Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionVIII. Topics in Corporate
Finance(^854) 24. Option Valuation © The McGraw−Hill
Companies, 2002
Value of assets (S) Value of stock (C) Value of bonds (EeRtP) [24.10]
Thus, the PCP condition and the balance sheet identity say the same thing, but recog-
nizing the nature of the optionlike features of the equity and debt in a leveraged firm
leads to a far richer understanding of corporate finance. We illustrate some important ex-
amples in the next section.
OPTIONS AND CORPORATE DECISIONS:
SOME APPLICATIONS
In this section, we explore the implications of options analysis in two key areas, capital
budgeting and mergers. We start with mergers and show a very surprising result. We
then go on to show that the net present value rule has some important wrinkles in a
leveraged firm.
Mergers and Diversification
Elsewhere in our book, we discuss mergers and acquisitions. There we mention that di-
versification is frequently cited as a reason for two firms to merge. Is diversification a
good reason to merge? It might seem so. After all, in an earlier chapter, we spent a lot of
time explaining why diversification is very valuable for investors in their own portfolios
because of the elimination of unsystematic risk.
To investigate this issue, let’s consider two companies, Sunshine Swimwear (SS) and
Polar Winterwear (PW). For obvious reasons, both companies have very seasonal cash
flows, and, in their respective off-seasons, both companies worry about cash flow. If the
two companies were to merge, the combined company would have a much more stable
cash flow. In other words, a merger would diversify away some of the seasonal variation
and, in fact, would make bankruptcy much less likely.
Notice that the operations of the two firms are very different, so the proposed merger
is a purely “financial” merger, which means that there are no “synergies” or other value-
creating possibilities except, possibly, gains from risk reduction. Here is some pre-
merger information:
The risk-free rate, continuously compounded, is 5 percent. Given this, we can calculate
the following (check these for practice):
Sunshine Swimwear Polar Winterwear
Market value of assets $30 million $10 million
Face value of pure discount debt $12 million $4 million
Debt maturity 3 years 3 years
Asset return standard deviation 50 percent 60 percent
CONCEPT QUESTIONS
24.4a Why do we say that the equity in a leveraged firm is a call option? What does
the delta of the call option tell us in this context?
24.4bWhat is the connection between the standard balance sheet identity and the
put-call parity (PCP condition)?
CHAPTER 24 Option Valuation 829