Applications of Option Pricing in Corporate Finance
Applications of option pricing in corporate finance
Option pricing is used in four major areas of corporate finance:
• Real Options
Suppose a company has a 1-year proprietary license to develop a software application for use in a new generation of wireless cellular telephones. Hiring programmers and marketing consultants to complete the project will cost $30 million. The good news is that if consumers love the new cell phones, there will be a tremendous demand for the software. The bad news is that if sales of the new cell phones are low, the software project will be a disaster. Should the company spend the $30 million and develop the software? Because the company has a license, it has the option of waiting for a year, at which time it might have a much better insight into market demand for the new cell phones. If demand is high in a year, then the company can spend the $30 million and develop the software. If demand is low, it can avoid losing the $30 million development cost by simply letting the license expire. Notice that the license is analogous to a call option: It gives the company the right to buy something (in this case, software for the new cell phones) at a fixed price ($30 million) at any time during the next year. The license gives the company a real option, because the underlying asset (the software) is a real asset and not a financial asset.
• Risk Management
Suppose a company plans to issue $400 million of bonds in 6 months to pay for a new plant now under construction. The plant will be profitable if interest rates remain at current levels, but if rates rise then it will be unprofitable. To hedge against rising rates, the company could purchase a put option on Treasury bonds. If interest rates go up then the company would “lose” because its bonds would carry a high interest rate, but it would have an offsetting gain on its put options. Conversely, if rates fall then the company would “win” when it issues its own low-rate bonds, but it
Option pricing is used in four major areas of corporate finance:
• Real Options
Suppose a company has a 1-year proprietary license to develop a software application for use in a new generation of wireless cellular telephones. Hiring programmers and marketing consultants to complete the project will cost $30 million. The good news is that if consumers love the new cell phones, there will be a tremendous demand for the software. The bad news is that if sales of the new cell phones are low, the software project will be a disaster. Should the company spend the $30 million and develop the software? Because the company has a license, it has the option of waiting for a year, at which time it might have a much better insight into market demand for the new cell phones. If demand is high in a year, then the company can spend the $30 million and develop the software. If demand is low, it can avoid losing the $30 million development cost by simply letting the license expire. Notice that the license is analogous to a call option: It gives the company the right to buy something (in this case, software for the new cell phones) at a fixed price ($30 million) at any time during the next year. The license gives the company a real option, because the underlying asset (the software) is a real asset and not a financial asset.
• Risk Management
Suppose a company plans to issue $400 million of bonds in 6 months to pay for a new plant now under construction. The plant will be profitable if interest rates remain at current levels, but if rates rise then it will be unprofitable. To hedge against rising rates, the company could purchase a put option on Treasury bonds. If interest rates go up then the company would “lose” because its bonds would carry a high interest rate, but it would have an offsetting gain on its put options. Conversely, if rates fall then the company would “win” when it issues its own low-rate bonds, but it