Schill Zhou.Pricing an Emerging Industry 15 upward biased.To investigate the importance of outstanding off-balance-sheet derivative contracts,the market value ratio is recast to consider such claims.The adjusted market value ratio is computed as: Adjusted Market Value Ratio = PsSsup Ds+Osut (7) P S+D +O where O,is the market value of outstanding subsidiary off-balance-sheet derivatives for the carve-out subsidiary held by the parent,and (is the market value of outstanding derivative securities for the parent.Defined properly.O and O capture all contingent claims including all options.convertible debt.warrants,or other securities that are exchangeable for claims on the parent or carve-out subsidiary assets. Equation 7 implies that the market value ratio is increasing in subsidiary off-balance-sheet value Since reliable market value estimates of ofr-balance-sheet contracts are empirically difficult to obtain,to gauge the potential importance of off-balance sheet claims,we estimate lower bounds on the adjusted market-value ratio.The value of all off-balance-sheet contracts on subsidiary assets are set to zero and the value of all off-balance sheet contracts on parent assets to its upper bound,the value of the underlying equity.By setting Oto its lower bound and O.to its upper bound,we intentionally further bias the value ratio downward. The true value of O and O.is expected to be substantially different from the respective lower and upper bound values.resulting in a larger inarket value ratio. To estimate the adjusted value ratio,we obtain the number of all outstanding derivative securities from the parent's 10-K filing.We use the riling date closest to the carve-out date. The data for Daisytek (DZTK).HNC Software (HNCS),and MALL is reported within six weeks following the carve-out.The data for DLIA is reported within the three months prior to the offering. We identify all contingent claims that are exercisable,convertible.or exchangeable into parent common equity.Table Il provides data on the contingent claims for our sample parent firms.Each of the parent firms maintain a large number of outstanding employee and director stock options granted as part of their incentive programs. The total number of stock options is three,four.six.and two million,for parent firms DLIA. DZTK,HNCS,and MALL,respectively.Although these options are,on average.highly"in the money"(share price>exercise price),the holders are generally restricted from exercising them.The fraction of exercisable shares to total shares is between 12%and 26%.HNCS also maintains some convertible debt(a $100,000 convertible subordinated note maturing in 2003). which provides the potential for 2.2 million additional shares.Based on the total number of contingent shares.the potential dilution of parent equity appears modest with contingent shares-to-outstanding shares of between 0.20 and 0.32. To more fully measure the potential effect of dilution,we need to value the dilution effect of the derivative claims.The value of the underlying security provides an upper bound and zero provides a lower bound for the dilution valuc of derivative claim.Using the closing price on the underlying common equity of the parent for the date reported.the share price is Since exercising the stock options and convertible notes gener.tes the issuance of new equity.the value of the dilution cannot be greater than the value of the new equity.In an extreme case in which the exercise price is zero. issuing equity with no proceeds dilutes existing equity by the amount of the prevailing stock price.Although stock options are generally granted at the prevailing stock price.we acknowledge that we may be understating the number of all contingent claims.since we do not include future awards of derivative contracts that investors might anticipate.Our generous valuation assumptions for the outstanding contracts are likely to offset any anticipated dilution from future awards