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Chapter

23

Options and Corporate Finance: Extensions


and Applications

McGraw-Hill/Irwin

Copyright 2010 by the McGraw-Hill Companies, Inc. All rights reserved.

Key Concepts and Skills

Understand executive stock options


Understand how the option to expand increases
the value of a start-up
Be able to apply the binomial model to
multiple periods
Understand how embedded options impact a
projects NPV
23-2

Chapter Outline
23.1 Executive Stock Options
23.2 Valuing a Start Up
23.3 More on the Binomial Model
23.4 Shutdown and Reopening Decisions

23-3

23.1 Executive Stock Options

Executive Stock Options exist to align the interests of


shareholders and managers.
Executive Stock Options are call options (technically warrants) on
the employers shares.

Inalienable
Typical maturity is 10 years.
Typical vesting period is 3 years.
Most include an implicit reset provision to preserve incentive compatibility.

Executive Stock Options give executives an important tax break:


grants of at-the-money options are not considered taxable income.
(Taxes are due if the option is exercised.)

23-4

Valuing Executive Compensation

FASB has historically allowed firms to record zero expense for


grants of at-the-money executive stock options.
However, the economic value of a long-lived call option is
enormous, especially given the propensity of firms to reset the
exercise price after drops in the price of the stock.
Due to the inalienability, the options are worth less to the
executive than they cost the company.

The executive can only exercise, not sell his options. Thus, he can
never capture the speculative valueonly the intrinsic value.

This dead weight loss is overcome by the incentive


compatibility for the grantor.
23-5

23.2 Valuing a Start-Up

An important option is the option to expand.


Imagine a start-up firm, Campusteria, Inc., which plans
to open private dining clubs on college campuses.
The test market will be your campus, and if the concept
proves successful, expansion will follow nationwide.
Nationwide expansion will occur in year four.
The start-up cost of the test dining club is only $30,000
(this covers leaseholder improvements and other
expenses for a vacant restaurant near campus).

23-6

Campusteria Pro Forma Income Statement


Investment
Revenues
Variable Costs
Fixed Costs
Depreciation
Pretax profit
Tax shield 34%
Net Profit
Cash Flow

Year 0

-$30,000

Years 1-4
$60,000
($42,000)
($18,000)
($7,500)
($7,500)
$2,550
($4,950)
$2,550

We plan to sell 25 meal


plans at $200 per month
with a 12-month contract.
Variable costs are
projected to be $3,500
per month.
Fixed costs (lease
payment) are projected
to be $1,500 per month.
We can depreciate our
capitalized leaseholder
improvements.
4

NPV $30,000
t 1

$2,550
$21,916.84
t
(1.10)
23-7

Valuing a Start-Up
Note that while the Campusteria test site has a
negative NPV, we are close to our break-even
level of sales.
If we expand, we project opening 20 Campusterias
in year four.
The value of the project is in the option to expand.
We will use the Black-Scholes option pricing
model to value this option.

23-8

Valuing a Start-Up with Black-Scholes


Recall the Black-Scholes Option Pricing Model
C0 S N(d1 ) Ee Rt N(d 2 )

Where
C0 = the value of a European option at time t = 0
R = the risk-free interest rate
2
ln(S / E ) ( R )t
2
d1
t
d 2 d1 t

N(d) = Probability that a


standardized, normally
distributed, random
variable will be less than
or equal to d.
23-9

Valuing a Start-Up with Black-Scholes


We need to find the value of a four-year call option with
an exercise price of $600,000 = $30,00020.
The interest rate available is R = 10%.
The option maturity is four years.
The volatility of the underlying asset is 30% per annum.
The current value of the underlying assets is $110,418.
4

$2,550
t
$161,663.14
t 1 (1.10)

$110,418
4
4
(1.10)
(1.10)

20

23-10

Valuing a Start-Up with BlackScholes


Lets try our hand again at using the model. If you have a calculator handy,
follow along.

ln( S / E ) ( R .5 2 )t
d1
t
ln(110,418 / 600,000) (.10 .5(0.30) 2 )4
d1
1.8544
0.30 4

Then,
d 2 d1 t 1.8544 0.30 4 2.45
23-11

Valuing a Start-Up with Black-Scholes


N(d1) = N(-1.8544) =0.032
N(d2) = N(-2.45) =0.007

C 0 $110,418 0.032 600,000e .104 0.007


C 0 $718.03
The option to expand, while valuable, is not as
great as the negative NPV of opening the trial
Campusteria. So, we should not proceed.
23-12

23.3 More on the Binomial Model

The binomial option pricing model is an alternative


to the Black-Scholes option pricing model.
In some situations, it is a superior alternative.
For example if you have path dependency in your
option payoff, you must use the binomial option
pricing model.

Path dependency is when how you arrive at a price (the


path you follow) for the underlying asset is important.
One example of a path dependent security is a no regret
call option where the exercise price is the lowest price of
the stock during the options life.
23-13

Three Period Binomial Option Pricing


Example
There

is no reason to stop with just two


periods.
Find the value of a three-period at-themoney call option written on a $25 stock
that can go up or down 15 percent each
period when the risk-free rate is 5
percent.
23-14

Three Period Binomial Process


$25.00 (1.15)3

$25.00 (1.15) 2
$25.00 (1.15)

2/3
33.06

2/3
28.75

$25.00 (1.15)(1 .15)

$25.00 (1.15) 2 (1 .15)


1/3
28.10

2/3

2/3

1/3
24.44

$25

2/3

$25.00 (1.15) (1 .15) 2


1/3

1/3
21.25

$25.00 (1 .15)

38.02

$25.00 (1. 15) 2

20.77

2/3

1/3
18.06

$25.00 (1 .15)3
1/3
15.35

23-15

C3 (U , U , U ) max[$38.02 $25,0]

C1 (U )

2 3 $13.02 (1 3) $3.10
C2 (U , U )
(1.05)

2 3 $9.25 (1 3) $1.97
(1.05)
28.75

2/3

C1 ( D)

$25
4.52

1/3

6.50

33.06

2/3

9.25

1.25

2/3

C3 (U , D, U ) C3 (U , U , D )
1/3

2 3 $3.10 (1 3) $0
2/3
(1.05)
1/3
24.44
1.97

C 2 ( D, D )

1/3

18.06
0

max[$28.10 $25,0]
28.10
3.10

C3 (U , D, D)

C3 ( D , U , D ) C3 ( D , D , U )

2 3 $0 (1 3) $0
2/3
(1.05)
1/3

2 3 $6.50 (1 3) $1.25
C0
(1.05)

13.02

C3 ( D , U , U )

C2 (U , D) C2 ( D,U )

2 3 $1.97 (1 3) $0
2/3
(1.05)
21.25

38.02

max[$20.77 $25,0]
20.77
0

C3 ( D , D , D )
max[$15.35 $25,0]

1/3

15.35
0

23-16

Valuation of a Lookback Option

When the stock price falls due to the stock market as


a whole falling, the board of directors tends to reset
the exercise price of executive stock options.
To see how this reset provision adds value, lets price
that same three-period call option (exercise price
initially $25) with a reset provision.
Notice that the exercise price of the call will be the
smallest value of the stock price depending upon the
path followed by the stock price to get there.
23-17

Three Period Binomial with Lookback


38.02
33.06
28.10
28.75
28.10
24.44
20.77
$25
28.10
24.44
20.77
21.25
20.77
18.06
15.35

23-18

C3 (U , U , U ) max[$38.02 $25,0]
C 3 (U , U , D) max[$28.10 $25,0] 3.10
28.75

38.02

13.02

28.10

$3.10

33.06

C 3 (U , D, U ) max[$28.10 $24.44,0] 3.66


28.10

$3.66

20.77

28.10

$6.85

20.77

24.44

$25

C 3 (U , D, D) max[$20.77 $24.44,0] 0
C 3 ( D, U , U ) max[$28.10 $21.25,0] 6.85
24.44

21.25

C 3 ( D, U , D) max[$20.77 $21.25,0] 0

C 3 ( D, D, U ) max[$20.77 $18.06,0] 2.71

20.77

2.71

15.35

18.06

C 3 ( D, D, D) max[$15.36 18.06,0]

23-19

C2 (U , U )

2 3 $13.02 (1 3) $3.10
(1.05)
28.75

C 2 (U , D )

38.02

13.02

28.10

$3.10

2 3 $3.66 (1 3) $0
(1.05)
28.10

$3.66

33.06
9.25

24.44
2.33
$25

C 2 ( D, U )

2 3 $6.85 (1 3) $0
(1.05)

20.77

28.10

$6.85

20.77

20.77

2.71

15.35

24.44
4.35
21.25

2 3 $2.71 (1 3) $0
C 2 ( D, D )
(1.05)

18.06
1.72

23-20

C1 (U )

38.02

13.02

28.10

$3.10

28.10

$3.66

20.77

28.10

$6.85

20.77

20.77

2.71

15.35

33.06

2 3 $9.25 (1 3) $2.33
(1.05)
28.75

9.25

6.61
24.44
2.33
$25
5.25

C1 ( D)
2 3 $4.35 (1 3) $1.72
(1.05)

24.44
4.35

21.25
3.31

2 3 $6.50 (1 3) $1.25
C0
(1.05)

18.06
1.72

23-21

23.4 Shutdown and Reopening Decisions

Can easily be seen as options.


The Woe is Me gold mine is currently closed.
The firm is publicly held and trades under the ticker WOE.
The firm has no debt and has assets of around $30 million.
The market capitalization is well over $1 billion
What could possibly explain why a firm with $30 million
in assets and a closed gold mine that is producing no cash
flow at all has this kind of market capitalization?
Options. This firm has them.
23-22

Discounted Cash Flows and Options

We can calculate the market value of a project as the sum of the NPV of
the project without options and the value of the managerial options
implicit in the project.
M = NPV + OPT

A good example would be comparing the

desirability of a specialized machine versus a more


versatile machine. If they both cost about the same
and last the same amount of time, the more
versatile machine is more valuable because it
comes with options.

23-23

The Option to Abandon: Example


Suppose that we are drilling an oil well. The
drilling rig costs $300 today, and in one year
the well is either a success or a failure.
The outcomes are equally likely. The
discount rate is 10%.
The PV of the successful payoff at time one
is $575.
The PV of the unsuccessful payoff at time
one is $0.

23-24

The Option to Abandon: Example


Traditional NPV analysis would indicate rejection of the project.
Expected Prob.
Payoff
Payoff
Prob.

payoff
sucess given success failure given failure

Expected
0.5 $575 0.5 0 $287.5
payoff

$287.50
NPV $300
$38.64
t
(1.10)
23-25

The Option to Abandon: Example


Success: PV = $500
Sit on rig; stare
at empty hole:
PV = $0.

Drill
$500

Failure
Do not
drill

NPV $0

Sell the rig;


salvage value
= $250

The firm has two decisions to make: drill or not, abandon or stay.
23-26

The Option to Abandon: Example


When we include the value of the option to abandon, the
drilling project should proceed:
Expected Prob.
Payoff
Payoff
Prob.

payoff
sucess given success failure given failure

Expected
0.5 $575 0.5 250 $412.50
payoff
$412.50
NPV $300
$75.00
t
(1.10)

23-27

Valuation of the Option to Abandon

Recall that we can calculate the market value


of a project as the sum of the NPV of the
project without options and the value of the
managerial options implicit in the project.

M = NPV + OPT
$75.00 = $38.64 + OPT
OPT = $113.64
23-28

Enrons Inefficient Plants

In 1999 Enron planned to open gas-fired power plants in


Mississippi and Tennessee. These plants were expected to
sit idle most of the year and, when operated, to produce
electricity at a cost of at least 50 percent higher than the
most efficient state-of-the-art facility.
Enron was buying a put option on electricity. They could
sell electricity when electricity prices spike. The typical
price is around $40 per megawatt-hour, but occasionally
the price is several thousand dollars.
Having a plant that was only economic to operate a few
weeks a year was a positive NPV investmentwhen you
include the value of that option.
23-29

Quick Quiz
Explain how to value executive stock options.
Discuss how the option to expand increases
the value of start-up firms.
Explain how the option to shut down affects
the value of projects.

23-30