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22-0
CHAPTER
22
Options and Corporate
Finance: Basic Concepts
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22-1
Chapter Outline
22.1 Options
22.2 Call Options
22.3 Put Options
22.4 Selling Options
22.5 Reading The Wall Street Journal
22.6 Combinations of Options
22.7 Valuing Options
22.8 An Option-Pricing Formula
22.9 Stocks and Bonds as Options
22.10 Capital-Structure Policy and Options
22.11 Mergers and Options
22.12 Investment in Real Projects and Options
22.13 Summary and Conclusions
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22-2
22.1 Options
Many corporate securities are similar to the stock
options that are traded on organized exchanges.
Almost every issue of corporate stocks and bonds
has option features.
In addition, capital structure and capital
budgeting decisions can be viewed in terms of
options.
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22.1 Options Contracts:
Preliminaries
An option gives the holder the right, but not the obligation, to buy
or sell a given quantity of an asset on (or perhaps before) a given
date, at prices agreed upon today.
Calls versus Puts
Call options gives the holder the right, but not the obligation, to buy
a given quantity of some asset at some time in the future, at prices
agreed upon today. When exercising a call option, you call in the
asset.
Put options gives the holder the right, but not the obligation, to sell a
given quantity of an asset at some time in the future, at prices agreed
upon today. When exercising a put, you put the asset to someone.
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22.1 Options Contracts: Preliminaries
Exercising the Option
The act of buying or selling the underlying asset through the option contract.
Strike Price or Exercise Price
Refers to the fixed price in the option contract at which the holder can buy or sell
the underlying asset.
Expiry
The maturity date of the option is referred to as the expiration date, or the expiry.
European versus American options
European options can be exercised only at expiry.
American options can be exercised at any time up to expiry.
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Options Contracts: Preliminaries
In-the-Money
The exercise price is less than the spot price of the underlying
asset.
At-the-Money
The exercise price is equal to the spot price of the underlying
asset.
Out-of-the-Money
The exercise price is more than the spot price of the
underlying asset.
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Options Contracts: Preliminaries
Intrinsic Value
The difference between the exercise price of the
option and the spot price of the underlying asset.
Speculative Value
The difference between the option premium and the
intrinsic value of the option.
Option
Premium
=
Intrinsic
Value
Speculative
Value
+
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22.2 Call Options
Call options gives the holder the right, but
not the obligation, to buy a given quantity
of some asset on or before some time in the
future, at prices agreed upon today.
When exercising a call option, you call in
the asset.

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Basic Call Option Pricing Relationships
at Expiry
At expiry, an American call option is worth the same as
a European option with the same characteristics.
If the call is in-the-money, it is worth S
T


E.
If the call is out-of-the-money, it is worthless:
C

= Max[S
T

E, 0]
Where
S
T
is the value of the stock at expiry (time T)
E is the exercise price.
C is the value of the call option at expiry
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Call Option Payoffs
20
120 20 40 60 80 100
40
20
40
60
Stock price ($)
O
p
t
i
o
n

p
a
y
o
f
f
s

(
$
)

Exercise price = $50
50
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Call Option Payoffs
20
120 20 40 60 80 100
40
20
40
60
Stock price ($)
O
p
t
i
o
n

p
a
y
o
f
f
s

(
$
)

Exercise price = $50
50
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22-11
Call Option Profits
Exercise price = $50;
option premium = $10
Sell a call
Buy a call
20
120 20 40 60 80 100
40
20
40
60
Stock price ($)
O
p
t
i
o
n

p
a
y
o
f
f
s

(
$
)

50
10
10
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22-12
22.3 Put Options
Put options gives the holder the right, but
not the obligation, to sell a given quantity of
an asset on or before some time in the
future, at prices agreed upon today.
When exercising a put, you put the asset
to someone.
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Basic Put Option Pricing Relationships
at Expiry
At expiry, an American put option is worth
the same as a European option with the
same characteristics.
If the put is in-the-money, it is worth E S
T
.
If the put is out-of-the-money, it is
worthless.
P

= Max[E S
T
, 0]
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Put Option Payoffs
20
0 20 40 60 80 100
40
20
0
40
60
Stock price ($)
O
p
t
i
o
n

p
a
y
o
f
f
s

(
$
)

Buy a put
Exercise price = $50
50
50
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Put Option Payoffs
20
0 20 40 60 80 100
40
20
0
40
50
Stock price ($)
O
p
t
i
o
n

p
a
y
o
f
f
s

(
$
)

Sell a put
Exercise price = $50
50
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Put Option Profits
20
20 40 60 80 100
40
20
40
60
Stock price ($)
O
p
t
i
o
n

p
a
y
o
f
f
s

(
$
)

Buy a put
Exercise price = $50; option premium = $10
10
10
Sell a put
50
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22.4 Selling Options
Exercise price = $50;
option premium = $10
Sell a call
Buy a call
50
60 40 100
40
40
Stock price ($)
O
p
t
i
o
n

p
a
y
o
f
f
s

(
$
)

Buy a put
Sell a put
The seller (or writer) of an option has an obligation.
The purchaser of an option has an option.
10
10
Buy a call
Sell a call
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22.5 Reading The Wall
Street Journal
Option/Strike Exp. Vol. Last Vol. Last
IBM 130 Oct 364 15 107 5
138 130 Jan 112 19 420 9
138 135 Jul 2365 4 2431 13/16
138 135 Aug 1231 9 94 5
138 140 Jul 1826 1 427 2
138 140 Aug 2193 6 58 7
--Put-- --Call--
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22.5 Reading The Wall Street Journal
Option/Strike Exp. Vol. Last Vol. Last
IBM 130 Oct 364 15 107 5
138 130 Jan 112 19 420 9
138 135 Jul 2365 4 2431 13/16
138 135 Aug 1231 9 94 5
138 140 Jul 1826 1 427 2
138 140 Aug 2193 6 58 7
--Put-- --Call--
This option has a strike price of $135;
a recent price for the stock is $138.25
July is the expiration month
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22.5 Reading The Wall Street Journal
Option/Strike Exp. Vol. Last Vol. Last
IBM 130 Oct 364 15 107 5
138 130 Jan 112 19 420 9
138 135 Jul 2365 4 2431 13/16
138 135 Aug 1231 9 94 5
138 140 Jul 1826 1 427 2
138 140 Aug 2193 6 58 7
--Put-- --Call--
This makes a call option with this exercise price in-the-
money by $3.25 = $138 $135.
Puts with this exercise price are out-of-the-money.
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22.5 Reading The Wall Street
Journal
Option/Strike Exp. Vol. Last Vol. Last
IBM 130 Oct 364 15 107 5
138 130 Jan 112 19 420 9
138 135 Jul 2365 4 2431 13/16
138 135 Aug 1231 9 94 5
138 140 Jul 1826 1 427 2
138 140 Aug 2193 6 58 7
--Put-- --Call--
On this day, 2,365 call options with this
exercise price were traded.
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22.5 Reading The Wall Street Journal
Option/Strike Exp. Vol. Last Vol. Last
IBM 130 Oct 364 15 107 5
138 130 Jan 112 19 420 9
138 135 Jul 2365 4 2431 13/16
138 135 Aug 1231 9 94 5
138 140 Jul 1826 1 427 2
138 140 Aug 2193 6 58 7
--Put-- --Call--
The CALL option with a strike price
of $135 is trading for $4.75.
Since the option is on 100 shares of stock, buying
this option would cost $475 plus commissions.
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22.5 Reading The Wall Street
Journal
Option/Strike Exp. Vol. Last Vol. Last
IBM 130 Oct 364 15 107 5
138 130 Jan 112 19 420 9
138 135 Jul 2365 4 2431 13/16
138 135 Aug 1231 9 94 5
138 140 Jul 1826 1 427 2
138 140 Aug 2193 6 58 7
--Put-- --Call--
On this day, 2,431 put options with this
exercise price were traded.
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22-24
22.5 Reading The Wall Street Journal
Option/Strike Exp. Vol. Last Vol. Last
IBM 130 Oct 364 15 107 5
138 130 Jan 112 19 420 9
138 135 Jul 2365 4 2431 13/16
138 135 Aug 1231 9 94 5
138 140 Jul 1826 1 427 2
138 140 Aug 2193 6 58 7
--Put-- --Call--
The PUT option with a strike price of $135 is
trading for $.8125.
Since the option is on 100 shares of stock, buying
this option would cost $81.25 plus commissions.
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22.6 Combinations of Options
Puts and calls can serve as the building
blocks for more complex option contracts.
If you understand this, you can become a
financial engineer, tailoring the risk-return
profile to meet your clients needs.
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Protective Put Strategy: Buy a Put and Buy
the Underlying Stock: Payoffs at Expiry
Buy a put with an exercise
price of $50
Buy the
stock
Protective Put payoffs
$50
$0
$50
Value at
expiry
Value of
stock at
expiry
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Protective Put Strategy Profits
Buy a put with exercise price of $50
for $10
Buy the stock at $40
$40
Protective Put
strategy has
downside protection
and upside potential
$40
$0
-$40
$50
Value at
expiry
Value of
stock at
expiry
-$10
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Covered Call Strategy
Sell a call with exercise price
of $50 for $10
Buy the stock at $40
$40
Covered Call strategy
$0
-$40
$50
Value at
expiry
Value of stock at expiry
-$30
$10
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22-29
Long Straddle: Buy a Call and a Put
30
40 60
70
30
40
Stock price ($)
O
p
t
i
o
n

p
a
y
o
f
f
s

(
$
)

Buy a put with exercise
price of $50 for $10
Buy a call with exercise
price of $50 for $10

A Long Straddle only makes money if the stock price moves
$20 away from $50.
$50
20
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22-30
Long Straddle: Buy a Call and a Put
30
30 40 60 70
40
Stock price ($)
O
p
t
i
o
n

p
a
y
o
f
f
s

(
$
)

$50
This Short Straddle only loses money if the stock
price moves $20 away from $50.
Sell a put with exercise price of
$50 for $10
Sell a call with an
exercise price of $50 for $10
20
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22-31
bond
Put-Call Parity: p
0
+ S
0
= c
0
+ E/(1+ r)
T
25
25
Stock price ($)
O
p
t
i
o
n

p
a
y
o
f
f
s

(
$
)

Consider the payoffs from holding a portfolio
consisting of a call with a strike price of $25 and a
bond with a future value of $25.
Call
Portfolio payoff
Portfolio value today = c
0
+

(1+ r)
T
E
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Put-Call Parity: p
0
+ S
0
= c
0
+ E/(1+ r)
T
25
25
Stock price ($)
O
p
t
i
o
n

p
a
y
o
f
f
s

(
$
)

Consider the payoffs from holding a portfolio
consisting of a share of stock and a put with a $25
strike.
Portfolio value today = p
0
+ S
0
Portfolio payoff
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Put-Call Parity: p
0
+ S
0
= c
0
+ E/(1+ r)
T
Since these portfolios have identical payoffs, they must have the same
value today: hence
Put-Call Parity: c
0
+ E/(1+r)
T
= p
0
+ S
0
25
25
Stock price ($)
O
p
t
i
o
n

p
a
y
o
f
f
s

(
$
)

25
25
Stock price ($)
O
p
t
i
o
n

p
a
y
o
f
f
s

(
$
)

Portfolio value today
= p
0
+ S
0
Portfolio value today


(1+ r)
T
E
= c
0
+
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22-34
22.7 Valuing Options
The last section
concerned itself with
the value of an option
at expiry.
This section considers
the value of an option
prior to the expiration
date.
A much more
interesting question.
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22-35
Option Value Determinants
Call Put
1. Stock price +
2. Exercise price +
3. Interest rate +
4. Volatility in the stock price + +
5. Expiration date + +

The value of a call option C
0
must fall within
max (S
0
E, 0) < C
0
< S
0
.
The precise position will depend on these factors.
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Market Value, Time Value and Intrinsic Value
for an American Call
The value of a call option C
0
must fall within max (S
0
E, 0) < C
0
< S
0
.
25
O
p
t
i
o
n

p
a
y
o
f
f
s

(
$
)

Call
S
T
loss
E
Profit
S
T

Time value
Intrinsic value
Market Value

In-the-money Out-of-the-money
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22-37
22.8 An Option-Pricing Formula
We will start with a
binomial option
pricing formula to
build our intuition.

Then we will
graduate to the
normal
approximation to
the binomial for
some real-world
option valuation.
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Binomial Option Pricing Model
Suppose a stock is worth $25 today and in one period will either be
worth 15% more or 15% less. S
0
= $25 today and in one year S
1
is
either $28.75 or $21.25. The risk-free rate is 5%. What is the
value of an at-the-money call option?
$25
$21.25 = $25(1 .15)
$28.75 = $25(1.15)
S
1
S
0

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22-39
Binomial Option Pricing Model
1. A call option on this stock with exercise price of $25 will have
the following payoffs.
2. We can replicate the payoffs of the call option. With a levered
position in the stock.

$25
$21.25
$28.75
S
1
S
0
C
1

$3.75
$0
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22-40
Binomial Option Pricing Model
Borrow the present value of $21.25 today and buy 1 share.
The net payoff for this levered equity portfolio in one period is either
$7.50 or $0.
The levered equity portfolio has twice the options payoff so the
portfolio is worth twice the call option value.

$25
$21.25
$28.75
S
1
S
0
debt
$21.25
portfolio
$7.50
$0
( ) =
=
=
C
1

$3.75
$0
$21.25
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22-41
Binomial Option Pricing Model
The value today of the levered equity portfolio is
todays value of one share less the present value
of a $21.25 debt:
) 1 (
25 . 21 $
25 $
f
r +

$25
$21.25
$28.75
S
1
S
0
debt
$21.25
portfolio
$7.50
$0
( ) =
=
=
C
1

$3.75
$0
$21.25
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22-42
Binomial Option Pricing Model
We can value the call option today
as half of the value of the
levered equity portfolio:
|
|
.
|

\
|
+
=
) 1 (
25 . 21 $
25 $
2
1
0
f
r
C
$25
$21.25
$28.75
S
1
S
0
debt
$21.25
portfolio
$7.50
$0
( ) =
=
=
C
1

$3.75
$0
$21.25
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If the interest rate is 5%, the call is worth:
The Binomial Option Pricing Model
( ) 38 . 2 $ 24 . 20 25 $
2
1
) 05 . 1 (
25 . 21 $
25 $
2
1
0
= =
|
|
.
|

\
|
= C
$25
$21.25
$28.75
S
1
S
0
debt
$21.25
portfolio
$7.50
$0
( ) =
=
=
C
1

$3.75
$0
$21.25
$2.38
C
0

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22-44


the replicating portfolio intuition.
Binomial Option Pricing Model
Many derivative securities can be valued by
valuing portfolios of primitive securities
when those portfolios have the same
payoffs as the derivative securities.
The most important lesson (so far) from the
binomial option pricing model is:
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22-45
Delta and the Hedge Ratio
This practice of the construction of a
riskless hedge is called delta hedging.
The delta of a call option is positive.
Recall from the example:
The delta of a put option is negative.
2
1
5 . 7 $
75 . 3 $
25 . 21 $ 75 . 28 $
0 75 . 3 $
= =

= A =
Swing of call
Swing of stock
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Delta
Determining the Amount of Borrowing:



Value of a call = Stock price Delta Amount
borrowed

$2.38 = $25 Amount borrowed

Amount borrowed = $10.12
( ) 38 . 2 $ 24 . 20 $ 25 $
2
1
) 05 . 1 (
25 . 21 $
25 $
2
1
0
= =
|
|
.
|

\
|
= C
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22-47
The Risk-Neutral Approach to Valuation






We could value V(0) as the value of the replicating
portfolio. An equivalent method is risk-neutral
valuation
S(0), V(0)
S(U), V(U)
S(D), V(D)
q
1- q
) 1 (
) ( ) 1 ( ) (
) 0 (
f
r
D V q U V q
V
+
+
=
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The Risk-Neutral Approach to Valuation
S(0) is the value of the
underlying asset today.
S(0), V(0)
S(U), V(U)
S(D), V(D)
S(U) and S(D) are the values of the asset in
the next period following an up move and a
down move, respectively.
q
1- q
V(U) and V(D) are the values of the asset in the next period
following an up move and a down move, respectively.
q is the risk-neutral
probability of an
up move.
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The Risk-Neutral Approach to Valuation
The key to finding q is to note that it is already impounded into an
observable security price: the value of S(0):
S(0), V(0)
S(U), V(U)
S(D), V(D)
q
1- q
A minor bit of algebra yields:
) ( ) (
) ( ) 0 ( ) 1 (
D S U S
D S S r
q
f

+
=
) 1 (
) ( ) 1 ( ) (
) 0 (
f
r
D S q U S q
S
+
+
=
) 1 (
) ( ) 1 ( ) (
) 0 (
f
r
D V q U V q
V
+
+
=
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22-50
Example of the Risk-Neutral Valuation of a Call:
Suppose a stock is worth $25 today and in one period will
either be worth 15% more or 15% less. The risk-free rate is
5%. What is the value of an at-the-money call option?
The binomial tree would look like this:
$21.25,C(D)
q
1- q
$25,C(0)
$28.75,C(D)
) 15 . 1 ( 25 $ 75 . 28 $
=
) 15 . 1 ( 25 $ 25 . 21 $
=
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22-51
Example of the Risk-Neutral Valuation of a Call:
$21.25,C(D)
2/3
1/3
The next step would be to compute the risk
neutral probabilities
$25,C(0)
$28.75,C(D)
) ( ) (
) ( ) 0 ( ) 1 (
D S U S
D S S r
q
f

+
=
3 2
50 . 7 $
5 $
25 . 21 $ 75 . 28 $
25 . 21 $ 25 $ ) 05 . 1 (
= =


=
q
McGraw-Hill/Irwin
Corporate Finance, 7/e
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22-52
Example of the Risk-Neutral Valuation of a Call:
$21.25, $0
2/3
1/3
After that, find the value of the call in the up
state and down state.

$25,C(0)
$28.75, $3.75
] 0 , 75 . 28 $ 25 max[$ ) (
=
D C
25 $ 75 . 28 $ ) (
=
U C
McGraw-Hill/Irwin
Corporate Finance, 7/e
2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
22-53
Example of the Risk-Neutral Valuation of a Call:
Finally, find the value of the call at time 0:

$21.25, $0
2/3
1/3
$25,C(0)
$28.75,$3.75
$25,$2.38
) 1 (
) ( ) 1 ( ) (
) 0 (
f
r
D C q U C q
C
+
+
=
) 05 . 1 (
0 $ ) 3 1 ( 75 . 3 $ 3 2
) 0 (
+
=
C
38 . 2 $
) 05 . 1 (
50 . 2 $
) 0 (
= =
C
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22-54
This risk-neutral result is consistent with
valuing the call using a replicating portfolio.
Risk-Neutral Valuation
and the Replicating Portfolio
( ) 38 . 2 $ 24 . 20 25 $
2
1
) 05 . 1 (
25 . 21 $
25 $
2
1
0
= =
|
|
.
|

\
|
= C
38 . 2 $
05 . 1
50 . 2 $
) 05 . 1 (
0 $ ) 3 1 ( 75 . 3 $ 3 2
0
= =
+
= C
McGraw-Hill/Irwin
Corporate Finance, 7/e
2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
22-55
The Black-Scholes Model
The Black-Scholes Model is
Where
C
0
= the value of a European option at time t = 0
r = the risk-free interest rate.
N(d) = Probability that a
standardized, normally
distributed, random
variable will be less than
or equal to d.
The Black-Scholes Model allows us to value options in the
real world just as we have done in the 2-state world.
) N( ) N(
2 1 0
d Ee d S C
rT
=

T
T

r E S
d
o
)
2
( ) / ln(
2
1
+ +
=
T d d
o =
1 2
McGraw-Hill/Irwin
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22-56
The Black-Scholes Model
Find the value of a six-month call option on the Microsoft
with an exercise price of $150
The current value of a share of Microsoft is $160
The interest rate available in the U.S. is r = 5%.
The option maturity is 6 months (half of a year).
The volatility of the underlying asset is 30% per annum.
Before we start, note that the intrinsic value of the option
is $10our answer must be at least that amount.
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The Black-Scholes Model
Lets try our hand at using the model. If you have a
calculator handy, follow along.
Then,

First calculate d
1
and d
2

T
T r E S
d
o
) 5 . ( ) / ln(
2
1
+ +
=
5282 . 0
5 . 30 . 0
5 ). ) 30 . 0 ( 5 . 05 (. ) 150 / 160 ln(
2
1
=
+ +
=
d
31602 . 0 5 . 30 . 0 52815 . 0
1 2
= = =
T d d
o
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22-58
The Black-Scholes Model
N(d
1
) = N(0.52815) = 0.7013
N(d
2
) = N(0.31602) = 0.62401

) N( ) N(
2 1 0
d Ee d S C
rT
=

5282 . 0
1
=
d
31602 . 0
2
=
d
92 . 20 $
62401 . 0 150 7013 . 0 160 $
0
5 . 05 .
0
=
=

C
e C
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22-60
22.9 Stocks and Bonds as Options
Levered Equity is a Call Option.
The underlying asset comprise the assets of the firm.
The strike price is the payoff of the bond.
If at the maturity of their debt, the assets of the firm are
greater in value than the debt, the shareholders have an
in-the-money call, they will pay the bondholders and
call in the assets of the firm.
If at the maturity of the debt the shareholders have an
out-of-the-money call, they will not pay the bondholders
(i.e. the shareholders will declare bankruptcy) and let the
call expire.
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22.9 Stocks and Bonds as Options
Levered Equity is a Put Option.
The underlying asset comprise the assets of the firm.
The strike price is the payoff of the bond.
If at the maturity of their debt, the assets of the firm are
less in value than the debt, shareholders have an in-the-
money put.
They will put the firm to the bondholders.
If at the maturity of the debt the shareholders have an
out-of-the-money put, they will not exercise the option
(i.e. NOT declare bankruptcy) and let the put expire.
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22-62
22.9 Stocks and Bonds as Options
It all comes down to put-call parity.
Value of a
call on the
firm
Value of a
put on the
firm
Value of a
risk-free
bond
Value of
the firm
=
+

Stockholders
position in terms
of call options
Stockholders
position in terms
of put options
c
0
= S
0
+ p
0

(1+ r)
T
E
McGraw-Hill/Irwin
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22-63
22.10 Capital-Structure Policy
and Options
Recall some of the agency costs of debt:
they can all be seen in terms of options.
For example, recall the incentive
shareholders in a levered firm have to take
large risks.
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Balance Sheet for a Company
in Distress
Assets BV MV Liabilities BV MV
Cash $200 $200 LT bonds $300
Fixed Asset $400 $0 Equity $300
Total $600 $200 Total $600 $200

What happens if the firm is liquidated today?
The bondholders get $200; the shareholders get nothing.
$200
$0
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22-65
Selfish Strategy 1: Take Large Risks
The Gamble Probability Payoff
Win Big 10% $1,000
Lose Big 90% $0

Cost of investment is $200 (all the firms cash)
Required return is 50%

Expected CF from the Gamble = $1000 0.10 + $0 = $100


NPV = $200 +
$100
(1.10)
NPV = $133
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Selfish Stockholders Accept Negative NPV
Project with Large Risks
Expected CF from the Gamble
To Bondholders = $300 0.10 + $0 = $30
To Stockholders = ($1000 $300) 0.10 + $0 = $70
PV of Bonds Without the Gamble = $200
PV of Stocks Without the Gamble = $0
$20 =
$30
(1.50)
PV of Bonds With the Gamble:
$47 =
$70
(1.50)
PV of Stocks With the Gamble:
The stocks are worth more with the high risk project because the call
option that the shareholders of the levered firm hold is worth more when
the volatility of the firm is increased.
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22-67
22.11 Mergers and Options
This is an area rich with optionality, both in the
structuring of the deals and in their execution.
In the first half of 2000, General Mills was
attempting to acquire the Pillsbury division of
Diageo PLC.
The structure of the deal was Diageos
stockholders received 141 million shares of
General Mills stock (then valued at $42.55) plus
contingent value rights of $4.55 per share.
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22.11 Mergers and Options
Cash
payment to
newly
issued
shares
$0
Value of General
Mills in 1 year
$42.55 $38
$4.55
The contingent value rights paid
the difference between $42.55 and
General Mills stock price in one
year up to a maximum of $4.55.

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22.11 Mergers and Options
The contingent value plan can be viewed in
terms of puts:
Each newly issued share of General Mills
given to Diageos shareholders came with a
put option with an exercise price of $42.55.
But the shareholders of Diageo sold a put with
an exercise price of $38
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22.11 Mergers and Options
$38
$0
Value of General
Mills in 1 year
$42.55
$42.55
$38
Own a put
Strike $42.55
Sell a put
Strike $38
$38.00
$4.55
$42.55
Cash payment to newly issued shares
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22-71
22.11 Mergers and Options
Value of a share
$38
$4.55
$0
$42.55
Value of
General
Mills in 1
year
Value of General
Mills in 1 year
Value of a share
plus cash
payment
$42.55
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22-72
22.12 Investment in Real Projects & Options
Classic NPV calculations typically ignore
the flexibility that real-world firms typically
have.
The next chapter will take up this point.
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22.13 Summary and Conclusions
The most familiar options are puts and calls.
Put options give the holder the right to sell stock at a
set price for a given amount of time.
Call options give the holder the right to buy stock at a
set price for a given amount of time.
Put-Call parity

c
0

(1+ r)
T
E
= S
0
+ p
0
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22-74
22.13 Summary and Conclusions
The value of a stock option depends on six factors:
1. Current price of underlying stock.
2. Dividend yield of the underlying stock.
3. Strike price specified in the option contract.
4. Risk-free interest rate over the life of the contract.
5. Time remaining until the option contract expires.
6. Price volatility of the underlying stock.
Much of corporate financial theory can be presented in
terms of options.
1. Common stock in a levered firm can be viewed as a call option on the
assets of the firm.
2. Real projects often have hidden option that enhance value.