Options and Corporate Finance

1
Chapter 14

• Options and Corporate Finance

2
Key Concepts and Skills

• Understand the options terminology
• Be able to determine option payoffs
• Understand the determinants of option value
• Understand the differences between warrants and
  traditional call options
• Understand convertible securities

3
Option Terminology

• Call
• Put
• Strike or Exercise price
• Expiration date

• Option writer
• Option premium
• American option
• European option

4
Stock Option Quotations

• Prices are higher for options with the same
  strike price but longer expirations
• Call options with E lt P0 are worth more than the
  corresponding put
• Call options with E gt P0 are worth less than the
  corresponding puts

5
Options

• Options rely on parties with opposing opinions
  regarding the future price of an asset
• To write a call you must believe that the price
  of the stock is going to go down
• To purchase a call you must believe that the
  price of the stock is going to go up

6
Option Payoffs - Calls

• Assume that E 35
• S stock price
• The value of the call at expiration is the
  intrinsic value
• Range (0, E-S)
• If SltE, payoff 0
• If SgtE, payoff S - E

7
Option Payoffs - Puts

• Assume that E 35
• S stock price
• The value of the put at expiration is the
  intrinsic value
• Range (0, E-S)
• If SltE, payoff E -S
• If SgtE, payoff 0

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
• S - E or 0 lt Call price lt S

9
Figure 14.2
Upper bound C0 lt S0
Lower bound C0 gt0 C0gt S0 - E
Call price (C0)
Option value
Stock price (S0)
E
The curve represents the value of a call option
prior to maturity for different stock prices
10
More Option Terminology

• In the money
• Out of the money
• If a call option is sure to finish in the money,
  then the option value would be
• C0 S0 PV(E)
• If the call is worth something other than this,
  there is an arbitrage opportunity

11
Gains and Losses

• In-the-money
• Calls - S gt E
• Puts - S lt E
• Your gain S - E less the premium paid for the
  option

• Out-of-the-money
• Calls - S lt E
• Puts - S gt E
• It would not be profitable to exercise the option
• Your loss premium paid for the option

12
What Determines Option Values?

• Stock price
• As S0 increases, the call price increase and put
  price decreases
• Exercise price
• As E increases, the call price decreases and the
  put price increases
• Time to expiration
• 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

13
Variance and Option Prices

• When an option may finish out-of-the-money, the
  variance helps determine its price
• The greater the variance, the more the call and
  the put are worth
• The most you can lose is your premium
• The more an option is in-the-money, the greater
  the gain
• You gain from the volatility on the upside, but
  you do not lose on the downside

14
Table 14.2 Factors Affecting Option Value
15
How are Options Used?

• Employee Stock Options
• Benefits packages, bonuses or incentives
• Capital Budgeting Options
• Timing of new project investments
• Managerial Options
• Options after project implementation
• Expand if a project goes well
• Contract if the project goes poorly

16
Warrants

• A call option issued by corporations in
  conjunction with other securities to reduce the
  yield
• Warrants are generally very long term
• Written by the company and exercise results in
  additional shares outstanding
• Exercise price is paid to the company and
  generates cash for the firm
• Warrants can be detached from the original
  securities and sold separately

17
Convertibles

• Bondholder can convert bonds (or preferred stock)
  into a specified number of common shares
• Conversion price is the effective price paid for
  the stock
• Conversion ratio is the number of shares received
  when the bond is converted
• Convertible bonds are worth at least as much as
  the straight bond value or the conversion value,
  whatever is greater

18
Valuing Convertibles

• You have a 15 year, 10 bond that pays semiannual
  coupons. The face value is 1000 and the YTM on
  similar bonds is 9. The bond is 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 FV 1000, N 30, PMT 50, I/Y
  4.5, CPT PV
• Conversion ratio 1000/100 10
• Conversion value 10 110 1100
• Minimum price 1100

19
Other Options

• Call provision on a bond
• Companies can repurchase bonds prior to maturity
  at a specified price that is generally higher
  than face value
• Put bond
• Insurance and Loan Guarantees

20
Quick Quiz

• What is the difference between a call option and
  a put option?
• What is the payoff with a call? A put?
• What are the determinants of option prices?
• How would you value a convertible bond?