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^495

Companies, 2002

increases. For example, notice that increasing the exercise price reduces the value of a
call option. Increasing any of the other four factors increases the value of the call. No-
tice also that the time to expiration and the variance of return act the same for puts and
calls. The other three factors have opposite signs in the two cases.
We have not considered how to value a call option when the option can finish out of
the money and the stock price can take on more than two values. A very famous result,
the Black-Scholes option pricing model, is needed in this case. We cover this subject in
a later chapter.

EMPLOYEE STOCK OPTIONS

Options are important in corporate finance in a lot of different ways. In this section, we
begin to examine some of these by taking a look at employee stock options, or ESOs.
An ESO is, in essence, a call option that a firm gives to employees giving them the right
to buy shares of stock in the company. The practice of granting options to employees has
become widespread. It is almost universal for upper management, but some companies,
like The Gap and Starbucks, grant options to almost every employee. Thus, an under-
standing of ESOs is important. Why? Because you may very soon be an ESO holder!

ESO Features

Since ESOs are basically call options, we have already covered most of the important as-
pects. However, ESOs have a few features that make them different from regular stock
options. The details differ from company to company, but a typical ESO has a 10-year
life, which is much longer than most ordinary options. Unlike traded options, ESOs can-
not be sold. They also have what is known as a “vesting” period. Often, for up to three
years or so, an ESO cannot be exercised and also must be forfeited if an employee leaves
the company. After this period, the options “vest,” which means they can be exercised.

CONCEPT QUESTIONS

14.3a What are the five factors that determine an option’s value?

14.3bWhat is the effect of an increase in each of the five factors on the value of a call

option? Give an intuitive explanation for your answer.

14.3c What is the effect of an increase in each of the five factors on the value of a put

option? Give an intuitive explanation for your answer.

CHAPTER 14 Options and Corporate Finance 467

TABLE 14.2

Five Factors That

Determine Option

Values

Direction of Influence

Factor Calls Puts

Current value of the underlying asset ()(
)

Exercise price on the option (
)()

Time to expiration on the option ()()

Risk-free rate ()(
)

Variance of return on the underlying asset ()()

14.4

employee stock option

(ESO)

An option granted to an

employee by a company

giving the employee the

right to buy shares of

stock in the company at

a fixed price for a fixed

time.