Deck 20: Options and Corporate Finance

Question 1

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

Answer 1

False

Question 2

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

Answer 2

True

Question 3

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

Answer 3

True

Question 4

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

Question 5

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 6

Kelvin's Thermostats Co. sells equipment to residential and commercial customers. It is considering whether or not to develop a new line of advanced commercial thermostats. The discounted cash flows from commercial 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 7

Incorporating real options will not decrease the value of the project relative to the basic NPV analysis.

Question 8

A portfolio consisting of one put option and one call option, both with the same exercise price, is called a straddle. A straddle 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 9

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

Question 10

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

Question 11

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

Question 12

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 13

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 14

The option to abandon a project can decrease its value.

Question 15

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 16

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 17

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

Question 18

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

Question 19

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 20

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 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 $20,000 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

Consider an option that gives the owner the right to buy a stock for $20 only on the third Friday of May, next year. The option being described is

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

Question 23

An investor (the buyer) purchases a put option from a seller. On the expiration date of a call 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) None of the above

Question 24

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,

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

Question 25

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 buy the underlying asset and the seller has the right to sell it.
D) None of the above.

Question 26

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 27

Which one of the following statements is NOT true?

A) The value of a put option can never be negative.
B) The value of a put option can never be worth more than the underlying asset.
C) The value of a put option can never be less than the present value of the strike price minus the current value of the underlying asset.
D) All the above statements are true.

Question 28

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. 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 29

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

Question 30

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 31

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

Question 32

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 33

By designing 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 34

Consider an American and a European call option on a dividend-paying stock, with otherwise identical features (same strike price, etc.). Which one 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 options should always have the same value.
D) None of the above statements is true.

Question 35

A straddle is a combination of a put option and a call option on the same asset with the same strike price. Which one of the following statements about a straddle is NOT true?

A) The owner of a straddle will receive a payoff if the price of the underlying asset is higher than the strike price at expiration.
B) The owner of a straddle will receive a payoff if the price of the underlying asset is lower than the strike price at expiration.
C) The owner of a straddle will never exercise the put and the call option at the same time.
D) The owner of a straddle will receive a higher payoff if the price of the underlying asset at expiration is near the strike price.

Question 36

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

Question 37

Socrates Motor 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 38

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,

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

Question 39

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 wheat with a strike price of $15,000 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 40

Which one of the following statements is NOT true?

A) The value of a call option can never be negative.
B) The value of a call option can never 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 never be worth more than the strike price.

Question 41

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 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) a put option on the house.

Question 42

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 sort 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 43

Which of the following compensation methods is NOT likely to reduce agency costs between stockholders and managers?

A) Stock compensation-giving the CEO stock in the company as part of her salary.
B) A golden parachute-a guaranteed large lump-sum payment in the event that the CEO is fired.
C) A higher salary than that of other CEOs in similar companies.
D) Performance bonuses-a higher bonus if the company's cash flows are higher then expected.

Question 44

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 45

RealEstates LLP 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, RealEstates 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 46

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 select 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) None of these reasons support the decision to pursue the project.

Question 47

Socrates 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 48

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

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 49

The management at Socrates Motors 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 their new line of cars is poorly received, their 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 50

A start-up company is making a decision on whether to develop a new internet social networking site. The site will cost $1 million to develop, but it is unclear whether the new technology critical to the site will work correctly. If development is successful, it will cost an additional $20 million next year to advertise the site to Internet users. If the site becomes popular with Internet users, it is expected to generate a present value of $100 million in advertising revenue. There is a 10 percent chance that the site will be successfully developed and subsequently become popular with Internet users. The company's cost of capital is 15 percent. Should the company pursue the project?

A) No, the project has a negative NPV.
B) Yes, the project has a positive NPV.
C) It doesn't matter. The project has zero NPV.
D) There is not enough information to make a decision.

Question 51

Which of the following reasons is NOT a valid explanation of why managers sometimes choose to take on negative-NPV Projects:

A) The NPV analysis does not include a valuable real option to expand the project if things go well.
B) If the 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) All of the above descriptions are valid explanations for why managers sometimes take on negative NPV projects.

Question 52

With everything else held constant, what happens to the value of call and put options 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 53

Which of the following changes, when considered individually, 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) None of the above

Question 54

The management at Socrates 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 55

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 56

Franklin 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 then 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 57

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 58

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 one 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 59

Which of the following changes, when considered individually, 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

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 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 61

Option valuation: 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?

A) $0
B) $20.50
C) $21.00
D) None of the above

Question 62

Binomial pricing: Assume that the stock of Malcolm's Mufflers, Inc,. is currently trading for $18 and will either rise to $20 or fall to $14 in one year. The risk-free rate for one year is 10 percent. What is the value of a call option with a strike price of $15?

A) $4.39
B) $3.33
C) $2.04
D) $0.83

Question 63

Option payoffs: What is the payoff for a call option with a strike price of $30 if the underlying stock price at expiration is $25?

A) $5
B) $25
C) $30
D) None of the above

Question 64

Option payoffs: Kelvin's Thermostats, Inc., stock is currently trading at $20 per share. There are two types of options written on the stock. Call options with a strike price of $15, which expire next month, are currently trading at $6.00. Put options with a strike price of $15 which expire next month are currently trading at $1.00. Steve invests $120 in common stock. Carol invests $120 in the call options. Paul invests $120 in the put options. At the end of one month, the price of Kelvin's Thermostats, Inc., is $23. Who made the most money off of their investment?

A) Steve
B) Carol
C) Paul
D) Steve and Carol Tied

Question 65

Option payoffs: What is the payoff for a put option with a strike price of $65 if the underlying stock price at expiration is $33?

A) $0
B) $33
C) $32
D) $65

Question 66

Option payoffs: You own a put option on ABC. Co. stock with a strike price of $40. The current stock price is $40. You will benefit if

A) the stock price goes up.
B) the stock price goes down.
C) the stock price stays the same.
D) It doesn't matter; you are indifferent to changes in the stock price.

Question 67

Binomial pricing: ABC, Inc., stock is currently trading for $45 and will either rise to $47 or fall to $42 in one year. The risk-free rate for one year is 5 percent. You own a call option with a strike price of $30, which expires in one year. What is the value of your call option?

A) 0
B) 2.27
C) 12.05
D) 16.43

Question 68

Option valuation: 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?

A) $0.50
B) $16.50
C) $25.00
D) None of the above

Question 69

Option payoffs: Haumer Hardware Co. stock is currently trading at $20. There are two types of options written on the stock. Call options with a strike price of $20, which expire next year, are currently trading at $8. Put options with a strike price of $20, which expire next year, are currently trading for $2. Steve invests $120 in common stock. Carol invests $120 in the call options. Paul invests $120 in the put options. At the end of one year the price of Haumer Hardware Co. stock is $18. Who made the most money off of their investment?

A) Steve
B) Carol
C) Paul
D) Steve and Carol tied

Question 70

Binomial pricing: Assume that the stock of Malcolm's Mufflers, Inc., is currently trading for $43 and will either rise to $55 or fall to $17 in one year. The risk-free rate for one year is 8 percent. What is the value of a call option with a strike price of $45?

A) $4.40
B) $5.84
C) $6.84
D) $7.17

Question 71

Which of the following statements is NOT an example of the 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 a large amount of debt but very few investment opportunities. The board of directors decides to pay out a large special dividend, and the company subsequently enters bankruptcy. Lenders collect about 60 percent of the face value of the debt.
C) ABC Co. is very close to financial distress. The company has a positive-NPV investment opportunity, but even with the project the company is likely to enter bankruptcy. Investors refuse to invest the additional funds necessary to pursue the project, even though it has a positive 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 72

Option valuation: 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?

A) $0
B) $8
C) $15
D) None of the above

Question 73

Option payoffs: What is the payoff for a call option with a strike price of $45 if the underlying stock price at expiration is $75?

A) $30
B) $45
C) $75
D) None of the above

Question 74

Gnu 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 Gnu Homes will evaluate population and real estate trends in Austin. Their plan is to buy the land if real estate prices in Austin increase enough that developing the land would be worth more then 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 75

Option payoffs: What is the payoff for a put option with a strike price of $20 if the price of the underlying stock at expiration is $18?

A) $0
B) $2
C) $18
D) $20

Question 76

Option payoffs: You have sold a call option on ABC Co. stock with a strike price of $40. You do not intend to make any other transactions before the options expiration date. The current stock price is $20. Which of the following statements best describes your hopes for the stock?

A) You want the stock price to fall.
B) You want the stock price to rise.
C) You are indifferent, as long as the stock price stays under $40.
D) It doesn't matter; you are indifferent to changes in the stock price.

Question 77

Binomial pricing: Assume that the stock of ABC, Inc., is currently trading for $17 and will either rise to $23 or fall to $12 in one year. The risk-free rate for one year is 10 percent. What is the value of a call option with a strike price of $25?

A) $0
B) $6.23
C) $5.72
D) None of the above

Question 78

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 79

The claim stockholders hold on cash flows in a company with outstanding debt is often 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) none of the above

Question 80

Adding stock options and bonuses for performance to the compensation of a manager is intended to closer align the interest of the manager with

A) stockholders.
B) lenders.
C) employees.
D) none of the above.