Chapter 14 Options and Corporate Finance

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CHAPTER 14
OPTIONS AND CORPORATE FINANCE

Answers to Concepts Review and Critical Thinking Questions

1.A call option confers the right, without the obligation, to buy an asset at a given price on or before a given date. A put option confers the right, without the obligation, to sell an asset at a given price on or before a given date. You would buy a call option if you expect the price of the asset to increase. You would buy a put option if you expect the price of the asset to decrease. A call option has unlimited potential profit, while a put option has limited potential profit; the underlying asset’s price cannot be less than zero.

2.a.The buyer of a call option pays money for the right to buy.... b.The buyer of a put option pays money for the right to sell.... c.The seller of a call option receives money for the obligation to sell.... d.The seller of a put option receives money for the obligation to buy....

3. The intrinsic value of a call option is Max [S – E,0]. It is the value of the option at expiration.

4.The value of a put option at expiration is Max[E – S,0]. By definition, the intrinsic value of an option is its value at expiration, so Max[E – S,0] is the intrinsic value of a put option.

5.The call is selling for less than its intrinsic value; an arbitrage opportunity exists. Buy the call for $10, exercise the call by paying $35 in return for a share of stock, and sell the stock for $50. You’ve made a riskless $5 profit.

6.The prices of both the call and the put option should increase. The higher level of downside risk still results in an option price of zero, but the upside potential is greater since there is a higher probability that the asset will finish in the money.

7.False. The value of a call option depends on the total variance of the underlying asset, not just the systematic variance.

8.The call option will sell for more since it provides an unlimited profit opportunity, while the potential profit from the put is limited (the stock price cannot fall below zero).

9.The value of a call option will increase, and the value of a put option will decrease.

10.The reason they don’t show up is that the U.S. government uses cash accounting; i.e., only actual cash inflows and outflows are counted, not contingent cash flows. From a political perspective, they would make the deficit larger, so that is another reason not to count them! Whether they should be included depends on whether we feel cash accounting is appropriate or not, but these contingent liabilities should be measured and reported. They currently are not, at least not in a systematic fashion.

11.The option to abandon reflects our ability to shut down a project if it is losing money. Since this option acts to limit losses, we will underestimate NPV if we ignore it. 12.The option to expand reflects our ability to increase production if the new product sells more than we initially expected. Since this option increases the potential future cash flows beyond our initial estimate, we will underestimate NPV if we ignore it.

13.This is a good example of the option to expand.

14.With oil, for example, we can simply stop pumping if prices drop too far, and we can do so quickly. The oil itself is not affected; it just sits in the ground until prices rise to a point where pumping is profitable. Given the volatility of natural resource prices, the option to suspend output is very valuable.

15.There are two possible benefits. First, awarding employee stock options may better align the interests of the employees with the interests of the stockholders, lowering agency costs. Secondly, if the company has little cash available to pay top employees, employee stock options may help attract qualified employees for less pay.

Solutions to Questions and Problems

NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to space...
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