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
2
Call option
Value of call
option at
option maturity
$5.00
$22.50
$27.50
Value of Sprint stock at option maturity
P.V. Viswanath
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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
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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
asset.
P.V. Viswanath
5
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...