Options and Corporate Finance
Call option contracts Citigroup Inc. (C) are priced at $1 with an exercise price of $5. What is the intrinsic value of this call option if the current price of C stock is $3?
$0
A call option with an exercise price of $37 costs $10. If the underlying stock is currently trading for $48, what is the arbitrage profit?
$1 (-10-37+48=1)
During reorganization, GS issued bonds with detachable warrants. The warrants have an exercise price of $20 and mature in 1 year. The bonds have a par value of $1,000. What will the payoff per warrant be if the stock price at the expiration date is $28 and the price of the bond is $900?
$8 gain $28-$20=$8comm
What are the similarities between call options and warrants?
1. common stock is the underlying asset for both warrants and options. 2. both can be traded in a secondary market 3. both give the owner the right to buy
Repricing of employee stock options is controversial because
1. if employees know that options will be repriced, then incentive effect is lost 2. a lowered stock price is, in essence, a reward for failing
Four Factors Determining Option Values
1. stock price:The higher the stock price is, the more the call is worth. This comes as no surprise because the option gives us the right to buy the stock at a fixed price. 2. exercise price: The higher the exercise price is, the less the call is worth. This is also not a surprise because the exercise price is what we have to pay to get the stock. 3. the time to expiration: The longer the time to expiration is, the more the option is worth. Once again, this is obvious. Because the option gives us the right to buy for a fixed length of time, its value goes up as the length of time increases. 4. the risk-free rate: The higher the risk-free rate is, the more the call is worth. This result is a little less obvious. Normally, we think of asset values as going down as rates rise. In this case, the exercise price is a cash outflow, a liability. The current value of the liability goes down as the discount rate goes up.
The CEO of JNL Corporation has been recently awarded 10,000 stock options. What are some factors that may influence the value of these options?
1. the exercise price of the stock options 2. the number of months to expirations 3. the volatility of JNL stocks
Why are ESOs granted?
1. the owners of a corporation (the shareholders) face the basic problem of aligning shareholder and management interests and also of providing incentives for employees to focus on corporate goals 2. an ESO has no immediate, up-front, out-of-pocket cost to the corporation. In smaller, possibly cash-strapped companies, ESOs are a substitute for ordinary wages. Employees are willing to accept them instead of cash, hoping for big payoffs in the future. In fact, ESOs are a major recruiting tool, allowing businesses to attract talent that they otherwise could not afford.
warrant
A security that gives the holder the right, but not the obligation, to purchase shares of stock directly from the company at a fixed price over a given period of time.; Each warrant specifies the number of shares of stock the holder can buy, the exercise price, and the expiration date.
American and European Options
An American option may be exercised anytime up to and including the expiration date. A European option may be exercised only on the expiration date.
Employee Stock Option (ESO)
An option granted to an employee by a company giving the employee the right to buy shares of stock in the company at a fixed price for a fixed time. A typical ESO has a 10-year life, and they cannot be sold
real options
An option that involves real assets as opposed to financial assets such as shares of stock.
What is the maximum potential value of a call option at maturity?
An unlimited amount minus the exercise price
What is the impact of arbitrage trade on option prices?
Arbitrage restores prices to equilibrium.
What exists if identical securities are listed at two different prices on two different exchanges? (3)
Arbitrage, riskless profits, inefficient markets
Where is the exercise price of an employee stock option generally set when issued?
At the current market price of the stock
When a call option is exercised, is there a change in issues of shares outstanding? A warrant?
Call option: No. Warrant: Yes.
True or False Backdating ESOs is illegal
False
True or False The interest rate on risky debt will be equal to the risk free rate.
False
Why will the value of a convertible bond always exceed the straight bond value and the conversion value unless the firm is in default or the bondholders are forced to convert?
Holders of the convertibles do not have to convert immediately, instead they can take advantage of whichever is greater in the future, straight bond or conversion value.
Put Option
Instead of giving the holder the right to buy some asset, it gives the holder the right to sell that asset for a fixed exercise price.
How is the conversion value on a convertible bond computed?
Multiply the number of shares of common stock obtained on conversion by the current market price of stock
When NPV is used to evaluate independent projects, projects should be accepted when:
NPV is greater than zero
Arbitrages, Arbitrage Opportunities
Opportunities for riskless profits
managerial options
Opportunities that managers can exploit if certain things happen in the future./Opportunities to modify a project. The ways in which a product is priced, manufactured, advertised, and produced can all be changed, and these are just a few of the possibilities.
What is the equation for the payoff to a call option buyer at the expiration date of a call option contract?
Payoff = Maximum of (Zero or The stock price minus the exercise price)
Call Option Value =
Stock Value - Present Value of the exercise price
We have seen that incorporating options into capital budgeting analysis is not easy. What can we do about them in practice?
The answer is that we need to keep them in mind as we work with the projected cash flows. We will tend to underestimate NPV by ignoring options. The damage might be small for a highly structured, very specific proposal, but it might be great for an exploratory one.
Investment timing decision
The evaluation of the optimal time to begin a project.
exercise price
The higher the exercise price is, the less the call is worth.
the risk-free rate
The higher the risk-free rate is, the more the call is worth.
stock price
The higher the stock price is, the more the call is worth.
Expiration date
The last day on which the option may be exercised
the time to expiration
The longer the time to expiration is, the more the option is worth.
intrinsic value
The lower bound of an option's value, or what the option would be worth if it were about to expire
Vesting period
The minimum number of years a worker must be employed before the company's contribution to a retirement account becomes permanent.; Often, for up to three years or so, an ESO cannot be exercised and also must be forfeited if an employee leaves the company. After this period, the options "vest," which means they can be exercised. Sometimes, employees who resign with vested options are given a limited time to exercise their options.
A project costs $100 and has a single future cash flow. If we take it today, the cash flow will be $120 in one year. If we wait one year, the project will still cost $100, but the cash flow the following year (two years from now) will be $130 because the potential market is bigger. If these are the only two options, and the relevant discount rate is 10 percent, what should we do?
To answer this question, we need to compute the two NPVs. If we take it today, the NPV is: NPV = −$100 + $120/1.1 = $9.09 If we wait one year, the NPV at that time will be: NPV = −$100 + $130/1.1 = $18.18 This $18.18 is the NPV one year from now. We need the value today, so we discount back one period: NPV = $18.18/1.1 = $16.53 So, the choice is clear. If we wait, the NPV is $16.53 today compared to $9.09 if we start immediately, so the optimal time to begin the project is one year from now.
Is an ESO is classified as a call option or a warrant? Why?
Warrants because they are issued by corporations
Difference between call options and warrants?
Warrants usually have much longer maturity periods. Some warrants are actually perpetual and have no fixed expiration date. ; Call options are issued by individuals and warrants are issued by firms. When a call option is exercised, one investor buys stock from another investor. The company is not involved. When a warrant is exercised, the firm must issue new shares of stock. Each time a warrant is exercised, then, the firm receives some cash and the number of shares outstanding increases. Notice that employee stock options (ESOs) are issued by corporations; so, strictly speaking, they are warrants rather than options.
When should an investor not convert convertible bonds to common stocks at the maturity date?
When the conversion value is less than the straight bond value
When will a call option on a stock be classified as an "underwater" call option?
When the market price of stock is far below the exercise price
Option
a financial contract that gives its owner the right to buy or sell some asset at a fixed price on or before a given date.; gives the buyer the right, but not the obligation, to do something.; the buyer only uses the option if it is profitable to do so.
convertible bonds are
bonds that can be converted to stock
Sultan Enterprises currently has 1,000 shares of common stock and 200 convertible;e bonds outstanding. Each zero coupon bond has a par value of $1,000. At maturity, each bond can be converted into 5 newly issued shares in Sultan Enterprises. It will be advantageous for the convertible bondholder to convert their bonds to equity if the value of the firm:
exceeds $400,000 Since the bondholders will be 50% owners, they will gain only if the value of the firm exceeds $400,000. Otherwise, they can redeem the bonds for $200,00.
Call Option
gives the owner the right to buy an asset at a fixed price during a particular time period.; price, volume, and open interest
"underwater"
if the stock fall significantly after an ESO is granter. On occasion, a company will decide to lower the strike price on underwater options. Such options are said to be "restruck" or "repriced."
What is an important drawback of traditional NPV analysis?
it ignores embedded options in investment decisions
The value of the convertible bonds is significantly influenced by the straight bond value when the value of the firm is very _____ and is significantly influenced by the conversion value when the value of the firm is very ______.
low; high
It is not desirable to convert convertible bonds to common stock at the maturity date if the conversion value is:
lower than the straight bond value
Intrinsic value =
market price - exercise price
Open Interest
number of option contracts outstanding
Many corporate investment decisions really amount to the evaluation of _____
real options
When the value of a firm is very low, the ______ primarily determines the value of its convertible bonds.
straight bond value
In the case of a call option, to prevent arbitrage, the value of the call today must be greater than___?
than the stock price less the exercise price.
Exercising the option
the act of buying or selling the underlying asset via the option contract
Net Present Value (NPV)
the difference between the present value of cash inflows and the present value of cash outflows over a period of time
"option to wait"
the fact that we do not have to take a project immediately.; often very valuable
The Fifth factor
the fifth and final factor that determines an option's value is the variance of the return on the underlying asset. The greater the variance, the more the option is worth.
Strike price (exercise price)
the fixed price specified in the option contract at which the holder can buy or sell the underlying asset
The total value of the convertible is equal to the sum of:
the floor value and the option value
"at-the-money"
the stock price is equal to the strike price
Two floor values
the straight bond value and the conversion value; the minimum value of a convertible bond is given by the greater of the two.
Warrants are sometimes called sweeteners or equity kickers because
they are often issued in combination with privately placed loans or bonds.; Throwing in some warrants is a way of making the deal a little more attractive to the lender, and it is a common practice. Warrants have been listed and traded on the NYSE since April 13, 1970. In early 2017, there were only 20 warrants listed on the NYSE. In Europe, warrants are still popular. Also in early 2017, Euronext listed about 57,000 of them.; In many cases, warrants are attached to bonds when issued. The loan agreement will state whether the warrants are detachable from the bond. Usually, the warrant can be detached immediately and sold by the holder as a separate security.
The greater the ____ of the return on the underlying asset, the higher the value of the call option.
variability
Straight Bond Value
what a convertible bond would sell for if it could not be converted into common stock.; This value will depend on the general level of interest rates on debentures and on the default risk of the issuer.
Upper bound and Lower bound
what is the most a stock option can sell for? A call option will always sell for no more than the underlying asset. what is the least a stock option can sell for? Can't sell for less than zero. Furthermore, if the stock price is greater than the exercise price, the call option is worth at least stock price today - exercise price on option.
Conversion Value
what the bond would be worth if immediately converted into common stock.; We compare this value by multiplying the current price of the stock by the number of shares that will be received when the bond is converted.; A convertible cannot sell for less than its conversion value, or an arbitrage opportunity exists (the difference between the value of the stock and the bond's conversion value).
When is it profitable to exercise warrants?
when the value of the underlying asset exceeds the exercise price
the number of options that you need to buy to replicate the value of the stock is always equal to______
ΔS/ΔC, where ΔS is the difference in the possible stock prices and ΔC is the difference in the possible option values.
