Introduction to Corporate Finance

ParT 2: ValuaTION, rISk aNd reTurN

10 To value options using the binomial method, is it necessary to know the expected return on the

shares? Why or why not?

11 There is an old saying that nature abhors a vacuum. The financial equivalent is, ‘Markets abhor

arbitrage opportunities.’ Explain the central role this principle plays in the binomial model.

CONCEPT REVIEW QUESTIONS 8-4

8-5 OPTIONS IN COrPOraTe FINaNCe

Thus far, our emphasis has been on share options that trade in financial markets. The principles we’ve

developed to understand those options can be applied more broadly in a wide range of corporate finance

problems. We conclude this chapter with a brief overview of the applications of option-pricing techniques

to the problems that corporate financial managers encounter on a regular basis.

8-5a eMPlOYee SHare OPTIONS

Many companies around the world now use employee share option grants (ESOs) as part of their

compensation packages. ESOs are essentially call options that give employees the right to buy shares

in the company they work for, at a fixed price. When companies distribute ESOs to their employees,

they typically set the strike price equal to the current market price, so ESOs are typically at the money

when they are issued. Like the ordinary call options that trade in financial markets, ESOs are most

valuable when the price of the underlying shares is well above the strike price. Thus, granting ESOs gives

employees an incentive to take actions that increase the company’s share price. Aligning the interests

of employees with those of shareholders is one of the primary reasons that companies compensate their

people with options. Options do not result in a perfect alignment of interests, however. For example, we

know that option values increase if the volatility of the underlying shares increases, so paying managers

in options creates at least some incentive for them to take added risk. That added risk may or may not be

in the interests of shareholders.

ESOs differ from ordinary call options in several important ways. Whereas the majority of options

traded in financial markets expire within a few months, ESOs grant employees the right to buy shares for

as long as 10 years. We know that call option values increase as the time toward expiration grows longer,

so the long life of ESOs makes them particularly attractive to employees. However, many companies do

not allow employees to exercise their options until a ‘vesting’ period has passed. For example, a common

requirement is that the employee must work for the company for five years after receiving an ESO grant

before the option can be exercised. In a sense, ESOs are a blend of American and European options.

Like European options, ESOs cannot be exercised immediately, but like American options, they can be

exercised at any time after the vesting period has passed.

Besides using options to give employees an incentive to increase the share price, companies issue

options because they require no immediate cash outlay. Small companies, rapidly growing companies

and companies that do not have an abundance of cash may elect to pay employees with options as a way

of conserving cash.

LO8.5

Why do you think that companies

might offer options on their own

shares?

thinking cap
question