Introduction to Corporate Finance

ParT 2: ValuaTION, rISk aNd reTurN

finance in practice

‘WE’RE IN THE MONEY’

Suppose that during your final year of university,

you obtain a job offer from a mining company in

Western Australia. Rather than offering you a cash

signing bonus, they offer 400 call options with an

exercise price set at the current market price of

the company’s shares, $40. These options ‘vest’ in

five years, meaning that you have to wait five years

before you can exercise them. How valuable might

these options become?

Table 8.1A illustrates how the payoff on your

options depends on the company’s share price,

assuming that you plan to exercise them as soon as

they vest if they are in the money.

What happens if the share price is $40 or less in

five years? As long as the options have not expired,

you would continue to hold them in the hope that

the share price will go up. This means that although

you cannot obtain any cash payoff from the options

when they vest, they still have some value because

you might obtain a cash payoff later.

TaBle 8.1a DECISIONS AND PAYOFFS FOR

ST KILDA OPTICS OPTIONS IN

FIVE YEARS

Share price

in five years

Options

payoff

Calculation

$30 $ 0 Out of the money

40 0 Out of the money

45 2,000 400 × (45 – 40)

55 6,000 400 × (55 – 40)

Suppose you purchase the May call, with a $30 strike price, for $2.53. On the option’s expiration date,

the price of St Kilda Optics shares has grown from $30 to $35, an increase of $5, or 16.7%. What would

the option be worth at that time? Because the option holder can buy a share at $30 and then immediately

resell it for $35, the option should be worth $5. If the option sells for $5, that’s an increase of $2.47, or

a percentage increase of almost 98% from the $2.53 purchase price! Similarly, if St Kilda Optics’ share

price is just $25 when the option expires, then the option will be worthless. If you purchased the call for

$2.53, your return on that investment would be –100%, even though St Kilda Optics’ shares fell just $5,

or –16.7%, from the date of your purchase.

This example illustrates what may be the most important fact to know about options. When the price

of the shares moves, the dollar change of the shares is generally more than the dollar change of the option

price, but the percentage change in the option price is greater than the percentage change in the share

price. We have heard students argue that buying a call option is less risky than buying the underlying

share because the maximum dollar loss that an investor can experience is much less on the option.

That’s only true when we compare the $30 investment required to buy one share of St Kilda Optics

with the $2.53 required to buy one May call. It is accurate to say that the call investor can lose, at most,

$2.53, whereas an investor in St Kilda Optics shares may lose $30. But there are two problems with this

comparison. First, the likelihood that St Kilda Optics will go bankrupt and that its shares will fall to $0

in a short time frame is negligible. The likelihood that the shares could dip below $30, resulting in a

$0 value for the call option, is much greater. Second, it is better to compare an equal dollar investment

in St Kilda Optics shares and calls than to compare one share to one call. An investment of $30 would

purchase almost 12 St Kilda Optics call options. Which position, do you think, is riskier – one share or

12 call options?

Which is riskier, a specific share

or a call option on that share?

thinking cap
question