© Prentice Hall, Chapter 7 Options and Corporate Finance Shapiro and Balbirer: Modern Corporate Finance: A Multidisciplinary Approach to Value Creation Graphics by Peeradej Supmonchai

© Prentice Hall, Learning Objectives è Explain the distinction between different types of options. è Identify the factors that influence an option’s value and describe how changes in these factors can influence the value of an option. è Indicate how options may be embedded in investment decisions and why management flexibility may be considered an option. è Describe the ways in which a company’s common stock and a call option are similar. è Indicate how option pricing theory can help us understand complex securities like convertible debt. è Use option pricing theory to describe the agency’s conflicts between stockholders and creditors.

© Prentice Hall, Option Terminology è Option is the right, but not the obligation, to buy or sell any asset at a set price at some future date. èRight to buy is a call option èRight to sell is a put option è Premium - Amount paid for the option privilege è Exercise, or Strike Price - Price at which the option can be exercised è Long - a position in which one has bought options è Short - a position in which one has sold options

© Prentice Hall, Option Terminology (Cont.) è Profit if exercised at current price èIn-the-money option èAt-the-money option èOut-of-the-money option è Exercise timing èEuropean option èAmerican option

© Prentice Hall, Payoffs From a European Call Option Payoff Stock Price 2528 Call Premium of $3 40

© Prentice Hall, Mathematical Representation of a European Call Option Where: C = the value of call options max = the maximum of (S  X) and 0 S = the selling price of underlining assets X = the exercise price of options

© Prentice Hall, Payoff From a European Put Option Payoff Put Premium of $2 Stock Price

© Prentice Hall, Mathematical Representation of a European Put Option Where: P = the value of put options max = the maximum of (X-S) and 0 S = the selling price of underlining assets X= the exercise price of options

© Prentice Hall, Black-Scholes Option Pricing Model Where: C(t) = the value of a call option t = the time until the option expires S = the current price of the stock X = the exercise ( or strike) price of the option r = the continuously compounded risk-free rate of interest N(d) = the value of a probability density function in which the probability of a normally-distributed random variable taking on a value is less than d.

© Prentice Hall, Call Option Valuation VARIABLE INCREASES OPTION VALUE Stock Price Volatility Increases Time to Expiration Increases Exercise Price Decreases Current Stock Price Increases Risk-Free Interest Rate Increases

© Prentice Hall, Option Values and Stock Prices for Various Expiration Times Option Value X Y Z 45° 1 year 5 years 10 years Stock Price(s)

© Prentice Hall, Option Valuation and Investment Decisions è Potential Plant Expansion è R&D as an option è Project Abandonment

© Prentice Hall, Common Stock as a Call Option - An Example Suppose that Greene Products has borrowed $2 million that must be repaid next year. At this time, Greene’s owners must decide whether to repay the debt. How would they make that decision?

© Prentice Hall, Payoffs to Greene’s Stockholders Payoffs to Stockholders $2,000 45º 0 Market Value of the Firm’s Asset

© Prentice Hall, Payoffs to Greene’s Bondholders Market Value of the Firm’s Asset Payoffs to Stockholders

© Prentice Hall, Solutions to Agency Problems - Insights From Option Pricing Theory è Stockholder - Creditor Conflicts èCovenants in Bond Contracts èUse of Convertible Debt è Owner - Manager Conflicts èUse of Stock Options