Real Options and Mergers
P.V. Viswanath

Class Notes for FIN 648: Mergers and Acquisitions

Stock Options
 A call option on a stock is the right to buy a share of stock at
a pre-specified price (exercise price) within a specified time
period (time to maturity).
 Thus, a call on Sprint with an exercise price of $22.50 and
an expiration date of May 19, 2006 traded at a price of $2.15
at close on Feb. 22, 2006.
 The closing price of the stock on that day was $23.80, so if
the call had been exercised right away, it would have
resulted in a loss. Still the option has value because the
stock price might well go up before May 19, 2006.

P.V. Viswanath


Call option
Value of call
option at
option maturity




Value of Sprint stock at option maturity

P.V. Viswanath


Real options
 A real option is similar to a stock option. The primary
difference is that the real option is not traded on a market
and, often,
 The underlying asset may not be traded on a market, either.
 Thus, a patent grants the owner an option because s/he has
the sole right for a certain amount of time (time to maturity)
to develop a product based on the patented idea by investing
the necessary capital (exercise price).
 The patent may or may not be traded;
 The underlying asset in this case, is the product based on the
patent. In this case, the underlying asset is not traded, either.

P.V. Viswanath


Importance of Real Options
 Real options are pervasive; for example, flexibility
usually implies a real option.
 Real options have a big effect on firm value where
the firm is growing and/or has unique assets.
 Real options capture effects that DCF doesn’t.
DCF analysis alone misestimates the value of an

P.V. Viswanath


Using real options in M&A
 Estimate the value of optionality.

The right to take action, the triggering of which is
contingent on some other event.

 Structure...

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