Valuing Options

You’re considering buying a business in one month. You estimate that the business is worth around $110,000. Which of these two options should you prefer?

(a.) Six months from now you must pay $100,000 for the business.

(b.) Six months from now you have the option of paying $100,000 for the business.

An option gives you the right but not the obligation to do something. Options are valuable because you can choose not to exercise them if conditions become unfavorable. In the previous example, arrangement (b) is far preferable to (a) because in six months if the business is worth less than $100,000, then under (a) you must still buy the business while under (b) you can forgo the transaction. If you are forced to buy the business in six months, you must purchase it whether the business is doing well or poorly. If you have an option to buy, you need only acquire the business when it is doing well.

Options mitigate the danger of uncertainty. With an option you are not locked into a transaction, so if circumstances move against you, you can withdraw. Options are valuable because they eliminate downside risk while allowing you to capture the upside benefit.

Options are more valuable the greater the underlying level of uncertainty. If, in the previous example, you know that the business will be worth $110,000 in six months, then arrangements (a) and (b) are identical, because you will always exercise the option in (b). If, however, there is some chance that in six months the business will be worth, say, $50,000, then you should much prefer having the option to having the obligation to buy.

Options are also more valuable the farther into the future they run. Uncertainty increases with time. The greater the amount of time that will elapse before your deal must be consummated, the higher the chance of something going wrong.

Options should cause you to take risks. Imagine that you are considering launching a very risky product. The product will either do well or poorly. If it does poorly, it will cost you $20 million each year it is being marketed. If it does well, it will provide you with $20 million a year in profits.

Table 3

Value If Product Does Poorly	Value If Product Does Well
–$20 million	$20 million

At the end of the year you will know how the product did and will have an option to keep the product in the market for future years. Assume that there is a 70 percent chance that the product will do poorly. Should you launch the product?

If you introduce the item, you will probably lose money. Any losses will be limited to one year. If the product does well, you can earn $20 million a year forever. Consequently, you probably should release the product.

Many business ventures have inherent option value because they can often be canceled if things go poorly and continued if they go well. You should be willing to try new ventures that have option value even if you believe they will probably fail.

Because of option value you should be more adventurous in trying new restaurants when at home than when abroad. It’s rational to try a local restaurant that you will almost certainly hate. If you do dislike the restaurant you need never eat there again. If the local restaurant is surprisingly good, however, you can go back many times. You don’t get option value from visiting a restaurant far from home, because even if you like it you may never go back.

Employees give firms varying degrees of option value. When you hire someone, you have some control over how long he will work for you. You should be more willing to take a chance on a new employee the greater their option value. Legally, it can be difficult to fire employees. If you can’t fire an employee, you don’t have an option on him. Regardless of whether you like or hate a difficult-to-fire employee, you may be stuck with him. This means that, paradoxically, antidiscrimination laws can hurt minorities.

Imagine there are two potential employees, one white and the other a protected minority. Both have exactly the same qualifications. Both employees are risky hires, and there exists a good chance that neither would work out. You know it would be much harder to fire the minority employee because of antidiscrimination laws. It might be rational (although not ethical) for you to hire the white employee because he can be more easily fired. It would be worth taking a chance on the white employee whom you could easily fire, because if he doesn’t work out, you’re not stuck with him. In contrast, if your legal department won’t let you fire minorities, the profit-maximizing move might be to hire only a minority candidate if you are almost certain that he would be a productive employee.

It’s much harder to fire workers in Western Europe than in the United States. Therefore, American workers have greater option value than their European counterparts do. Consequently, unemployment rates in the United States are lower because American businesses have a greater willingness to hire new employees.