Introduction to Corporate Finance

8: Options

Now, a pilot program (or market test) is not a novel idea; but its use tells us something about choices

that we now seem to have with the new product launch that were not visible when we thought about

the project as a simple, ‘we start it now or we never start it’ venture based on whether the NPV for the

project was positive or negative. The use of a pilot first shows us that we do not have to start all projects

immediately: we can perhaps wait some time before launching. It also gives us new information about

the market that we do not currently possess, which may change our risk evaluation of the project.

Having these choices or options is valuable for the project. They are ‘real options’, in the terminology

of Stewart Myers of MIT, who coined the phrase in a publication in 1978. (Real options are discussed in

detail in Chapter 11.) In our example, we have an option (choice) on when to begin the project because

of the delay induced by running the pilot; and an option on scale of the project once we have the results

of the pilot – we can implement the launch of the new product (full-scale) or not (zero-scale). Each of

these options has its own NPV; so we can compare these, as we would any set of project NPVs, and adopt

the project with the highest NPV.

In Chapter 11 we will explore in detail the formal framework for real options, but we can conclude

our discussion here by listing some types of real options:

■ Waiting-to-invest option. Should we start a project immediately, or wait for some time?

■ Growth options. At what scale should we run our project (most projects have several scales, from zero

to some maximum level) once we start it?

■ Flexibility options. Once the project is running, can we change the scale at which we operate?

■ Exit options. No project really lasts forever, but most projects also do not have a single fixed endpoint;

if we learn new information about the likely future cash flows or their risks while running the project,

we may recalculate the NPVs of continuing the project and find that we should close it down, or

extend it, earlier than thought.

In summary, any project or investment does contain options about its operation that we should account

for in the valuation of the project. These real (or embedded) options may be very valuable, and we may

undervalue a project in a major way if we ignore them.

SuMMarY

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■ Options are contracts that grant the buyer

the right to buy or sell shares at a fixed price.

■ Call options grant the right to purchase

shares; put options grant the right to sell

shares.

■ Options provide a real economic benefit

to society and are not simply a form of

legalised gambling.

■ American options allow investors to exercise

their options before they expire, but

European options do not.

■ Payoff diagrams show the value of options or

portfolios of options on the expiration date.

Payoff diagrams can be used to illustrate how

portfolios of options and other securities

perform as the underlying share price moves.

■ Put–call parity establishes a link between

the market prices of calls, puts, shares and

bonds.

■ Call option prices rise and put option prices

fall as S–X (the share price minus the strike

price) increases.

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