Question

Options in corporate finance

A. The CEO of a growing cyber-security firm was awarded 25,000 stock options as part of her pay package.  She can exercise the options -turn them into stock- in two years.  The company’s stock price was $35.00 per share at the time of the stock option grant.  Shortly after the option award was received, she went to an investment banking firm and bought put options at a strike price of $35.00.  The option expires in two years.

(i) What does the put option do for the CEO?  Carefully explain why your stated result occurs.

(ii) Stock options and stock ownership are included in compensation packages to create incentives for CEOs to create value for shareholders.  Does this put option purchase change those incentives? If so, how?  

(iii) If you were a shareholder in this company, would you want to be informed about these types of transactions by the CEO?

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B.  Company B is a small, publicly-traded technology company.  Company B is close to completing development of a new software/hardware product for schools that uses voice recognition to quickly translate a lecture into written notes that are projected onto a screen and automatically sent to students as PDF documents.  The lecturer can then annotate the notes with a drawing pad linked to the computer projection system.  These annotations are included in the PDF that is distributed after the lecture is complete.  

      The company needs about $30 million to complete development and begin production and marketing of this product.  The company is profitable with one other product that generates about $1,200,000 in cash flow annually.  For many reasons the company has been very secretive about its new product so its stock price is quite low, being based on the modest cash flows of its existing product.  Company officials and outside consultants agree that it is too early to reveal the new product’s details given what they know of competing products.

      The company has hired an investment banker to help it determine how to raise the $30 million.  The banker immediately recommends convertible bonds.  Current interest rates on bonds or notes for companies of this type are in the range of 8% to 10%, but convertible debt would probably have a coupon rate of 3% to 5% depending on the conversion price.  The higher the conversion price the higher the coupon rate.  

The banker says that convertible bonds are a win-win for the company in this situation.  The company can keep their product secret but issue stock at a higher price (the conversion price) than the current stock price.  In the meantime, the interest rate on the debt will be about 4% or 5%, which the company should be able to support from its cash flow.  The banker explains that if for some reason the product is not a success, and there is no conversion to stock, the company has issued debt at a very low rate. Probably 5% below the rate on non-convertible debt.  Win-win!

The company’s tax rate is about 28%.

1. Can the company afford the interest on $30 million of convertible debt?
2. Is the banker correct about this being a win-win situation for the company?  Is there a different perspective that company managers need to understand before making this decision?  Explain.
3. If convertible debt has a lower coupon rate because the conversion option has value.  Why don’t all companies issue convertible debt and save on interest costs?

Answer 1

Answer A(i)

In case the price of company stock falls below $35, she will be covered against fall in the price of stock as she holds put option against the buy option. here profit or loss will be nil. hence she is covered for any downside risk of stock price.

In case price of stock goes above $35, same will happen again in vice versa situation. her profit from price increase will be nil as she will have same loss on put option.

Hence this put option will cover her wealth for coming 2 years against the price fluctuation in stock price of company.

(ii)

This put option covers her risks for any downside risk in stock price. her wealth is intact at the current price. These options are usually given to encourage the executives for better performance. She may not be so encouraged in her efforts to increase the shareholders wealth, as she will not be feeling the pressure of her own wealth erosion.

(iii) As shareholder of the company, these types of transactions by CEO have impact on shareholder's. Any shareholder will be interested in knowing the competence and good governance practices of the management. Management's overall approach will affect the future of company, hence wealth of its shareholders. It may impact the decisions of shareholders to invest or not invest of company.