Deck 23: Options and Corporate Finance: Extensions and Applications

Question 1

If an infinite number of intervals is applied to the binomial option pricing model,then the value of a call is equal to:

A)the risk-free rate of return.
B)zero.
C)the exercise price.
D)the Black-Scholes model's call value.
E)the stock price.

Answer 1

the Black-Scholes model's call value.

Question 2

The opportunity to defer investing in a project until a later date may have value primarily because:

A)the cost of capital may increase.
B)project cash flows may be lower in the future.
C)investment costs tend to increase over time.
D)the option to abandon may disappear.
E)market conditions may improve.

Answer 2

market conditions may improve.

Question 3

A ________ period prohibits executives from exercising their options for a stated period of time.

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

Answer 3

freeze-out

Question 4

Which one of these statements is true?

A)If virtually all projects have embedded options,then ignoring these options does not affect the value of the projects.
B)Every business will benefit if it exercises its expansion option.
C)The option to abandon a project lowers the project's value.
D)Start-up businesses do not have any options until they have succeeded for one year.
E)Every business idea has at least two possible outcomes.

Question 5

The binomial option pricing model is:

A)bell-curve shaped.
B)symmetrical.
C)hyperbolic.
D)asymmetric.
E)curvilinear.

Question 6

Investing in a negative NPV project today may be a feasible choice if:

A)the project has future option alternatives.
B)all the project's future options were included in the NPV analysis.
C)the current discount rate is low.
D)all the project's future options will be ignored by decision makers.
E)the discount rate is expected to increase over time.

Question 7

Which one of these is not a reason why executives place less value on employee stock options than their face value would indicate?

A)The option's value depends on the stock price exceeding the exercise price.
B)Options must generally be held for a period of time.
C)Options may create a highly undiversified portfolio for the executive.
D)Options always create taxable income for the executive when granted.
E)Options could be out of the money.

Question 8

With the binominal option pricing model,it is reasonable to assume:

A)there is a varying rate of price change from one time interval to the next time interval.
B)any new information impacting prices is similar from one interval to another interval.
C)the discount rate increases with each time interval.
D)the call price will only be usable if the time interval is extremely small.
E)that each project is limited to two outcomes over its life.

Question 9

Assume you are determining the risk-neutral probabilities of a price increase and decrease.In this situation,you know the expected return on the asset must equal the:

A)sponsoring firm's cost of capital.
B)risk-free rate.
C)market rate of return.
D)annual inflation rate.
E)CAPM rate of return.

Question 10

When valuing a project using the Black-Scholes option pricing model,R is set equal to the:

A)historical real market rate of return.
B)annually compounded risk-free rate.
C)expected future real market rate of return.
D)continuously compounded risk-free rate.
E)project's CAPM rate of return.

Question 11

A branching tree depicting the binomial model of a projected investment:

A)should capture all possible future paths the investment could take.
B)will have more up-branches than down-branches if there are two or more time intervals.
C)can only have one final point that has an option value of zero.
D)only depicts paths that will lead to acceptable project decisions.
E)should lead to the same result if you take an up-branch followed by a down-branch or a down-branch followed by an up-branch.

Question 12

Net present value analysis frequently ignores:

A)project risk.
B)cash flows after the first three years.
C)the time value of money.
D)some or all of a project's options.
E)start-up costs.

Question 13

Executive stock options generally have all the following characteristics except:

A)aligning executive goals with shareholder goals.
B)linking executive compensation to performance.
C)providing tax efficiency.
D)increasing executive base salaries.
E)putting executive pay at risk.

Question 14

Under risk neutrality,the expected return on an asset will equal:

A)the market risk premium.
B)the market rate of return.
C)zero.
D)the risk-free rate of interest.
E)the asset beta times the market risk premium.

Question 15

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

A)more valuable because of the dividend payments.
B)equal in value.
C)less valuable because cash dividends lower the stock price.
D)equal to the cost of the non-dividend paying stock option.
E)either equal to or greater than the value of the non-dividend paying stock option.

Question 16

Sam owns an oil field with a number of producing wells.In the past,he has started and stopped production of these wells as the price of oil fluctuated over time.Assume the government imposes additional requirements on non-producing wells that are still production capable.These requirements are expected to increase the cost of stopping well production by 30 percent.As a result,Sam should be:

A)keeping all wells open continuously.
B)closing wells only if he plans to keep them closed permanently.
C)willing to keep wells operating at a lower level of profitability than he has in the past.
D)increasing the cost of capital he applies to his well evaluation analysis.
E)opening wells at a lower p_open price.

Question 17

Permanently rejecting an investment project today may not be a wise decision primarily because:

A)the size of the firm will be less than it would be with the project.
B)there are always errors in the estimation of NPVs.
C)the management team may be replaced.
D)the company is foregoing all future options.
E)the firm may not have any other investment opportunities.

Question 18

Which one of the following is not included as an input for the Black-Scholes option pricing model?

A)Standard deviation
B)Time to maturity
C)Exercise price
D)Par value
E)Continuously compounded interest rate

Question 19

The value of an executive stock option will be lowered if:

A)the volatility of the firm's stock returns increases.
B)the executive improves firm performance causing the stock price to rise.
C)a freeze-out period is required.
D)the firm extends the option expiration date.
E)the strike price is lowered.

Question 20

In the binomial option pricing model the:

A)number of intervals required for convergence is quite large.
B)interval time span decreases as time moves forward.
C)result based on infinitesimally small intervals will differ significantly from the value developed by the Black-Scholes model.
D)percentage increase in price in each interval can differ from the percentage decrease in price.
E)value of u remains constant as the number of intervals increases.

Question 21

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

Question 22

Assume a firm in the extraction industry has major assets consisting solely of cash,equipment,and a closed facility but yet the firm appears to have extraordinary value.This value is least apt to be attributable to the:

A)low exercise price held by the shareholders.
B)option to open the facility when prices rise dramatically.
C)option to keep the facility closed for an extended period of time.
D)current operating cash flow.
E)potential sale of the firm.

Question 23

A stock has a market price of $25 and a standard deviation of returns of 24 percent.The $25 call option matures in 4 months and the risk-free rate is 2.89 percent.N(d₁)is .555198 and N(d₂)is .500096.What is the value of the call option per share of stock?

A)$1.71
B)$1.86
C)$1.50
D)$1.62
E)$2.16

Question 24

Jeff is analyzing an expansion project for a new business and has developed this input for a Black-Scholes model.Stock price = $7,365,000,exercise price = $12,400,000,time period = 3 years,standard deviation = 14.5 percent,and the continuously compounded interest rate = 4.2 percent.What is the value of d₁ as it is used in the model?

A).1945
B).5487
C)−1.4102
D).4593
E)−1.4470

Question 25

One of Modular Products (MP)customers would like to obtain a 6-month option to purchase 500,000 tables for $119 each.These tables currently sell for $110 each.Assume u equals 1.0994 and d equals .9096.What price should MP charge for this option if the annual risk-free rate is 3.2 percent? Round your answer to the nearest $100.

A)$338,400
B)$421,900
C)$598,100
D)$479,900
E)$533,600

Question 26

The option to abandon is:

A)a real option.
B)usually of little value because of the costs associated with abandonment.
C)irrelevant in capital budgeting analysis.
D)generally ignored.
E)of no value to a project.

Question 27

The price of oil is currently at $24 but you expect it to either increase by 18 percent or decrease by 7 percent over the next 6 months.The 6-month risk-free rate of interest is 1.98 percent.What is the probability that the price will increase?

A)32.47 percent
B)36.03 percent
C)38.06 percent
D)35.92 percent
E)37.94 percent

Question 28

The CFO of Financial Savings has just been granted at-the-money options on 200,000 shares.The options expire in three years.The firm's stock is currently trading at $22 a share,the volatility of the returns as measured by standard deviation is 19 percent,and the continuously compounded risk-free rate is 3.6 percent.What is the value of d₁ as it is used in the Black-Scholes option pricing model?

A).1842
B).4102
C).4583
D).4927
E).5412

Question 29

Assume you are being granted at-the-money stock options today when the stock is trading at $32 a share.These options mature in one year,the continuously compounded risk-free rate is 4.2 percent,and the volatility of the stock's returns is 22 percent.What is the value of d₂ as it is used in the Black-Scholes model?

A).0927
B).0752
C).0809
D).0847
E).0936

Question 30

A CEO is being granted 1,000,000 at-the-money options.The current stock price is $45,the continuously compounded risk-free rate is 5 percent,and the variance on the stock's return is .04.The options expire in 5 years.What is the value of the options contract? If the CEO had negotiated a larger salary and only 10,000 options,what would be the value of that options contract?

Question 31

I.M.Not.Greedy has been granted options on 50,000 shares.The stock is currently trading at $17 a share and the options are at the money.The volatility of the stock returns averages 16 percent.The options mature in 2 years and the risk-free rate is 3.45 percent.N(d₁)is .662055 and N(d₂)is .576052.Given this information,what is the value of a call option on one share of this stock?

A)$2.11
B)$1.70
C)$1.89
D)$2.28
E)$2.21

Question 32

What are the values of 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; 1.0327
C).0317; .9683
D).2193; .7807
E)1.1159; −.1159

Question 33

Alpha stock is currently trading at $34.50 a share and the 6-month call options are at the money.The stock returns have a standard deviation of 21 percent and the risk-free rate is 4.21 percent.What is the price of the call option per share given that N(d₁)is .585508 and N(d₂₎ is .526913?

A)$1.07
B)$2.79
C)$1.38
D)$2.40
E)$1.64

Question 34

If a project has both expansion and abandonment options,then the:

A)shorter the available life of the project the less valuable the project is.
B)longer the available life of the project the less valuable the project is.
C)options will offset each other and therefore add no value to the project.
D)project life becomes irrelevant.
E)project should always be accepted.

Question 35

I.M.Greedy has been granted options on 500,000 shares.The stock is currently trading at $48 a share and the options are at the money.The standard deviation of returns averages 31 percent.The options mature in 5 years and the risk-free rate is 3.68 percent.What is the value of e^−Rt?

A).6087
B).7087
C).7952
D).8476
E).8319

Question 36

Jennifer has just been granted at-the-money company options on 300,000 shares.These options expire in 5 years and are exercisable after 3 years.The options are valued at $1.2 million.It is normal for her to receive annual option grants such as this.She also receives a current salary of $550,000.Why might Jennifer prefer to receive a straight annual salary of $1.5 million rather than this salary and option combination?

Question 37

Katrina is analyzing an expansion project for a new business and has developed this input for a Black-Scholes model.Stock price = $4,186,300,exercise price = $7,250,000,time period = 4 years,standard deviation = 13.8 percent,and the continuously compounded interest rate = 3.84 percent.What is the value of d₂ as it is used in the model?

A).01338
B)1.2784
C)1.2953
D)−1.5713
E)−1.0293

Question 38

Ernst is trying to evaluate some options for a firm.However,he can't remember how to compute e^−Rt.Can you help him? If the rate is 4.38 percent and the time period is 6 months,what is the value of e^−Rt?

A).9087
B).8087
C).9952
D).8476
E).9783

Question 39

Which one of these statements is true?

A)The Black-Scholes model is most applicable to complex situations.
B)The binomial model is limited to a two-period time sequence.
C)The binomial model is limited to ten time intervals for any single analysis.
D)The binomial model is basically equivalent to the Black-Scholes model when there is a single time interval.
E)The Black-Scholes model is simpler to use,but for complex situations,the binomial model is preferred.

Question 40

A SunSet Co.customer would like to obtain a 3-month option to purchase additional units of a product for $77 each.This product currently sells for $76 each.Assume u equals 1.1502 and d = .8694.Approximately what price per unit should SunSet charge for this option if the annual risk-free rate is 2.8 percent?

A)$4.79
B)$5.98
C)$6.17
D)$6.02
E)$5.07

Question 41

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

Question 42

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

Question 43

You want to become a very successful entrepreneur.Your desire is to operate a business from a single location without becoming so large you lose personal touch with all the firm's employees and the day-to-day operations.Before determining what type of business you want to open,you have decided to compile a list of options that would add value to whatever business you select.Identify options that you would include in this list.