Logic – the study of arguments

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