Introduction to Corporate Finance

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