

If S>E, then the payoff is 0 (Assume that the exercise price is $30) Payoff Diagram for Put Options Stock Price

Work the Web

24-10 • • • •

Where can we find option prices?

On the Internet , of course! One site that provides option prices is www.Finance.Yahoo.com

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

24-11

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 (i.e., the option’s intrinsic value) If either of these bounds are violated, there is an arbitrage opportunity

24-12

Call Option Bounds

24-13

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

24-14

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

24-15

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

24-16

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

24-17

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

24-18

Factors of Influence

Factor

Current value of the underlying asset

Direction of Influence Calls Puts

+ Exercise price on the option Time to expiration on the option Risk-free rate Variance of return on the underlying asset + + + + + +

24-19

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

24-20

Employee Stock Options

ESO’s are options that are given to employees as part of their benefits packages

24-21

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

24-22

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

24-23

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

24-24

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

24-25

Equity: A Call Option

If the assets are worth retain ownership more than the debt when it comes due, the option will be exercised and the stockholders

24-26

Equity: A Call Option

If the assets are worth bondholders less than the debt, the stockholders will let the option expire and the assets will belong to the

24-27

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

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

24-28

24-29

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

24-30

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

24-31

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 = -5,000 + 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

24-32

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

24-33

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

24-34

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

24-35

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

24-36

Warrant Uniqueness

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”

Convertibles

24-37

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

24-38

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

24-39

Valuing Convertibles

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

24-40

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

24-41

Other Options



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

24-42

Ethics Issues

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?

Quick Quiz

24-43     

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?

24-44

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?

24-45

Terminology

•

Bond

•

Par value (face value)

•

Coupon rate

•

Coupon payment

•

Maturity date

•

Yield or Yield to Maturity (YTM)

24-46

Formulas

C

0

= S

0

– PV(E)

24-47

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

24-48

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.

24-49 What are the most important topics of this chapter?

1.

Put sell and or Call buy the future.

options are contracts to something at a fixed price in 2. Options may happen (exercised) or they may not (expired) based on the value at some specific time.

24-50 What are the most important topics of this chapter?

3. Warrants provide for the purchase of shares of stock at a fixed price in the future.

4. Convertible bonds may become shares of common stock instead of paying the maturity value.

24-51