1. Options and Corporate Finance
Chapter 24
Options and
Corporate Finance
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

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

3. 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. Option Terminology Call Put Strike or Exercise price Expiration date
Option premium
Option writer
American Option
European Option

5. 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

6. Stock Option Quotations
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

7. 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

8. 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)
24-8

9. Option Payoffs - Puts Max(0, E-S) If S<E, then the payoff is E-S
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)
24-9

10. Work the Web Where can we find option prices?
On the Internet, of course!
One site that provides option prices is
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

11. Call Option Bounds Upper bound Lower 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

12. Call Option Bounds

13. A Simple Model C0 = S0 – PV(E)
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

14. 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

15. What Determines Option Values?
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

16. 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

17. What about Variance?
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 doesn’t lose any more from volatility on the downside

18. Factors of Influence Factor Direction of Influence Calls Puts
Current value of the underlying asset + -
Exercise price on the option
Time to expiration on the option
Risk-free rate
Variance of return on the underlying asset

19. 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

20. Employee Stock Options
ESO’s are options that are given to employees as part of their benefits packages

21. Employee Stock Options
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

22. Employee Stock Options
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

23. 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

24. 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

25. Equity: A Call Option
If the assets are worth more than the debt when it comes due, the option will be exercised and the stockholders retain ownership

26. Equity: A Call Option
If the assets are worth less than the debt, the stockholders will let the option expire and the assets will belong to the bondholders

27. 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

28. 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

29. Timing Options A good project may be worth more if we wait
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

30. Timing Options
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

31. 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, /.13 = $384.62
NPV waiting one year = (-5, /.13)/(1.13) = $578.62
It is a good project either way, but we should wait until next year

32. 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

33. Managerial Option Examples
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

34. 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

35. Warrants
Definition: A warrant is a call option issued by corporations in conjunction with other securities to reduce the yield required on the other securities

36. Warrant Uniqueness Warrants are generally very long term
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”

37. Convertibles
Convertible bonds (or preferred stock) may be converted into a specified number of common shares at the option of the bondholder

38. Convertibles
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

39. Valuing Convertibles Straight bond value = $1,081.44
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 = $1,081.44
Conversion ratio = 1,000/100 = 10
Conversion value = 10*110 = $1,100
Minimum price = $1,100

40. 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

41. Other Options Put bond Insurance and Loan Guarantees
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

42. Ethics Issues When is this practice beneficial for the firm?
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?

43. 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?

44. 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?

45. Terminology Bond Par value (face value) Coupon rate Coupon payment
Maturity date
Yield or Yield to Maturity (YTM)

46. Formulas
C0 = S0 – PV(E)

47. Key Concepts and Skills
Differentiate between
put and call options.
Determine option payoffs
and pricing bounds
Explain how options are valued
Describe why companies
offer stock options to new employees

48. Key Concepts and Skills
Describe how a firm’s
equity can be viewed
as a call option on the
firm’s assets.
Explain how option valuation
can be used in capital budgeting
Identify the determinants of warrant and convertible valuation.

49. What are the most important topics of this chapter?
Put and Call options are contracts to sell or buy something at a fixed price in the future.
Options may happen (exercised) or they may not (expired) based on the value at some specific time.

50. What are the most important topics of this chapter?
Warrants provide for the purchase of shares of stock at a fixed price in the future.
Convertible bonds may become shares of common stock instead of paying the maturity value.

51. Questions?