Logic – the study of arguments
• "the tool for distinguishing between the true and the false;“
• "the Science, as well as the Art, of reasoning”• inductive reasoning: drawing general conclusions
from specific examples/ analysis : from object to its components
• deductive reasoning: drawing logical conclusions from definitions and axioms/ synthesis: how parts can be combined to form a whole.
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OPTIONS AND CORPORATE SECURITIES
Chapter 25
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Chapter OutlineOptions: The BasicsOption PayoffsEmployee Stock OptionsEquity as a Call Option on the Firm’s
AssetsWarrantsConvertible BondsReasons For Issuing Warrants and
ConvertiblesOther Options
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Options: The Basics
Put option – the right to sell some asset
Call option – the right to buy some asset
American vs. European options
Option – a contract that gives its owner the right to buy or sell
some asset at a fixed price on or before a given date
Option Payoffs – Calls The value of the
call at expiration is the intrinsic value◦ C1 = Max(0, S1 - E)◦ If S1<E, then the
payoff is 0◦ If S1>E, then the
payoff is S1 – EAssume that the
exercise price is $35
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Option Payoffs - PutsThe value of a
put at expiration is the intrinsic value◦ P1 = Max (0, K –
S1)◦ If S1<K, then the
payoff is K-S1◦ If S1>E, then the
payoff is 0Assume that the
strike price is $35
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Employee Stock OptionsOptions that are given to
employees as part of their benefits package
Often used as a bonus or incentive◦Designed to align employee interests
with stockholder interests and reduce agency problems
◦Empirical evidence suggests that they don’t work as well as anticipated due to the lack of diversification introduced into the employees’ portfolios
◦The stock just isn’t worth as much to the employee as it is to an outside investor
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Equity: a Call OptionEquity can be viewed as a call
option on the company’s assets when the firm is leveraged
The exercise price is the value of the debt
If the assets are worth more than the debt when it comes due, the option will be exercised and the stockholders retain ownership
If the assets are worth less than the debt, the stockholders will let the option expire and the assets will belong to the bondholders
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Warrants A security that gives the holder
the right to purchase shares of stock at a fixed price over a given period of time
It is a call option issued by corporations in conjunction with other securities to reduce the yield
Usually included with a new debt or preferred shares issue as a sweetener or equity kicker
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Differences between warrants and traditional call options
Warrants are generally very long term
They are written by the company and exercise results in additional shares outstanding
The exercise price is paid to the company and generates cash for the firm
Warrants can be detached from the original securities and sold separately
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ConvertiblesConvertible bonds (or preferred stock)
may be converted into a specified number of common shares at the option of the security holder
The conversion price is the effective price paid for the stock
The conversion ratio is the number of shares received when the bond is converted
Convertible bonds will be worth at least as much as the straight bond value or the conversion value, whichever is greater
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Minimum value of a convertible bond versus the value of the stock for a given interest rate
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Valuing ConvertiblesSuppose you have a 10% bond that pays
semi-annual coupons and will mature in 15 years. The face value is $1,000 and the yield to maturity on similar bonds is 9%. The bond is also convertible with a conversion price of $100. The stock is currently selling for $110. What is the minimum price of the bond?
◦ Straight bond value ◦ Conversion ratio ◦ Conversion value ◦ Minimum price
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Reasons for Issuing Warrants and Convertibles
They allow companies to issue cheap bonds by attaching sweeteners to the new bond issue. Coupon rates can then be set at below market rate for straight bonds
They give companies the chance to issue common stock in the future at a premium over current prices
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The case for and against convertibles
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Other OptionsCall provision on a bond
◦Allows the company to repurchase the bond prior to maturity at a specified price that is generally higher than the face value
◦Increases the required yield on the bond – this is effectively how the company pays for the option
Put bond◦Gives the bondholder the right to
require the company to repurchase the bond prior to maturity at a fixed price
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Other Options continuedOver allotment option
◦Underwriters have the right to purchase additional shares from a firm in an IPO
Insurance and Loan Guarantees◦These are essentially put options
Managerial options
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