Finance

In July 2001, Fortune magazine 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! Fortune went 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 Fortunes rule of thumb.

Options are a part of everyday life. "Keep your options open" is sound business advice, and "We're out of options" is a sure sign of trouble. In finance, an option is 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 options. 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 different 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 analysis 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 option 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.

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.

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

V. Risk and Return

14. Options and Corporate Finance

© The McGraw-Hill Companies, 2002

PART FIVE Risk and Return

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