Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

V. Risk and Return 14. Options and Corporate

Finance

© The McGraw−Hill^499

Companies, 2002

OPTIONS AND CAPITAL BUDGETING

Most of the options we have discussed so far are financial options because they involve
the right to buy or sell financial assets such as shares of stock. In contrast, real options
involve real assets. As we will discuss in this section, our understanding of capital bud-
geting can be greatly enhanced by recognizing that many corporate investment deci-
sions really amount to the evaluation of real options.
To give a simple example of a real option, imagine that you are shopping for a used
car. You find one that you like for $4,000, but you are not completely sure. So, you give
the owner of the car $150 to hold the car for you for one week, meaning that you have
one week to buy the car or else you forfeit your $150. As you probably recognize, what
you have done here is to purchase a call option, giving you the right to buy the car at a
fixed price for a fixed time. It’s a real option because the underlying asset (the car) is a
real asset.
The use of options such as the one in our car example is very common in the business
world. For example, real estate developers frequently need to purchase several smaller
tracts of land from different owners to assemble a single larger tract. The development
can’t go forward unless all of the smaller properties are obtained. In this case, the de-
veloper will often buy options on the individual properties, but only exercise those op-
tions if all of the necessary pieces can be obtained.
These examples involve explicit options. As it turns out, almost all capital budgeting
decisions contain numerous implicitoptions. We discuss the most important types of
these next.

The Investment Timing Decision

Consider a business that is examining a new project of some sort. What this normally
means is management must decide whether to make an investment outlay to acquire the
new assets needed for the project. If you think about it, what management has is the

CONCEPT QUESTIONS

14.5a Why do we say that the equity in a leveraged firm is effectively a call option on

the firm’s assets?

14.5bAll other things being the same, would the stockholders of a firm prefer to in-

crease or decrease the volatility of the firm’s return on assets? Why? What

about the bondholders? Give an intuitive explanation.

CHAPTER 14 Options and Corporate Finance 471

To replicate the value of the assets of the firm, we first need to invest the present value of

$55 in the risk-free asset. This costs $55/1.10 $50. If the assets turn out to be worth $160,

then the option is worth $160
 100 $60. Our risk-free asset will be worth $55, so we

need ($160
 55)/60 1.75 call options. Because the firm is currently worth $110, we have:

$110 1.75 C 0 $50

C 0 $34.29

The equity is thus worth $34.29; the debt is worth $110
 34.29 $75.71. The interest rate

on the debt is about ($100/75.71)
 1 32.1%.

14.6

real option

An option that involves

real assets as opposed

to financial assets such

as shares of stock.