Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

14. Options and Corporate Finance

Finance

© The McGraw−Hill^481

Companies, 2002

CHAPTER

14

Options and Corporate

Finance

In July 2001,Fortunemagazine ran a cover picture with the headline “The Great

CEO Pay Heist,” which also mentioned that Steven Jobs of Apple Computer was

granted stock options worth $872,000,000! Fortunewent on to clarify that this

was actually the face value, but the true value was estimated to be about $291

million based on a rule of thumb that options are worth one-third of the

exercise price. The issue also included a letter from Jobs with his estimate of the

value of the options: $0. That’s a big difference! So who is correct? As we will

see in this chapter, they’re probably both wrong. The options certainly have

value, but that value is a lot more complicated than indicated by Fortune’s rule

of thumb.

ptions are a part of everyday life. “Keep your options open” is sound business ad-

vice, and “We’re out of options” is a sure sign of trouble. In finance, an optionis

an arrangement that gives its owner the right to buy or sell an asset at a fixed

price anytime on or before a given date. The most familiar options are stock op-

tions. These are options to buy and sell shares of common stock, and we will discuss

them in some detail in the following pages.

Of course, stock options are not the only options. In fact, at the root of it, many dif-

ferent kinds of financial decisions amount to the evaluation of options. For example, we

will show how understanding options adds several important details to the NPV analy-

sis we have discussed in earlier chapters.

Also, virtually all corporate securities have implicit or explicit option features, and

the use of such features is growing. As a result, understanding securities that possess op-

tion features requires a general knowledge of the factors that determine an option’s

value.

This chapter starts with a description of different types of options. We identify and

discuss the general factors that determine option values and show how ordinary debt and

equity have optionlike characteristics. We then examine employee stock options and the

important role of options in capital budgeting. We conclude by illustrating how option

features are incorporated into corporate securities by discussing warrants, convertible

bonds, and other optionlike securities.

O

453

option

A contract that gives its

owner the right to buy or

sell some asset at a fixed

price on or before a

given date.