S 1 <E, then the payoff is 0 ◦ If S 1 >E, then the payoff is S 1 – E Assume that the exercise price is $35 3

5. Option Payoffs - Puts The value of a put at expiration is the intrinsic value ◦ P 1 = Max (0, E – S 1 ) ◦ If S 1 <E, then the payoff is E-S 1 ◦ If S 1 >E, then the payoff is 0 Assume that the exercise price is $35 4

6. 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 just isn’t worth as much to the employee as it is to an outside investor 5

7. 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 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 6

8. Warrants A security that gives the holder the right to purchase shares of stock at a fixed price over a given period of time It is a call option issued by corporations in conjunction with other securities to reduce the yield Usually included with a new debt or preferred shares issue as a sweetener or equity kicker 7

9. 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 8

10. Convertibles Convertible bonds (or preferred stock) may be converted into a specified number of common shares at the option of the security holder 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 9

11. Minimum value of a convertible bond versus the value of the stock for a given interest rate 10

12. Valuing Convertibles Suppose you have a 10% bond that pays semi- annual 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 ◦ Conversion ratio ◦ Conversion value ◦ Minimum price 11

13. Reasons for Issuing Warrants and Convertibles They allow companies to issue cheap bonds by attaching sweeteners to the new bond issue. Coupon rates can then be set at below market rate for straight bonds They give companies the chance to issue common stock in the future at a premium over current prices 12

14. The case for and against convertibles 13

15. 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 ◦ Gives the bondholder the right to require the company to repurchase the bond prior to maturity at a fixed price 14

16. Other Options continued Over allotment option ◦ Underwriters have the right to purchase additional shares from a firm in an IPO Insurance and Loan Guarantees ◦ These are essentially put options Managerial options 15