Option Pricing Theory and Real

Option Applications

1
 What is an option?

 An option provides the holder with the right to buy or sell a specified
quantity of an underlying asset at a fixed price (called a strike price or
an exercise price) at or before the expiration date of the option.
 Since it is a right and not an obligation, the holder can choose not to
exercise the right and allow the option to expire.
 There are two types of options - call options (right to buy) and put
options (right to sell).

2
 Call Options

 A call option gives the buyer of the option the right to buy the
underlying asset at a fixed price (strike price or K) at any time prior to
the expiration date of the option. The buyer pays a price for this right.
 At expiration,
• If the value of the underlying asset (S) > Strike Price(K)
– Buyer makes the difference: S - K
• If the value of the underlying asset (S) < Strike Price (K)
– Buyer does not exercise
 More generally,
• the value of a call increases as the value of the underlying asset increases
• the value of a call decreases as the value of the underlying asset decreases

3
 Put Options

 A put option gives the buyer of the option the right to sell the
underlying asset at a fixed price at any time prior to the expiration date
of the option. The buyer pays a price for this right.
 At expiration,
• If the value of the underlying asset (S) < Strike Price(K)
– Buyer makes the difference: K-S
• If the value of the underlying asset (S) > Strike Price (K)
– Buyer does not exercise
 More generally,
• the value of a put decreases as the value of the underlying asset increases
• the value of a put increases as the value of the underlying asset decreases

4
 PAYOFFS PROFILES FOR CALL
AND PUT OPTIONS

V V

XP P P

(A) BUY CALL (B) SELL A CALL

V V

P P

(C) BUY A PUT (D) SELL A PUT

5
Profit Diagram on a Call

Net Payoff
on Call

Strike
Price

Price of underlying asset

6
 Profit Diagram on Put Option

Net Payoff
On Put

Strike
Price
Price of underlying asset

7
 Put-Call Parity

 Value of call + PV of Exercise Price = Value of Put + Share Price

 Payoff of [Buy call, invest present value of exercise price in safe asset]
is identical to the payoff from [Buy put, buy share]

8
 Determinants of option value

 Variables Relating to Underlying Asset

• Value of Underlying Asset; as this value increases, the right to buy at a
fixed price (calls) will become more valuable and the right to sell at a
fixed price (puts) will become less valuable.
• Variance in that value; as the variance increases, both calls and puts will
become more valuable because all options have limited downside and
depend upon price volatility for upside.
• Expected dividends on the asset, which are likely to reduce the price
appreciation component of the asset, reducing the value of calls and
increasing the value of puts.
 Variables Relating to Option
• Strike Price of Options; the right to buy (sell) at a fixed price becomes
more (less) valuable at a lower price.
• Life of the Option; both calls and puts benefit from a longer life.
 Level of Interest Rates; as rates increase, the right to buy (sell) at a
fixed price in the future becomes more (less) valuable. 9
10
A Summary of the Determinants of Option
Value

Factor Call Value Put Value

Increase in Stock Price Increases Decreases
Increase in Strike Price Decreases Increases
Increase in variance of underlying asset Increases Increases
Increase in time to expiration Increases Increases
Increase in interest rates Increases Decreases
Increase in dividends paid Decreases Increases

11
 Creating a replicating portfolio

 The objective in creating a replicating portfolio is to use a combination

of riskfree borrowing/lending and the underlying asset to create the
same cashflows as the option being valued. Since the two strategies
give identical payoffs in the future, they must sell for the same price
today.
• Call = Borrowing + Buying  of the Underlying Stock
• Put = Selling Short  on Underlying Asset + Lending
• The number of shares bought or sold is called the option delta.
 The principles of arbitrage then apply, and the value of the option has
to be equal to the value of the replicating portfolio.

12
 Example

 Consider a 6 months option with a Strike (Exercise Price) of 55

Asset Value is 55 today.
After 6 months the Asset Value can be either 73.33 or 41.25 (only one
change in price in 6 months)

Risk Free rate is 4% per annum or approximately 2% for a 6 months

period.

13
Call Option

14
Call Option

15
 Call Option

Payoff 6 months from now

Value of 0.5714 of
Asset
41.90

16
Call Option

17
Put Option

18
Put Option

19
 Put Option
Payoff after 6 months

Money required to square of

short sale of 0.4286 of asset

20
Put Option

21
If asset value was 70 today and the asset value after 6 months were 60 and 80, then payoff diagram with strike price of 55
is

70

22
 Risk-Neutral Valuation

 Pretend that the investors do not care about the risk, so that the
expected return on the stock is equal to the interest rate. Calculate the
expected future value of the option in this hypothetical risk-neutral
world and discount it at the risk free interest rate.

23
24
25
 (p X 0.333) + (1-p)(-0.25) = 0.02
p = 0.463

26
27
28
The Binomial Model

29
 Upside and Downside Values

 1 + Upside change = u = e σ√ h

 1 + downside change = d = 1/u

 Suppose σ = .4069

Intervals in a year Upside change per Downside Change

interval per interval
2 +33.3 -25
4 +22.6 -18.4
12 +12.4 -11.1
52 +5.8 -5.5

30
 If asset value is 55 today and price changes every 3 months

After 3 months

After 6 months

31
Payoffs is the strike price is 55

(27.67)

32
 The Limiting Distributions….

 As the time interval is shortened, the limiting distribution, as t -> 0,

can take one of two forms.
• If as t -> 0, price changes become smaller, the limiting distribution is the
normal distribution and the price process is a continuous one.
• If as t->0, price changes remain large, the limiting distribution is the
poisson distribution, i.e., a distribution that allows for price jumps.
 The Black-Scholes model applies when the limiting distribution is
the normal distribution , and explicitly assumes that the price process
is continuous and that there are no jumps in asset prices.

33
 The Black-Scholes Model

 The version of the model presented by Black and Scholes was

designed to value European options, which were dividend-protected.
In other words, the strike price gets adjusted as dividend gets paid out.
 The value of a call option in the Black-Scholes model can be written
as a function of the following variables:
S = Current value of the underlying asset
K = Strike price of the option
t = Life to expiration of the option
r = Riskless interest rate corresponding to the life of the option
2 = Variance in the ln(value) of the underlying asset

34
 The Black-Scholes Model

All of the inputs to the Black-Scholes should be

a. Consistent in relation to time - generally, you annualize all of the
inputs. 3 months becomes 0.25 (1/4 of a year)…
b. In continuous terms… to get the riskfree rate in continuous terms for
instance,
• Continuous riskfree rate =ln(1+ Discrete riskfree rate)
 We use the ln(stock prices) to get the variance both to ensure that we
obtain a continuous variance and to get a semblance of normality in
the distribution (prices themselves cannot be normally distributed).

35
 The Black Scholes Model

Value of call = [ delta * shareprice] – [ Bank Loan]

Value of call = S N (d1) - PV (K) N(d2)

d1 = { log [S/PV(K)] / σ√ t } + σ√ t / 2

d2 = d1 - σ√ t

36
 The Black Scholes Model

Value of call = S N (d1) - K e-rt N(d2)

where, 2
S 
ln 
+ (r + )t
d1 = K 2
 t

• d2 = d1 -  √ t
 The replicating portfolio is embedded in the Black-Scholes model. To
replicate this call, you would need to
• Buy N(d1) shares of stock; N(d1) is called the option delta
• Borrow K e-rt N(d2)

37
 Adjusting for Dividends

 If the dividend yield (y = dividends/ Current value of the asset) of the

underlying asset is expected to remain unchanged during the life of the
option, the Black-Scholes model can be modified to take dividends
into account.
C = S e-yt N(d1) - K e-rt N(d2)
where, S  2
ln + (r - y + )t
d1 = K 2
 t

d2 = d1 -  √ t
 The value of a put can also be derived:
P = K e-rt (1-N(d2)) - S e-yt (1-N(d1))

38
 American Calls – No Dividends

 An American option can be exercised at any time prior to its

expiration, while a European option can be exercised only at
expiration.
• The possibility of early exercise makes American options more valuable
than otherwise similar European options.
• However, in most cases, the time premium associated with the remaining
life of an option makes early exercise sub-optimal. Value of call
increases with time to maturity.
• If you exercised an American Option Early, you would needlessly reduce
its value.
• Since American Option should not be exercised before maturity, its value
is same as European Call and Black-Scholes Model Applies.

39
 European Puts – No Dividends

 Use put call parity

 Value of Put = Value of Call – Value of Stock + PV of Exercise Price

40
 American Puts – No Dividends

 Sometimes it pays to exercise an American put before maturity .

 When Stock price falls to zero
 No advantage in holding as it cannot become more valuable.
 Exercise put and invest the exercise money
 American Put always more valuable than European Put
 Difference is equal to present value of interest you can earn on
exercise price.
 Cannot use Black Scholes as it does not allow for early exercise.
 Use step by step binomial and check at every point whether option is
worth more dead or alive.

41
European Calls on Dividend Paying Stock

 Part of share value comprises of PV of Dividends

 Option holder not entitled to dividends
 Use Black Scholes
 Reduce price of stock by PV of dividends before option maturity.

 Instances where asset holder gets benefits and option holder does not.

42
American Calls on Dividend Paying Stock

 American Option is always worth more alive than dead in case of no

dividends.
 Even if there are dividends, American Call should never be exercised
early if dividend gain is less than interest lost by paying exercise price
early.
 However if dividend is sufficiently large, capture it by exercising
option just before ex-dividend date.
 Step by Step binomial. Check at each stage whether option is more
valuable if exercised just before ex-dividend date than if held for
atleast one more period.

43
 Problem

 ABC’s stock price is 220 and could half or double in each six
month period (SD = 98%). A one year call option on ABC’s
stock has an exercise price of 165. The interest rate is 21% per
year.
 Value of ABC’s call
• Let p equal the probability of a rise in the stock price. Then, if
investors are risk-neutral:
• p (1.00) + (1 - p)(-0.50) = 0.10
• p = 0.4

44
 Problem

 If the stock price in month 6 is 110,

then the option will not be
exercised so that it will be worth:
[(0.4  55) + (0.6  0)]/1.10 = 20
 Similarly, if the stock price is 440
220
in month 6, then, if it is exercised, (116.36)
it will be worth (440 - 165) = 275.
If the option is not exercised, it will 110 440
be worth: (20) (290)
[(0.4  715) + (0.6  55)]/1.10 = 290 55 220 880
 Therefore, the call option will not (0) (55) (715)
be exercised, so that its value today
is:
[(0.4  290) + (0.6  20)]/1.10 =
116.36

45
 Problem - Dividends

 Suppose at the end of the first six months the company pays a
dividend of 25

The option values in month 6, if the option is not exercised

(0.4  5)  (0.6  0) (0.4  665)  (0.6  42.5)
 1.82  265
1.10 1.10

 If the stock price in month 6 is 110, then it would not pay to exercise
the option. If the stock price in month 6 is 440, then the call is
worth: (440 - 165) = 275. Therefore, the option would be exercised
at that time.
 Working back to month 0, 220 (100.99)

(0.4  275)  (0.6 1.82) 440

Option value   100.99 110 415 (275)
1.10 85 (1.82)

830
42.5 170 207.5
(0) (5) (42.5) (665)

46
 Problem – European Option

If the option were European, it would not be possible to exercise

early. Therefore, if the price rises to 440 at month 6, the value of the
option is 265, not 275 as is the case for the American option.
Therefore, in this case, the value of the European option is less than
the value of the American option.

(0.4  265)  (0.6 1.82)

Option value   97.36
1.10

47
REAL OPTIONS

48
49

Underlying Theme: Searching for an Elusive

Premium

Traditional discounted cashflow models under estimate the value of investments,

where there are options embedded in the investments to
Delay or defer making the investment (delay)
Adjust or alter production schedules as price changes
(flexibility)
Expand into new markets or products at later stages in
the process, based upon observing favorable outcomes at
the early stages (expansion)
Stop production or abandon investments if the outcomes
are unfavorable at early stages (abandonment)
Put another way, real option advocates believe that you should be paying a
premium on discounted cashflow value estimates.

49
50

Three Basic Questions

 When is there a real option embedded in a decision or an asset?

 When does that real option have significant economic value?
 Can that value be estimated using an option pricing model?

50
51

When is there an option embedded in an action?

 An option provides the holder with the right to buy or sell a specified
quantity of an underlying asset at a fixed price (called a strike price or an
exercise price) at or before the expiration date of the option.
 There has to be a clearly defined underlying asset whose value changes
over time in unpredictable ways.
 The payoffs on this asset (real option) have to be contingent on an
specified event occurring within a finite period.

51
Options in Projects/Investments/Acquisitions

 One of the limitations of traditional investment analysis is that it is

static and does not do a good job of capturing the options embedded in
investment.
• The first of these options is the option to delay taking a investment, when
a firm has exclusive rights to it, until a later date.
• The second of these options is taking one investment may allow us to take
advantage of other opportunities (investments) in the future
• The last option that is embedded in projects is the option to abandon a
investment, if the cash flows do not measure up.
 These options all add value to projects and may make a “bad”
investment (from traditional analysis) into a good one.

52
53

A bad investment…

53
54

Becomes a good one…

54
Problems with Real Option Pricing Models

1. The underlying asset may not be traded, which makes it difficult to

estimate value and variance for the underlying asset.
2. The price of the asset may not follow a continuous process, which
makes it difficult to apply option pricing models (like the Black
Scholes) that use this assumption.
3. The variance may not be known and may change over the life of the
option, which can make the option valuation more complex.
4. Exercise may not be instantaneous, which will affect the value of the
option.
5. Some real options are complex and their exercise creates other options
(compound) or involve learning (learning options)

55
 The Option to Delay

 When a firm has exclusive rights to a project or product for a specific

period, it can delay taking this project or product until a later date.
 A traditional investment analysis just answers the question of whether
the project is a “good” one if taken today.
 Thus, the fact that a project does not pass muster today (because its
NPV is negative, or its IRR is less than its hurdle rate) does not mean
that the rights to this project are not valuable.

56
 Valuing the Option to Delay a Project

PV of Cash Flows
from Project

Initial Investment in
Project

Present Value of Expected

Cash Flows on Product
Project's NPV turns
Project has negative positive in this section
NPV in this section

57
 Insights for Investment Analyses

 Having the exclusive rights to a product or project is valuable, even if

the product or project is not viable today.
 The value of these rights increases with the volatility of the underlying
business.
 The cost of acquiring these rights (by buying them or spending money
on development, for instance) has to be weighed off against these
benefits.

58
Example 1: Valuing product patents as options

 A product patent provides the firm with the right to develop the
product and market it.
 It will do so only if the present value of the expected cash flows from
the product sales exceed the cost of development.
 If this does not occur, the firm can shelve the patent and not incur any
further costs.
 If I is the present value of the costs of developing the product, and V is
the present value of the expected cashflows from development, the
payoffs from owning a product patent can be written as:
Payoff from owning a product patent =V-I if V> I
=0 if V ≤ I

59
Payoff on Product Option

Net Payoff to
introduction

Cost of product
introduction

Present Value of
cashflows on product

60
 Obtaining Inputs for Patent Valuation

Input Estimation Process

1. Value of the Underlying Asset  Present Value of Cash Inflows from taking project
now

2. Variance in value of underlying asset  Variance in cash flows of similar assets or firms
 Variance in present value from capital budgeting
simulation.
3. Exercise Price on Option  Option is exercised when investment is made.
 Cost of making investment on the project; assumed
to be constant in present value dollars.
4. Expiration of the Option  Life of the patent

5. Dividend Yield  Cost of delay

 Each year of delay translates into one less year of
value-creating cashflows
1
Annual cost of delay =
n

61
 Valuing a Product Patent: Avonex

 Biogen, a bio-technology firm, has a patent on Avonex, a drug to treat

multiple sclerosis, for the next 17 years, and it plans to produce and
sell the drug by itself. The key inputs on the drug are as follows:
PV of Cash Flows from Introducing the Drug Now = S = $ 3.422 billion
PV of Cost of Developing Drug for Commercial Use = K = $ 2.875 billion
Patent Life = t = 17 years Riskless Rate = r = 6.7% (17-year T.Bond rate)
Variance in Expected Present Values =2 = 0.224 (Industry average firm
variance for bio-tech firms)
Expected Cost of Delay = y = 1/17 = 5.89%
d1 = 1.1362 N(d1) = 0.8720
d2 = -0.8512 N(d2) = 0.2076
Call Value= 3,422 exp(-0.0589)(17) (0.8720) - 2,875 (exp(-0.067)(17) (0.2076)= $
907 million

62
 Valuing a firm with patents

 The value of a firm with a substantial number of patents can be

derived using the option pricing model.
Value of Firm = Value of commercial products (using DCF value
+ Value of existing patents (using option pricing)
+ (Value of New patents that will be obtained in the
future – Cost of obtaining these patents)
 The last input measures the efficiency of the firm in converting its
R&D into commercial products. If we assume that a firm earns its cost
of capital from research, this term will become zero.
 If we use this approach, we should be careful not to double count and
allow for a high growth rate in cash flows (in the DCF valuation).

63
 Value of Biogen’s existing products

 Biogen had two commercial products (a drug to treat Hepatitis B and

Intron) at the time of this valuation that it had licensed to other
pharmaceutical firms.
 The license fees on these products were expected to generate $ 50
million in after-tax cash flows each year for the next 12 years. To
value these cash flows, which were guaranteed contractually, the pre-
tax cost of debt of 7% of the licensing firms was used:
Present Value of License Fees = $ 397.13 million

64
 Value of Biogen’s Future R&D

 Biogen continued to fund research into new products, spending about

$ 100 million on R&D in the most recent year. These R&D expenses
were expected to grow 20% a year for the next 10 years, and 5%
thereafter.
 It was assumed that every dollar invested in research would create $
1.25 in value in patents (valued using the option pricing model
described above) for the next 10 years, and break even after that (i.e.,
generate $ 1 in patent value for every $ 1 invested in R&D).
 There was a significant amount of risk associated with this component
and the cost of capital was estimated to be 15%.

65
 Value of Future R&D

Yr Value of R&D Cost Excess Value Present Value

Patents (at 15%)
1 $ 150.00 $ 120.00 $ 30.00 $ 26.09
2 $ 180.00 $ 144.00 $ 36.00 $ 27.22
3 $ 216.00 $ 172.80 $ 43.20 $ 28.40
4 $ 259.20 $ 207.36 $ 51.84 $ 29.64
5 $ 311.04 $ 248.83 $ 62.21 $ 30.93
6 $ 373.25 $ 298.60 $ 74.65 $ 32.27
7 $ 447.90 $ 358.32 $ 89.58 $ 33.68
8 $ 537.48 $ 429.98 $ 107.50 $ 35.14
9 $ 644.97 $ 515.98 $ 128.99 $ 36.67
10 $ 773.97 $ 619.17 $ 154.79 $ 38.26
$ 318.30

66
 Value of Biogen

 The value of Biogen as a firm is the sum of all three components – the
present value of cash flows from existing products, the value of
Avonex (as an option) and the value created by new research:
Value = Existing products + Existing Patents + Value: Future R&D
= $ 397.13 million + $ 907 million + $ 318.30 million
= $1622.43 million
 Since Biogen had no debt outstanding, this value was divided by the
number of shares outstanding (35.50 million) to arrive at a value per
share:
Value per share = $ 1,622.43 million / 35.5 = $ 45.70

67
Example 2: Valuing Natural Resource Options

 In a natural resource investment, the underlying asset is the resource

and the value of the asset is based upon two variables - the quantity of
the resource that is available in the investment and the price of the
resource.
 In most such investments, there is a cost associated with developing
the resource, and the difference between the value of the asset
extracted and the cost of the development is the profit to the owner of
the resource.
 Defining the cost of development as X, and the estimated value of the
resource as V, the potential payoffs on a natural resource option can be
written as follows:
• Payoff on natural resource investment = V - X if V > X
• =0 if V≤ X

68
Payoff Diagram on Natural Resource Firms

Net Payoff on
Extraction

Cost of Developing
Reserve

Value of estimated reserve

of natural resource

69
 Estimating Inputs for Natural Resource Options

Input Estimation Process

1. Value of Available Reserves of the Resource  Expert estimates (Geologists for oil..); The
present value of the after-tax cash flows from
the resource are then estimated.
2. Cost of Developing Reserve (Strike Price)  Past costs and the specifics of the investment

3. Time to Expiration  Relinqushment Period: if asset has to be

relinquished at a point in time.
 Time to exhaust inventory - based upon
inventory and capacity output.
4. Variance in value of underlying asset  based upon variability of the price of the
resources and variability of available reserves.

5. Net Production Revenue (Dividend Yield)  Net production revenue every year as percent
of market value.

6. Development Lag  Calculate present value of reserve based upon

the lag.

70
 Valuing an Oil Reserve

 Consider an offshore oil property with an estimated oil reserve of 50

million barrels of oil, where the present value of the development cost
is $12 per barrel and the development lag is two years.
 The firm has the rights to exploit this reserve for the next twenty years
and the marginal value per barrel of oil is $12 per barrel currently
(Price per barrel - marginal cost per barrel).
 Once developed, the net production revenue each year will be 5% of
the value of the reserves.
 The riskless rate is 8% and the variance in ln(oil prices) is 0.03.

71
 Inputs to Option Pricing Model

 Current Value of the asset = S = Value of the developed reserve

discounted back the length of the development lag at the dividend
yield = $12 * 50 /(1.05)2 = $ 544.22
 (If development is started today, the oil will not be available for sale
until two years from now. The estimated opportunity cost of this delay
is the lost production revenue over the delay period. Hence, the
discounting of the reserve back at the dividend yield)
 Exercise Price = Present Value of development cost = $12 * 50 = $600
million
 Time to expiration on the option = 20 years
 Variance in the value of the underlying asset = 0.03
 Riskless rate =8%
 Dividend Yield = Net production revenue / Value of reserve = 5%

72
 Valuing the Option

 Based upon these inputs, the Black-Scholes model provides the

following value for the call:
d1 = 1.0359 N(d1) = 0.8498
d2 = 0.2613 N(d2) = 0.6030
 Call Value= 544 .22 exp(-0.05)(20) (0.8498) -600 (exp(-0.08)(20) (0.6030)= $
97.08 million
 This oil reserve, though not viable at current prices, still is a valuable
property because of its potential to create value if oil prices go up.

73
Extending the option pricing approach to value
natural resource firms

 Since the assets owned by a natural resource firm can be viewed

primarily as options, the firm itself can be valued using option
pricing models.
 The preferred approach would be to consider each option separately,
value it and cumulate the values of the options to get the firm value.
 Since this information is likely to be difficult to obtain for large
natural resource firms, such as oil companies, which own hundreds of
such assets, a variant is to value the entire firm as one option.

74
 Inputs to the Model

Input to model Corresponding input for valuing firm

Value of underlying asset Value of cumulated estimated reserves of the
resource owned by the firm, discounted back at the
dividend yield for the development lag.
Exercise Price Estimated cumulated cost of developing estimated
reserves
Time to expiration on option Average relinquishment period across all reserves
owned by firm (if known) or estimate of when
reserves will be exhausted, given current
production rates.
Riskless rate Riskless rate corresponding to life of the option
Variance in value of asset Variance in the price of the natural resource
Dividend yield Estimated annual net production revenue as
percentage of value of the reserve.

75
The Option to Expand/Take Other Projects

 Taking a project today may allow a firm to consider and take other
valuable projects in the future.
 Thus, even though a project may have a negative NPV, it may be a
project worth taking if the option it provides the firm (to take other
projects in the future) provides a more-than-compensating value.
 These are the options that firms often call “strategic options” and use
as a rationale for taking on “negative NPV” or even “negative return”
projects.

76
 The Option to Expand

PV of Cash Flows
from Expansion

Additional Investment
to Expand

Present Value of Expected

Cash Flows on Expansion
Expansion becomes
Firm will not expand in attractive in this section
this section

77
 An Example of an Expansion Option

 Ambev is considering introducing a soft drink to the U.S. market. The

drink will initially be introduced only in the metropolitan areas of the
U.S. and the cost of this “limited introduction” is $ 500 million.
 A financial analysis of the cash flows from this investment suggests
that the present value of the cash flows from this investment to Ambev
will be only $ 400 million. Thus, by itself, the new investment has a
negative NPV of $ 100 million.
 If the initial introduction works out well, Ambev could go ahead with
a full-scale introduction to the entire market with an additional
investment of $ 1 billion any time over the next 5 years. While the
current expectation is that the cash flows from having this investment
is only $ 750 million, there is considerable uncertainty about both the
potential for the drink, leading to significant variance in this estimate.

78
 Valuing the Expansion Option

 Value of the Underlying Asset (S) = PV of Cash Flows from

Expansion to entire U.S. market, if done now =$ 750 Million
 Strike Price (K) = Cost of Expansion into entire U.S market = $ 1000
Million
 We estimate the standard deviation in the estimate of the project value
by using the annualized standard deviation in firm value of publicly
traded firms in the beverage markets, which is approximately 34.25%.
• Standard Deviation in Underlying Asset’s Value = 34.25%
 Time to expiration = Period for which expansion option applies = 5
years
Call Value= $ 234 Million

79
Considering the Project with Expansion Option

 NPV of Limited Introduction = $ 400 Million - $ 500 Million = - $ 100

Million
 Value of Option to Expand to full market= $ 234 Million
 NPV of Project with option to expand
= - $ 100 million + $ 234 million
= $ 134 million
 Invest in the project

80
 The Link to Strategy

 In many investments, especially acquisitions, strategic options or

considerations are used to take investments that otherwise do not meet
financial standards.
 These strategic options or considerations are usually related to the
expansion option described here. The key differences are as follows:
• Unlike “strategic options” which are usually qualitative and not valued,
expansion options can be assigned a quantitative value and can be brought
into the investment analysis.
• Not all “strategic considerations” have option value. For an expansion
option to have value, the first investment (acquisition) must be necessary
for the later expansion (investment). If it is not, there is no option value
that can be added on to the first investment.

81
The Exclusivity Requirement in Option Value

82
83

The Real Options Test for Expansion Options

The Options Test
Underlying Asset: Expansion Project
Contingency
If PV of CF from expansion > Expansion Cost: PV - Expansion Cost
If PV of CF from expansion < Expansion Cost: 0

The Exclusivity Test

Barriers may range from strong (exclusive licenses granted by the government) to weaker
(brand name, knowledge of the market) to weakest (first mover).

The Pricing Test

Underlying Asset: As with patents, there is no trading in the underlying asset and you have
to estimate value and volatility.
Option: Licenses are sometimes bought and sold, but more diffuse expansion options are not.
Cost of Exercising the Option: Not known with any precision and may itself evolve over
time as the market evolves.

Using option pricing models to value expansion options will not only yield extremely noisy
estimates, but may attach inappropriate premiums to discounted cashflow estimates.

83
 The Determinants of Real Option Value

 Does taking on the first investment/expenditure provide the firm with

an exclusive advantage on taking on the second investment?
• If yes, the firm is entitled to consider 100% of the value of the real option
• If no, the firm is entitled to only a portion of the value of the real option,
with the proportion determined by the degree of exclusivity provided by
the first investment?
 Is there a possibility of earning significant and sustainable excess
returns on the second investment?
• If yes, the real option will have significant value
• If no, the real option has no value

84
 The Option to Abandon

 A firm may sometimes have the option to abandon a project, if the

cash flows do not measure up to expectations.
 If abandoning the project allows the firm to save itself from further
losses, this option can make a project more valuable.
PV of Cash Flows
from Project

Cost of Abandonment

Present Value of Expected

Cash Flows on Project

85
 Valuing the Option to Abandon

 Airbus is considering a joint venture with Lear Aircraft to produce a

small commercial airplane (capable of carrying 40-50 passengers on
short haul flights)
• Airbus will have to invest $ 500 million for a 50% share of the venture
• Its share of the present value of expected cash flows is 480 million.
 Lear Aircraft, which is eager to enter into the deal, offers to buy
Airbus’s 50% share of the investment anytime over the next five years
for $ 400 million, if Airbus decides to get out of the venture.
 A simulation of the cash flows on this time share investment yields a
variance in the present value of the cash flows from being in the
partnership is 0.16.
 The project has a life of 30 years.

86
 Project with Option to Abandon

 Value of the Underlying Asset (S) = PV of Cash Flows from Project

= $ 480 million
 Strike Price (K) = Salvage Value from Abandonment = $ 400 million
 Variance in Underlying Asset’s Value = 0.16
 Time to expiration = Life of the Project =5 years
 Dividend Yield = 1/Life of the Project = 1/30 = 0.033 (We are
assuming that the project’s present value will drop by roughly 1/n each
year into the project)
 Assume that the five-year riskless rate is 6%. The value of the put
option can be estimated as follows:

87
Should Airbus enter into the joint venture?

 Value of Put =Ke-rt (1-N(d2))- Se-yt (1-N(d1))

=400 (exp(-0.06)(5) (1-0.4624) - 480 exp(-0.033)(5) (1-0.7882)
= $ 73.23 million
 The value of this abandonment option has to be added on to the net
present value of the project of -$ 20 million, yielding a total net
present value with the abandonment option of $ 53.23 million.

88
 Implications for Investment Analysis

 Having a option to abandon a project can make otherwise unacceptable

projects acceptable.
 Actions that increase the value of the abandonment option include
• More cost flexibility, that is, making more of the costs of the projects into
variable costs as opposed to fixed costs.
• Fewer long-term contracts/obligations with employees and customers,
since these add to the cost of abandoning a project
• Finding partners in the investment, who are willing to acquire your
investment in the future
 These actions will undoubtedly cost the firm some value, but this has
to be weighed off against the increase in the value of the abandonment
option.

89
Option Pricing Applications in the Capital
Structure Decision

90
 Options in Capital Structure

 The most direct applications of option pricing in capital structure

decisions is in the design of securities. In fact, most complex financial
instruments can be broken down into some combination of a simple
bond/common stock and a variety of options.
• If these securities are to be issued to the public, and traded, the options
have to be priced.
• If these are non-traded instruments (bank loans, for instance), they still
have to be priced into the interest rate on the instrument.
 The other application of option pricing is in valuing flexibility. Often,
firms preserve debt capacity or hold back on issuing debt because they
want to maintain flexibility.

91
 The Value of Flexibility

 Firms maintain excess debt capacity or larger cash balances than are
warranted by current needs, to meet unexpected future requirements.
 While maintaining this financing flexibility has value to firms, it also
has a cost; the excess debt capacity implies that the firm is giving up
some value and has a higher cost of capital.
 The value of flexibility can be analyzed using the option pricing
framework; a firm maintains large cash balances and excess debt
capacity in order to have the option to take projects that might arise in
the future.

92
Determinants of Value of Flexibility Option

 Quality of the Firm’s Projects: It is the excess return that the firm
earns on its projects that provides the value to flexibility. Other things
remaining equal, firms operating in businesses where projects earn
substantially higher returns than their hurdle rates should value
flexibility more than those that operate in stable businesses where
excess returns are small.
 Uncertainty about Future Projects: If flexibility is viewed as an
option, its value will increase when there is greater uncertainty about
future projects; thus, firms with predictable capital expenditures and
excess returns should value flexibility less than those with high
variability in both of those variables.

93
 Value of Flexibility as an Option

 Consider a firm that has expected reinvestment needs of X each year,

with a standard deviation in that value of X. These external
reinvestments include both internal projects and acquisitions.
 Assume that the firm can raise L from internal cash flows and its
normal access to capital markets. (Normal access refers to the external
financing that is used by a firm each year)
 Excess debt capacity becomes useful if external reinvestment needs
exceed the firm’s internal funds.
If X > L: Excess debt capacity can be used to cover the difference and
invest in projects
If X<L: Excess debt capacity remains unused (with an associated cost)

94
What happens when you make the investment?

 If the investment earns excess returns, the firm’s value will increase by
the present value of these excess returns over time. If we assume that
the excess return each year is constant and perpetual, the present value
of the excess returns that would be earned can be written as:
Value of investment = (ROC - Cost of capital)/ Cost of capital
 The value of the investments that you can take because you have
excess debt capacity becomes the payoff to maintaining excess debt
capacity.
If X > L: [(ROC - Cost of capital)/ Cost of capital] New investments
If X<L: 0

95
The Value of Flexibility

96
 ABC’s Optimal Debt Ratio

Debt Ratio Cost of Equity Cost of Debt Cost of Capital

0.00% 13.00% 4.61% 13.00%
10.00% 13.43% 4.61% 12.55%
Current:18%13.85% 4.80% 12.22%
20.00% 13.96% 4.99% 12.17%
30.00% 14.65% 5.28% 11.84%
40.00% 15.56% 5.76% 11.64%
50.00% 16.85% 6.56% 11.70%
60.00% 18.77% 7.68% 12.11%
70.00% 21.97% 7.68% 11.97%
80.00% 28.95% 7.97% 12.17%
90.00% 52.14% 9.42% 13.69%

97
 Inputs to Option Valuation Model

 To value flexibility as a percent of firm value (as an annual cost), these would be the
inputs to the model:
• S = Expected Reinvestment needs as percent of Firm Value
– (Net Cap Ex + Change in Non Cash WC)/Market Value of Firm
• K = Expected Reinvestment needs that can be financed without financing
flexibility
– If Firm cannot or does not want to use external financing
• (Net Income + Dividend + Dep)/Market Value of firm
– If Firm uses external capital (debt, bonds, equity) regularly
• (Net Income + Dep + Net external financing) / Market value of firm
• t = 1 year To get annual estimate of value of flexibility
2 = Variance in ln(Net Capital Expenditures)
Variance in reinvestment as percentage of firm value (using historical data)
 Once this option has been valued, estimate the present value of the excess returns that
will be gained by taking the additional investments by multiplying by (ROC -
WACC)/WACC

98
 The Inputs for ABC

 Expected reinvestment needs as a percent of firm value:

• Over the last 5 years, reinvestment (net cap ex, acquisitions and changes in
working capital) had been approximately 5.3% of firm value
• Assuming that this is the expected reinvestment need; the variance in
ln(reinvestment) over the last 5 years was 0.375
 Reinvestment needs that can be financed without flexibility.
• look at internal funds, after debt payments but before reinvestment needs, as a
percent of firm value over the last 5 years. (Internal funds = (Net Income +
Depreciation)/Market Value of the Firm)
• look at net debt financing each period, as a percent of firm value (as a measure of
access to external financing each year). (New Debt - Debt Repaid)/Market Value of
Firm)
• Reinvestment needs that can be financed without flexibility = (Net Income +
Depreciation + Net Debt Issued)/Market Value of Firm
• This number averaged 4.8%, over the last 5 years

99
 ABC

The value of flexibility as a percentage of firm value can be estimated as

follows:
 S = 5.3%
 K = 4.8%
 t = 1 year
 2 = 0.375 ( Variance in ln(Reinvestment Needs/Firm Value))
The value of an option with these characteristics is 1.6092%
 ABC earns 18.69% on its projects has a cost of capital of 12.22%. The
excess return (annually) is 6.47%.
Value of Flexibility (annual)= 1.6092%(.0647/.1222) = 0.85 % of value
 ABC’s cost of capital at its optimal debt ratio is 11.64%. The cost it
incurs to maintain flexibility is therefore 0.58% annually (12.22%-
11.64%). It therefore pays to maintain flexibility.
100
 Determinants of the Value of Flexibility

 Capacity to raise funds to meet financing needs: The greater the

capacity to raise funds, either internally or externally, the less the value
of flexibility.
• Firms with significant internal operating cash flows should value
flexibility less than firms with small or negative operating cash flows.
• Firms with easy access to financial markets should have a lower value for
flexibility than firms without that access.
 Unpredictability of reinvestment needs: The more unpredictable the
reinvestment needs of a firm, the greater the value of flexibility.
 Capacity to earn excess returns: The greater the capacity to earn excess
returns, the greater the value of flexibility.
• Firms that do not have the capacity to earn or sustain excess returns get no
value from flexibility.

101
Option Pricing Applications in Valuing Equity
Value in Deeply Troubled Firms

102
Option Pricing Applications in Equity Valuation

 Equity in a troubled firm (i.e. a firm with high leverage, negative

earnings and a significant chance of bankruptcy) can be viewed as a
call option, which is the option to liquidate the firm.

103
 Valuing Equity as an option

 The equity in a firm is a residual claim, i.e., equity holders lay claim
to all cashflows left over after other financial claim-holders (debt,
preferred stock etc.) have been satisfied.
 If a firm is liquidated, the same principle applies, with equity investors
receiving whatever is left over in the firm after all outstanding debts
and other financial claims are paid off.
 The principle of limited liability, however, protects equity investors
in publicly traded firms if the value of the firm is less than the value of
the outstanding debt, and they cannot lose more than their investment
in the firm.

104
 Spotting Options

 Book Value weights

Asset Value 100 Bonds 50

Equity 50

Total Assets 100 Total Value 100

105
 Spotting Options

 Market Value weights

Asset Value 30 Bonds 25

Bond Value = asset value – value of call
Bond Value = PV of promised payment –
value of default put
Equity 5
Stock Value = Value of Call
Stock Value = asset value – PV of
promised payment + value of put
Total Assets 30 Firm Value 30
Firm Value = Asset Value

106
 Equity as a call option

 The payoff to equity investors, on liquidation, can therefore be written

as:
Payoff to equity on liquidation = V - D if V > D
=0 if V ≤ D
where,
V = Value of the firm
D = Face Value of the outstanding debt and other external claims
 A call option, with a strike price of K, on an asset with a current value
of S, has the following payoffs:
Payoff on exercise =S-K if S > K
=0 if S ≤ K

107
Payoff Diagram for Liquidation Option

Net Payoff
on Equity

Face Value
of Debt

Value of firm

108
Application to valuation: A simple example

 Assume that you have a firm whose assets are currently valued at $100
million and that the standard deviation in this asset value is 40%.
 Further, assume that the face value of debt is $80 million (It is zero
coupon debt with 10 years left to maturity).
 If the ten-year treasury bond rate is 10%,
• how much is the equity worth?
• What should the interest rate on debt be?

109
 Model Parameters

 Value of the underlying asset = S = Value of the firm = $ 100 million

 Exercise price = K = Face Value of outstanding debt = $ 80 million
 Life of the option = t = Life of zero-coupon debt = 10 years
 Variance in the value of the underlying asset = 2 = Variance in firm
value = 0.16
 Riskless rate = r = Treasury bond rate corresponding to option life =
10%

110
 Valuing Equity as a Call Option

 Based upon these inputs, the Black-Scholes model provides the

following value for the call:
• d1 = 1.5994 N(d1) = 0.9451
• d2 = 0.3345 N(d2) = 0.6310
 Value of the call = 100 (0.9451) - 80 exp(-0.10)(10) (0.6310) = $75.94
million
 Value of the outstanding debt = $100 - $75.94 = $24.06 million
 Interest rate on debt = ($ 80 / $24.06)1/10 -1 = 12.77%

111
The Effect of Catastrophic Drops in Value

 Assume now that a catastrophe wipes out half the value of this firm
(the value drops to $ 50 million), while the face value of the debt
remains at $ 80 million. What will happen to the equity value of this
firm?
 It will drop in value to $ 25.94 million [ $ 50 million - market value of
debt from previous page]
 It will be worth nothing since debt outstanding > Firm Value
 It will be worth more than $ 25.94 million

112
 Illustration : Value of a troubled firm

 Assume now that, in the previous example, the value of the firm were
reduced to $ 50 million while keeping the face value of the debt at $80
million.
 This firm could be viewed as troubled, since it owes (at least in face
value terms) more than it owns.
 The equity in the firm will still have value, however.

113
 Valuing Equity in the Troubled Firm

 Value of the underlying asset = S = Value of the firm = $ 50 million

 Exercise price = K = Face Value of outstanding debt = $ 80 million
 Life of the option = t = Life of zero-coupon debt = 10 years
 Variance in the value of the underlying asset = 2 = Variance in firm
value = 0.16
 Riskless rate = r = Treasury bond rate corresponding to option life =
10%

114
 The Value of Equity as an Option

 Based upon these inputs, the Black-Scholes model provides the

following value for the call:
• d1 = 1.0515 N(d1) = 0.8534
• d2 = -0.2135 N(d2) = 0.4155
 Value of the call = 50 (0.8534) - 80 exp(-0.10)(10) (0.4155) = $30.44
million
 Value of the bond= $50 - $30.44 = $19.56 million
 The equity in this firm drops by, because of the option characteristics
of equity.
 This might explain why stock in firms essentially bankrupt, still has
value.

115
 Equity value persists ..

Value of Equity as F irm Value Changes

80

70

60

50
Value of Equity

40

30

20

10

0
100 90 80 70 60 50 40 30 20 10
Value of Firm ($ 80 Face Value of Debt)

116
 Valuing equity in a troubled firm

 The first implication is that equity will have value, even if the value
of the firm falls well below the face value of the outstanding debt.
 Such a firm will be viewed as troubled by investors, accountants and
analysts, but that does not mean that its equity is worthless.
 Just as deep out-of-the-money traded options command value because
of the possibility that the value of the underlying asset may increase
above the strike price in the remaining lifetime of the option, equity
will command value because of the time premium on the option
(the time until the bonds mature and come due) and the possibility that
the value of the assets may increase above the face value of the bonds
before they come due.

117
 The Conflict between bondholders and
stockholders

 Stockholders and bondholders have different objective functions, and

this can lead to conflicts between the two.
 For instance, stockholders have an incentive to take riskier projects
than bondholders do, and to pay more out in dividends than
bondholders would like them to.
 This conflict between bondholders and stockholders can be illustrated
dramatically using the option pricing model.
• Since equity is a call option on the value of the firm, an increase in the
variance in the firm value, other things remaining equal, will lead to
an increase in the value of equity.
• It is therefore conceivable that stockholders can take risky projects with
negative net present values, which while making them better off, may
make the bondholders and the firm less valuable. This is illustrated in the
following example.

118
Illustration: Effect on value of the conflict
between stockholders and bondholders

 Consider again the firm described in the earlier example , with a value
of assets of $100 million, a face value of zero-coupon ten-year debt of
$80 million, a standard deviation in the value of the firm of 40%. The
equity and debt in this firm were valued as follows:
• Value of Equity = $75.94 million
• Value of Debt = $24.06 million
• Value of Firm == $100 million
 Now assume that the stockholders have the opportunity to take a
project with a negative net present value of -$2 million, but assume
that this project is a very risky project that will push up the standard
deviation in firm value to 50%.

119
 Valuing Equity after the Project

 Value of the underlying asset = S = Value of the firm = $ 100 million -

$2 million = $ 98 million (The value of the firm is lowered because of
the negative net present value project)
 Exercise price = K = Face Value of outstanding debt = $ 80 million
 Life of the option = t = Life of zero-coupon debt = 10 years
 Variance in the value of the underlying asset = 2 = Variance in firm
value = 0.25
 Riskless rate = r = Treasury bond rate corresponding to option life =
10%

120
 Option Valuation

 Option Pricing Results for Equity and Debt Value

• Value of Equity = $77.71
• Value of Debt = $20.29
• Value of Firm = $98.00
 The value of equity rises from $75.94 million to $ 77.71 million ,
even though the firm value declines by $2 million. The increase in
equity value comes at the expense of bondholders, who find their
wealth decline from $24.06 million to $20.19 million.

121
 Effects of an Acquisition

 Assume that you are the manager of a firm and that you buy another
firm, with a fair market value of $ 150 million, for exactly $ 150
million. In an efficient market, the stock price of your firm will
 Increase
 Decrease
 Remain Unchanged

122
II. Effects on equity of a conglomerate merger

 You are provided information on two firms, which operate in unrelated

businesses and hope to merge.
• Firm A Firm B
• Value of the firm $100 million $ 150 million
• Face Value of Debt $ 80 million $ 50 million (Zero-coupon debt)
• Maturity of debt 10 years 10 years
• Std. Dev. in value 40 % 50 %
• Correlation between cashflows 0.4
• The ten-year bond rate is 10%.
 The variance in the value of the firm after the acquisition can be
calculated as follows:
Variance in combined firm value = w12 12 + w22 22 + 2 w1 w2 r1212
= (0.4)2 (0.16) + (0.6)2 (0.25) + 2 (0.4) (0.6) (0.4) (0.4) (0.5)
= 0.154
123
 Valuing the Combined Firm

 The values of equity and debt in the individual firms and the combined firm
can then be estimated using the option pricing model:
Firm A Firm B Combined firm
Value of equity in the firm $75.94 $134.47 $ 207.43
Value of debt in the firm $24.06 $ 15.53 $ 42.57
Value of the firm $100.00 $150.00 $ 250.00
 The combined value of the equity prior to the merger is $ 210.41 million and it
declines to $207.43 million after.
 The wealth of the bondholders increases by an equal amount.
 There is a transfer of wealth from stockholders to bondholders, as a
consequence of the merger. Thus, conglomerate mergers that are not followed
by increases in leverage are likely to see this redistribution of wealth occur
across claim holders in the firm.
 equity investors lose about $ 3 million, because of the drop in variance. To
prevent this from happening, you would need to
• Increase the debt ratio after conglomerate mergers to take advantage of
the lower risk and higher debt capacity
• Renegotiate with existing lenders to reduce interest rates that they charge
to reflect the lower risk of the firm.
124
Obtaining option pricing inputs - Some real
world problems

 The examples that have been used to illustrate the use of option pricing
theory to value equity have made some simplifying assumptions.
Among them are the following:
(1) There were only two claim holders in the firm - debt and equity.
(2) There is only one issue of debt outstanding and it can be retired at face
value.
(3) The debt has a zero coupon and no special features (convertibility, put
clauses etc.)
(4) The value of the firm and the variance in that value can be estimated.

125
Real World Approaches to Getting inputs

Input Estimation Process

Value of the Firm  Cumulate market values of equity and debt (or)
 Value the assets in place using FCFF and WACC (or)
 Use cumulated market value of assets, if traded.
Variance in Firm Value  If stocks and bonds are traded,
2firm = we2 e2 + wd2 d2 + 2 w e wd red ed
where e2 = variance in the stock price
we = MV weight of Equity
d2 = the variance in the bond price w d = MV weight of debt
 If not traded, use variances of similarly rated bonds.
 Use average firm value variance from the industry in which
company operates.
Value of the Debt  If the debt is short term, you can use only the face or book value
of the debt.
 If the debt is long term and coupon bearing, add the cumulated
nominal value of these coupons to the face value of the debt.
Maturity of the Debt  Face value weighted duration of bonds outstanding (or)
 If not available, use weighted maturity

126
Valuing Equity as an option - Eurotunnel in
early 1998

 Eurotunnel has been a financial disaster since its opening

• In 1997, Eurotunnel had earnings before interest and taxes of -£56 million
and net income of -£685 million
• At the end of 1997, its book value of equity was -£117 million
 It had £8,865 million in face value of debt outstanding
• The weighted average duration of this debt was 10.93 years
Debt Type Face Value Duration
Short term 935 0.50
10 year 2435 6.7
20 year 3555 12.6
Longer 1940 18.2
Total £8,865 mil 10.93 years

127
 The Basic DCF Valuation

 The value of the firm estimated using projected cashflows to the firm,
discounted at the weighted average cost of capital was £2,278 million.
 This was based upon the following assumptions –
• Revenues will grow 10% a year for the next 5 years and 3% a year in perpetuity
after that.
• The cost of goods sold which was 72% of revenues in 1997 will drop to 60% of
revenues by 2002 in linear increments and stay at that level.
• Capital spending and depreciation will grow 3% a year for the next 5 years. Note
that the net capital expenditure is negative for each of these years – we are
assuming that the firm will be able to not make significant reinvestments for the
next 5 years. Beyond year 5, capital expenditures will offset depreciation.
• There are no working capital requirements.
• The debt ratio, which was 95.35% at the end of 1997, will drop to 70% by 2002.
The cost of debt is 10% for the next 5 years and 8% after that.
• The beta for the stock will be 2.00 for the next five years, and drop to 0.8 thereafter
(as the leverage decreases).

128
 Other Inputs

 The stock has been traded on the London Exchange, and the
annualized std deviation based upon ln (prices) is 41%.
 There are Eurotunnel bonds, that have been traded; the annualized std
deviation in ln(price) for the bonds is 17%.
• The correlation between stock price and bond price changes has been 0.5.
The proportion of debt in the capital structure during the period (1992-
1996) was 85%.
• Annualized variance in firm value
= (0.15)2 (0.41)2 + (0.85)2 (0.17)2 + 2 (0.15) (0.85)(0.5)(0.41)(0.17)= 0.0335
 The 15-year bond rate is 6%. (I used a bond with a duration of roughly
11 years to match the life of my option)

129
 Valuing Eurotunnel Equity and Debt

 Inputs to Model
• Value of the underlying asset = S = Value of the firm = £2,278 million
• Exercise price = K = Face Value of outstanding debt = £8,865 million
• Life of the option = t = Weighted average duration of debt = 10.93 years
• Variance in the value of the underlying asset = 2 = Variance in firm
value = 0.0335
• Riskless rate = r = Treasury bond rate corresponding to option life = 6%
 Based upon these inputs, the Black-Scholes model provides the following
value for the call:
d1 = -0.8582 N(d1) = 0.1955
d2 = -1.4637 N(d2) = 0.0717
 Value of the call = 2278 (0.1955) - 8,865 exp(-0.06)(10.93) (0.0717) = £116
million
 Appropriate interest rate on debt = (8865/2162)(1/10.93)-1= 13.7%
 There is a very high probability of bankruptcy (about 93%) and the default
spread is huge (about 7.7%). The equity still has value because the debt is very
long term. The fact that the French and the British governments put pressure
on the banks to roll over their debt makes the option even more attractive. 130