Options Corporate Finance∶ Extensions Applications.pptVIP

Executive Summary This chapter extends the analysis of options contained in Chapter 22. We describe four types of options found in common corporate finance decisions. Executive stock options The option to expand embedded in a start-up. The option in simple business contracts. The option to shut down and reopen a project. Chapter Outline 23.1 Executive Stock Options 23.2 Valuing a Start Up 23.3 More on the Binomial Model 23.4 Shutdown and Reopening Decisions 23.5 Summary and Conclusions 23.1 Executive Stock Options Executive Stock Options exist to align the interests of shareholders and managers. Executive Stock Options are call options (technically warrants) on the employer’s shares. Inalienable Typical maturity is 10 years. Typical vesting period is 3 years. Most include implicit reset provision to preserve incentive compatibility. Executive Stock Options give executives an important tax break: grants of at-the-money options are not considered taxable income. (Taxes are due if the option is exercised.) Valuing Executive Compensation FASB allows firms to record zero expense for grants of at-the-money executive stock options. However the economic value of a long-lived call option is enormous, especially given the propensity of firms to reset the exercise price after drops in the price of the stock. Due to the inalienability, the options are worth less to the executive than they cost the company. The executive can only exercise, not sell his options. Thus he can never capture the speculative value—only the intrinsic value. This “dead weight loss” is overcome by the incentive compatibility for the grantor. Top Stock Option Grants 23.2 Valuing a Start-Up An important option is the option to expand. Imagine a start-up firm, Campusteria, Inc. which plans to open private dining clubs on college campuses. The test market will be your campus, and if the concept proves successful, expansion will follow nationwide. Nationwide expansion will occur in year four. The start-