Chapter 11

OPTIONS IN CORPORATE
FINANCE AND REAL OPTIONS
CHAPTER 11
Chapter Objectives
This Chapter designed to provide an options perspective to commonly found
corporate financing methods such as debt.
This Chapter examines the motivational issues of capital structure and corporate
finance instruments with option-like features.
You should have a good understanding of concept of real options and their increasing
Importance.
On completion of this chapter you should also have an understanding of exotic

options and hybrid instruments.
CHAPTER 11: Options In Corporate Finance and Real Options Copyright 2017 by McGraw-Hill Education (Malaysia) Sdn. Bhd.
3
Equity v/s Debt
Debt and equity financing are probably the two most common forms by which
businesses finance themselves.
Equity as we know represents ownership whereas debt, a financial obligation.
Equity is perpetual and residual in claim while debt is terminal and fixed in claim.
Equity has no maturity, thus it is perpetual.
An equity holder has a residual claim on assets.
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Equity v/s Debt
Companies raise equity financing by issuing shares or common stock while debt is
raised typically through direct borrowing or through the issue of bonds.
A position in equity is essentially a position in a company stock.
What is equity payoff when combined with debt?
What is the potential payoff to the debt holders who lend to the company?
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Levered Equity: An Options Approach
Payoff to Levered Equity
Assume a firm currently has RM 200,000 of equity. The firm is now considering an investment of
RM 1,000,000 in a new project.
Assume that the investment has a one year life, at the end of which the outcome is known and all
financing partners get their respective returns.
The equity holder seeks and receives RM 800,000 of debt financing at a 10% annual interest rate.
The equity is now levered equity, what is its payoff?
Total value of firm = Value of equity + Value of debt

RM 1,000,000 = RM 200,000 + RM 800,000
The value of equity will depend on what the total firm value is at year end.
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The equity holder losses all his equity for any firm value equal or below RM 880,000.
It equals the principal of RM 800,000 plus the accrued 10% interest of RM 80,000 for the year
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The equity holder losses all his equity for any firm value equal or below RM 880,000.
It equals the principal of RM 800,000 plus the accrued 10% interest of RM 80,000 for the year
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After the break even point of RM 880,000, every one ringgit increase in firm value beyond that
amount constitutes a one ringgit increase in value of equity.
The equity holder losses all his equity if firm value is less than RM 880,000.
Levered equity represents a call option on the firms assets. The payoff profit to equity holders of a
leveraged firm has limited downside and unlimited upside.
It is essentially a European call-option (since the outcome is only known at year end) with the
following features.
Maturity = 1 year
Exercise price = RM 880,000
Asset value = RM 1,000,000
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Payoff to Debt
If the payoff to levered equity is that of a call option, what is the payoff to debt?
For any value below RM 880,000, notice that the payoff to debt equals firm value.
For firm values higher than RM 880,000, debt holders get no higher return.
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Payoff to Debt
For any value below RM 880,000, notice that the payoff to debt equals firm value.
For firm values higher than RM 880,000, debt holders get no higher return.
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Payoff to Debt
The payoff profile to lenders resembles that of a short put position. If the firm succeeds, debt
holders receive their fixed returns and principal, otherwise they incur losses equivalent to the
difference between loan principal and remaining firm value.
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Payoff Profile and Incentive Effects
The levered equity holder is getting a call option, The risk profile of a call option is limited
downside risk and unlimited upside potential.
The payoff profile to levered equity and the fact that equity holders keep everything beyond that
due to debt holders can lead to moral hazard where leverage is high.
Moral hazard is the incentive for equity holders to undertake high risk high return projects.
As a check on such motivational problems, transactions such as Leveraged Buyouts (LBOs), in

which extensive debt financing is used, often use securities that are neither solely debt nor equity.
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Rights Issue
A rights issue gives each shareholder the right to buy additional shares at a fixed
exercise price.
The number of shares offered are proportional to shares already owned.
Given the time difference between the announcement of rights issue and final date
of purchase, the issuing firm faces risk of not all of the rights being taken up.
One way in which an issuing firm can reduce this risk is by setting the exercise price at
a deep discount.
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Rights Issue
Illustration
Suppose you own two lots of Syarikat ABC stock and are offered a rights issue to purchase one lot
at RM 5.00 (a 1 for 2 offer). The offer will expire in 30 days.
What is the payoff?
How could the option be valued?
The payoff profile would be that of a call option. If the stock price is less than the rights price, you
would not exercise. But if the stock price is higher than rights price, you would exercise; profiting
the difference.
The value of the call option can be valued using the standard BSOPM with adjustments as follows:
C = value of one right to each new share
S = the ex-rights value of stock (adjust current stock price for increased number of stocks)
K = the exercise price or rights offer price
t = days between receipt of offer and final purchase date
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Value of Underwriting a Securities Issue
A common method by which a company issuing stocks protects itself from issuance
failure is through the underwriting process.
A rights issue provides shareholders with a call option on additional new shares of the
firm.
An underwriting arrangement provides a long put position to the issuing firm on the
securities to be issued.
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Securities with Option-like Features
Several commonly traded securities have embedded options or option-like features.
We examine five such securities:
Transferable Subscription Rights (TSRs)/Warrant
Call Warrants
Callable Bonds,
Convertible Bonds
Irredeemable Convertible Unsecured Loan Stock (ICULS).
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Transferable Subscription Rights
Warrants/TSRs are typically attached to loan-stocks or bonds. They represent a long dated call
option on the issuing company stock.
A warrant/TSR provides the holder the right but not the obligation to buy the issuing companys
common stock at a predetermined price.
The holder has the right to exercise the warrant at specified times until maturity.
Transferable Subscription Rights (TSRs) were introduced in Malaysia in 1990.
The first warrant was issued by Rashid Hussain Bhd. (RHB) in May 1990.
As of end December 2011, a total of 167 different warrants are listed and traded on Bursa
Malaysia.
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Warrants/TSRs are essentially long dated call options. Aside from maturity there are a number of
other differentiating features.
The exercise of warrants/TSRs leads to dilution. When warrants/TSRs are exercised, unlike equity
options.
When warrants/TSRs are exercised, the issuing company satisfies the exercise by issuing new stock
to the warrant/ TSR holders.
This dilution effect has an impact on the pricing of warrants.
In addition to adjusting for expected dividends, which is important given the long maturity of warrants,
dilution has also to be adjusted for.
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This dilution effect has an impact on the pricing of warrants.
In addition to adjusting for expected dividends, which is important given the long maturity of warrants,
dilution has also to be adjusted for.
Dubosky (1992) suggests the following adjustment for dilution in valuing warrants.
20
Call Warrants
Call warrants are essentially call options issued by a third party, usually a merchant bank, on a
listed stock.
Unlike warrants/TSRs that went on to become popular in Malaysia, call warrants died a natural
death after only three issues.
Malaysias first call warrant was issued by CIMB on Maybank stock. The call warrants had a 18-
month maturity, and could be exercised only at maturity at the stated exercise price of RM 19.00.
The two main differences of Call Warrants with TSRs are:

The issuer of call warrants is a merchant bank, whereas warrants/TSRs are issued by the companies
themselves
Unlike warrants/TSRs that cause dilution upon exercise of the warrants, the exercise of call warrants
does not increase the outstanding number of shares.
21
Callable Bonds
A callable bond is a bond that is callable or redeemable by the issuer at a predetermined price
before maturity.
The call provision in the bond provides a call option to the issuer.
The exercise price is equal to the price at which the bond will be called.
A callable bond arrangement is essentially the sale of a straight bond to the investor and the
concurrent sale of a call option by the investor to the bond issuing firm.
As payment for this call option, the investor is paid with a higher coupon rate than that of a straight
bond with the same features and risk class.
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Convertible Bonds
A convertible bond allows the holder to either receive the face value of the bond or convert the
bond to a predetermined number of common stocks at maturity.
The number of stocks that each bond can be converted to is predetermined and stated as the
conversion ratio.
With a convertible bond, the investor is assured a minimum payoff equal to the face value of the
bond and potentially much more if the underlying stock rises.
The investor pays for the call option by agreeing to receive a lower coupon rate than otherwise would
have been.
Convertible bonds therefore pay a lower coupon/yield relative to a straight bond with same features and
risk level.
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ICULS (Irredeemable Convertible Unsecured Loan Stock)
An irredeemable convertible unsecured loan stock (ICULS) is a hybrid instrument that has the
features of both debt and equity.
In essence, it resembles a fixed income debt instrument until converted into equity at
predetermined dates, at or prior to maturity.
Features of ICULS
ICULS carry fixed interest, coupons, payable either semiannually or annually.
It is unsecured and normally subordinated to all other obligations of the company.
ICULS have fixed maturity dates and holders of ICULS must convert their ICULS into the underlying ordinary
shares either at predetermined exercise points before maturity or at maturity as specified by the issuer.
Unlike convertible bonds where partial dilution is possible, ICULS ultimately result in full dilution.
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Real Options and Capital Budgeting
Real options refers to options, often implicit that may be embedded within capital
investments.
Real options are not a derivative instrument but constitute an actual option; real,
because they are associated with investments in real/physical assets rather than
financial assets.
Capital budgeting refers to the process of identifying and evaluating investment

projects.
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While financial options have their specifications clearly identified and stated in the
option contract, real options embedded within investment projects must first be
identified and specified in order to put a monetary value on them.
Flexibilities arising from embedded options are often contingent in nature.
The typical real options embedded within investment projects are

(i) Growth Options, (ii) Exit Options, (iii) Guarantees, (iv) Timing Options
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Illustration: Implicit Options in Capital Budgeting
Suppose you are a large Malaysian company involved in the manufacture of power generation
equipment and electrical parts.
You are now evaluating an investment to build and operate a plant that will produce and supply
electrical parts for the National Electric Utility in Vietnam.
In order to evaluate using Net Present Value (NPV), you have determined the initial investment
(RM 100 million), the types of parts to be produced, the expected annual demand, their inflation
adjusted prices etc.
You are concerned however that you do not miss out implicit options that may be available.
Suppose the following were available, identify the option.
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Government Guarantee
The Vietnamese government is offering a guarantee on your initial investment of RM 100 million.
What type of option is this? How should you adjust the NPV?
Answer
A government guarantee received is a long put option with exercise price of RM 100 million.
The value of this put could be determined using BSOPM and the adjustment would be to add the put
value to NPV.
The period over which the guarantee is valid will be the maturity period.
The projects standard deviation would be the volatility estimate to be used in the put valuation.
While a guarantee received is equivalent to being long a put option with exercise price equal to
guarantee amount, a guarantee extended or granted is equivalent to being short a put option.
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Exit Option
The contract with the Vietnamese Utility allows you to pull out at the end of the third year by
turning over all assets to the utility.
The foreign utility will take over operations for a payment of RM 150 million.
Answer
This is a put option.
The exercise price is RM 150 million with maturity equal to 3 years.
The value of this long put option should be added to NPV.
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Growth Option
If company does well on this project, it can be awarded at least one other project to build and
supply related electrical parts.
Alternatively, it may also be able to expand production for supply to neighboring countries such as
Cambodia and Laos.
Answer
The option to expand is a call option.
The exercise price will be the needed new investment and S = the present value of cash flows that can
be derived.
The standard deviation will be the volatility of the new project cash flows.
The value of this call option should be added to the NPV of the current project.
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Timing Option
Given Vietnams economic and political risk, you feel uneasy about making too large a
commitment.
Rather than make a huge upfront investment to produce a multitude of products, you plan to go in
small and than expand if viable, in stages.
What type of option is this?
Answer
This option to time investments by first waiting to see constitutes a series of call options.
You will exercise the option to expand in stages if it becomes viable to do so.
Should it not be viable, you will simply not exercise by not expanding.
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Flexibility Option
Suppose in this investment you have two alternatives.
The first alternative is to build one large plant in Vietnam to service both Vietnam and Cambodia.
The second alternative is to build two smaller plants, one in each country.
Which is the better alternative?
Answer
From a traditional discounted cash flow viewpoint, the first alternative may seem better. However, when
viewed from an options viewpoint, in the light of the extensive economic and political risks in each
country the second alternative might be more sensible.
The flexibility constitutes a call option.
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Exotic Options
Exotic options are non-standard options traded in over-the counter markets. They are
usually custom designed to meet specific needs.
The need for such exotic options come from either the need to hedge complicated
cash flows, to get around regulations or simply to suit a finance managers perception
of forecast events.
Exotics can have different underlying assets, but they are more popular in foreign
exchange markets with currencies being probably the most common underlying asset.
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Exotic Options
Barrier Options
A barrier option is an option whose payoff is triggered by the underlying asset reaching a certain
predetermined price level.
There are typically two kinds of barrier options, knock-out options and knock-in options.
A knock-out option is usually designed to expire once the underlying asset reaches a certain price.
A knock-in option on the other hand would begin once the underlying asset reaches the predetermined
price.
The option could be a call or a put.

Example, An up and out call option would cease to exist once the underlying asset reaches a
predetermined (barrier) price level
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Exotic Options
Forward Start Options
Forward start options are essentially options that will be activated at some future point in time.
The exercise price is usually set to be at-the-money when the option is initiated
Binary Options
Binary options typically have payoffs that are all or nothing.
Example: a cash or nothing call option pays a fixed cash amount if the underlying assets price at
maturity is above the exercise price but nothing if the asset price is below exercise.
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Exotic Options
Asian Options
An Asian option is one where the exercise price is not predetermined but arrived at by averaging
the spot price of the underlying asset over a predetermined period until maturity.
Asian options may actually be better suited to hedge underlying exposures where cash flows are
spread evenly over a period of time.
Example: A company that will be receiving payments in foreign currency on a weekly basis may be better
hedged using Asian put options on the foreign currency. Similarly, a company with payables due in
foreign currency with weekly or monthly payments, may be better off with Asian call options.
Since the average price used in determining exercise price would be a closer reflection of the home
currency cost of gradual cash flows, the Asian option would be a more effective hedge instrument than a
regular option.
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Exotic Options
Structured Warrants
Structured warrants are essentially long dated options written on stocks.
The underlying asset could also be a stock index.
These structured warrants are issued by third parties such as a stock brokerage firm, an
investment bank, asset management firm of some other financial institution
The structured warrant can either be a call or a put.
Functionally structured warrants operate exactly as options
In Malaysia, Macquarie, an Australian asset management firm with a Malaysian subsidiary is

probably the biggest issuer of structured warrants
37
Thank You

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Chapter 11

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OPTIONS IN CORPORATE

FINANCE AND REAL OPTIONS

On completion of this chapter you should also have an understanding of exotic

Equity as we know represents ownership whereas debt, a financial obligation.

Equity has no maturity, thus it is perpetual.

An equity holder has a residual claim on assets.

A position in equity is essentially a position in a company stock.

What is equity payoff when combined with debt?

Total value of firm = Value of equity + Value of debt

As a check on such motivational problems, transactions such as Leveraged Buyouts (LBOs), in

The number of shares offered are proportional to shares already owned.

We examine five such securities:

Transferable Subscription Rights (TSRs)/Warrant

Irredeemable Convertible Unsecured Loan Stock (ICULS).

Transferable Subscription Rights (TSRs) were introduced in Malaysia in 1990.

This dilution effect has an impact on the pricing of warrants.

The two main differences of Call Warrants with TSRs are:

It is unsecured and normally subordinated to all other obligations of the company.

Capital budgeting refers to the process of identifying and evaluating investment

Flexibilities arising from embedded options are often contingent in nature.

The typical real options embedded within investment projects are

What type of option is this?

The flexibility constitutes a call option.

The option could be a call or a put.

Binary options typically have payoffs that are all or nothing.

The structured warrant can either be a call or a put.

Functionally structured warrants operate exactly as options

In Malaysia, Macquarie, an Australian asset management firm with a Malaysian subsidiary is

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