1. 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

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

3. Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 24- 3 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.

4. Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 24- 4 Irwin/McGraw Hill Option Obligations

5. Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 24- 5 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

6. Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 24- 6 Irwin/McGraw Hill Option Value Call option value (graphic) given a $55 exercise price. Share Price Call option value 55 65 $10

7. Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 24- 7 Irwin/McGraw Hill Option Value Put option value (graphic) given a $55 exercise price. Share Price Put option value 45 55 $10

8. Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 24- 8 Irwin/McGraw Hill Option Value Call option payoff (to seller) given a $55 exercise price. Share Price Call option $ payoff 55

9. Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 24- 9 Irwin/McGraw Hill Option Value Put option payoff (to seller) given a $55 exercise price. Share Price Put option $ payoff 55

10. Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 24- 10 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)

11. Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 24- 11 Irwin/McGraw Hill Option Value Black-Scholes Option Pricing Model O C = P s [N(d 1 )] - S[N(d 2 )]e -rt

12. Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 24- 12 Irwin/McGraw Hill WSJ Options (9/29/03)  How to Value a Call Option OPTION AMD STRIKEEXPCALL VOL CALL LAST PUT VOL PUT LAST 10.8711Oct 12514 0.7546580.85 10.8711Jan 3390 1.65301.60 10.8712.5Jan 3544 1.152.45

13. Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 24- 13 Irwin/McGraw Hill Options on Real Assets Real Options - Options embedded in real assets

14. Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 24- 14 Irwin/McGraw Hill Options on Real Assets Real Options - Options embedded in real assets Option to Expand Option to Abandon

15. Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 24- 15 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

16. Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 24- 16 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*150,000 + 1 = $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?

17. Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 24- 17 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?

18. Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 24- 18 Irwin/McGraw Hill  Option Value Exercise price = $8 million  Current “Price” = $7 million

19. Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 24- 19 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.

20. Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 24- 20 Irwin/McGraw Hill Calculate the Option value  Go to  http://www.numa.com http://www.numa.com

21. Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 24- 21 Irwin/McGraw Hill Web Resources www.cboe.com http://finance.yahoo.com www.fintools.net/options/optcalc.html www.optionscentral.com www.pcquote.com/options www.pmpublishing.com www.schaffersresearch.com/stock/calculator.asp Click to access web sites Internet connection required