FNCE30007 Chapter Notes - Chapter 10: Call Option, Option Style, Cash Flow

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orangemole587

29 Jun 2020

School

University of Melbourne

Department

Finance

Course

FNCE30007

Professor

Federico Nardari

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Document Summary

Call options become more valuable as stock price increases. Put options become less valuable as stock price increases. Call options become less valuable as strike price increase. Put options become more valuable as strike price increases. American options become more valuable as time to expiration increases. A dividend can cause stock price to fall, so an option with a shorter maturity may be worth more. Volatility of the stock price is a measure of how uncertain future stock price movements are. Owner of a call benefits from price increases but has limited downside risk. Owner of a put benefits from price decreases but has limited downside risk. Call and puts become more valuable as volatility increases. As interest rates increase, expected return required by investors increase and the present value of any future cash flow received decreases. Dividends reduce the stock price on the ex-dividend date. European call european put american call american put.

Related Questions

Kevin examines both American- and European-style options that have the same stock, expiration date, and strike price. Kevin argues that the European-style option will be sold at a higher price than the American-style option.

A. Examine Kevinâs belief given that the stock closed at $40, has an exercise price of $42 on the put and call options, the one-year put option is $3, the Treasury bill is 4.5%, and it expires in one year.

B. Calculate the value of a European-style option given put-call parity.

C. Determine the impact on the call option if (i) there is a rise in volatility; (ii) there is an increase in interest rate; and (iii) the time of option expiration declines.

Please be more specific in your response. Thank you in advance!

As a newly minted MBA. you've taken a management position with Exotic Cuisines, Inc., a restaurant chain that just went public last year. The company's restaurants specialize in exotic main dishes, using ingredients such as alligator, buffalo, and ostrich. A concern you had going in was that the restaurant business is very risky. However, after some due diligence, you discovered a common misperception about the restaurant industry. It is widely thought that 90 percent of new restaurants close within three years; however, recent evidence suggests the failure rate is closer to 60 percent over three years. So, it is a risky business, although not as risky as you originally thought. During your interview process, one of the benefits mentioned was employee stock options. Upon signing your employment contract, you received options with a strike price of $50 for 10,000 shares of company stock. As is fairly common, your stock options have a three-year vesting period and a 10-year expiration, meaning that you cannot exercise the options for a period of three years, and you lose them if you leave before they vest. After the three-year vesting period, you can exercise the options at any time. Thus, the employee stock options are European (and subject to forfeit) for the first three years and American afterward. Of course, you cannot sell the options, nor can you enter into any sort of hedging agreement. If you leave the company after the options vest, you must exercise within 90 days or forfeit. Exotic Cuisines stock is currently trading at $26.12 per share, a slight increase from the initial offering price last year. There are no market traded options on the company's stock. Because the company has only been traded for about a year, you are reluctant to use the historical returns to estimate the standard deviation of the stock's return. However, you have estimated that the average annual standard deviation for restaurant company stocks is about 55 percent. Since Exotic Cuisines is a newer restaurant chain, you decide to use a 65 percent standard deviation in your calculations. The company is relatively young, and you expect that all earnings will be reinvested back into the company for the near future. Therefore, you expect no dividends will be paid for at least the next 10 years. A three-year Treasury note currently has a yield of 1.5 percent, and a 10-year Treasury note has a yield of 2.6 percent.

4. Why do you suppose employee stock options usually have a vesting provision? Why must they be exercised shortly after you depart the company even after they vest?

5. A controversial practice with employee stock options is repricing. What happens is that a company experiences a stock price decrease, which leaves employee stock options far out of the money or "underwater." In such cases, many companies have "repriced" or "restruck" the options, meaning that the company leaves the original terms of the option intact, but lowers the strike price. Proponents of repricing argue that since the option is very unlikely to end in the money because of the stock price decline, the motivational force is lost. Opponents argue that repricing is in essence a reward for failure. How do you evaluate this argument? How does the possibility of repricing affect the value of an employee stock option at the time it is granted?

6. As we have seen, much of the volatility in a company's stock price is due to systematic or marketwide risks. Such risks are beyond the control of a company and its employees. What are the implications for employee stock options? In light of your answer, can you recommend an improvement over traditional employee stock options?

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QUESTION 1

In the lease versus buy decision, leasing is often preferable

	A.	because the lessee owns the property at the end of the least term.
	B.	because lease obligations do not affect the firm's risk as seen by investors.
	C.	because, generally, no down payment is required, and there are no indirect interest costs.
	D.	because it has no effect on the firm's ability to borrow to make other investments.
	E.	because the lessee may have greater flexibility in abandoning the project in which the leased property is used than if the lessee bought and owned the asset.

2 points

QUESTION 2

The tighter the probability distribution of its expected future returns, the greater the risk of a given investment as measured by its standard deviation.

True

False

2 points

QUESTION 3

Ratio analysis involves analyzing financial statements in order to appraise a firm's financial position and strength.

True

False

2 points

QUESTION 4

Which of the following statements is CORRECT?

	A.	If the returns on two stocks are perfectly positively correlated (i.e., the correlation coefficient is +1.0) and these stocks have identical standard deviations, an equally weighted portfolio of the two stocks will have a standard deviation that is less than that of the individual stocks.
	B.	If a stock has a negative beta, its expected return must be negative.
	C.	A portfolio with a large number of randomly selected stocks would have less market risk than a single stock that has a beta of 0.5.
	D.	According to the CAPM, stocks with higher standard deviations of returns must also have higher expected returns.
	E.	A portfolio with a large number of randomly selected stocks would have more market risk than a single stock that has a beta of 0.5, assuming that the stock's beta was correctly calculated and is stable.

2 points

QUESTION 5

Many leases written today combine the features of operating and financial leases. Such leases are often called "combination leases."

True

False

2 points

QUESTION 6

The owner of a convertible bond owns, in effect, both a bond and a call option.

True

False

2 points

QUESTION 7

If a firm raises capital by selling new bonds, it is called the "issuing firm," and the coupon rate is generally set equal to the required rate on bonds of equal risk.

True

False

2 points

QUESTION 8

Which of the following statements is most CORRECT?

	A.	Warrants can sometimes be detached and traded separately from the debt with which they were issued, but this is unusual.
	B.	One important difference between warrants and convertibles is that convertibles bring in additional funds when they are converted, but exercising warrants does not bring in any additional funds.
	C.	The coupon rate on convertible debt is normally set below the coupon rate that would be set on otherwise similar straight debt even though investing in convertibles is more risky than investing in straight debt.
	D.	Warrants have an option feature but convertibles do not.
	E.	The value of a warrant to buy a safe, stable stock should exceed the value of a warrant to buy a risky, volatile stock, other things held constant.

2 points

QUESTION 9

Because of improvements in forecasting techniques, estimating the cash flows associated with a project has become the easiest step in the capital budgeting process.

True

False

2 points

QUESTION 10

The form of organization for a business is not an important issue, as this decision has very little effect on the income and wealth of the firm's owners.

True

False

2 points

QUESTION 11

Two important issues in corporate governance are (1) the rules that cover the board's ability to fire the CEO and (2) the rules that cover the CEO's ability to remove members of the board.

True

False

2 points

QUESTION 12

The "preferred" feature of preferred stock means that it normally will provide a higher expected return than will common stock.

True

False

2 points

QUESTION 13

If an investment project would make use of land which the firm currently owns, the project should be charged with the opportunity cost of the land.

True

False

2 points

QUESTION 14

Operating leases help to shift the risk of obsolescence from the user to the lessor.

True

False

2 points

QUESTION 15

Starting to invest early for retirement increases the benefits of compound interest.

True

False

2 points

QUESTION 16

Market risk refers to the tendency of a stock to move with the general stock market. A stock with above-average market risk will tend to be more volatile than an average stock, and its beta will be greater than 1.0.

True

False

2 points

QUESTION 17

Other things held constant, an increase in the cost of capital will result in a decrease in a project's IRR.

True

False

2 points

QUESTION 18

An option is a contract that gives its holder the right to buy or sell an asset at a predetermined price within a specified period of time.

True

False

2 points

QUESTION 19

The optimal distribution policy strikes that balance between current dividends and capital gains that maximizes the firm's stock price.

True

False

2 points

QUESTION 20

If the current price of a stock is below the strike price, then an option to buy the stock is worthless and will have a zero value.

True

False

2 points

QUESTION 21

The desire for floating-rate bonds, and consequently their increased usage, arose out of the experience of the early 1980s, when inflation pushed interest rates up to very high levels and thus caused sharp declines in the prices of outstanding bonds.

True

False

2 points

QUESTION 22

Taylor Inc. estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the company accept?

	A.	Project C, which is of above-average risk and has a return of 11%.
	B.	Project A, which is of average risk and has a return of 9%.
	C.	None of the projects should be accepted.
	D.	All of the projects should be accepted.
	E.	Project B, which is of below-average risk and has a return of 8.5%.

2 points

QUESTION 23

To finance the construction of a new plant, Pietersen Corporation must raise an additional $10,000,000 of equity capital through the sale of common stock. The firm currently has an EPS of $5.40 and a P/E ratio of 10, with 1,200,000 shares outstanding. If the firm wants its ex-rights price to be $50, what subscription price must it set on the new shares?

	A.	$39.28
	B.	$50.00
	C.	$29.55
	D.	$41.80
	E.	$33.78

2 points

QUESTION 24

Which of the following statements is CORRECT, assuming positive interest rates and holding other things constant?

	A.	A 30-year, $150,000 amortized mortgage will have larger monthly payments than an otherwise similar 20-year mortgage.
	B.	A bank loan's nominal interest rate will always be equal to or less than its effective annual rate.
	C.	The present value of a 5-year, $250 annuity due will be lower than the PV of a similar ordinary annuity.
	D.	If an investment pays 10% interest, compounded annually, its effective annual rate will be less than 10%.
	E.	Banks A and B offer the same nominal annual rate of interest, but A pays interest quarterly and B pays semiannually. Deposits in Bank B will provide the higher future value if you leave your funds on deposit.

2 points

QUESTION 25

Which of the following statements is CORRECT?

	A.	In the statement of cash flows, a decrease in inventories is reported as a use of cash.
	B.	In the statement of cash flows, a decrease in accounts receivable is reported as a use of cash.
	C.	In the statement of cash flows, depreciation charges are reported as a use of cash.
	D.	In the statement of cash flows, a decrease in accounts payable is reported as a use of cash.
	E.	Dividends do not show up in the statement of cash flows because dividends are considered to be a financing activity, not an operating activity.

2 points

QUESTION 26

The term "additional funds needed (AFN)" is generally defined as follows:

	A.	A forecasting approach in which the forecasted percentage of sales for each balance sheet account is held constant.
	B.	Funds that are obtained automatically from routine business transactions.
	C.	Funds that a firm must raise externally from non-spontaneous sources, i.e., by borrowing or by selling new stock to support operations.
	D.	The amount of internally generated cash in a given year minus the amount of cash needed to acquire the new assets needed to support growth.
	E.	The amount of assets required per dollar of sales.

2 points

QUESTION 27

The cash flows associated with common stock are more difficult to estimate than those related to bonds because stock has a residual claim against the company versus a contractual obligation for a bond.

True

False

2 points

QUESTION 28

Which of the following statements is CORRECT?

	A.	The NPV method automatically deals correctly with externalities, even if the externalities are not specifically identified, but the IRR method does not. This is another reason to favor the NPV.
	B.	Identifying an externality can never lead to an increase in the calculated NPV.
	C.	Both the NPV and IRR methods deal correctly with externalities, even if the externalities are not specifically identified. However, the payback method does not.
	D.	An example of an externality is a situation where a bank opens a new office, and that new office causes deposits in the bank's other offices to increase.
	E.	An externality is a situation where a project would have an adverse effect on some other part of the firm's overall operations. If the project would have a favorable effect on other operations, then this is not an externality.

2 points

QUESTION 29

Time lines can be constructed in situations where some of the cash flows occur annually but others occur quarterly.

True

False

2 points

QUESTION 30

A warrant is an option, and as such it cannot be used as a "sweetener."

True

False

2 points

QUESTION 31

BLW Corporation is considering the terms to be set on the options it plans to issue to its executives. Which of the following actions would decrease the value of the options, other things held constant?

	A.	The life of the option is increased, i.e., the time until it expires is lengthened.
	B.	The exercise price of the option is increased.
	C.	The Federal Reserve takes actions that increase the risk-free rate.
	D.	BLW's stock price becomes more risky (higher variance).
	E.	BLW's stock price suddenly increases.

2 points

QUESTION 32

Convertible debentures for Kulik Corporation were issued at their $1,000 par value in 2012. At any time prior to maturity on February 1, 2032, a debenture holder can exchange a bond for 25 shares of common stock. What is the conversion price, Pc?

	A.	$48.62
	B.	$40.00
	C.	$42.00
	D.	$46.31
	E.	$44.10

2 points

QUESTION 33

A stock is expected to pay a dividend of $0.75 at the end of the year. The required rate of return is rs = 10.5%, and the expected constant growth rate is g = 6.4%. What is the stock's current price?

	A.	$18.29
	B.	$17.39
	C.	$19.22
	D.	$18.75
	E.	$17.84

2 points

QUESTION 34

If a firm's goal is to maximize its earnings per share, this is the best way to maximize the price of the common stock and thus shareholders' wealth.

True

False

2 points

QUESTION 35

The common stock of Southern Airlines currently sells for $33, and its 8% convertible debentures (issued at par, or $1,000) sell for $850. Each debenture can be converted into 25 shares of common stock at any time before 2025. What is the conversion value of the bond?

	A.	$783.75
	B.	$744.56
	C.	$825.00
	D.	$866.25
	E.	$707.33

2 points

QUESTION 36

Which of the following statements is CORRECT?

	A.	If interest rates increase, the price of a 10-year coupon bond will decline by a greater percentage than the price of a 10-year zero coupon bond.
	B.	If a bond's yield to maturity exceeds its annual coupon, then the bond will trade at a premium.
	C.	If a coupon bond is selling at par, its current yield equals its yield to maturity.
	D.	If a coupon bond is selling at a premium, its current yield equals its yield to maturity.
	E.	If a coupon bond is selling at a discount, its price will continue to decline until it reaches its par value at maturity.

2 points

QUESTION 37

A proxy is a document giving one party the authority to act for another party, including the power to vote shares of common stock. Proxies can be important tools relating to control of firms.

True

False

2 points

QUESTION 38

Projects S and L are equally risky, mutually exclusive, and have normal cash flows. Project S has an IRR of 15%, while Project L's IRR is 12%. The two projects have the same NPV when the WACC is 7%. Which of the following statements is CORRECT?

	A.	Project S's NPV is more sensitive to changes in WACC than Project L's.
	B.	If the WACC is 13%, Project S will have the lower NPV.
	C.	If the WACC is 6%, Project S will have the higher NPV.
	D.	If the WACC is 10%, both projects will have positive NPVs.
	E.	If the WACC is 10%, both projects will have a negative NPV.

2 points

QUESTION 39

A firm's AFN must come from external sources. Typical sources include short-term bank loans, long-term bonds, preferred stock, and common stock.

True

False

2 points

QUESTION 40

Which of the following could explain why a business might choose to operate as a corporation rather than as a sole proprietorship or a partnership?

	A.	Less of a corporation's income is generally subjected to taxes than would be true if the firm were a partnership.
	B.	Corporate shareholders escape liability for the firm's debts, but this factor may be offset by the tax disadvantages of the corporate form of organization.
	C.	Corporations generally find it relatively difficult to raise large amounts of capital.
	D.	Corporations generally face relatively few regulations.
	E.	Corporate investors are exposed to unlimited liability.

2 points

QUESTION 41

The cost of debt is equal to one minus the marginal tax rate multiplied by the average coupon rate on all outstanding debt.

True

False

2 points

QUESTION 42

Amram Company's current ratio is 1.9. Considered alone, which of the following actions would reduce the company's current ratio?

	A.	Use cash to reduce accruals.
	B.	Borrow using short-term notes payable and use the proceeds to reduce long-term debt.
	C.	Use cash to reduce accounts payable.
	D.	Borrow using short-term notes payable and use the proceeds to reduce accruals.
	E.	Use cash to reduce short-term notes payable.

2 points

QUESTION 43

ESOPs were originally designed to help improve worker productivity, but today they are also used to help prevent hostile takeovers.

True

False

2 points

QUESTION 44

High current and quick ratios always indicate that a firm is managing its liquidity position well.

True

False

2 points

QUESTION 45

A firm should never accept a project if its acceptance would lead to an increase in the firm's cost of capital (its WACC).

True

False

2 points

QUESTION 46

"Capital" is sometimes defined as funds supplied to a firm by investors.

True

False

2 points

QUESTION 47

Heavy use of off-balance sheet lease financing will tend to

	A.	affect a company's cash flows but not its degree of risk.
	B.	make a company appear less risky than it actually is because its stated debt ratio will appear lower.
	C.	make a company appear more risky than it actually is because its stated debt ratio will be increased.
	D.	affect the lessee's cash flows but only due to tax effects.
	E.	have no effect on either cash flows or risk because the cash flows are already reflected in the income statement.

2 points

QUESTION 48

As a firm's sales grow, its current assets also tend to increase. For instance, as sales increase, the firm's inventories generally increase, and purchases of inventories result in more accounts payable. Thus, spontaneous liabilities that reduce AFN arise from transactions brought on by sales increases.

True

False

2 points

QUESTION 49

On the balance sheet, total assets must always equal total liabilities and equity.

True

False

2 points

QUESTION 50

The annual report contains four basic financial statements: the income statement, balance sheet, statement of cash flows, and statement of stockholders' equity.

True

False

FNCE30007 Chapter Notes - Chapter 10: Call Option, Option Style, Cash Flow

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