Chapter 24 Fundamentals of Corporate Finance Fourth Edition Options Slides by Matthew Will Irwin/McGraw Hill Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved

24- 2 Irwin/McGraw Hill Topics Covered  Calls and Puts  What Determines Option Values  Spotting the Option

Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Irwin/McGraw Hill Option Terminology Put Option Right to sell an asset at a specified exercise price on or before the exercise date. Call Option Right to buy an asset at a specified exercise price on or before the exercise date.

Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Irwin/McGraw Hill Option Obligations

Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Irwin/McGraw Hill Option Value  The value of an option at expiration is a function of the stock price and the exercise price. Example - Option values given a exercise price of $55

Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Irwin/McGraw Hill Option Value Call option value (graphic) given a $55 exercise price. Share Price Call option value $10

Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Irwin/McGraw Hill Option Value Put option value (graphic) given a $55 exercise price. Share Price Put option value $10

Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Irwin/McGraw Hill Option Value Call option payoff (to seller) given a $55 exercise price. Share Price Call option $ payoff 55

Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Irwin/McGraw Hill Option Value Put option payoff (to seller) given a $55 exercise price. Share Price Put option $ payoff 55

Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Irwin/McGraw Hill Option Value Components of the Option Price 1 - Underlying stock price 2 - Striking or Exercise price 3 - Volatility of the stock returns (standard deviation of annual returns) 4 - Time to option expiration 5 - Time value of money (discount rate)

Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Irwin/McGraw Hill Option Value Black-Scholes Option Pricing Model O C = P s [N(d 1 )] - S[N(d 2 )]e -rt

Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Irwin/McGraw Hill WSJ Options (9/29/03)  How to Value a Call Option OPTION AMD STRIKEEXPCALL VOL CALL LAST PUT VOL PUT LAST Oct Jan Jan

Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Irwin/McGraw Hill Options on Real Assets Real Options - Options embedded in real assets

Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Irwin/McGraw Hill Options on Real Assets Real Options - Options embedded in real assets Option to Expand Option to Abandon

Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Irwin/McGraw Hill Option to Expand  Technique  Start Pilot Project  Plan to invest if pilot project is successful Example: Pilot project involves the LEGAL sale and distribution of a new software enabling copying of copyright protected music and video CD’s Initial Investment for Pilot = $200,000 PV of Anticipated Profits over 1 year: = $150,000 What is NPV? But provides an option to expand if successful. In particular

Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Irwin/McGraw Hill Project Expansion  Initial Investment $8 million  PV of Anticipated Cash Flow = 40 times pilot project Cash Flows (PV) + $1 million  That is present value is: 40*150, = $7 million  Should you undertake the project?  Returns on Pilot Project has a standard deviation of $25,000 so standard deviation of the Full blown project is ~~ $200,000 =.20  Should the Project be undertaken?

Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Irwin/McGraw Hill Financials  NPV of full-blown option?  But Note that if the project ends up generating cash flow of more than $8 million we get a positive NPV, but if less we get zero. That is, do not invest the $8 million. What is the value of this option?

Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Irwin/McGraw Hill  Option Value Exercise price = $8 million  Current “Price” = $7 million

Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Irwin/McGraw Hill Options on Financial Assets Warrants - Right to buy shares from a company at a stipulated price before a set date. Convertible Bond - Bond that the holder may exchange for a specific number of shares. Callable Bond - Bond that may be repurchased by the issuer before maturity at specified call price.

Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Irwin/McGraw Hill Calculate the Option value  Go to 

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