1. McGraw-Hill/Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 22-0 Corporate Finance Ross  Westerfield  Jaffe Seventh Edition 22 Chapter Twenty Two Options and Corporate Finance: Basic Concepts

2. McGraw-Hill/Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 22-1 Chapter Outline Options Call Options Put Options The Put-Call Parity Stocks and Bonds as Options Summary and Conclusions

3. McGraw-Hill/Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 22-2 22.1 Options Many corporate securities are similar to the stock options that are traded on organized exchanges. Almost every issue of corporate stocks and bonds has option features. In addition, capital structure and capital budgeting decisions can be viewed in terms of options.

4. McGraw-Hill/Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 22-3 22.1 Options Contracts: Preliminaries An option gives the holder the right, but not the obligation, to buy or sell a given quantity of an asset on (or perhaps before) a given date, at prices agreed upon today. Calls versus Puts –Call options gives the holder the right, but not the obligation, to buy a given quantity of some asset at some time in the future, at prices agreed upon today. When exercising a call option, you “call in” the asset. –Put options gives the holder the right, but not the obligation, to sell a given quantity of an asset at some time in the future, at prices agreed upon today. When exercising a put, you “put” the asset to someone.

5. McGraw-Hill/Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 22-4 Options Contracts: Preliminaries Exercising the Option –The act of buying or selling the underlying asset through the option contract. Strike Price or Exercise Price –Refers to the fixed price in the option contract at which the holder can buy or sell the underlying asset. Expiry –The maturity date of the option is referred to as the expiration date, or the expiry. European versus American options –European options can be exercised only at expiry. –American options can be exercised at any time up to expiry.

6. McGraw-Hill/Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 22-5 Options Contracts: Preliminaries In-the-Money –The exercise price is less than the spot price of the underlying asset. At-the-Money –The exercise price is equal to the spot price of the underlying asset. Out-of-the-Money –The exercise price is more than the spot price of the underlying asset.

7. McGraw-Hill/Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 22-6 Basic Call Option Pricing Relationships at Expiry At expiry, an American call option is worth the same as a European option with the same characteristics. –If the call is in-the-money, it is worth S T – E. –If the call is out-of-the-money, it is worthless: C = Max[S T – E, 0] Where S T is the value of the stock at expiry (time T) E is the exercise price. C is the value of the call option at expiry

8. McGraw-Hill/Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 22-7 Call Option Payoffs –20 120 204060 80 100 –40 20 40 60 Stock price ($) Option payoffs ($) Buy a call Exercise price = $50 50

9. McGraw-Hill/Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 22-8 Call Option Payoffs –20 120 204060 80 100 –40 20 40 60 Stock price ($) Option payoffs ($) Sell a call Exercise price = $50 50

10. McGraw-Hill/Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 22-9 Call Option Profits Exercise price = $50; option premium = $10 Sell a call Buy a call –20 120 204060 80 100 –40 20 40 60 Stock price ($) Option payoffs ($) 50 –10 10

11. McGraw-Hill/Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 22-10 Basic Put Option Pricing Relationships at Expiry At expiry, an American put option is worth the same as a European option with the same characteristics. If the put is in-the-money, it is worth E – S T. If the put is out-of-the-money, it is worthless. P = Max[E – S T, 0] Where S T is the value of the stock at expiry (time T) E is the exercise price. C is the value of the call option at expiry

12. McGraw-Hill/Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 22-11 Put Option Payoffs –20 0204060 80 100 –40 20 0 40 60 Stock price ($) Option payoffs ($) Buy a put Exercise price = $50 50

13. McGraw-Hill/Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 22-12 Put Option Payoffs –20 0204060 80 100 –40 20 0 40 –50 Stock price ($) Option payoffs ($) Sell a put Exercise price = $50 50

14. McGraw-Hill/Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 22-13 Put Option Profits –20 204060 80 100 –40 20 40 60 Stock price ($) Option payoffs ($) Buy a put Exercise price = $50; option premium = $10 –10 10 Sell a put 50

15. McGraw-Hill/Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 22-14 Put-Call Parity: The fundamental equation for pricing put and call options relative to each other is the Put-Call Parity equation: Put-Call Parity: c 0 + E/(1+r) T = p 0 + S 0

16. McGraw-Hill/Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 22-15 Valuing American Options Prior to Expiry Value of Call Put 1.Stock price+ – 2.Exercise price– + 3.Interest rate + – 4.Volatility in the stock price+ + 5.Expiration date+ +

17. McGraw-Hill/Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 22-16 Stocks and Bonds as Options Levered Equity is a Call Option. –The underlying asset comprise the assets of the firm. –The strike price is the payoff of the bond. If at the maturity of their debt, the assets of the firm are greater in value than the debt, the shareholders have an in-the-money call, they will pay the bondholders and “call in” the assets of the firm. If at the maturity of the debt the shareholders have an out-of-the-money call, they will not pay the bondholders (i.e. the shareholders will declare bankruptcy) and let the call expire.

18. McGraw-Hill/Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 22-17 Stocks and Bonds as Options Levered Equity is a Put Option. –The underlying asset comprise the assets of the firm. –The strike price is the payoff of the bond. If at the maturity of their debt, the assets of the firm are less in value than the debt, shareholders have an in-the-money put. They will put the firm to the bondholders. If at the maturity of the debt the shareholders have an out-of-the-money put, they will not exercise the option (i.e. NOT declare bankruptcy) and let the put expire.

19. McGraw-Hill/Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 22-18 Stocks and Bonds as Options It all comes down to put-call parity. Value of a call on the firm Value of a put on the firm Value of a risk-free bond Value of the firm = + – Stockholder’s position in terms of call options Stockholder’s position in terms of put options c 0 = S 0 + p 0 – (1+ r) T E

20. McGraw-Hill/Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 22-19 Summary and Conclusions The most familiar options are puts and calls. –Put options give the holder the right to sell stock at a set price for a given amount of time. –Call options give the holder the right to buy stock at a set price for a given amount of time. Put-Call parity c0+c0+ (1+ r) T E = S 0 + p 0

21. McGraw-Hill/Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 22-20 Summary and Conclusions The value of a stock option depends on six factors: 1. Current price of underlying stock. 2. Dividend yield of the underlying stock. 3. Strike price specified in the option contract. 4. Risk-free interest rate over the life of the contract. 5. Time remaining until the option contract expires. 6. Price volatility of the underlying stock. Much of corporate financial theory can be presented in terms of options. Common stock in a levered firm can be viewed as a call option on the assets of the firm.