14-1

Week 12

Lecture 12

Ross, Westerfield and Jordan 7e

Chapter 14

Options and Corporate Finance

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Last Week..

• Dividends matter• Chronology of dividend payment

• Ex-dividend Date

• Dividend Policy doesn’t matter (in theory..)• Homemade dividends• Clientele effect• In real life – policy matters (low/high payouts)

• Information content effect – signalling to the market

• Types of dividend policies• Stock repurchases, splits, reverse splits

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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

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Option Terminology

• Call option• Right without the obligation to buy a specified asset at

a specified price on or before a specified date.

• Put option• Right without the obligation to sell a specified asset at

a specified price on or before a specified date.

• Option premium• The price paid by the buyer for the right to buy or sell

an asset.

• Strike or Exercise price• The contracted price at which the underlying asset can

be bought (call) or sold (put).

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Option Terminology• Option contract counterparties: buyer and seller

• An investor who sells the option – the option writer, holds a short position in the contract

• An investor who buys the option – holds a long position in the contract

• Expiration date• The date at which an option expires.

• European option• An option that can only be exercised on a particular date (on

expiry).• American option

• An option that can be exercised at any time up to its expiry date.

• Exercising the option• The act of buying or selling the underlying asset via the option

contract.

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Option Contract Characteristics

• Expiration month• Every month is coded A-L for calls and M-X for puts

• Option type• Call or Put

• Contract size• 1 contract is for 100 shares of stock

• Exercise price• Coded multiple prices that increases by $5

• Open Interest• The number of contracts outstanding

14-7

Option Quote - Intel Corp. (INTC)

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Option Valuation

• ST = share price at expiration

• S0 = share price today

• C or P= value of call/put option on expiration

• C0 or P0 = value of call/put option today

• E = exercise price on the option

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Value of Option

• At the money:• stock price equals exercise price

• Out-of-the-money• option has no intrinsic value

• In-the-money• option has intrinsic value

• Intrinsic value • the value of the option if exercised it immediately - Call: stock price – exercise price > 0

- Put: exercise price – stock price > 0

• The time premium or time value component • the difference between the option premium and the

intrinsic value

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Share price (S0)

Call option value (C0)

S0 EOut of the money

S0 > EIn the money

Exercise price (E) S0 = E At the money

45 °

Value of Call Option (C0)

Value of Call

Intrinsic ValueTime value

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Value of Call and Put Option at Expiry (C & P)

• At time T:• If the call is in-the-money, it is worth: C = ST – E.• If the call is out-of-the-money, it is worthless: C = 0

• If the put is in-the-money, it is worth: P = E – ST.• If the put is out-of-the-money, it is worthless: P = 0

Where

ST is the value of the stock at expiry (time T)E is the exercise price.C is the value of the call option at expiryP is the value of put option at expiry

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Call Option Payoffs – for Buyer

–20

12020 40 60 80 100

–40

20

40

60

Stock price ($)

Cal

l p

ayo

ff (

$)

Buy a

cal

l

Exercise price: E = $50

If share at expiration: ST = $80, ST = $20

Buyer payoff: ST – E = 80 – 50 = $30 ST – E = 20 – 50 = -$30

50

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Call Option Payoffs - for Seller

–20

12020 40 60 80 100

–40

20

40

60

Stock price ($)

Op

tio

n P

ayo

ff (

$)

Sell a call

50

Exercise price: E = $50

If share at expiration: ST = $80, ST = $20

Seller payoff: 50 – 80 = -$30 50 – 20 = $30

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Call Option Profits/Losses

Exercise price: E =$50 Option premium: C0 = $10If ST = $80

Sell a callLoss = +10 +50-80 = -20

Buy a callProfit = -10 -50 + 80 = 20

–20

12020 40 60 80 100

–40

20

40

60

Stock price ($)

Op

tio

n p

ayo

ffs

($)

50–10

10

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Put Option Payoffs - for Buyer

–20

0 20 40 60 80 100

–40

20

0

40

60

Stock price ($)

Op

tio

n p

ayo

ffs

($)

Buy a put

50

50

Exercise price: E = $50

If share at expiration: ST = $20, ST = $80

Buyer payoff: E - ST = 50 – 20 = $30 E - ST = 50 – 80 = -$30

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Put Option Payoffs - for Seller

–20

0 20 40 60 80 100

–40

20

0

40

–50

Stock price ($)Op

tio

n p

ayo

ffs

($)

Sell a put

50

Exercise price: E = $50

If share at expiration: ST = $20, ST = $80

Seller payoff: 20 – 50 = -$30 50 – 20 = $30

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Put Option Profits

–20

20 40 60 80 100

–40

20

40

60

Stock price ($)

Op

tio

n p

ayo

ffs

($)

Buy a putProfit = -10 - 20 + 50 = 20

Exercise price: E = $50Option premium: P0 = $10If ST = $20

–10

10

Sell a putLoss = +10 + 20 – 50 = -20

50

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Valuing a Call (1)

• If a call option is sure to finish in-the-money (ST-E)>0, the option value today would be:

• C0 = S0 – PV(E) C1 = ST - E

• C0 = Stock value – Present value of Exercise Price

• Example:• S0 = $100

• E = $105• Rf = 20%

• S1 = $110 or $130

• C1 = $5 or $25

• C0 = ????

C0

S0 E St St

100 105 110 130

C0

S0 E St St

100 105 110 130

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Valuing a Call (2)

• In one year the payoff of owning the stock must equal the payoff of taking the option

Stock value = Call Value + Exercise Price

S1 = C1 + E $110 = $5 +$105 $130 = $25+$105• Today, the same relationship must hold:

S0 = C0+E/(1+Rf)t

$100 = C0 + $105/(1.20)

$100 = C0 + $87.50

C0 = $12.50

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Valuing a Call (3)

• If a call option can finish out of the money (ST – E) ≤ 0, what would be the value of the option today?

Example: SU = $130

S0 = $100 S1 SD = $110

Rf = 20% CU = $10 (130-120)

E = $120 C1 CD = 0 (110-120)

C0 = ???

C0

S0 SD E SU

100 110 120 130

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Valuing a Call (4)

• Payoff of owning the stock = payoff of taking the option and investing some money at the risk free rate

out of the money in the money

S1D = SD + CD S1U = SD + 2*CU

110 = 110 + 0 130 = 110 + 2*10 • Same relationship must hold today:

• The value of stock today = value of calls today +PV of lowest price

100 = nc*C0 +110/1.2 nc = (130-110)/(10-0) = 2

100 = 2*C0 + 110/1.2

100 = 2*C0 + 91.67

C0 = $4.17

DU

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SCn S

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Factors that Determine Option Value

Current value of the underlying asset (+) ( )

Exercise price on the option ( ) (+)

Time to expiration on the option (+) (+)

Risk-free rate (+) ( )

Variance of return on underlying asset (+) (+)

Factor Calls Puts

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Employee Stock Options (ESO)

• Call options that give employees the right to buy stock in the company

• Given as part of their benefits package and are used as a bonus or incentive• Designed to align employee interests with

stockholder interests and reduce agency problems

• Cannot be traded• Cannot be exercised before a certain date

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• If the firm Value (Assets) = Debt + Equity• The exercise price of the call option is the loan

amount to be repaid (like E) and the value of the firm is the underlying asset (like ST)

• Treat shareholders as having bought a call option on the value of the firm• If the assets > debt, equivalent to ST > E• Call is in-the-money, option will be exercised • Shareholders retain ownership.

• Treat bondholders as having written a call option on the value of the firm• If the assets < debt, equivalent to ST < E• Call is out-of-the-money, the shareholders let the option expire• Assets will belong to the bondholders.

Equity: A Call Option

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Equity as Call Option: Example (1)

• Suppose firm has debt with face value $1000 due in 1 year. Value of firm now is $950, and in 1 yr will be either $800 or $1200. Risk-free rate is 12.5%. What is the value of equity and (risky) debt?

• Value of firm now = S0 = $950 Rf = 12.5%

• Value of debt in 1yr = E = $1000

SU = $1200

• Value of firm in 1 year or

SD = $800

CU = $200 (1200 -1000)

• Value of Call in 1 year = Equity or

CD = 0 (800 -1000)

• C0 = ??

• Equity today = ? Debt today = ?

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Equity as Call Option: Example (2)

• At expiry in year 1:• 1200 = nc*200 + 800

• Today in year 0:• $950 = 2*C0 + 800/1.125

• C0 = $119.44

• C0 = $119.44 means that value of equity today is $119.44.

• If Value of firm today = $950 • Value of Equity today = $119.44• Value of Debt today = $950 - $119.44 = $830.56

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Capital Budgeting Options

• Almost all capital budgeting scenarios contain implicit options

• A proposed project = A real option • Such options are valuable

• Make the capital budgeting project worth more than it may appear

• Failure to account for these options can cause firms to reject good projects

• Examples:• Timing Options• Options to Expand• Options to Abandon

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Timing Options

• With standard NPV we normally assume that a project

must be taken today or forgone completely

• Option to wait = the fact that we don’t have to take the

project now• 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

• Value of Option to wait = NPV future – NPV now

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Options to Expand/Abandon

• Managers often have options even after a project has been implemented

• Contingency planning – looking ahead to determine what will cause the options to be exercised

• 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 reduce operations• Strategic options – look at how taking this project

opens up other opportunities that would be otherwise unavailable

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Warrants

• Warrants are similar to call options and give the holder the right, but not the obligation, to buy shares of common stock directly from a company at a fixed price for a given period of time.

• Warrants tend to have longer maturity periods than exchange traded options

• Warrants are generally issued attached to privately placed bonds as an “equity kicker” or “sweeteners”.

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The Difference Between Warrants and Call Options

• Call options are written by individuals whereas warrants are issued by firms.

• When a call option is exercised, one investor buys from another investor.

• When a warrant is exercised, the firm must issue new shares of stock.

• This can have the effect of diluting the claims of existing shareholders.

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Conclusion

• Options are valuable financial instruments

• Increases upside potential

• Reduces or limits the downside

• Provide greater flexibility in capital budgeting decisions

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End Chapter 14