Deck 20: Options and Corporate Finance

Question 1

The option to abandon a project can decrease its value.

Answer 1

False

Question 2

A call option can sometimes be priced higher than the underlying asset.

Answer 2

False

Question 3

It is possible that some projects with a negative NPV should be pursued after taking into account the value of real options.

Answer 3

True

Question 4

The option to choose to terminate a project is like a put option.

Question 5

Suppose you have sold a put option on a stock with a strike price of $25 and the current price of the stock is $25. If the stock price at expiration is $30, your payoff will be -$5.

Question 6

Consider a put option on a stock with a strike price of $60. If the stock price at expiration is $50, then the payoff from the put option is $10.

Question 7

In the binomial pricing model, an option is priced using a replicating portfolio that typically consists of a risk-free bond and the asset underlying the option.

Question 8

The option to defer investment can be characterized as the flexibility to wait and learn more information about a project before committing resources to the project.

Question 9

To price an option using the binomial pricing model, it is important that we know the probability that the asset will increase in value.

Question 10

A stock is selling for $50 today. A call option on the stock with a strike price of $50 is set to expire next month. If the price of the stock goes down tomorrow, we would expect the price of the call option to go down as well.

Question 11

If a firm adds financial options to its debt securities, it will increase the interest expense to the firm.

Question 12

If the risk-free rate of interest increases, all else being equal, we would expect the value of a call option to increase.

Question 13

The current price of an asset is $75. A put option on the asset with a strike price of $100 expires one year from now. It is possible, without arbitrage, for this put option to be priced at $24 today.

Question 14

When using the binomial pricing model to price an option, the volatility of the underlying asset's value is represented by the difference between the two possible future values of the underlying asset.

Question 15

A put option with a strike price of $20 is expiring today. The stock is currently selling at $25. Based on this information, the put option should not be exercised.

Question 16

If a project has a positive NPV, then the real options that are relevant to the project are not important to estimating the value of the project.

Question 17

A portfolio consisting of one put option and one call option, both with the same exercise price, is a good investment strategy for investors who don't know whether an asset's value is likely to go up or down but think that the volatility of the asset will increase.

Question 18

Consider a call option on a stock with a strike price of $60. If the stock price at expiration is $50, then the payoff from the call option is $10.

Question 19

A company is negotiating for the option to develop a platinum mine. Under the terms of the option contract, the company would be able to purchase the development rights to the mine one year from now for an exercise price specified today. If, during the negotiations over the option contract, the volatility of the price of platinum increases, the company should expect to pay a higher price for the development option.

Question 20

Neither a call nor a put option can have a negative price.

Question 21

Suppose the current spot price of wheat is $25 a bushel. A wheat farmer expects to produce 1,000 bushels at the end of the season, and she wants to ensure that she gets at least $19 a bushel. If a put option on 1,000 bushels of wheat with a strike price of $20 and an expiration date at the end of the season is selling for $1,000, the farmer can purchase the put option to guarantee she gets $19 a bushel.

Question 22

Hedging is use of financial instruments such as options, forwards, futures, and swaps to reduce the financial risks faced by a firm.

Question 23

The likelihood of financial distress increasing with leverage that results in managers using less debt than shareholders would like them to use is an example of agency costs of equity.

Question 24

Consider a company that is likely to go bankrupt in the next year. Stockholders may wish to pursue negative-NPV projects, even if there is no additional value to the project from real options.

Question 25

Consider a firm with a single loan. There are no interest payments on the loan, but the principal and interest are all due in two years. It is uncertain whether the cash flow the company will produce will be enough to pay off the debt. The payoff to stockholders in this company resembles a call option.

Question 26

Which of the following statements is true of a call option?

A) The value of a call option can never be positive.
B) The value of a call option can be more than the value of the underlying asset.
C) The value of a call option can never be worth less than the current value of the asset minus present value of the strike price.
D) The value of a call option can be worth more than the strike price.

Question 27

Suppose you own a call option on a stock with a strike price of $20 that expires today. The price of the underlying stock is $15. If you exercise the option and immediately sell the stock, then:

A) you will earn $5.
B) you will lose $5.
C) you will lose $15.
D) you will earn $15.

Question 28

Harmostrax Co. has a defined-benefit pension plan for its employees. To fund the plan, the company makes periodic contributions to a stock investment fund. If the stock market declines significantly, the company would have to make additional contributions to make up for lost revenue. The company could hedge its risk of a market downturn by periodically purchasing put options on the stock market.

Question 29

Ecofren Thermostats Co. sells equipment to residential and commercial customers. It is considering whether or not to develop a new line of smart thermostats. The discounted cash flows from smart thermostat sales are not likely to cover the development costs. However, the company has decided to pursue the project anyway. If the commercial technology is successful, it might be applied to a new line of very profitable residential thermostats. This is an example of the option to make follow-on investments.

Question 30

Consider an American and a European call option on a dividend-paying stock, with otherwise identical features (same strike price, etc.). Which of the following statements is true?

A) The American call option will never be worth less than the European call option.
B) The European call option will never be worth less than the American call option.
C) Both European call and American call option should always have the same value.
D) The American option can be exercised only on specific dates during the life of the option.

Question 31

Financial options can be used to hedge risks such as interest rates and foreign exchange rates.

Question 32

By designing executive compensation plans with performance bonuses, stock-based compensation, and stock options, corporate boards are attempting to make the payoff function for managers look similar to the payoff function for stockholders.

Question 33

An investor (the buyer) purchases a put option from a seller. On the expiration date of a put option:

A) the buyer has the obligation to sell the underlying asset and the seller has the right to buy it.
B) the buyer has the obligation to sell the underlying asset and the seller has the obligation to buy it.
C) the buyer has the right to sell the underlying asset and the seller has the obligation to buy it.
D) the buyer has the right to buy the underlying asset and the seller has the right to sell it.

Question 34

Suppose the current spot price of corn is $20 a bushel. A corn farmer expects to produce 2,000 bushels at the end of the season, and she wants to ensure that she gets at least $18 per bushel. Call options on 1,000 bushels of corn with a strike price of $15 and an expiration date at the end of the season are selling for $3,000. By selling call options on her corn crop, the farmer can guarantee that she gets at least $18 per bushel.

Question 35

Consider a company that is likely to go bankrupt in the next year. The bondholders may encourage the company to pursue risky negative-NPV projects in hopes that the firm will avoid financial distress.

Question 36

Which of the following statements is true of a put option?

A) The value of a put option can be negative.
B) The value of a put option can be worth more than the underlying asset.
C) The value of a put option can be less than the present value of the strike price minus the current value of the underlying asset.
D) The value of a put option increases when the stock price increases.

Question 37

An investor (the buyer) purchases a call option from a seller. On the expiration date of a call option:

A) the buyer has the obligation to buy the underlying asset and the seller has the obligation to sell it.
B) the buyer has the right to buy the underlying asset and the seller has the obligation to sell it.
C) the buyer has the obligation to sell the underlying asset and the seller has the right to buy it.
D) the buyer has the right to sell the underlying asset and the seller has the right to buy it.

Question 38

Consider an option that gives the owner the right to buy the underlying stock for $20 only on the third Friday of May, next year. This option can best be described as:

A) an American call option.
B) a European put option.
C) an American put option.
D) a European call option.

Question 39

A small soybean farmer wants to hedge the price risk of his next crop, but he is financially constrained. He can't raise capital by either borrowing money or selling his current assets. Instead, he sells call options on his soybean crop with a strike price of $14 per bushel at a premium of $0.50 a bushel. Using the proceeds from selling the call options, he buys put options on his soybean crop with a strike price of $11.00 per bushel at a premium of $0.35 per bushel. Assume the risk-free interest rate is 0 percent. By taking these derivative positions, the farmer has guaranteed that he will earn somewhere between $14.15 and $11.15 per bushel.

Question 40

Suppose you own a put option on a stock with a strike price of $35 that expires today. The price of the underlying stock is $25. If you purchase the stock and exercise the put option, then:

A) you will earn $10.
B) you will lose $10.
C) you will earn $25.
D) you will lose $25.

Question 41

Adosonic Reality is considering the construction of a new development of condominiums in downtown Austin, Texas. The site for the new development is currently occupied by an office building owned by the city. The project's profitability will depend largely on the population increase in Austin over the next several years. Rather than buy the site, Adosonic Reality has entered into an agreement with the city to pay $200,000 for the right to purchase the site for $10 million two years from now. The real option embedded in this contract is best described as:

A) the option to defer investment.
B) the option to make follow-on investments.
C) the option to change operations.
D) the option to abandon projects.

Question 42

The employment contracts for professional athletes often contain options for either the player or the team. Consider one recent contract in Major League Baseball. The player's salary was guaranteed for the first couple of years. However, after several years, the team had the option to cancel the contract if the player became injured. If we think of each player as a project for the team, this option feature of the contract is best described as:

A) the option to defer investment.
B) the option to make follow-on investments.
C) the option to change operations.
D) the option to abandon projects.

Question 43

If the price of the underlying asset increases, what happens to the value of call and put options?

A) Put options will be worth more, call options will be worth less.
B) Put options will be worth less, call options will be worth more.
C) Both call and put options will be worth more.
D) Both call and put options will be worth less.

Question 44

Which of the following changes, everything else held constant, will increase the value of a put option?

A) An increase in the risk-free interest rate
B) Lower volatility of the price of the underlying asset
C) A higher strike price
D) The option is nearing its expiration date.

Question 45

Consider a new firm that is working on the first generation of long-awaited consumer jet packs. The project will take a tremendous amount of R&D expenditure. Even if the development is successful, manufacturing the first generation of jet packs is likely to be so expensive that only a selected few consumers will be able to afford them. The projected sales of the first generation of jet packs almost certainly won't cover the development and manufacturing costs-the project has a negative NPV. Which of these reasons would validate the firm's decision to pursue the jet pack project?

A) If development is unsuccessful, it can abandon the project before spending money on manufacturing.
B) If the project is successful, it may lead to a very profitable second project-a cheaper jet pack that will be a positive-NPV project.
C) Because it is a high-tech firm, the cash flows generated by a project are not important to valuing the company.
D) If development is successful, it allows managers to reach wide range of consumers.

Question 46

As the manager of a sporting goods company, you are presented with a new golf project. An inventor has recently patented the design for a new golf club that makes playing golf much easier. Your company has made contact with the inventor, who is willing to sell the exclusive rights to the technology, but if you don't act fast he will sell the rights to a rival company. You are not certain whether the new golf club will become popular, but your analysts have completed a basic NPV analysis. Given the available information, the project has a positive NPV. However, you know there are several real options associated with the project, including the option to abandon the project and the option to make follow-on investments. Which of the following statements regarding the project is correct?

A) Based on the NPV analysis, you should accept the project. The value of the project may be worth more than the NPV analysis but not less.
B) Based on the NPV analysis, you should accept the project. The NPV analysis contains all the information about the value of the project.
C) Based on the NPV analysis, you should reject the project. Without additional information about the value of the real options, there is no way to make a decision.
D) Based on the NPV analysis, you should reject the project. The NPV analysis contains all the information about the value of the project.

Question 47

What happens to the value of call and put options if the volatility of the price of underlying asset decreases?

A) Put options will be worth more, call options will be worth less.
B) Put options will be worth less, call options will be worth more.
C) Both call and put options will be worth more.
D) Both call and put options will be worth less.

Question 48

Which of the following is a valid reason for managers selecting negative-NPV projects?

A) The NPV analysis includes a valuable real option to expand the project if things go well.
B) If a firm has debt, managers may create value for shareholders by taking on some risky negative NPV projects.
C) Managers' payoff functions represent the payoffs of lenders. By taking negative NPV projects, the managers can create value for lenders.
D) Projects having negative NPV can have high internal rate of return.

Question 49

Which of the following would be a reason to bundle options with stock in an IPO?

A) To increase the supply of outstanding shares in order to attract more investors
B) To promote the dilution of common stockholders' control on assets
C) To reduce the number of common shares that must be sold at the IPO price in order to raise the amount of money that the firm needs
D) To bring down the earnings per share of common stockholders

Question 50

Arctic Inc. has built a highly interactive operating system for mobile and other electronic gadgets. The development cost to the company was high but the system was inexpensive to sustain and market. The NPV of this project was negative. However, in the coming years the company plans to launch mobile phones, portable audio and video devices. The decision of launching the operating system for mobile and other devices is an example of:

A) option to defer investment.
B) option to abandon a project.
C) option to change operations.
D) option to make follow-on investments.

Question 51

The option payoff function describes the relationship:

A) between the value of an option and the value of a firm.
B) between the value of an option and the price of the underlying asset.
C) between the call premium and the value of an option.
D) between the call premium and the price of underlying asset.

Question 52

Consider a CEO who holds neither stock nor stock options in the company she runs. Her payoff function regarding the firm's performance is most likely to resemble:

A) stockholders.
B) lenders.
C) owners of a call option on the firm.
D) holders of a risk-free bond with coupon payments equal to her salary.

Question 53

The management at PhoneUn considered the option to abandon when building their new manufacturing plant. The design of the plant allows it to be easily converted to manufacture other types of large machinery. If its new line of cars is poorly received, its plant should be easy to sell to another manufacturing company. In this example, the price at which they expect to sell the plant if things go poorly resembles:

A) the premium of a put option on the plant.
B) the premium of a call option on the plant.
C) the strike price of a put option on the plant.
D) the strike price of a call option the plant.

Question 54

Frost1 Motors is very likely to enter financial distress. Without a dramatic change of events over the next couple of years, the company will be unable to pay its lenders, who will then gain control of the company's assets. A group of stockholders has pressured the company's management to begin manufacturing and selling one of the company's concept cars in the hope that it will be a big hit. Concept cars are prototypes that are developed to test new ideas and to show off at auto shows. Although elements of concept cars are often incorporated into product lines, rushing a concept car into production is very risky. The best estimates about the concept car make it appear to be a negative-NPV project. This is a good example of:

A) the dividend payout problem.
B) the underinvestment problem.
C) the asset substitution problem.
D) the agency cost of equity.

Question 55

When the value of the firm is above the face value of the debt:

A) the stockholders repay the debt and the equity is worth less than $0.
B) the stockholders repay the debt and the equity is worth the difference between the firm value and the face value of the debt.
C) the stockholders default and the lenders receive the value of the firm.
D) the stockholders default and the equity is worth $0.

Question 56

What happens to the value of call and put options, with everything else held constant, if the risk-free interest rate increases?

A) Call options will be worth more, put options will be worth less.
B) Call options will be worth less, put options will be worth more.
C) Both call and put options will be worth less.
D) Both call and put options will be worth more.

Question 57

A local city government has awarded a contract to sequentially build five new elementary schools over the next 10 years. The price for each school has been spelled out in the contract, but at the beginning of each year the city can cancel the order for the remaining schools. The city government is concerned that if the population of the town does not grow as expected it may not need all of the schools. What type of financial option does the option to cancel the order resemble?

A) Owning a call option on the value of the new schools
B) Owning a put option on the value of the new schools
C) Selling a call option on the value of the new schools
D) Selling a put option on the value of the new schools

Question 58

What happens to the value of call and put options, with everything else constant, as the expiration date gets closer?

A) Call option will be worth more, put options will be worth less.
B) Call option will be worth less, put options will be worth more.
C) Both call and put options will be worth more.
D) Both call and put options will be worth less.

Question 59

Which of the following changes, everything else held constant, will increase the value of a call option?

A) The value of the underlying asset becomes more volatile
B) The price of the underlying asset goes down
C) Getting closer to the expiration date (the passage of time)
D) A higher strike price

Question 60

When a company issues convertible bonds with a $1,000 par value that can be converted to 20 shares of common stock, each bond includes:

A) a put option with an exercise price of $200 per share.
B) a call option with an exercise price of $50 per share.
C) a put option with an exercise price of $20 per share.
D) a call option with an exercise price of $20 per share

Question 61

Adding stock options and bonuses for performance to the compensation of a manager is intended to more closely align the interests of the manager with those of:

A) stockholders.
B) lenders.
C) employees.
D) public.

Question 62

What is the payoff for the buyer of a call option with a strike price of $35 if the underlying stock price at expiration is $30?

A) $10
B) $20
C) $5
D) $0

Question 63

What is the payoff for a call option with a strike price of $50 if the underlying stock price at expiration is $85?

A) $35
B) $50
C) $45
D) $140

Question 64

Tunerecord Unit Co. stock is currently trading at $24. There are two types of options available on the stock. Call options with a strike price of $24, which expire next year, are currently trading at $9.6. Put options with a strike price of $24, which expire next year, are currently trading for $2.4. Berniss invests $144 in common stock. Jewel invests $144 in the call options. Reynardo invests $144 in the put options. At the end of one year the price of Tunerecord Unit stock is $21.6. Who made the least losses from their investment?

A) Berniss
B) Jewel
C) Reynardo
D) Berniss and Jewel tied

Question 65

Bifive Homes, Inc., is a developer of planned residential communities. It has entered into an option contract with a land owner outside Austin, Texas. It will pay the land owner $100,000 for the option to buy the land in two years at a price of $20 million. During that time Bifive Homes will evaluate population and real estate trends in Austin. Its plan is to buy the land if real estate prices in Austin increase enough that developing the land would be worth more than the $20 million price. The $20 million purchase price resembles:

A) the premium price of a put option on the land.
B) the premium price of a call option on the land.
C) the strike price of a put option on the land.
D) the strike price of a call option on the land.

Question 66

The claim lenders' hold on cash flows in a company with outstanding risky debt is often thought of as:

A) holding a call option on the firm's assets.
B) holding a put option on the firm's assets.
C) selling a put option on the firm's assets and holding a risk-free bond.
D) selling a call option on the firm's asset and holding a risk-free bond.

Question 67

Purchasing a house is a somewhat complicated process. Typically, if the buyer's offer is accepted by the seller, the transaction will not be completed or "closed" for several weeks. During this time the buyer may gather more information about the house or research other houses in the area. Some home purchase contracts include an option fee. The buyer may pay the seller a few hundred dollars for the right to walk away from the contract prior to closing for any reason. This option fee can be best described as:

A) the option to defer investment.
B) the option to make follow-on investments.
C) the option to change operations.
D) a put option on the house.

Question 68

You have sold a call option on Ausia Co. stock with a strike price of $50. You do not intend to make any other transactions before the options expiration date. The current stock price is $30. Which of the following statements best describes your hopes for the stock?

A) You want the stock price to fall below $30.
B) You want the stock price to rise above $50.
C) You are indifferent, as long as the stock price stays under $50.
D) It doesn't matter; you are indifferent to changes in the stock price.

Question 69

The claim stockholders hold on cash flows in a company with outstanding debt can best be described as:

A) a call option on the firm's assets.
B) a put option on the firm's assets.
C) an interest-free bond with the same value as the firm's assets.
D) a put option on the firm's liabilities.

Question 70

Anonxy Foods has made the decision to invest in a new line of organic microwave dinners. The new line of dinners is a negative-NPV project; paying its suppliers to convert to organic practices will be expensive. However, the company will be in a good position to expand into more profitable lines of food if consumer demand for organic foods grows more than expected. The negative value of the organic dinner project most closely resembles:

A) the premium of a put option on future organic projects.
B) the premium of a call option on future organic projects.
C) the strike price of a put option on future organic projects.
D) the strike price of a call option on future organic projects.

Question 71

The management at Sevenglobe Motors considered the option to abandon when building their new manufacturing plant. The design of the plant allows it to easily be converted to manufacture other types of large machinery. If their new line of cars is poorly received, their plant should be easy to sell to another manufacturing company. In this example, the extra cost of building the plant in such a way that it can easily be converted for other uses resembles:

A) the premium of a put option on the plant.
B) the premium of a call option on the plant.
C) the strike price of a put option on the plant.
D) the strike price of a call option on the plant.

Question 72

Consider a put option with a strike price of $40, which expires in one year. The risk-free rate of interest is 8 percent. The current underlying stock price is $20. Without arbitrage, which of the following is a possible price for the put option? (Round intermediate computations to two decimal places.)

A) $0.50
B) $16.20
C) $25.00
D) $10.20

Question 73

Consider a call option with a strike price of $20, which expires in one year. The risk-free rate of interest is 5 percent. The underlying stock price is $30. Without arbitrage, which of the following is a possible price for the call option? (Round intermediate computations to two decimal places.)

A) $0
B) $8
C) $15
D) $1

Question 74

Consider a call option with a strike price of $10, which expires in one year. The risk-free rate of interest is 10 percent. The current underlying stock price is $30. Without arbitrage, which of the following is a possible price for the call option? (Round intermediate computations to two decimal places.)

A) $0
B) $19.50
C) $21.00
D) $19.00

Question 75

What is the payoff for the buyer of a put option with a strike price of $63 if the underlying stock price at expiration is $43?

A) $126
B) $43
C) $20
D) $63

Question 76

Pitchgent, Inc., stock is currently trading at $22 per share. There are two types of options available on the stock. Call options with a strike price of $16, which expire next month, are currently trading at $7.00. Put options with a strike price of $16 which expire next month are currently trading at $1.10. Larry invests $132 in common stock. Keaty invests $132 in the call options. Marek invests $132 in the put options. At the end of one month, the price of Pitchgent, Inc., is $25. Who made the most money from their investment?

A) Larry
B) Keaty
C) Marek
D) Larry and Keaty tied

Question 77

Which of the following statements is an example of an agency cost of debt?

A) ABC Co. shareholders pressure management to invest in very risky projects in hopes that one of the investments might pay off. The company is highly leveraged, so shareholders have little to lose.
B) ABC Co. has no debt but very few investment opportunities. The board of directors decides not to pay out a large special dividend. Lenders collect 100 percent of the face value of the debt.
C) ABC Co. is financially sound. The company has a negative-NPV investment opportunity. Investors refuse to invest the additional funds necessary to pursue the project, as it has negative NPV.
D) Investors are unsure of the value for ABC Co. ABC Co. decides to issue equity to pay down debt. The market assumes that ABC Co.'s managers are issuing equity because they think that the company's stock is overvalued. As a result, the company's stock price falls when the equity issue is announced.

Question 78

Assume that the stock of Alitor Craft, Inc., is currently trading for $19 and will either rise to $21 or fall to $15 in one year. The risk-free rate for one year is 12 percent. What is the value of a call option with a strike price of $16? (Do not round intermediate computations. Round final answer to two decimal places.)

A) $4.67
B) $2.33
C) $1.04
D) $6.83

Question 79

You own a put option on Phosfranc Inc. stock with a strike price of $50. The current stock price is $50. Which of the following would you prefer?

A) The stock price goes up
B) The stock price goes down
C) The stock price stays the same
D) You don't care what happens to the stock price.

Question 80

What is the payoff for a put option with a strike price of $22 if the price of the underlying stock at expiration is $19?

A) $1
B) $3
C) $20
D) $22