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CHAPTER 23
OPTIONS AND CORPORATE FINANCE
EXTENSIONS AND APPLICATIONS
SLIDES
CHAPTER ORGANIZATION
23.1 Executive Stock Options
Why Options?
Valuing Executive Compensation
23.1 Key Concepts and Skills
23.2 Chapter Outline
23.3 Executive Stock Options
23.4 Valuing Executive Compensation
23.5 Valuing a Start-Up
23.6 Campusteria Pro Forma Income Statement
23.7 Valuing a Start-Up
23.8 Valuing a Start-Up with Balck-Scholes
23.9 Valuing a Start-Up with Balck-Scholes
23.10 Valuing a Start-Up with Balck-Scholes
23.11 Valuing a Start-Up with Balck-Scholes
23.12 More on the Binomial Model
23.13 Three Period Binomial Option Pricing Example
23.14 Three Period Binomial Process
23.15 (ctd.)
23.16 Valuation of a Lookback Option
23.17 Three Period Binomial with Lookback
23.18 (ctd.)
23.19 (ctd.)
23.20 (ctd.)
23.21 Shutdown and Reopening Decisions
23.22 Discounted Cash Flows and Options
23.23 The Option to Abandon: Example
23.24 The Option to Abandon: Example
23.25 The Option to Abandon: Example
23.26 The Option to Abandon: Example
23.27 Valuation of the Option to Abandon
23.28 Enron’s Inefficient Plants
23.29 Quick Quiz
23.2 Valuing a Start-Up
23.3 More on the Binomial Model
Heating Oil
23.4 Shutdown and Reopening Decisions
Valuing a Gold Mine
The Abandonment and Opening Decisions
Valuing the Simple Gold Mine
ANNOTATED CHAPTER OUTLINE
Slide 23.0 Chapter 23 Title Slide
Slide 23.1 Key Concepts and Skills
Slide 23.2 Chapter Outline
23.1. Executive Stock Options
.A Why Options
Slide 23.3 Executive Stock Options
Executive Stock Options (ESOs) exist to align the interests of
shareholders and managers.
ESOs are call options (technically warrants) on the employer’s
shares. They typically have the following characteristics:
–Inalienable (cannot be sold)
–Typical maturity is 10 years.
–Typical vesting period is 3 years.
–Most include implicit reset provisions 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.) 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.
.B Valuing Executive Compensation
Slide 23.4 Valuing Executive Compensation
Since ESOs are essentially like a call option, they can be valued
using the Black-Scholes Model, or other option pricing models.
However, due to the intricacies of some contracts, the value
provided by the models may only be good estimates of true value.
For example, 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 time
(speculative) value—only the intrinsic value. This “dead weight
loss” is overcome by the incentive compatibility for the grantor.
23.2. Valuing a Start-Up
Slide 23.5 Valuing a Start-Up
When estimating the value of a start-up firm, the option to expand
is of great importance in determining the underlying value of the
venture. To illustrate this point, we provide an additional example
in the following slides.
Slide 23.6 Campusteria Pro Forma Income Statement
Slide 23.7 Valuing a Start-Up
Slide 23.8 –
Slide 23.11 Valuing a Start-Up with Black-Scholes
23.3. More on the Binomial Model
Slide 23.12 More on the Binomial Model
The binomial model is an alternative to Black-Scholes, and it may,
particularly in cases of path dependence, be a better approach.
Slide 23.13 Three Period Binomial Option Pricing Example
Slide 23.14 –
Slide 23.15 Three Period Binomial Process
Further, although we still consider only two possible movements
(up or down), we extend the model to illustrate multiple periods,
which essentially creates a tree with many branches.
Slide 23.16 Valuation of a Lookback Option
Slide 23.17 –
Slide 23.20 Three Period Binomial with Lookback
An example of path dependence is a lookback option, with which
the exercise price of the option is determined based on the lowest
stock price over the time period.
.A Heating Oil
23.4. Shutdown and Reopening Decisions
Slide 23.21 Shutdown and Reopening Decisions
Slide 23.22 Discounted Cash Flows and Options
The true value of a project is equal to its NPV plus any embedded
option value, such as the option to abandon, wait, or expand.
Slide 23.23 –
Slide 23.26 The Option to Abandon: Example
Slide 23.27 Valuation of the Option to Abandon
Slide 23.28 Enron’s Inefficient Plants
.A Valuing a Gold Mine
.B The Abandonment and Opening Decisions
.C Valuing the Simple Gold Mine
Slide 23.29 Quick Quiz
