Deck 23: Options and Corporate Finance: Extensions and Applications

Question 1

Executives cannot 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.

Answer 1

freeze-out period.

Question 2

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

A)the value to the executive depends on the equity 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 equities.
D)All of the above.
E)The value of the option can never be less than the face value.

Answer 2

All of the above.

Question 3

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

A)accept a negative 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)option the project to another firm.
D)not take a positive NPV project even if the NPV is adequate reward to forego the option.
E)None of the above.

Answer 3

accept a marginally acceptable NPV project limiting the corporation's ability to choose a
Competing project.

Question 4

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 5

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 is forgoing the future rights or options to the investment.
E)None of the above.

Question 6

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

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

Question 7

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 root n.
C)the number of intervals in a year.
D)All of the above.
E)Increase in the number of intervals in a binomial model does not effect the price shift
Parameters.

Question 8

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 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 9

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 10

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)opportunity to defer investing to a later date does not have value.
E)None of the above.

Question 11

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.

Question 12

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 13

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 14

Corporations by rewarding executives with large option positions:

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 equity to fall because the options are theft.
D)are really valueless because most options are never exercised.
E)None of the above.

Question 15

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 equity
E)Interest rate

Question 16

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 17

An example of a special option is:

A)an executive share options.
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 18

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

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

Question 19

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.
E)None of the above.

Question 20

A branching tree for the binomial model:

A)Should captures 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 21

Ima Greedy, the CFO of Financial Saving Techniques has been granted options on 200,000 shares. The equity is currently trading at £22 a share and the options are at the money.The volatility of the
Equity has been about .20 on an annual basis over the last several years.The option mature in 3
Years and the risk free rate is 4%.
What is d2?

A).0121
B).0252
C)-.2324
D).0452
E).0525

Question 22

Executive options have a number of advantages, including:

A)Aligning shareholders interests to that of executives.
B)Increasing executives' base pay.
C)Increasing the volatility of executives' pay as a function of the performance of the firm.
D)Both A and C are correct.
E)None of the above.

Question 23

The executive janitor of NuValue was granted 1,000,000 options.The equity 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 equity is .04.What is the value of the options
contract?

Question 24

Walter Maxim, the CEO of Digital Storage Devices has been granted options on 300,000 shares. The equity is currently trading at £27 a share and the options are at the money.The volatility of the equity has been about .15 on an annual basis over the last several years.The option 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 25

The Nu-Tech Company has a new project available to it at a cost of £6,000,000.The project that
they can 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 year you can dispose of the asset for £1,000,000 at what price would it make sense to
abandon the project?

Question 26

Executive options do not always have the intended effects.Consider the following two statements: (i) The recent shift from executive share options to restricted stock units suggest that in practice, the
Effective minimum value of executive share options is not zero.
(ii) When options are a large portion of an executive's net worth, the total value of the option
Position to the executive is less than market value.

A)(i) is correct, (ii) is incorrect.
B)(i) is incorrect, (ii) is correct.
C)Both (i) and (ii) are correct.
D)Both (i) and (ii) are incorrect.
E)only (i) is correct, but only if zero is replaced with "negative".

Question 27

Ima Greedy, the CFO of Financial Saving Techniques has been granted options on 200,000 shares. The equity is currently trading at £22 a share and the options are at the money.The volatility of the
Equity has been about .20 on an annual basis over the last several years.The option mature in 3
Years and the risk free rate is 4%.
Calculate N(d2).

A).4081
B).5578
C).6085
D).7085
E).7142

Question 28

The CFO of NuValue was granted 1,000,000 options.The equity 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 equity 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?

Question 29

Executive stock options are one way of rewarding executives.Restricted stock units are another way.Cash payments are yet another way.Consider the following two statements:
(i) Restricted stock units become more attractive compared to stock options as stock price volatility
Increases.
(ii) Cash payments become more attractive compared to restricted stock units as stock price
Volatility increases.

A)(i) is correct, (ii) is incorrect.
B)(i) is incorrect, (ii) is correct.
C)Both (i) and (ii) are correct.
D)Both (i) and (ii) are incorrect.
E)only (i) is correct, if we replace "more" with "less".

Question 30

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 31

Ima Greedy, the CFO of Financial Saving Techniques has been granted options on 200,000 shares. The equity is currently trading at £22 a share and the options are at the money.The volatility of the
Equity has been about .20 on an annual basis over the last several years.The option mature in 3
Years and the risk free rate is 4%.
What is e-rt ?

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

Question 32

Walter Maxim, the CEO of Digital Storage Devices has been granted options on 300,000 shares. The equity is currently trading at £27 a share and the options are at the money.The volatility of the equity has been about .15 on an annual basis over the last several years.The option 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 33

Ima Greedy, the CFO of Financial Saving Techniques has been granted options on 200,000 shares. The equity is currently trading at £22 a share and the options are at the money.The volatility of the
Equity has been about .20 on an annual basis over the last several years.The option mature in 3
Years and the risk free rate is 4%.
What is d1?

A).1842
B).4102
C).4583
D).4909
E).5422

Question 34

Executive options are different from standard options in a number of ways.Consider the following two statements:
(i) A freeze-out period lowers the value of a standard option compared to an executive option.
(ii) The Black-Scholes formula cannot be used to value executive options, if the volatility of equity
Changes randomly over time.

A)(i) is correct, (ii) is incorrect.
B)(i) is incorrect, (ii) is correct.
C)Both (i) and (ii) are correct.
D)Both (i) and (ii) are incorrect.
E)only (ii) is correct, but only if the option comes with a freeze out.

Question 35

Ima Greedy, the CFO of Financial Saving Techniques has been granted options on 200,000 shares. The equity is currently trading at £22 a share and the options are at the money.The volatility of the
Equity has been about .20 on an annual basis over the last several years.The option mature in 3
Years and the risk free rate is 4%.
What is the value of a call option?

A)£4.14
B)£4.86
C)£7.57
D)£5.62
E)£6.16

Question 36

The CEO of NuValue was granted 1,000,000 options.The equity 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 equity 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 37

Ima Greedy, the CFO of Financial Saving Techniques has been granted options on 200,000 shares. The equity is currently trading at £22 a share and the options are at the money.The volatility of the
Equity has been about .20 on an annual basis over the last several years.The option mature in 3
Years and the risk free rate is 4%.
Calculate N(d1).

A).5054
B).6508
C).7062
D).7047
E).8096

Question 38

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
Undervalution.
B)There are 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)Pundits rely solely on net present value approach for capital budgeting decisions.

Question 39

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)the option to open the facility when prices fall dramatically.
E)None of the above.

Question 40

Real option valuation requires a thorough knowledge of financial option valuation.Consider the following two statements:
(i) Most real option problems require a European style option valuation technique.
(ii) The most important difference between real and financial options is the fact that real options are
Never exercised.

A)(i) is correct, (ii) is incorrect.
B)(i) is incorrect, (ii) is correct.
C)Both (i) and (ii) are correct.
D)Both (i) and (ii) are incorrect.
E)None of the above.

Question 41

Managers come in all shapes and sizes.You own a company, and are worried about whether its management is active and flexible enough.Explain your worries, using real option valuation.

Question 42

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