Deck 23: Options and Corporate Finance: Extensions and Applications

Question 1

The option to abandon is:

A)a real option.
B)usually of little value because of the cost associated with abandonment.
C)irrelevant in capital budgeting analysis.
D)nearly always less relevant the option to expand.
E)All of the above.

Answer 1

a real option.

Question 2

The value of the options awarded executives is much less than face value to the executives because:

A)the value to the executive depends on the stock price being greater than the exercise price.
B)the options must be held beyond the freeze-out period.
C)a highly undiversified portfolio can have a large drop in value with high variance stocks.
D)All of the above.
E)None of the above.

Answer 2

All of the above.

Question 3

The volatility of interest rates can affect the value of the project by:

A)increasing the value as volatility increases.
B)increasing the value as volatility decreases.
C)decreasing the value as volatility increases.
D)interest rate volatility does not affect value.
E)None of the above.

Answer 3

increasing the value as volatility increases.

Question 4

The NPV approach must be:

A)augmented by added analysis if there are a few embedded options.
B)augmented by added analysis if a decision has significant embedded options.
C)jettisoned if there are any embedded options.
D)computed carefully to identify the options.
E)None of the above.

Question 5

A branching tree for the binomial model:

A)should capture all possible futures paths for the asset.
B)has a move down followed by a move up on a subsequent branch to end at the same value as the reverse path.
C)has a move down followed by a move up on a subsequent branch to end at a lower value than a move up then a move down.
D)Both A and C.
E)Both A and B.

Question 6

By rewarding executives with large option positions, corporations:

A)cause the executives to hold highly undiversified portfolios.
B)put the firm in a risky position to pay off the options.
C)cause the value of the stock to fall because the options are theft.
D)are really valueless because most options are never exercised.
E)None of the above.

Question 7

Options are granted to top corporate executives because:

A)executives will make better business decisions in line with benefiting the shareholders.
B)executive pay is at risk and linked to firm performance.
C)options are tax-efficient and taxed only when they are exercised.
D)All of the above.
E)None of the above.

Question 8

Investing in a negative NPV project today is a feasible choice if:

A)there are future option alternatives.
B)investing is sequentially limited.
C)the discount rate is low.
D)Both A and B.
E)Both A and C.

Question 9

The most correct method to determine the current value of future payoffs would be to:

A)take the discounted expected value at the risk-free rate.
B)take the expected value using the probabilities.
C)take the discounted expected value using the risk-neutral probabilities and the risk free rate.
D)sum the payoffs discounted at the risk free rate.
E)None of the above.

Question 10

The risk-neutral probabilities for an asset, with a current value equal to the present value of future payoffs are:

A)given by the probability of each state occurring.
B)given by the value of the underlying asset under good news and the risk free rate.
C)given by the value of the underlying asset under good news and bad news.
D)given by the value of the underlying asset under good news, bad news, and the risk free rate.
E)None of the above.

Question 11

Increasing the number of intervals in the binomial model causes the price shift parameters to change.New estimates are related to:

A)the standard deviation of the underlying asset.
B)the up state multiplier equals the standard deviation divided by root n.
C)the number of intervals in a year.
D)All of the above.
E)None of the above.

Question 12

Executives can not exercise their options for a fixed period of time.This is the:

A)investing period.
B)freeze-out period.
C)valuation period.
D)guaranteed growth period.
E)strike period.

Question 13

The call option on a dividend paying stock compared to a non-dividend paying stock is:

A)more valuable because of the extra dividend payment.
B)equal in value because cash dividends are paid on stock only.
C)less valuable because cash dividends are paid on stock only.
D)less valuable if the dividend paying stock is in-the-money while the non-dividend paying stock if out-of-the-money.
E)None of the above.

Question 14

The opportunity to defer investing to a later date may have value because:

A)the cost of capital may decline in the near future.
B)certainty may be reduced in the future.
C)investment costs fluctuate in time.
D)All of the above.
E)None of the above.

Question 15

If a project has optionality:

A)the shorter the available life of the project the less valuable the project is.
B)the longer the available life of the project the less valuable the project is.
C)the shorter the available life of the project the more valuable the project is.
D)available project life does not change optionality.
E)None of the above.

Question 16

A financial manager who does not follow the general constraints of the NPV rule may:

A)accept a negative NPV project for fear of losing an investment opportunity.
B)accept a marginally acceptable NPV project limiting the corporation's ability to choose a competing project.
C)not consider all options available in a capital budgeting decision.
D)not take a positive NPV project even if the NPV is adequate reward to forego the option.
E)All of the above.

Question 17

Rejecting an investment today forever may not be a good choice because:

A)the size of the firm will decline.
B)there are always errors in the estimation of NPVs.
C)the option value is negative.
D)the company's foregoing the future rights or option to the investment.
E)None of the above.

Question 18

The equal rate of price change from each subsequent up state and fixed rate price change from each subsequent down state are reasonable if:

A)there is a constant variability.
B)any new information impacting prices is similar period to period.
C)interest or discount rates are constant.
D)Both A and C.
E)Both A and B.

Question 19

Which of the following statements is true?

A)The Black Scholes model is the simplest to use and best used for complex situations.
B)The binomial model does not handle options with dividend payments prior to expiration date.
C)The Black Scholes model adequately handles the valuation of an American put.
D)The binomal model is better for complex situations and is the simplest tool to use.
E)The Black Scholes model is simpler to use, but for complex situations, the binomial model is the necessary tool.

Question 20

An example of a special option is:

A)an executive stock option.
B)the embedded option in a start-up company.
C)the option in simple business contracts.
D)the option to shut down and reopen a project.
E)All of the above.

Question 21

Walter Maxim. the CWO of digitl storage Devices has been granted option on 300,000 shares. The stock is currently trading at $27 a share and the options are at the money. The volatility of the stock has been about .15 on an annual basis over the last several years. The options mature in 5 years, become exercisable in 3 years, and the risk free rate is 4%.
If Mr.Maxim earned $500,000 in regular annual salary why might he prefer to have $1,500,000 in straight salary versus salary and options?

Question 22

The Nu-Tech Company has a new project available to it at a cost of $6,000,000.If the project is accepted, the company will be able to sell 13,000 personal organizers at $172 in net cash flow for each of the next five years.Nu-Tech's discount rate is 15%.What is the NPV of the investment? The executives of Nu-Tech are concerned about the potential of future competition and a subsequent drop in sales and price.If after two years you can dispose of the asset for $1,000,000 at what price would it make sense to abandon the project?

Question 23

Which of the following is not part of the Black Scholes option pricing model?

A)Standard deviation
B)Time to maturity
C)Exercise price
D)Par value of the company's stock
E)Interest rate

Question 24

Walter Maxim. the CWO of digitl storage Devices has been granted option on 300,000 shares. The stock is currently trading at $27 a share and the options are at the money. The volatility of the stock has been about .15 on an annual basis over the last several years. The options mature in 5 years, become exercisable in 3 years, and the risk free rate is 4%.
What is the value of Mr.Maxim's options?

Question 25

If real options were not included in calculations of value, would the valuation be under or over valued and why?

Question 26

Why would the company pay the executive in options as opposed to salary?

Question 27

On the notion of embedded options, which of the following is/are true?

A)If virtually all projects have embedded options, ignoring options is likely to lead to serious undervaluation.
B)There are at least two possible outcomes for virtually every business idea.
C)Virtually every business has both the option to abandon and the option to expand.
D)All of the above.
E)Both B and C.

Question 28

The executive janitor of NuValue was granted 1,000,000 options.The stock price at the time of the granting of the options was $25 and the options are at the money.The risk free rate was 3% and the options expire in 3 years.The variance on the stock is .04.What is the value of the options contract?

Question 29

The CEO of NuValue was granted 1,000,000 options.The stock price at the time of the granting of the options was $45 and the options are at the money.The risk free rate was 5% and the options expire in 5 years.The variance on the stock is .04.What is the value of the options contract? If he had negotiated a larger salary and only 10,000 options, what would be the value of the options contract?

Question 30

Your firm is considering leasing a new laser light. The lease lasts for 3 years. The lease calls for 4 payments of $10,000 per year with the first payment occurring immediately. The computer would cost $45,000 to buy and would be straight-line depreciated to a zero salvage value over 3 years. The actual salvage value is negligible because of technological obsolescence. The firm can borrow at a rate of 10%. The corporate tax rate is 35%.
Calculate N(d₂).

A).5130
B).5578
C).6085
D).7085
E).7142

Question 31

Your firm is considering leasing a new laser light. The lease lasts for 3 years. The lease calls for 4 payments of $10,000 per year with the first payment occurring immediately. The computer would cost $45,000 to buy and would be straight-line depreciated to a zero salvage value over 3 years. The actual salvage value is negligible because of technological obsolescence. The firm can borrow at a rate of 10%. The corporate tax rate is 35%.
What is the value of a call option?

A)$4.14
B)$4.86
C)$5.13
D)$5.62
E)$6.16

Question 32

In what instances is the binomial option pricing model superior to the Black Scholes option pricing model?

Question 33

A firm in the extraction industry whose major assets are cash, equipment and a closed facility may appear to have extraordinary value.This value can be primarily attributed to:

A)the potential sale of the company.
B)the low exercise price held by the shareholders.
C)the option to open the facility when prices rise dramatically.
D)All of the above.
E)None of the above.

Question 34

What are the u, the up state multiplier, and d, the down state multiplier, if there are monthly intervals and the standard deviation is .38?

A)1.1159; .8961
B).0317; 31.5789
C).0317; .9683
D).2193; .7807
E)None of the above

Question 35

Your firm is considering leasing a new laser light. The lease lasts for 3 years. The lease calls for 4 payments of $10,000 per year with the first payment occurring immediately. The computer would cost $45,000 to buy and would be straight-line depreciated to a zero salvage value over 3 years. The actual salvage value is negligible because of technological obsolescence. The firm can borrow at a rate of 10%. The corporate tax rate is 35%.
Calculate N(d₁).

A).5054
B).6508
C).6882
D).7047
E).8096

Question 36

Your firm is considering leasing a new laser light. The lease lasts for 3 years. The lease calls for 4 payments of $10,000 per year with the first payment occurring immediately. The computer would cost $45,000 to buy and would be straight-line depreciated to a zero salvage value over 3 years. The actual salvage value is negligible because of technological obsolescence. The firm can borrow at a rate of 10%. The corporate tax rate is 35%.
What is d₂?

A).0121
B).0252
C).0326
D).0452
E).0525

Question 37

Your firm is considering leasing a new laser light. The lease lasts for 3 years. The lease calls for 4 payments of $10,000 per year with the first payment occurring immediately. The computer would cost $45,000 to buy and would be straight-line depreciated to a zero salvage value over 3 years. The actual salvage value is negligible because of technological obsolescence. The firm can borrow at a rate of 10%. The corporate tax rate is 35%.
What is e^-rt?

A).6087
B).7087
C).7952
D).8476
E).8869

Question 38

Your firm is considering leasing a new laser light. The lease lasts for 3 years. The lease calls for 4 payments of $10,000 per year with the first payment occurring immediately. The computer would cost $45,000 to buy and would be straight-line depreciated to a zero salvage value over 3 years. The actual salvage value is negligible because of technological obsolescence. The firm can borrow at a rate of 10%. The corporate tax rate is 35%.
What is d₁?

A).1842
B).4102
C).4583
D).4909
E).5412

Question 39

Why is straight NPV analysis flawed as compared to models that include option pricing in the NPV analysis?

Question 40

The CFO of NuValue was granted 1,000,000 options.The stock price at the time of the granting of the options was $20 and the options are at the money.The risk free rate was 4% and the options expire in 5 years.The variance on the stock is .05.What is the value of her options contract? If she had negotiated a larger salary and only 10,000 options, what would be the value of the options contract?