Chapter 23

Options and Corporate Finance: Extension

and Applications

McGraw-Hill/Irwin Copyright © 2013 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
project’s NPV

23-1
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

23-2
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 employer’s 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.)
23-3
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 value—only the intrinsic value.
 This “dead weight loss” is overcome by the incentive
compatibility for the grantor.

23-4
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).
23-5
Campusteria Pro Forma Income Statement
Investment Year 0 Years 1-4 We plan to sell 25 meal
plans at $200 per month
Revenues $60,000 with a 12-month contract.

Variable Costs ($42,000) Variable costs are

projected to be $3,500
Fixed Costs ($18,000) per month.

Depreciation ($7,500) Fixed costs (lease

payment) are projected
Pretax profit ($7,500) to be $1,500 per month.
Tax shield 34% $2,550 We can depreciate our
capitalized leaseholder
Net Profit ($4,950) improvements.
Cash Flow -$30,000 $2,550
4
$2,550
NPV  $30,000   t
 $21,916.84
t 1 (1.10) 23-6
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.
23-7
Valuing a Start-Up with Black-Scholes
Recall the Black-Scholes Option Pricing Model
C 0  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
σ2 N(d) = Probability that a
ln( S / E )  ( R  )t standardized, normally
d1  2
 t distributed, random
variable will be less than
d 2  d1   t or equal to d.
23-8
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 = $30,000×20.
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
20   t
t 1 (1.10) $161,663.14
4
 4
 $110,418
(1.10) (1.10)

23-9
Valuing a Start-Up with Black-
Scholes
Let’s try our hand again at using the model. If
you have a calculator handy, follow along.
ln( S / E )  ( R  .5σ 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
23-10
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 .104  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.

23-11
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 option’s life.

23-12
Three Period Binomial Option Pricing
Example
 There is no reason to stop with just two
periods.
 Find the value of a three-period at-the-
money 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.

23-13
Three Period Binomial Process

$25.00  (1.15)3
38.02
$25.00  (1.15) 2
2/3

$25.00  (1.15) 33.06 $25.00  (1.15) 2 (1  .15)

2/3
1/3
28.75
$25.00  (1.15)(1  .15) 28.10

2/3 2/3
1/3
$25 24.44 $25.00  (1.15)  (1  .15) 2
2/3
1/3 1/3
21.25 $25.00  (1.  15) 2 20.77
2/3
1/3
$25.00  (1  .15) 18.06
$25.00  (1  .15)3
1/3
15.35
23-14
 C3 (U , U , U )  max[$ 38.02  $25,0]
38.02
2 3  $13.02  (1 3)  $3.10
C 2 (U , U )  2/3 13.02
(1.05)
C1 (U )  C3 ( D , U , U ) 
33.06
2 3  $9.25  (1 3)  $1.97 C3 (U , D, U )  C3 (U , U , D) 
2/3 9.25
(1.05) 1/3 max[$ 28.10  $25,0]
C 2 (U , D )  C 2 ( D, U ) 
28.75 28.10
2/3 6.50
2 3  $3.10  (1 3)  $0 3.10
2/3
C1 ( D )  1/3 (1.05) C3 (U , D, D ) 
$25
2 3  $1.97  (1 3)  $0 24.44
C3 ( D , U , D )  C3 ( D , D , U ) 
4.52 2/3 1.97
(1.05)
1/3 max[$ 20.77  $25,0]
C 2 ( D, D )  1/3
21.25 20.77
2 3  $0  (1 3)  $0
1.25 2/3 0
1/3 (1.05)
C3 ( D , D , D ) 
18.06
2 3  $6.50  (1 3)  $1.25 max[$ 15.35  $25,0]
C0  0
1/3
(1.05) 15.35
0
23-15
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, let’s 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.

23-16
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
23-17
 C3 (U , U , U )  max[$ 38.02  $25,0]
38.02 13.02

C 3 (U , U , D )  max[$ 28.10  $25,0]  3.10 33.06

28.10 $3.10

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

28.10 $3.66
24.44

20.77 0
C 3 (U , D , D )  max[$ 20.77  $24.44,0]  0
$25
C 3 ( D , U , U )  max[$ 28.10  $21.25,0]  6.85 28.10 $6.85

24.44

20.77 0
21.25 C 3 ( D , U , D )  max[$ 20.77  $21.25,0]  0
20.77 2.71

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

15.35 0
C 3 ( D , D , D )  max[$ 15.36  18.06,0]
23-18
 38.02 13.02
2 3  $13.02  (1 3)  $3.10
C 2 (U , U )  33.06
(1.05) 9.25 28.10 $3.10
2 3  $3.66  (1 3)  $0
28.75
C 2 (U , D ) 
(1.05) 28.10 $3.66
24.44

2.33 20.77 0

$25
2 3  $6.85  (1 3)  $0
C 2 ( D, U )  28.10 $6.85
(1.05)
24.44

4.35 20.77 0
21.25

20.77 2.71

2 3  $2.71  (1 3)  $0 18.06
C 2 ( D, D )  1.72 15.35 0
(1.05)
23-19
 38.02 13.02

C1 (U )  33.06
2 3  $9.25  (1 3)  $2.33 9.25 28.10 $3.10
(1.05) 28.75
6.61 28.10 $3.66
24.44

2.33 20.77 0

$25 C1 ( D ) 
5.25 2 3  $4.35  (1 3)  $1.72 28.10 $6.85
(1.05)
24.44

4.35 20.77 0
21.25
3.31 20.77 2.71

2 3  $6.50  (1 3)  $1.25 18.06

C0  1.72
(1.05) 15.35 0

23-20
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 $6 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.

23-21
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. 23-22
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.
23-23
The Option to Abandon: Example
Traditional NPV analysis would indicate rejection of the project.

Expected  Prob. Payoff   Prob. Payoff 

       
payoff  sucess given success   failure given failure 

Expected
 0.5  $575  0.5  0   $287.5
payoff

$287.50
NPV  $300  t
 $38.64
(1.10)
23-24
The Option to Abandon: Example
Success: PV = $500

Drill Sit on rig; stare

at empty hole:
 $500 PV = $0.
Failure

Do not Sell the rig;

NPV  $0 salvage value
drill
= $250

The firm has two decisions to make: drill or not, abandon or stay.
23-25
The Option to Abandon: Example
• When we include the value of the option to abandon, the
drilling project should proceed:

Expected  Prob. Payoff   Prob. Payoff 

       
payoff  sucess given success   failure given failure 

Expected
 0.5  $575  0.5  250   $412.50
payoff

$412.50
NPV  $300  t
 $75.00
(1.10)
23-26
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

23-27
Enron’s 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 investment—when
you include the value of that option. 23-28
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.

23-29