Chapter 14 Options and Corporate Finance Mc GrawHillIrwin

Chapter 14 • Options and Corporate Finance Mc. Graw-Hill/Irwin Copyright © 2006 by The Mc. Graw-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 1

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 2

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

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 4

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 5

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 6

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 7

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 8

Figure 14. 2 9

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-themoney, 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 10

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 11

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 anymore from volatility on the downside 12

Table 14. 2 13

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 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 14

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 15

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 16

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 17

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 will increase to $800. If the required return is 13%, should we accept the project? If so, when should we begin? • NPV starting today = -5000 + 700/. 13 = 384. 62 • NPV waiting one year = (-5500 + 800/. 13)/(1. 13) = 578. 62 • It is a good project either way, but we should wait until next year 18

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 19

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 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” 20

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 21

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 = 1081. 44 Conversion ratio = 1000/100 = 10 Conversion value = 10*110 = 1100 Minimum price = $1100 22

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 23

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? 24

Chapter 14 • End of Chapter Mc. Graw-Hill/Irwin Copyright © 2006 by The Mc. Graw-Hill Companies, Inc. All rights reserved.