Introduction to Corporate Finance

(avery) #1
Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate Edition

V. Risk and Return 14. Options and Corporate
Finance

(^508) © The McGraw−Hill
Companies, 2002
convertible is most significantly influenced by the underlying value as straight debt. How-
ever, when the value of the firm is very high, the value of a convertible bond is mostly de-
termined by the underlying conversion value. This is also illustrated in Figure 14.3.
Option Value The value of a convertible bond will always exceed the straight bond
value and the conversion value unless the firm is in default or the bondholders are
forced to convert. The reason is that holders of convertibles do not have to convert im-
mediately. Instead, by waiting, they can take advantage of whichever is greater in the fu-
ture, the straight bond value or the conversion value.
This option to wait has value, and it raises the value of the convertible bond over its
floor value. The total value of the convertible is thus equal to the sum of the floor value
and the option value. This is illustrated in Figure 14.4. Notice the similarity between this
picture and the representation of the value of a call option in Figure 14.2, referenced in
our earlier discussion.
Other Options
We’ve discussed two of the more common optionlike securities, warrants and convert-
ibles. Options appear in many other places. We briefly describe a few in this section.
The Call Provision on a Bond As we discussed in Chapter 7, most corporate bonds
are callable. A call provision allows a corporation to buy the bonds at a fixed price for a
fixed period of time. In other words, the corporation has a call option on the bonds. The
cost of the call feature to the corporation is the cost of the option.
480 PART FIVE Risk and Return


FIGURE 14.3


Minimum Value of a
Convertible Bond
versus the Value of the
Stock for a Given
Interest Rate

Minimum convertible
bond value
(floor value)

Stock
Straight bond value price
greater than
conversion value

Convertible bond
floor value

Conversion
value

Straight bond
value

Straight bond value
less than conversion
value

As shown, the minimum, or floor, value of a convertible bond is either
its straight bond value or its conversion value, whichever is greater.

= Conversion
ratio
Free download pdf