Pike Robert, Neal Bill. Corporate finance and investment: decisions and strategy

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Chapter 12 Identifying and valuing options 315

Self-assessment activity 12.4

What is the type of option available to Eurotunnel and what factors would you consider in

assessing its value?

(Answer in Appendix A at the back of the book)

The options literature has developed highly complex models for valuing options, but

insufficient attention has been paid to value creation through options.

Options or option-like features permeate virtually every area of financial manage-

ment. A better understanding of options and the development of option pricing have

made the topic an increasingly important part of financial theory. We have sought to

increase your awareness of what options are, where they are to be found, and how

managers can begin to value them. The topic is still in its infancy, but its study will

yield important insights into financial and investment decisions.

Key points

■ Option features are to be found in most areas of finance (e.g. convertibles and war-

rants, insurance, currency and interest rate management, and capital budgeting).

■ Pure options are financial instruments created by exchanges (e.g. stock markets)

rather than companies.

■ The two main types of option are (1) call options, giving the holder the right to buy

a share (or other asset) at the exercise price at some future time, and (2) put options,

giving the holder the right to sell shares at a given price at some future time.

■ The minimum value of a call option is the difference between the share price and

the present value of the exercise price.

■ The value of call options increases as:

– The underlying share price increases.

– The exercise price falls.

– The time to expiry lengthens.

Continued

SUMMARY

Eurotunnel asked two consultants to investigate seven

options for a second link – over and under the water. The

study settled on two options: a two-tier road tunnel or a

second rail tunnel.

Both would probably run alongside the existing

Chunnel; the main difference being that technological

advances would make it possible to build a large single-

bore tunnel, rather than the existing two main tunnels

sandwiching a third service tunnel.

The rail option – to be reserved exclusively for

Eurostars and freight trains – sounds safe. For an estimat-

ed £3 billion Eurotunnel could simply extend services it

and customers already know.

But the report suggests the road tunnel would be more

financially viable. Initial studies suggest that a rail option

would not make an adequate return unless there was a

very significant shift from road to rail.

Whether there will be the passenger demand for a sec-

ond tunnel of either type is too early to say. Eurotunnel

estimates the existing tunnel will reach capacity use in

2025 – but great changes could happen to travel needs

and methods over a quarter of a century.

The company has ten years to make up its mind – the

deadline is 2010 and it seems in no hurry to be rushed.

Source: Based on Juliette Jowit, Financial Times, 6 January 2000.

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316 Part III Investment risk and return

Further reading

A more detailed treatment of options is found in Brealey, Myers and Allen (2005) and Bodie and

Merton (2000). An introduction to options is given by Redhead (1990). Kester (1984) discusses

the topic of real options and Dixit and Pindyck (1995) provide an easy-to-read article on the

options approach to capital investment. Brennan and Trigeorgis (2000) offer a number of useful

papers on real options. Those who like a mathematical challenge may want to try Black and

Scholes’ (1973) classic paper or Cox et al. (1979). Merton (1998) gives an excellent review of the

application of option pricing, particularly to investment decisions.

Useful websites

Futures and Options World: www.fow.com

Euronext.liffe: www.liffe.com

International Swaps and Derivatives Association: www.isda.org

– The risk-free interest rate rises.

– The volatility of the underlying share price increases.

■ The Black–Scholes Option Pricing Model can be applied to estimate the value of call

options.

■ Capital investment decisions may have options attached covering the option to

(1) abandon, (2) delay or (3) invest in follow-on opportunities.

■ Where the value of a company’s assets falls below the value of its borrowings,

shareholders may not exercise their option to repay the loan, but prefer the compa-

ny to default on the debt.

APPENDIX

BLACK-SCHOLES OPTION PRICING FORMULA

The Black–Scholes formula, for valuing a call option (C), with no adjustment for divi-

dends, is given by:

where:

We already have described S as the underlying share price and E as the exercise

price. In addition, is the standard deviation of the underlying asset, t is the time, in

years, until the option expires, k is the risk-free rate of interest continuously com-

pounded, N(d) is the value of the cumulative distribution function for a standardised

normal random variable and is the present value of the exercise price continuously

discounted.

tk

 d

 st

1>2



ln1S>E2  tk

1>2



1>2

C  SN1d

2  EN1d

tk

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Chapter 12 Identifying and valuing options 317

■

Example

Acorn plc shares are currently worth 28p each with a standard deviation of 30 per cent.

The risk-free interest rate is 6 per cent, continuously compounded. Compute the value

of a call option on Acorn shares expiring in nine months and with an exercise price of

30p.

We can list the values for each parameter:

Using cumulative distribution function tables:

Inserting the above into the original equation:

The value of the call is 2.6p.

Strictly speaking, adjustment for dividends on shares should be made by applying

the Merton formula, not dealt with in this text.

 2.6p

 2810.51602  3010.41292e

0.045

C  SN1d

2  EN1d

tk

N1d

2  N10.222  0.4129

N1d

2  N10.042  0.5160

002223, say 0.22

 d

 sr

1>2

 0.0375  0.2598

 0.0375, say 0.04

0.2655  0.1732  0.1299



ln128>302  0.75 10.062

0.2598



0.2598



ln1S>E2  tk

1>2



1>2

 10.32 10.752

1>2

 0.2598

t  0.75.

K  0.06,E  30,s  0.30,S  28,

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318 Part III Investment risk and return

Questions with a coloured number have solutions in Appendix B on page 703.

1 Give two examples where companies can issue call options (or something similar).

2 On 1 March the ordinary shares of Gaymore plc stood at 469p. The traded options market in the shares quotes

April 500p puts at 47p. If the share price falls to 450p, how much, if any, profit would an investor make? What

will the option be worth if the share price moves up to 510p?

3 What is the difference between traditional and exchange traded options?

4 Explain the factors influencing the price of a traded option and whether volatility of a company’s share

option price is necessarily a sign of financial weakness.

5 Frank purchased a call option on 100 shares in Marmaduke plc six months ago at 10p per share. The share

price at the time was 110p and the exercise price was 120p. Just prior to expiry the share price has risen

to 135p.

Required

(a) State whether the option should be exercised.

(b) Calculate the profit or loss on the option.

10 per cent p.a.?

6 Find the value of the call option given that the present value of the exercise price is 10p, the value of the put

option is 15p and the current value of the share on which the option is based is 25p.

7 Find the present value of the exercise price given that the value of the call is 19p, the value of the put is 5p

and the current market price of the underlying share is 30p.

8 The current price of a share is 38p and a call option written on this share with six months to run to maturity

has an exercise price of 40p. If the risk-free rate of interest is 10 per cent per annum and the volatility of the

returns on the share is 20 per cent, use the Black and Scholes model to estimate the value of the call.

9 The current price on British Sky Broadcasting is 420.5p and the price of a call option with a strike price of

420p with six months to maturity is 50.5p. The value of a put option with the same strike price and time to

maturity is 38.5p. Determine the annualised rate of interest if put–call parity holds.

10 The following are the closing prices of options on the shares of BAT on Wednesday 10 March 2004.

Refer to the table as required when answering this question.

(a) Explain the fundamental reasons for the large difference between the price of a September 800 call and

an April 800 put.

(b) Outline a strategy that combines short calls and short puts. Why would an investor adopt such a strategy?

Use data from the table to illustrate some possible payoffs.

Calls Puts

Exercise Price Apr Jun Sep Apr June Sep

BAT 800 36.5 53.5 62.5 9.0 20.0 31.5

(*825) 850 11.0 25.5 35.0 33.0 42.0 55.5

*Current price

QUESTIONS

318 Part III Investment risk and return

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Chapter 12 Identifying and valuing options 319

11 Spot the options in Enigma Drugs plc. The mini-case presented below incorporates five options. Can you iden-

tify the type of option, its length and exercise price? Recall that American options offer the holder the right

to exercise at any time up to a certain date, while a European option is exercised on one particular date.

Enigma Drugs plc is an innovative pharmaceutical company. The management team is considering set-

ting up a separate limited company to develop and produce a new drug.

The project is forecast to incur development costs and new plant expenditure totalling million and

to break even over the next five years (by which time its competitors are likely to have found a way round

the patent rights). Enigma’s management is considering deferring the whole decision by two years, when

the outcome of a major court case with important implications for the drug’s success will be known.

The risks on the venture are high, but should the project prove unsuccessful and have to be abandoned,

the ‘know-how’ developed from the project can be used inside the group or sold to its competitors for a

considerable sum. Enigma’s management realises that there is little or no money to be made in the initial

five years, but it should allow them to gain vital expertise for the development of a ‘wonder drug’ costing

million, which could be launched in four years’ time.

The newly-formed company would be largely funded by borrowing million in the first instance,

repayable in total after eight years, unless the company prefers to be ‘wound up’ for defaulting on the loan.

Some of the debt raised will be by 9 per cent Convertible Loan Stock, giving holders the right to convert

to equity at any time over the next four years at 360p compared with the current price of 297p.

£40

£120

£50

1 Choose two forms of financial contracting arrangement with option features and show how option pricing theory

can help in analysing them.

2 Consider a major capital investment recently undertaken or under review. Does it offer an option? Could an

option feature be introduced? What would the rough value of the option be?

Practical assignment

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The acquisition of every asset has to be financed. Companies obtain two forms of finance, short and

long term, although, in practice, it is difficult to make a rigid demarcation between them. Part IV is

devoted to analysing short-term financing, while the analysis of long-term financing decisions

appears in Part V.

Chapter 13 offers an overview of the financing operations of the modern corporation, focusing on

balancing the inflows and outflows of funds in the process of treasury management. The chapter

examines the importance of working capital management, and how the financial manager may use

the derivatives markets.

Chapter 14 looks at managing short-term assets – cash, stocks, debtors – and the financing

implications of different working capital policies. Chapter 15 describes the various forms of short-

(and medium-) term sources of finance, especially trade credit and the banking system, and also

discusses the analysis of leasing decisions and the finance of foreign trade.

Chapter 13 Treasury management and working capital policy

321

Chapter 14 Short-term asset management 353

Chapter 15 Short- and medium-term finance 379

SHORT-TERM FINANCING AND POLICIES

Part

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Treasury Management and working

capital policy

Learning objectives

Treasury management and working capital policy are central to the whole of corporate finance.

After reading this chapter, you should appreciate the following:

■ The purpose and structure of the treasury function.

■ Treasury funding issues.

■ How to manage banking relationships.

■ Risk management, hedging and the use of derivatives.

■ Working capital policies.

■ The cash operating cycle and overtrading problems.

Treasury Management at DS Smith plc

The Group treasury strategy is controlled through a

Treasury Committee, which meets regularly and

includes the Chairman, the Group Chief Executive

and the Group Finance Director. The Group Treasury

function operates in accordance with documented

policies and procedures approved by the Board and

controlled by the Group Treasurer. The function

arranges funding for the Group, provides a service to

operations and implements strategies for interest rate

and foreign exchange exposure management.

The major treasury risks to which the Group is

exposed relate to movements in interest rates and

currencies. The overall objective of the Treasury

function is to control these exposures whilst striking

an appropriate balance between minimising risks

and costs. Financial instruments and derivatives may

be used in implementing hedging strategies, but no

speculative use of derivatives or other instruments

is permitted.

The Treasury Committee regularly reviews the Group’s

exposure to interest rates and considers whether to

borrow on fixed or floating terms. For the last few

years the Group has generally chosen to borrow on

floating rates, which the Committee believes have

provided better value. During the year, however, the

Group took advantage of the historically low level of

medium to long-term sterling interest rates and fixed

the interest rate on £40 million of sterling denomi-

nated borrowings for a period of five years at an

average rate (before margin) of just under 4%.

Group policy is to hedge the net assets of major

overseas subsidiaries by means of borrowings in the

same currency to a level determined by the Treasury

Committee. The borrowings in currency give rise to

exchange differences on translation into sterling,

which are taken to reserves. A portion of the Group’s

net borrowings are denominated in euros, which are

held to hedge the underlying assets of our eurozone

operations. At the year end, these borrowings repre-

sented 64% of our eurozone net assets.

Reprinted with permission, DS Smith plc, Annual Report and Accounts,

2004.

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The size, structure and responsibilities of the treasury function will vary greatly among

organisations. Key factors will be corporate size, listing status, degree of international

business and attitude to risk. For example, BP plc is a major multinational company

with a strong emphasis on value creation, where currency and oil price movements can

have a dramatic impact on corporate earnings. It is not surprising that it has a highly

developed group treasury function, covering the following:

1 Global dealing – foreign exchange, interest rate management, short-term borrowing,

short-term deposits.

2 Treasury services – cash management systems, transactional banking.

3 Corporate finance – capital markets, banking relationships, trade finance, risk man-

agement, liability management.

4 M&A equity management – mergers and acquisitions, equity markets, investor rela-

tions and divestitures (from The Treasurer, February 1992).

In most companies, the treasury department is much simpler, typically with a dis-

tinction between funding (cash and liquidity management, short-term financing and

cash forecasting) and treasury operations (financial risk management and portfolio

management). Treasury departments have come under increasing scrutiny by the

financial press. Barely a month passes without some large company announcing hefty

losses resulting from some major blunder by its treasury department. In the highly

complex, highly volatile world of finance, there are bound to be mistakes; the secret is

to set up the treasury function such that mistakes are never catastrophic.

It is the responsibility of the board of directors to set the treasury aims, policies,

authorisation levels, risk position and structure. It should establish, for example, the

following:

■ The degree of treasury centralisation.

■ Whether it should be a profit centre or cost centre.

■ The extent to which the company should be exposed to financial risk.

■ The level of liquidity desired.

324 Part IV Short-term financing and policies

13.1 INTRODUCTION

The introductory case study gives a flavour of the work of the Treasury in a large mod-

ern organisation (DS Smith is a leading packaging manufacturer). It also identifies

some of the areas where things can potentially go wrong.

Treasury management, once viewed as a peripheral activity conducted by back-

office boffins, today plays a vital role in corporate management. Most business deci-

sions have implications for cash flow and risk, both of which are of direct relevance to

treasury management. Many major firms have experienced problems through poor

treasury management in recent years. This area has become a major concern in busi-

ness, particularly the manner in which companies manage exposure to currency and

other risks.

Most companies do not have a corporate treasurer; such a person is usually war-

ranted only in larger companies. However, all firms are involved in treasury manage-

ment to some degree. Treasury management can be defined in many ways. We will

adopt the Association of Corporate Treasurers definition: ‘the efficient management of

liquidity and financial risk in the business’.

This chapter seeks to explain the main functions of treasury management and to

provide an overview of working capital management. It also acts as an introduction to

many of the succeeding chapters in this book.

13.2 THE TREASURY FUNCTION

funding

Cash and liquidity manage-

ment, short-term financing

and cash forecasting

treasury operations

Financial risk management,

and portfolio management

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