Real Options and Mergers
P.V. ViswanathClass Notes for FIN 648: Mergers and AcquisitionsStock 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. Viswanath2Call option
Value of call
option maturity$5.00$22.50$27.50Value of Sprint stock at option maturityP.V. Viswanath3Real options
? A real option is similar to a stock option. The primary
difference is that the real option is not traded on a market
? 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. Viswanath4Importance 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. Viswanath5Using 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…