McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

14
Options and
Corporate Finance
14-1
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
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 Firms
Assets
Options and Capital Budgeting
Options and Corporate Securities
14-3
Option Terminology
Call
Put
Strike or Exercise price
Expiration date
Option premium
Option writer
American Option
European Option

14-4
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
14-5
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

Call Option Payoff
Diagram
0
5
10
15
20
25
0 10 20 30 40 50 60
Stock Price
C
a
l
l

V
a
l
u
e
14-6
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
Payoff Diagram for Put
Options
0
5
10
15
20
25
30
35
0 10 20 30 40 50 60
Stock Price
O
p
t
i
o
n

V
a
l
u
e
14-7
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
14-8
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
14-9
Figure 14.2
14-10
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
14-11
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
14-12
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 dont lose anymore from volatility on the
downside
14-13
Table 14.2
14-14
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 isnt 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
14-15
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 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
14-16
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
14-17
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

14-18
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 = -5,000 + 700/.13 = 384.62
NPV waiting one year = (-5,500 + 800/.13)/(1.13) =
578.62
It is a good project either way, but we should wait
until next year
14-19
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
14-20
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 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
14-21
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 the straight
bond value or the conversion value, whichever
is greater
14-22
Valuing Convertibles
Suppose you have a 10% bond that pays
semiannual 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
14-23
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
14-24
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?
McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14
End of Chapter
14-26
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 exercise 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?