Chap024

Chapter 24 - Options and Corporate Finance

Chapter 24Options and Corporate Finance

Multiple Choice Questions

1. Which one of the following grants its owner the right to buy or to sell an asset at a prespecified price at any time during a stated period? A. optionB. forward contractC. futures contractD. swapE. intrinsic contract

2. Elizabeth owns a call option on 100 shares of Microsoft stock. She has decided to buy those shares. This purchase is commonly referred to as: A. striking the asset.B. expiring the option.C. exercising the option.D. putting the collar.E. the collar option.

3. Marti owns an option that allows him to purchase ABC stock at $50 a share. The $50 price is referred to as the: A. opening price.B. intrinsic value.C. strike price.D. market price.E. time value.

4. What is the final day on which an option can be exercised called? A. payment dateB. ex-option dateC. opening dateD. expiration dateE. intrinsic date

24-1


5. Felicia purchased an option which she can exercise anytime within the next six months. Which type of option did she purchase? A. market-readyB. portableC. dailyD. EuropeanE. American

6. Brad purchased an option that he can only exercise on the final day of the option period. Which type of option did he purchase? A. EuropeanB. AmericanC. inflexibleD. datedE. pointed

7. Which of the following grants its owner the right to purchase an asset at a stated price?I. American callII. European callIII. American putIV. European put A. I onlyB. I and II onlyC. I and III onlyD. II and IV onlyE. III and IV only

8. The owner of a put option has the _____ an asset at a fixed price during a stated period of time. A. right to sellB. right to buyC. obligation to sellD. obligation to buyE. obligation to trade

24-2


9. Which one of the following terms applies to the value of an option on its expiration date? A. strike priceB. upper limitC. deadline priceD. time valueE. intrinsic value

10. Suzie is the controller of The Price Rite Company. She has been granted to the right to buy 1,000 shares of her employer's stock at $25 a share anytime within the next three years. Which one of the following has Suzie been granted? A. employee stock optionB. company bonus optionC. employee grantD. employee exercise optionE. company benefits option

11. Which one of the following terms applies to an option that has an office building as its underlying asset? A. financial optionB. liquid optionC. fixed optionD. real optionE. concrete option

12. The investment timing decision is the: A. determination of when an option should be exercised.B. decision of when to purchase an option on an underlying asset.C. analysis of determining when an asset should be sold.D. determination of when a project should be abandoned.E. evaluation of the optimal time to begin a project.

24-3


13. Lucas Enterprises recently opted to open a new retail outlet. If the outlet outperforms the expectations, the manager can opt to increase the store's size. If it underperforms, the manager can opt to close the store. These choices that the manager has been given are called: A. call options.B. put options.C. straddles.D. managerial options.E. executive options.

14. Which one of the following considers all of the options implicit in a project? A. expansion planningB. contingency planningC. asset management reviewD. prospective evaluationE. strategic evaluation

15. KT Enterprises has expanded its operations into a new field, which is the production of everyday dinnerware. If this project goes well, the firm has the option to expand its production into fine china. What type of option is this? A. financialB. strategicC. putD. intangibleE. call

16. Amy is a current shareholder of DJ Industries. She has been given the right to purchase an additional 25 shares of DJ Industries stock at a price of $32 a share if she exercises that right within the next 12 months. What is this security called that Amy has been given? A. convertible bondB. warrantC. straddleD. spreadE. put

24-4


17. Jeff owns a $1,000 face value bond. He can exchange that bond for 25 shares of KNJ stock at any time within the next 2 years. What type of bond does Jeff own? A. securedB. warrantedC. convertibleD. junkE. callable

18. The dollar amount of a bond's par value that is exchangeable for one share of stock is called the: A. conversion premium.B. par value.C. conversion value.D. conversion price.E. conversion ratio.

19. Alicia owns a $1,000 face value bond that can be converted into 20 shares of AB Limited stock. Which one of the following terms refers to these 20 shares? A. conversion premiumB. straight bond valueC. conversion valueD. conversion priceE. conversion ratio

20. The difference between the conversion price and the current stock price, divided by the current stock price, is called the: A. conversion premium.B. straight bond value.C. conversion value.D. conversion price.E. conversion ratio.

24-5


21. Latetia owns a convertible bond. Which one of the following terms would describe the value of this bond if it were not convertible? A. conversion premiumB. straight bond valueC. conversion valueD. inverted valueE. market value

22. Brad owns a convertible bond. Which one of the following terms would apply to the value of this bond if he were to convert it into shares of stock today? A. conversion premiumB. straight bond valueC. conversion valueD. inverted valueE. prescribed value

23. Which one of the following statements correctly describes your situation as the holder of a European call option? A. You are obligated to buy if the option is exercised.B. You have a right to sell.C. You have a right to buy but only on the expiration date.D. You are obligated to sell if the option is exercised.E. You have a right to buy at any time before the option expires.

24. Julie opted to exercise her August option on June 20th and as a result received $2,500 for the sale of her shares. Which one of the following did Julie own? A. warrantB. American callC. American putD. European callE. European put

24-6


25. Josh opted to exercise his January option at the end of December and paid $3,250 at that time to acquire 100 shares of stock. Which one of the following did Josh own? A. American callB. American putC. European callD. European putE. European convertible bond

26. Steve owns an option which grants him the right to purchase shares of Lokier Tool stock at a price of $45 a share. Currently, the stock is selling for $52.40 a share. Steve would like to realize his profits but is not permitted to exercise the option for another two weeks. Which one of the following does Steve own? A. straight bondB. American callC. American putD. European callE. European put

27. What is the primary difference between an American call option and a European call option? A. The American call has a fixed strike price while the European strike price varies over time.B. An American call is a right to buy while a European call is an obligation to buy.C. An American call has an expiration date while the European call does not.D. An American call is written on 100 shares of the underlying security while the European call covers 1,000 shares.E. An American call an be exercised at any time up to the expiration date while the European call can only be exercised on the expiration date.

28. You own a July $15 call on ABC stock. Assume today is April 20 and the call has zero intrinsic value. Which one of the following best describes this option? A. worthlessB. unfundedC. expiredD. in-the-moneyE. out-of-the-money

24-7


29. A $20 put option on Wildwood stock expires today. The current price of the stock is $18.50. Which one of the following best describes this option? A. fundedB. unfundedC. at-the-moneyD. in-the-moneyE. out-of-the-money

30. Which one of the following describes the maximum value of a call option? A. strike price minus the initial cost of the optionB. exercise price plus the price of the underlying stockC. strike priceD. market price of the underlying stockE. purchase price

31. Which one of the following describes the lower bound of a call's value? A. strike price or zero, whichever is greaterB. stock price minus the exercise price or zero, whichever is greaterC. strike price or the stock price, whichever is lowerD. strike price or zero, whichever is lowerE. stock price minus the exercise price or zero, whichever is lower

32. Which one of the following describes the intrinsic value of a call option? A. the call's upper bound valueB. the call's lower bound valueC. market price of the underlying securityD. zero, if the call is in-the-moneyE. negative amount, if the call is out-of-the-money.

33. Which one of the following describes the intrinsic value of a put option? A. lesser of the strike price or the stock priceB. lesser of the stock price minus the exercise price or zeroC. lesser of the stock price or zeroD. greater of the strike price minus the stock price or zeroE. greater of the stock price minus the exercise price or zero

24-8


34. Which one of the following statements is correct? A. The value of a call decreases as the price of the underlying stock increases.B. The value of a call increases as the exercise price decreases.C. The value of a put increases as the price of the underlying stock increases.D. The value of a put decreases as the exercise price increases.E. The intrinsic value of a put must be zero on the expiration date.

35. An increase in which of the following will increase the value of a call?I. time to expirationII. underlying stock priceIII. risk-free rate of returnIV. price volatility of the underlying stock A. I and III onlyB. II, III, and IV onlyC. I, III, and IV onlyD. I, II, and III onlyE. I, II, III, and IV

36. Which of the following will decrease the value of a call option?I. a decrease in the exercise priceII. a decrease in the value of the underlying securityIII. an increase in the risk-free rateIV. an increase in the time to expiration A. II onlyB. I and II onlyC. III and IV onlyD. I, II, and IV onlyE. I, II, and III only

24-9


37. Mark owns both a March $20 put and a March $20 call on Alpha stock. Which one of the following statements correctly relates to Mark's position? Ignore taxes and transaction costs. A. A price decrease in Alpha stock will increase the value of Mark's call option.B. A March $30 call is worth more than Mark's $20 call.C. The time premium on an April $20 put is less than the time premium on Mark's put. (Assume both puts expire in the same calendar year.)D. A price increase in Alpha stock from $26 to $28 will increase the value of Mark's put.E. If the intrinsic value of Mark's put increases by $1 then the intrinsic value of his call must either decrease by $1 or equal zero.

38. Travis owns both a September $30 call and a September $30 put. If the call finishes at-the-money, then the put will: A. also finish in-the-money.B. finish at-the-money.C. finish out-of-the-money.D. either finish at-the-money or in-the-money.E. either finish at-the-money or out-of-the-money.

39. Which one of the following statements regarding employee stock options (ESOs) is correct? A. ESOs grant an employee the right to buy a fixed number of shares of company stock at the market price.B. Employees must exercise their ESOs prior to those ESOs becoming vested.C. Employees may forfeit their ESOs if they terminate their employment with the issuing firm.D. If a firm issue ESOs it must make them available to all employees.E. Employees can sell their ESOs if they do not want to personally exercise them.

40. Employee stock options are primarily designed to do which one of the following? A. provide employees with put options on their shares of company stockB. provide an immediately vested benefit to key employeesC. influence the actions and priorities of employeesD. distribute excess cash to key employees to avoid corporate taxationE. provide an immediate capital gain to certain employees

24-10


41. Employee stock options: A. usually have a positive intrinsic value when issued.B. must be backdated at least six months to comply with Sarbanes-Oxley.C. are generally "underwater" when issued.D. are frequently repriced if the options are in-the-money.E. are generally issued with a zero intrinsic value.

42. The Sarbanes-Oxley Act of 2002 requires firms to report ESO grants within how many days of the grant? A. 2 calendar daysB. 2 business daysC. 7 calendar daysD. 30 business daysE. 45 calendar days

43. Delta Importers has a pure discount loan with a face value of $180,000 due in one year. The assets of the firm are currently worth $265,000. The shareholders in this firm basically own a _____ option on the assets of the firm with a strike price of _____. A. put; $180,000.B. put; $265,000.C. warrant; $265,000.D. call; $180,000.E. call; $265,000.

44. Jack and Jill are house hunting. They find House A situated on a hill. They really like the house but want to continue searching the market for one more week before making their final decision to buy the house. To avoid having someone else purchase House A while they continue their house hunting, they decide to place a $2,500 deposit on House A. This deposit will apply to the purchase price if they buy House A. If they do not buy House A, they will forfeit the $2,500. Essentially, Jack and Jill have a _____ on House A. A. financial putB. financial callC. warrantD. real putE. real call

24-11


45. The option to wait:I. may be of minimal value if a project is dependent upon rapidly changing technology.II. is partially dependent upon the discount rate applied to the project being evaluated.III. is defined as temporarily shutting down a project for a period of time.IV. has a value equal to the NPV of a project if it is started at a later date minus the NPV if the project is started today. A. I and III onlyB. II and IV onlyC. I and II onlyD. II, III, and IV onlyE. I, II, and IV only

46. Ignoring which of the following will cause the NPV of a project to be underestimated?I. option to abandonII. option to expandIII. option to waitIV. option to contract A. I and III onlyB. II, III, and IV onlyC. I, II, and III onlyD. I, III, and IV onlyE. I, II, III, and IV

47. Which one of the following is an example of a strategic option for a restaurant? A. opening a new restaurant with a different look and an entirely different menu to see if that type of restaurant appeals to the publicB. deciding to close one hour earlier during the winter months due to slow salesC. abandoning a menu item based on customer complaintsD. deciding to open only two new locations next year instead of the five that were originally scheduledE. deciding to create separate lunch and dinner menus rather than have them combined on one menu

24-12


48. Last month, Hill Side Markets introduced a new board game. Consumer demand has been overwhelming and appears that strong demand will exist over the long-term as young children absolutely love the game. Given this, which one of the following options should Hill Side Markets consider in respect to this game? A. suspensionB. expansionC. abandonmentD. contractionE. withdrawal

49. Three months ago, Toy Town introduced a new toy for pre-school children. The store expected this toy to be an instant success and a fast moving item. To their surprise, children have zero interest in this toy so sales have been abysmal. Which one of the following options should Toy Town consider in respect to this toy? A. suspensionB. expansionC. abandonmentD. contractionE. re-introduction

50. Which of the following are managerial options once a project is commenced?I. modifying the production processII. re-pricing the productIII. revising the marketing planIV. modifying the product's color and shape A. I and II onlyB. III and IV onlyC. I, II, and III onlyD. II, III, and IV onlyE. I, II, III, and IV

51. Which one of the following statements related to warrants is correct? A. Warrants are generally issued as an attachment to publicly-issued bonds.B. Warrants are excluded from trading on an organized exchange.C. Warrants are structured as long-term put options.D. Warrants are issued by individual investors.E. Warrants are generally added as an incentive to a private debt issue.

24-13


52. Which of the following statements are correct concerning warrants?I. Warrants are similar to put options.II. Warrants are similar to call options.III. When a warrant is exercised, the issuer is not involved in the transaction.IV. When a warrant is exercised, the issuer must issue new shares of stock. A. I onlyB. II onlyC. I and III onlyD. II and IV onlyE. I and IV only

53. When warrants are exercised, the: A. earnings per share decrease.B. earnings per share remain constant.C. total equity in a firm remains constant.D. total equity in a firm decreases.E. number of bonds outstanding increases.

54. Which of the following statements are correct concerning convertible bonds?I. New shares of stock are issued when a convertible bond is converted.II. A convertible bond is similar to a bond with a call option.III. A convertible bond should always be worth less than a comparable straight bond.IV. A convertible bond can be described as having upside potential with downside protection. A. I and III onlyB. I, II, and IV onlyC. I, II, and III onlyD. I, III, and IV onlyE. II, III, and IV only

55. The conversion value of a convertible bond is equal to which one of the following? A. Conversion ratio Stock priceB. Conversion ratio Conversion priceC. Face value of the bond/Conversion premiumD. Face value of the bond (1 + Conversion premium)E. Stock price (1 + Conversion ratio)

24-14


56. The maximum value of a convertible bond is theoretically: A. equal to the conversion value minus the straight bond value.B. equal to the face value of the bond multiplied by (1 + Conversion price).C. limited to the maximum straight bond value.D. limited by the face value of the bond.E. unlimited.

57. What is the cost of two November $25 put option contracts on Dove stock given the following price quotes?

A. $0.15B. $0.30C. $1.50D. $15.00E. $30.00

58. What is the value of five August $25 call contracts on Dove stock?

A. $34B. $68C. $340D. $680E. $3,400

24-15


59. What is the intrinsic value of the November $25 call on Dove stock?

A. -$0.98B. $0C. $0.15D. $6.12E. $7.10

60. You purchased six call option contracts on ABC stock with a strike price of $32.50 when the option was quoted at $1.80. The option expires today when the value of ABC stock is $34.60. Ignoring trading costs and taxes, what is the net profit or loss on this investment? A. $0B. $180C. $210D. $840E. $1,260

61. You sold one call option contract with a strike price of $55 when the option was quoted at $0.80. The option expires today when the value of the underlying stock is $53.70. Ignoring trading costs and taxes, what is the net profit or loss on this investment? A. -$250B. -$80C. $0D. $50E. $80

24-16


62. You sold three $35 call option contracts at a quoted price of $1.40. What is your net profit or loss on this investment if the price of the underlying asset is $36.70 on the option expiration date? A. -$510B. -$90C. $90D. $510E. $930

63. You wrote eight call option contracts with a strike price of $42.50 at a call price of $1.35 per share. What is your net gain or loss on this investment if the price of the underlying stock is $40.30 per share on the option expiration date? A. -$2,840B. -$1,760C. -$1,080D. $1,080E. $1,760

64. The market price of Southern Press stock has been relatively volatile and you think this volatility will continue for a couple more months. Thus, you decide to purchase a two-month European call option on this stock with a strike price of $45 and an option price of $2.20. You also purchase a two-month European put option on the stock with a strike price of $45 and an option price of $0.30. What will be your net profit or loss on these option positions if the stock price is $48 on the day the options expire? Ignore trading costs and taxes. A. -$30B. $50C. $80D. $270E. $330

24-17


65. Several rumors concerning Value Rite stock are causing the market price of the stock to be quite volatile. Given this situation, you decide to buy both a one-month European $25 put and a one-month European $25 call on this stock. The call price per share is $0.60 and the put price per share is $2.10. What will be your net profit or loss on these option positions if the stock price is $18 on the day the options expire? Ignore trading costs and taxes. A. -$210B. -$150C. -$60D. $430E. $490

66. Three months ago, Central Supply stock was selling for $51.40 a share. At that time, you purchased five put options on the stock with a strike price of $50 per share and an option price of $0.60 per share. The option expires today when the value of the stock is $42.70 per share. What is your net profit or loss on this investment? Ignore trading costs and taxes. A. -$1,300B. -$1,000C. -$300D. $3,350E. $3,650

67. You wrote two put options on Xylo stock with an exercise price of $30 per share and an option price of $1.05 per share. Today, the contracts expire and the stock is selling for $31.15 a share. What is your net profit or loss on this investment? Ignore trading costs and taxes. A. -$115B. -$105C. $20D. $105E. $210

24-18


68. You sold ten put contracts on Cross Town Bank stock at an option price per share of $0.85. The options have an exercise price of $37.50 per share. The options were exercised today when the stock price was $34 a share. What is your net profit or loss on this investment assuming that you closed out your positions at a stock price of $34? Ignore transaction costs and taxes. A. -$3,500B. -$2,650C. $1,800D. $850E. $3,500

69. You own eight call option contracts on Swift Water Tours stock with a strike price of $15. When you purchased the shares the option price was $0.30 and the stock price was $15.25. What is the total intrinsic value of these options if the stock is currently selling for $16.08 a share? A. -$83B. -$1.08C. $0D. $108E. $864

70. You recently purchased three put option contracts on Guillepsi stock with an exercise price of $42.50. What is the total intrinsic value of these contracts if the stock is currently selling for $43.70 a share? A. -$360B. -$120C. $0D. $120E. $360

24-19


71. Last week, you purchased a call option on Edgewater stock with a strike price of $40. The stock price was $39.80 and the option price was $0.45 at that time. What is the intrinsic value per share if the stock is currently priced at $39.10? A. -$90B. -$70C. $0D. $70E. $90

72. Three weeks ago, you purchased a June $30 put option on Leeper Metals stock at an option price of $1.80. The market price of the stock three weeks ago was $30.60. Today, the stock is selling at $29.80 a share. What is the intrinsic value of your put contract? A. -$100B. -$20C. $0D. $20E. $60

73. This morning, you purchased a call option on Schoolhouse Supply Co. stock that expires in one year. The exercise price is $40. The current price of the stock is $43.40 and the risk-free rate of return is 3.6 percent. Assume the option will finish in the money. What is the current value of the call option? A. $0B. $1.49C. $3.97D. $4.79E. $5.46

74. You currently own a one-year call option on Rail Company, Inc., stock. The current stock price is $51.80 and the risk-free rate of return is 4.25 percent. Your option has a strike price of $50 and you assume the option will finish in the money. What is the current value of your call option? A. $1.20B. $2.59C. $3.84D. $5.13E. $7.27

24-20


75. The common stock of Hazelton Refiners is selling for $72.30 a share. U.S. Treasury bills are currently yielding 4.8 percent. What is the current value of a one-year call option on this stock if the exercise price is $70 and you assume the option will finish in the money? A. $0B. $1.20C. $3.00D. $4.20E. $5.51

76. The common stock of Westover Foods is currently priced at $27.90 a share. One year from now, the stock price is expected to be either $25 or $30 a share. The risk-free rate of return is 4.2 percent. What is the current value of one call option on this stock if the exercise price is $27.50? A. $0B. $1.95C. $2.00D. $3.80E. $4.00

77. You own one call option with an exercise price of $40 on S'more Good stock. The stock is currently selling for $41 a share but is expected to sell for either $37 or $43 a share in one year. The risk-free rate of return is 4.25 percent and the inflation rate is 3.6 percent. What is the current call option price if the option expires one year from now? A. $0.55B. $0.69C. $1.37D. $2.43E. $2.75

24-21


78. The assets of Uptown Stores are currently worth $136,400. These assets are expected to be worth either $120,000 or $150,000 one year from now. The company has a pure discount bond outstanding with a $130,000 face value and a maturity date of one year. The risk-free rate is 4.3 percent. What is the value of the equity in this firm? A. $11,920B. $14,232C. $19,507D. $21,347E. $26,408

79. Electronic Importers has a pure discount bond with a face value of $25,000 that matures in one year. The risk-free rate of return is 3.8 percent. The assets of the business are expected to be worth either $23,000 or $35,000 in one year. Currently, these assets are worth $27,500. What is the current value of the bond? A. $17,746B. $19,207C. $20,222D. $22,549E. $23,048

80. The Glass House has total assets currently valued at $17,200. These assets are expected to increase in value to either $18,000 or $21,000 by next year. The company has a pure discount bond outstanding with a face value of $20,000. This bond matures in one year. Currently, U.S. Treasury bills are yielding 5.4 percent. What is the value of the equity in this firm? A. -$3,000.00B. -$908.00C. $0D. $40.73E. $122.20

24-22


81. You are considering a project that has been assigned a discount rate of 14 percent. If you start the project today, you will incur an initial cost of $8,500 and will receive cash inflows of $5,550 a year for two years. If you wait one year to start the project, the initial cost will rise to $9,200 and the cash flows will increase to $5,800 a year for two years. What is the value of the option to wait? A. -$331.40B. -$194.46C. $228.51D. $230.49E. $334.68

82. Southern Shores is considering a project that has an initial cost today of $12,500. The project has a two-year life with cash inflows of $7,500 a year. Should the firm opt to wait one year to commence this project, the initial cost will increase by 5 percent and the cash inflows will increase to $8,500 a year. What is the value of the option to wait if the applicable discount rate is 14 percent? A. $614.52B. $721.56C. $914.62D. $982.67E. $1,021.66

83. Western Industrial Products is considering a project with a four-year life and an initial cost of $212,000. The discount rate for the project is 16 percent. The firm expects to sell 9,600 units on the last day of each year. The cash flow per unit is $50. The firm will have the option to abandon this project at the end of year one (after year one's sales) at which time the project's assets could be sold for an estimated $125,000. The firm should abandon the project at the end of year one if the expected level of annual sales, starting with year 2, falls to _____ units or less. Ignore taxes. A. 1,113 unitsB. 1,267 unitsC. 1,922 unitsD. 2,034 unitsE. 2,108 units

24-23


84. Dressler Technologies is considering a project with a 3-year life and an initial cost of $85,000. The discount rate for the project is 14.5 percent. The firm expects to sell 1,200 units on the last day of each year. The cash flow per unit is $32. The firm will have the option to abandon this project at the end two years (after year 2 sales) at which time the project's assets could be sold for an estimated $30,000. The firm's managers are interested in knowing how the project will perform if the sales forecast for year 3 of the project is revised such that there is a 50/50 chance that the sales will be either 1,000 or 1,400 units a year. What is the net present value of this project at time zero given the current sales forecasts? A. -$3,474B. -$2,526C. $4,191D. $6,192E. $6,887

85. Patience is reviewing a project with projected sales of 4,200 units a year, a cash flow of $28 a unit, and a four-year project life. Assume all operating cash flows occur on the last day of each year. The initial cost of the project is $247,000. The relevant discount rate is 13 percent. Patience has the option to abandon the project after two years at which time she feels she could sell the project's assets for $110,000. At what level of annual sales, starting in year 3, should she be willing to abandon this project? A. 2,119 unitsB. 2,355 unitsC. 2,367 unitsD. 2,516 unitsE. 2,667 units

86. You own a convertible bond with a face value of $1,000 and a market value of $1,034. The bond can be converted into 14 shares of stock. What is the conversion price? A. $71.43B. $72.00C. $72.67D. $73.86E. $74.33

24-24


87. You own nine convertible bonds. These bonds have a 7 percent coupon, a $1,000 face value, and mature in 6 years. The bonds are convertible into shares of common stock at a conversion price of $25. How many shares of stock will you receive if you convert all of your bonds? A. 285B. 300C. 350D. 360E. 400

88. A convertible bond has a face value of $5,000 and a conversion price of $80. The bond has a 6 percent coupon, pays interest semi-annually, and matures in 12 years. Similar bonds are yielding 7.5 percent. The current price of the stock is $41.20 per share. What is the conversion value of this bond? A. $1,680B. $2,415C. $2,575D. $4,651E. $5,000

89. A convertible bond has a face value of $1,000 and a conversion price of $12.50. The bond has a 6 percent coupon, pays interest semi-annually, and matures in 12 years. Similar bonds are yielding 9 percent. The current price of the stock is $13.40 per share. What is the straight bond value? A. $782.57B. $781.82C. $827.74D. $832.09E. $843.47

24-25


90. Kurt owns a convertible bond that matures in three years. The bond has a 7.5 percent coupon and pays interest semi-annually. The face value of the bond is $1,000 and the conversion price is $25. Similar bonds have a market return of 9.25 percent. The current price of the stock is $26.50 per share. What is the straight bond value? A. $948.20B. $955.05C. $972.80D. $987.78E. $991.15

91. Lucinda owns a convertible bond that matures in six years. The bond has a 9 percent coupon and pays interest annually. The face value of the bond is $1,000 and the conversion price is $22. Similar bonds have a market return of 8.75 percent. The current price of the stock is $21.60 per share. What is the conversion value of this bond? A. $835.60B. $848.40C. $942.11D. $981.82E. $1,000.00

Essay Questions

92. Circle Stores stock is priced at $28 a share. A $40 call on this stock has five months until expiration and a call price of $0.15. Why would an investor purchase a call that is so far out of the money?

24-26


93. What are the basic similarities and basic differences between warrants and call options?

94. What are the upper and lower bounds for an American call option? Explain what would happen in each case if the bound was violated.

95. Explain the rationale behind the idea that equity is a call option on a firm's assets. When would a shareholder allow this call to expire?

96. Call options are frequently attached to bonds, making them callable at the option of the issuer. Consider a firm that just issued two sets of bonds: One is callable, has a 7 percent coupon rate, 15 years to maturity, and cannot be called during the first three years; the second is noncallable, has a 7 percent coupon rate, 15 years to maturity, and is identical to the first bond in every way except for the call option. Suppose the noncallable bonds are sold for $1,000 each. Will the callable bonds sell for more or less than $1,000? Who "purchases" the option in this case and who "sells" it?

24-27


97. Explain how the floor and the ceiling prices for a convertible bond are determined.


98. T-bills currently yield 6.3 percent. Stock in Pinta Manufacturing is currently selling for $46 per share. There is no possibility that the stock will be worth less than $39 per share in one year. What is the value of a call option on this stock if the exercise price is $22 per share? A. $21.40B. $22.00C. $24.00D. $25.30E. $25.70

99. The price of Time Squared Corp. stock will be either $80 or $95 at the end of the year. Call options are available with one year to expiration. T-bills currently yield 6 percent and the current price of Time Squared Corp. stock is $85. What is the value of a call option if the exercise price is $75 per share? A. $14.25B. $15.06C. $18.78D. $24.25E. $25.06

24-28


100. The price of Dimension, Inc. stock will be either $65 or $85 at the end of the year. Call options are available with one year to expiration. T-bills currently yield 5 percent. Suppose the current price of Dimension stock is $70. What is the value of the call option if the exercise price is $70 per share? A. $6.07B. $8.48C. $11.58D. $15.39E. $17.62

101. Rackin Pinion Corporation's assets are currently worth $1,260. In one year, they will be worth either $1,200 of $1,610. The risk-free interest rate is 5 percent. Suppose Rackin Pinion has an outstanding debt issue with a face value of $1,200. What is the current value of the firm's debt? A. $60.00B. $114.14C. $1,142.86D. $1,263.19E. $1,504.20

102. Buckeye Industries has a bond issue with a face value of $1,000 that is coming due in one year. The value of Buckeye's assets is currently $1,200. Jim Tressell, the CEO, believes that the assets in the firm will be worth either $600 or $1,700 in a year. The going rate on one-year T-bills is 6 percent. What is the current value of the firm's debt? A. $601.18B. $796.57C. $844.24D. $878.78E. $911.03

103. A $1,000 convertible debenture has a conversion price for common stock of $85 per share. The common stock is selling at $92 a share. What is the conversion value of this bond? A. $920.00B. $923.91C. $1,000.00D. $1,082.35E. $1,092.00

24-29


104. A bond with 10 detachable warrants has just been offered for sale at $1,000. The bond matures in 15 years and has an annual coupon of $80. Each warrant gives the owner the right to purchase two shares of stock in the company at $14 per share. Ordinary bonds (with no warrants) of similar quality are priced to yield 11 percent. What is the value of one warrant? A. $7.00B. $13.58C. $14.00D. $16.67E. $21.57

105. Your company is deciding when to invest in a new machine. The new machine will increase cash flow by $240,000 per year. You believe the technology used in the machine has a 10-year life; in other words, no matter when you purchase the machine, it will be obsolete 10 years from today. The machine is currently priced at $1,200,000. The cost of the machine will decline by $120,000 per year until it reaches $720,000, where it will remain. Your required return is 8 percent. In which year should you purchase the machine? A. Year 0B. Year 1C. Year 2D. Year 3E. Year 4

106. We are examining a new project. We expect to sell 9,000 units per year at $45 net cash flow apiece for the next 20 years. In other words, the annual operating cash flow is projected to be $45 9,000 = $405,000. The relevant discount rate is 14 percent, and the initial investment required is $1,730,000. After the first year, the project can be dismantled and sold for $1,350,000. If expected sales are revised based on the first year's performance, it would make sense to abandon the investment if the sales are less than which of the following number of units? A. 4,580 unitsB. 4,620 unitsC. 4,750 unitsD. 4,810 unitsE. 5,020 units

24-30


107. We are examining a new project. We expect to sell 8,000 units per year at $80 net cash flow apiece for the next 15 years. In other words, the annual operating cash flow is projected to be $80 8,000 = $640,000. The relevant discount rate is 16 percent, and the initial investment required is $2,740,000. The project can be dismantled after the first year and sold for $2,130,000. Suppose you think it is likely that expected sales will be revised upward to 9,600 units if the first year is a success and revised downward to 3,000 units if the first year is not a success. Suppose the scale of the project can be doubled in one year in the sense that twice as many units can be produced and sold. Naturally, expansion would be desirable only if the project is a success. This implies that if the project is a success, projected sales after expansion will be 19,200. Assume that success and failure are equally likely. Note that abandonment is still an option if the project is a failure. What is the value of the option to expand? A. $1,774,328B. $1,809,941C. $1,828,406D. $1,848,920E. $1,872,312

24-31


Chapter 24 Options and Corporate Finance Answer Key


1. Which one of the following grants its owner the right to buy or to sell an asset at a prespecified price at any time during a stated period? A. optionB. forward contractC. futures contractD. swapE. intrinsic contract

Refer to section 24.1

AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 24-1Section: 24.1Topic: Option

2. Elizabeth owns a call option on 100 shares of Microsoft stock. She has decided to buy those shares. This purchase is commonly referred to as: A. striking the asset.B. expiring the option.C. exercising the option.D. putting the collar.E. the collar option.


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 24-1Section: 24.1Topic: Exercising the option

24-32


3. Marti owns an option that allows him to purchase ABC stock at $50 a share. The $50 price is referred to as the: A. opening price.B. intrinsic value.C. strike price.D. market price.E. time value.


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 24-1Section: 24.1Topic: Strike price

4. What is the final day on which an option can be exercised called? A. payment dateB. ex-option dateC. opening dateD. expiration dateE. intrinsic date


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 24-1Section: 24.1Topic: Expiration date

24-33


5. Felicia purchased an option which she can exercise anytime within the next six months. Which type of option did she purchase? A. market-readyB. portableC. dailyD. EuropeanE. American


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 24-1Section: 24.1Topic: American option

6. Brad purchased an option that he can only exercise on the final day of the option period. Which type of option did he purchase? A. EuropeanB. AmericanC. inflexibleD. datedE. pointed


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 24-1Section: 24.1Topic: European option

24-34


7. Which of the following grants its owner the right to purchase an asset at a stated price?I. American callII. European callIII. American putIV. European put A. I onlyB. I and II onlyC. I and III onlyD. II and IV onlyE. III and IV only


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 24-1Section: 24.1Topic: Call option

8. The owner of a put option has the _____ an asset at a fixed price during a stated period of time. A. right to sellB. right to buyC. obligation to sellD. obligation to buyE. obligation to trade


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 24-1Section: 24.1Topic: Put option

24-35


9. Which one of the following terms applies to the value of an option on its expiration date? A. strike priceB. upper limitC. deadline priceD. time valueE. intrinsic value


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 24-2Section: 24.2Topic: Intrinsic value

10. Suzie is the controller of The Price Rite Company. She has been granted to the right to buy 1,000 shares of her employer's stock at $25 a share anytime within the next three years. Which one of the following has Suzie been granted? A. employee stock optionB. company bonus optionC. employee grantD. employee exercise optionE. company benefits option


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 24-3Section: 24.4Topic: Employee stock option

24-36


11. Which one of the following terms applies to an option that has an office building as its underlying asset? A. financial optionB. liquid optionC. fixed optionD. real optionE. concrete option


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 24-5Section: 24.6Topic: Real options

12. The investment timing decision is the: A. determination of when an option should be exercised.B. decision of when to purchase an option on an underlying asset.C. analysis of determining when an asset should be sold.D. determination of when a project should be abandoned.E. evaluation of the optimal time to begin a project.


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 24-5Section: 24.6Topic: Investment timing decision

24-37


13. Lucas Enterprises recently opted to open a new retail outlet. If the outlet outperforms the expectations, the manager can opt to increase the store's size. If it underperforms, the manager can opt to close the store. These choices that the manager has been given are called: A. call options.B. put options.C. straddles.D. managerial options.E. executive options.


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 24-5Section: 24.6Topic: Managerial options

14. Which one of the following considers all of the options implicit in a project? A. expansion planningB. contingency planningC. asset management reviewD. prospective evaluationE. strategic evaluation


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 24-5Section: 24.6Topic: Contingency planning

24-38


15. KT Enterprises has expanded its operations into a new field, which is the production of everyday dinnerware. If this project goes well, the firm has the option to expand its production into fine china. What type of option is this? A. financialB. strategicC. putD. intangibleE. call


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 24-5Section: 24.6Topic: Strategic options

16. Amy is a current shareholder of DJ Industries. She has been given the right to purchase an additional 25 shares of DJ Industries stock at a price of $32 a share if she exercises that right within the next 12 months. What is this security called that Amy has been given? A. convertible bondB. warrantC. straddleD. spreadE. put


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 24-6Section: 24.7Topic: Warrants

24-39


17. Jeff owns a $1,000 face value bond. He can exchange that bond for 25 shares of KNJ stock at any time within the next 2 years. What type of bond does Jeff own? A. securedB. warrantedC. convertibleD. junkE. callable


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 24-6Section: 24.7Topic: Convertible bonds

18. The dollar amount of a bond's par value that is exchangeable for one share of stock is called the: A. conversion premium.B. par value.C. conversion value.D. conversion price.E. conversion ratio.


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 24-6Section: 24.7Topic: Conversion price

24-40


19. Alicia owns a $1,000 face value bond that can be converted into 20 shares of AB Limited stock. Which one of the following terms refers to these 20 shares? A. conversion premiumB. straight bond valueC. conversion valueD. conversion priceE. conversion ratio


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 24-6Section: 24.7Topic: Conversion ratio

20. The difference between the conversion price and the current stock price, divided by the current stock price, is called the: A. conversion premium.B. straight bond value.C. conversion value.D. conversion price.E. conversion ratio.


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 24-6Section: 24.7Topic: Conversion premium

24-41


21. Latetia owns a convertible bond. Which one of the following terms would describe the value of this bond if it were not convertible? A. conversion premiumB. straight bond valueC. conversion valueD. inverted valueE. market value


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 24-6Section: 24.7Topic: Straight bond value

22. Brad owns a convertible bond. Which one of the following terms would apply to the value of this bond if he were to convert it into shares of stock today? A. conversion premiumB. straight bond valueC. conversion valueD. inverted valueE. prescribed value


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 24-6Section: 24.7Topic: Conversion value

24-42


23. Which one of the following statements correctly describes your situation as the holder of a European call option? A. You are obligated to buy if the option is exercised.B. You have a right to sell.C. You have a right to buy but only on the expiration date.D. You are obligated to sell if the option is exercised.E. You have a right to buy at any time before the option expires.


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 24-1Section: 24.1Topic: European option

24. Julie opted to exercise her August option on June 20th and as a result received $2,500 for the sale of her shares. Which one of the following did Julie own? A. warrantB. American callC. American putD. European callE. European put


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 24-1Section: 24.1Topic: American option

24-43


25. Josh opted to exercise his January option at the end of December and paid $3,250 at that time to acquire 100 shares of stock. Which one of the following did Josh own? A. American callB. American putC. European callD. European putE. European convertible bond


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 24-1Section: 24.1Topic: American option

26. Steve owns an option which grants him the right to purchase shares of Lokier Tool stock at a price of $45 a share. Currently, the stock is selling for $52.40 a share. Steve would like to realize his profits but is not permitted to exercise the option for another two weeks. Which one of the following does Steve own? A. straight bondB. American callC. American putD. European callE. European put


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 24-1Section: 24.1Topic: European option

24-44


27. What is the primary difference between an American call option and a European call option? A. The American call has a fixed strike price while the European strike price varies over time.B. An American call is a right to buy while a European call is an obligation to buy.C. An American call has an expiration date while the European call does not.D. An American call is written on 100 shares of the underlying security while the European call covers 1,000 shares.E. An American call an be exercised at any time up to the expiration date while the European call can only be exercised on the expiration date.


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 24-1Section: 24.1Topic: European option

28. You own a July $15 call on ABC stock. Assume today is April 20 and the call has zero intrinsic value. Which one of the following best describes this option? A. worthlessB. unfundedC. expiredD. in-the-moneyE. out-of-the-money


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 24-2Section: 24.2Topic: Call value

24-45


29. A $20 put option on Wildwood stock expires today. The current price of the stock is $18.50. Which one of the following best describes this option? A. fundedB. unfundedC. at-the-moneyD. in-the-moneyE. out-of-the-money


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 24-2Section: 24.2Topic: Put value

30. Which one of the following describes the maximum value of a call option? A. strike price minus the initial cost of the optionB. exercise price plus the price of the underlying stockC. strike priceD. market price of the underlying stockE. purchase price


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 24-2Section: 24.2Topic: Call upper bound

24-46


31. Which one of the following describes the lower bound of a call's value? A. strike price or zero, whichever is greaterB. stock price minus the exercise price or zero, whichever is greaterC. strike price or the stock price, whichever is lowerD. strike price or zero, whichever is lowerE. stock price minus the exercise price or zero, whichever is lower


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 24-2Section: 24.2Topic: Call lower bound

32. Which one of the following describes the intrinsic value of a call option? A. the call's upper bound valueB. the call's lower bound valueC. market price of the underlying securityD. zero, if the call is in-the-moneyE. negative amount, if the call is out-of-the-money.


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 24-2Section: 24.2Topic: Call intrinsic value

24-47


33. Which one of the following describes the intrinsic value of a put option? A. lesser of the strike price or the stock priceB. lesser of the stock price minus the exercise price or zeroC. lesser of the stock price or zeroD. greater of the strike price minus the stock price or zeroE. greater of the stock price minus the exercise price or zero


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 24-1Section: 24.2Topic: Put intrinsic value

34. Which one of the following statements is correct? A. The value of a call decreases as the price of the underlying stock increases.B. The value of a call increases as the exercise price decreases.C. The value of a put increases as the price of the underlying stock increases.D. The value of a put decreases as the exercise price increases.E. The intrinsic value of a put must be zero on the expiration date.


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 24-2Section: 24.2Topic: Factors affecting option values

24-48


35. An increase in which of the following will increase the value of a call?I. time to expirationII. underlying stock priceIII. risk-free rate of returnIV. price volatility of the underlying stock A. I and III onlyB. II, III, and IV onlyC. I, III, and IV onlyD. I, II, and III onlyE. I, II, III, and IV


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 24-2Section: 24.2Topic: Factors affecting option values

36. Which of the following will decrease the value of a call option?I. a decrease in the exercise priceII. a decrease in the value of the underlying securityIII. an increase in the risk-free rateIV. an increase in the time to expiration A. II onlyB. I and II onlyC. III and IV onlyD. I, II, and IV onlyE. I, II, and III only


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 24-2Section: 24.2Topic: Factors affecting option values

24-49


37. Mark owns both a March $20 put and a March $20 call on Alpha stock. Which one of the following statements correctly relates to Mark's position? Ignore taxes and transaction costs. A. A price decrease in Alpha stock will increase the value of Mark's call option.B. A March $30 call is worth more than Mark's $20 call.C. The time premium on an April $20 put is less than the time premium on Mark's put. (Assume both puts expire in the same calendar year.)D. A price increase in Alpha stock from $26 to $28 will increase the value of Mark's put.E. If the intrinsic value of Mark's put increases by $1 then the intrinsic value of his call must either decrease by $1 or equal zero.


AACSB: N/ABloom's: AnalysisDifficulty: BasicLearning Objective: 24-2Section: 24.2Topic: Option value

38. Travis owns both a September $30 call and a September $30 put. If the call finishes at-the-money, then the put will: A. also finish in-the-money.B. finish at-the-money.C. finish out-of-the-money.D. either finish at-the-money or in-the-money.E. either finish at-the-money or out-of-the-money.


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 24-2Section: 24.2Topic: Option value

24-50


39. Which one of the following statements regarding employee stock options (ESOs) is correct? A. ESOs grant an employee the right to buy a fixed number of shares of company stock at the market price.B. Employees must exercise their ESOs prior to those ESOs becoming vested.C. Employees may forfeit their ESOs if they terminate their employment with the issuing firm.D. If a firm issue ESOs it must make them available to all employees.E. Employees can sell their ESOs if they do not want to personally exercise them.


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 24-3Section: 24.4Topic: Employee stock option

40. Employee stock options are primarily designed to do which one of the following? A. provide employees with put options on their shares of company stockB. provide an immediately vested benefit to key employeesC. influence the actions and priorities of employeesD. distribute excess cash to key employees to avoid corporate taxationE. provide an immediate capital gain to certain employees



24-51


41. Employee stock options: A. usually have a positive intrinsic value when issued.B. must be backdated at least six months to comply with Sarbanes-Oxley.C. are generally "underwater" when issued.D. are frequently repriced if the options are in-the-money.E. are generally issued with a zero intrinsic value.



42. The Sarbanes-Oxley Act of 2002 requires firms to report ESO grants within how many days of the grant? A. 2 calendar daysB. 2 business daysC. 7 calendar daysD. 30 business daysE. 45 calendar days


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 24-3Section: 24.4Topic: ESO backdating

24-52


43. Delta Importers has a pure discount loan with a face value of $180,000 due in one year. The assets of the firm are currently worth $265,000. The shareholders in this firm basically own a _____ option on the assets of the firm with a strike price of _____. A. put; $180,000.B. put; $265,000.C. warrant; $265,000.D. call; $180,000.E. call; $265,000.


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 24-4Section: 24.5Topic: Equity as a call option

44. Jack and Jill are house hunting. They find House A situated on a hill. They really like the house but want to continue searching the market for one more week before making their final decision to buy the house. To avoid having someone else purchase House A while they continue their house hunting, they decide to place a $2,500 deposit on House A. This deposit will apply to the purchase price if they buy House A. If they do not buy House A, they will forfeit the $2,500. Essentially, Jack and Jill have a _____ on House A. A. financial putB. financial callC. warrantD. real putE. real call


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 24-5Section: 24.6Topic: Real options

24-53


45. The option to wait:I. may be of minimal value if a project is dependent upon rapidly changing technology.II. is partially dependent upon the discount rate applied to the project being evaluated.III. is defined as temporarily shutting down a project for a period of time.IV. has a value equal to the NPV of a project if it is started at a later date minus the NPV if the project is started today. A. I and III onlyB. II and IV onlyC. I and II onlyD. II, III, and IV onlyE. I, II, and IV only


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 24-5Section: 24.6Topic: Option to wait

46. Ignoring which of the following will cause the NPV of a project to be underestimated?I. option to abandonII. option to expandIII. option to waitIV. option to contract A. I and III onlyB. II, III, and IV onlyC. I, II, and III onlyD. I, III, and IV onlyE. I, II, III, and IV



24-54


47. Which one of the following is an example of a strategic option for a restaurant? A. opening a new restaurant with a different look and an entirely different menu to see if that type of restaurant appeals to the publicB. deciding to close one hour earlier during the winter months due to slow salesC. abandoning a menu item based on customer complaintsD. deciding to open only two new locations next year instead of the five that were originally scheduledE. deciding to create separate lunch and dinner menus rather than have them combined on one menu


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 24-5Section: 24.6Topic: Strategic options

48. Last month, Hill Side Markets introduced a new board game. Consumer demand has been overwhelming and appears that strong demand will exist over the long-term as young children absolutely love the game. Given this, which one of the following options should Hill Side Markets consider in respect to this game? A. suspensionB. expansionC. abandonmentD. contractionE. withdrawal


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 24-5Section: 24.6Topic: Option to expand

24-55


49. Three months ago, Toy Town introduced a new toy for pre-school children. The store expected this toy to be an instant success and a fast moving item. To their surprise, children have zero interest in this toy so sales have been abysmal. Which one of the following options should Toy Town consider in respect to this toy? A. suspensionB. expansionC. abandonmentD. contractionE. re-introduction


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 24-5Section: 24.6Topic: Option to abandon

50. Which of the following are managerial options once a project is commenced?I. modifying the production processII. re-pricing the productIII. revising the marketing planIV. modifying the product's color and shape A. I and II onlyB. III and IV onlyC. I, II, and III onlyD. II, III, and IV onlyE. I, II, III, and IV



24-56


51. Which one of the following statements related to warrants is correct? A. Warrants are generally issued as an attachment to publicly-issued bonds.B. Warrants are excluded from trading on an organized exchange.C. Warrants are structured as long-term put options.D. Warrants are issued by individual investors.E. Warrants are generally added as an incentive to a private debt issue.


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 24-6Section: 24.7Topic: Warrants

52. Which of the following statements are correct concerning warrants?I. Warrants are similar to put options.II. Warrants are similar to call options.III. When a warrant is exercised, the issuer is not involved in the transaction.IV. When a warrant is exercised, the issuer must issue new shares of stock. A. I onlyB. II onlyC. I and III onlyD. II and IV onlyE. I and IV only



24-57


53. When warrants are exercised, the: A. earnings per share decrease.B. earnings per share remain constant.C. total equity in a firm remains constant.D. total equity in a firm decreases.E. number of bonds outstanding increases.



54. Which of the following statements are correct concerning convertible bonds?I. New shares of stock are issued when a convertible bond is converted.II. A convertible bond is similar to a bond with a call option.III. A convertible bond should always be worth less than a comparable straight bond.IV. A convertible bond can be described as having upside potential with downside protection. A. I and III onlyB. I, II, and IV onlyC. I, II, and III onlyD. I, III, and IV onlyE. II, III, and IV only



24-58


55. The conversion value of a convertible bond is equal to which one of the following? A. Conversion ratio Stock priceB. Conversion ratio Conversion priceC. Face value of the bond/Conversion premiumD. Face value of the bond (1 + Conversion premium)E. Stock price (1 + Conversion ratio)



56. The maximum value of a convertible bond is theoretically: A. equal to the conversion value minus the straight bond value.B. equal to the face value of the bond multiplied by (1 + Conversion price).C. limited to the maximum straight bond value.D. limited by the face value of the bond.E. unlimited.



24-59


57. What is the cost of two November $25 put option contracts on Dove stock given the following price quotes?

A. $0.15B. $0.30C. $1.50D. $15.00E. $30.00

Cost = 2 100 $0.15 = $30

AACSB: AnalyticBloom's: ApplicationDifficulty: BasicLearning Objective: 24-1Section: 24.1Topic: Option quotes

24-60


58. What is the value of five August $25 call contracts on Dove stock?

A. $34B. $68C. $340D. $680E. $3,400

Contract value = 5 100 $6.80 = $3,400


24-61


59. What is the intrinsic value of the November $25 call on Dove stock?

A. -$0.98B. $0C. $0.15D. $6.12E. $7.10

Intrinsic value = $31.12 - $25 = $6.12


60. You purchased six call option contracts on ABC stock with a strike price of $32.50 when the option was quoted at $1.80. The option expires today when the value of ABC stock is $34.60. Ignoring trading costs and taxes, what is the net profit or loss on this investment? A. $0B. $180C. $210D. $840E. $1,260

Total profit = ($34.60 - $32.50 - $1.80) 100 6 = $180

AACSB: AnalyticBloom's: ApplicationDifficulty: BasicLearning Objective: 24-1Section: 24.1Topic: Call payoff

24-62


61. You sold one call option contract with a strike price of $55 when the option was quoted at $0.80. The option expires today when the value of the underlying stock is $53.70. Ignoring trading costs and taxes, what is the net profit or loss on this investment? A. -$250B. -$80C. $0D. $50E. $80

Total profit = $0.80 100 1 = $80. The call finished out-of-the-money.


62. You sold three $35 call option contracts at a quoted price of $1.40. What is your net profit or loss on this investment if the price of the underlying asset is $36.70 on the option expiration date? A. -$510B. -$90C. $90D. $510E. $930

Total loss = ($1.40 + $35 - $36.70) 100 3 = -$90


24-63


63. You wrote eight call option contracts with a strike price of $42.50 at a call price of $1.35 per share. What is your net gain or loss on this investment if the price of the underlying stock is $40.30 per share on the option expiration date? A. -$2,840B. -$1,760C. -$1,080D. $1,080E. $1,760

Net profit = $1.35 100 8 = $1,080. The call finished out-of-the-money.


64. The market price of Southern Press stock has been relatively volatile and you think this volatility will continue for a couple more months. Thus, you decide to purchase a two-month European call option on this stock with a strike price of $45 and an option price of $2.20. You also purchase a two-month European put option on the stock with a strike price of $45 and an option price of $0.30. What will be your net profit or loss on these option positions if the stock price is $48 on the day the options expire? Ignore trading costs and taxes. A. -$30B. $50C. $80D. $270E. $330

Net profit = [-$2.20 + $48 - $45) 100] + [-$0.30 100] = $50

AACSB: AnalyticBloom's: ApplicationDifficulty: BasicLearning Objective: 24-1Section: 24.1Topic: Option payoffs

24-64


65. Several rumors concerning Value Rite stock are causing the market price of the stock to be quite volatile. Given this situation, you decide to buy both a one-month European $25 put and a one-month European $25 call on this stock. The call price per share is $0.60 and the put price per share is $2.10. What will be your net profit or loss on these option positions if the stock price is $18 on the day the options expire? Ignore trading costs and taxes. A. -$210B. -$150C. -$60D. $430E. $490

Net profit = [-$0.60 100] + [(-$2.10 + $25 - $18) 100] = $430

AACSB: AnalyticBloom's: ApplicationDifficulty: BasicLearning Objective: 24-1Section: 24.1Topic: Option payoffs

66. Three months ago, Central Supply stock was selling for $51.40 a share. At that time, you purchased five put options on the stock with a strike price of $50 per share and an option price of $0.60 per share. The option expires today when the value of the stock is $42.70 per share. What is your net profit or loss on this investment? Ignore trading costs and taxes. A. -$1,300B. -$1,000C. -$300D. $3,350E. $3,650

Net profit = (-$0.60 - $42.70 + $50) 100 5 = $3,350

AACSB: AnalyticBloom's: ApplicationDifficulty: BasicLearning Objective: 24-1Section: 24.1Topic: Put payoff

24-65


67. You wrote two put options on Xylo stock with an exercise price of $30 per share and an option price of $1.05 per share. Today, the contracts expire and the stock is selling for $31.15 a share. What is your net profit or loss on this investment? Ignore trading costs and taxes. A. -$115B. -$105C. $20D. $105E. $210

Net profit = $1.05 100 2 = $210. The put finished out of the money.


68. You sold ten put contracts on Cross Town Bank stock at an option price per share of $0.85. The options have an exercise price of $37.50 per share. The options were exercised today when the stock price was $34 a share. What is your net profit or loss on this investment assuming that you closed out your positions at a stock price of $34? Ignore transaction costs and taxes. A. -$3,500B. -$2,650C. $1,800D. $850E. $3,500

Net loss = ($0.85 - $37.50 + $34) 100 10 = -$2,650


24-66


69. You own eight call option contracts on Swift Water Tours stock with a strike price of $15. When you purchased the shares the option price was $0.30 and the stock price was $15.25. What is the total intrinsic value of these options if the stock is currently selling for $16.08 a share? A. -$83B. -$1.08C. $0D. $108E. $864

Intrinsic value = ($16.08 - $15) 100 8 = $864

AACSB: AnalyticBloom's: ApplicationDifficulty: BasicLearning Objective: 24-2Section: 24.2Topic: Intrinsic value

70. You recently purchased three put option contracts on Guillepsi stock with an exercise price of $42.50. What is the total intrinsic value of these contracts if the stock is currently selling for $43.70 a share? A. -$360B. -$120C. $0D. $120E. $360

The intrinsic value is equal to zero because the puts are out-of-the-money.


24-67


71. Last week, you purchased a call option on Edgewater stock with a strike price of $40. The stock price was $39.80 and the option price was $0.45 at that time. What is the intrinsic value per share if the stock is currently priced at $39.10? A. -$90B. -$70C. $0D. $70E. $90

The intrinsic value is zero because the call is currently out-of-the-money.


72. Three weeks ago, you purchased a June $30 put option on Leeper Metals stock at an option price of $1.80. The market price of the stock three weeks ago was $30.60. Today, the stock is selling at $29.80 a share. What is the intrinsic value of your put contract? A. -$100B. -$20C. $0D. $20E. $60

Contract intrinsic value = ($30 - $29.80) 100 = $20


24-68


73. This morning, you purchased a call option on Schoolhouse Supply Co. stock that expires in one year. The exercise price is $40. The current price of the stock is $43.40 and the risk-free rate of return is 3.6 percent. Assume the option will finish in the money. What is the current value of the call option? A. $0B. $1.49C. $3.97D. $4.79E. $5.46

C0 = $43.40 - [$40/(1 + 0.036)] = $4.79

AACSB: AnalyticBloom's: ApplicationDifficulty: BasicLearning Objective: 24-1Section: 24.2Topic: Call value

74. You currently own a one-year call option on Rail Company, Inc., stock. The current stock price is $51.80 and the risk-free rate of return is 4.25 percent. Your option has a strike price of $50 and you assume the option will finish in the money. What is the current value of your call option? A. $1.20B. $2.59C. $3.84D. $5.13E. $7.27

C0 = $51.80 - [$50/(1 + 0.0425) = $3.84


24-69


75. The common stock of Hazelton Refiners is selling for $72.30 a share. U.S. Treasury bills are currently yielding 4.8 percent. What is the current value of a one-year call option on this stock if the exercise price is $70 and you assume the option will finish in the money? A. $0B. $1.20C. $3.00D. $4.20E. $5.51

C0 = $72.30 - [$70/(1 + 0.048)] = $5.51


76. The common stock of Westover Foods is currently priced at $27.90 a share. One year from now, the stock price is expected to be either $25 or $30 a share. The risk-free rate of return is 4.2 percent. What is the current value of one call option on this stock if the exercise price is $27.50? A. $0B. $1.95C. $2.00D. $3.80E. $4.00

Number of options needed = ($30 - $25)/(2.50 - 0) = 2$27.90 = 2 C0 + [$25/(1 + 0.042)]; C0 = $1.95

AACSB: AnalyticBloom's: AnalysisDifficulty: BasicLearning Objective: 24-2Section: 24.3Topic: Call value

24-70


77. You own one call option with an exercise price of $40 on S'more Good stock. The stock is currently selling for $41 a share but is expected to sell for either $37 or $43 a share in one year. The risk-free rate of return is 4.25 percent and the inflation rate is 3.6 percent. What is the current call option price if the option expires one year from now? A. $0.55B. $0.69C. $1.37D. $2.43E. $2.75

Number of options needed = ($43 - $37)/(3 - 0) = 2$41 = 2C0 + [$37/(1 + 0.0425)]; C0 = $2.75

AACSB: AnalyticBloom's: AnalysisDifficulty: BasicLearning Objective: 24-2Section: 24.3Topic: Call value

78. The assets of Uptown Stores are currently worth $136,400. These assets are expected to be worth either $120,000 or $150,000 one year from now. The company has a pure discount bond outstanding with a $130,000 face value and a maturity date of one year. The risk-free rate is 4.3 percent. What is the value of the equity in this firm? A. $11,920B. $14,232C. $19,507D. $21,347E. $26,408

Number of options needed = ($150,000 - $120,000)/($20,000 - $0) = 1.5$136,400 = 1.5C0 + ($120,000/(1 + 0.043); C0 = $14,232

AACSB: AnalyticBloom's: AnalysisDifficulty: BasicLearning Objective: 24-4Section: 24.5Topic: Equity as a call option

24-71


79. Electronic Importers has a pure discount bond with a face value of $25,000 that matures in one year. The risk-free rate of return is 3.8 percent. The assets of the business are expected to be worth either $23,000 or $35,000 in one year. Currently, these assets are worth $27,500. What is the current value of the bond? A. $17,746B. $19,207C. $20,222D. $22,549E. $23,048

Number of options needed = ($35,000 - $23,000)/($10,000 - $0) = 1.2$27,500 = 1.2C0 + ($23,000/(1 + 0.038); C0 = $4,451.67Value of debt = $27,500 - $4,451.67 = $23,048


80. The Glass House has total assets currently valued at $17,200. These assets are expected to increase in value to either $18,000 or $21,000 by next year. The company has a pure discount bond outstanding with a face value of $20,000. This bond matures in one year. Currently, U.S. Treasury bills are yielding 5.4 percent. What is the value of the equity in this firm? A. -$3,000.00B. -$908.00C. $0D. $40.73E. $122.20

Number of options needed = ($21,000 - $18,000)/($1,000 - $0) = 3$17,200 = 3C0 + ($18,000/(1 + 0.054); C0 = $40.73


24-72


81. You are considering a project that has been assigned a discount rate of 14 percent. If you start the project today, you will incur an initial cost of $8,500 and will receive cash inflows of $5,550 a year for two years. If you wait one year to start the project, the initial cost will rise to $9,200 and the cash flows will increase to $5,800 a year for two years. What is the value of the option to wait? A. -$331.40B. -$194.46C. $228.51D. $230.49E. $334.68

Value of option to wait = $307.57 - $638.97 = -$331.40

AACSB: AnalyticBloom's: AnalysisDifficulty: BasicLearning Objective: 24-5Section: 24.6Topic: Option to wait

24-73


82. Southern Shores is considering a project that has an initial cost today of $12,500. The project has a two-year life with cash inflows of $7,500 a year. Should the firm opt to wait one year to commence this project, the initial cost will increase by 5 percent and the cash inflows will increase to $8,500 a year. What is the value of the option to wait if the applicable discount rate is 14 percent? A. $614.52B. $721.56C. $914.62D. $982.67E. $1,021.66

Value of option to wait = $871.61 - (-$150.05) = $914.62

AACSB: AnalyticBloom's: AnalysisDifficulty: BasicLearning Objective: 24-5Section: 24.6Topic: Option to wait

24-74


83. Western Industrial Products is considering a project with a four-year life and an initial cost of $212,000. The discount rate for the project is 16 percent. The firm expects to sell 9,600 units on the last day of each year. The cash flow per unit is $50. The firm will have the option to abandon this project at the end of year one (after year one's sales) at which time the project's assets could be sold for an estimated $125,000. The firm should abandon the project at the end of year one if the expected level of annual sales, starting with year 2, falls to _____ units or less. Ignore taxes. A. 1,113 unitsB. 1,267 unitsC. 1,922 unitsD. 2,034 unitsE. 2,108 units

AACSB: AnalyticBloom's: AnalysisDifficulty: IntermediateLearning Objective: 24-5Section: 24.6Topic: Option to abandon

24-75


84. Dressler Technologies is considering a project with a 3-year life and an initial cost of $85,000. The discount rate for the project is 14.5 percent. The firm expects to sell 1,200 units on the last day of each year. The cash flow per unit is $32. The firm will have the option to abandon this project at the end two years (after year 2 sales) at which time the project's assets could be sold for an estimated $30,000. The firm's managers are interested in knowing how the project will perform if the sales forecast for year 3 of the project is revised such that there is a 50/50 chance that the sales will be either 1,000 or 1,400 units a year. What is the net present value of this project at time zero given the current sales forecasts? A. -$3,474B. -$2,526C. $4,191D. $6,192E. $6,887

Level to abandon = $30,000 = $32Q/1.145; Q = 1,073.44 units

At 1,000 units, you will abandon the project and receive $30,000 at the end of year 2.At 1,400 units, you will continue the project and the project will have a value at the end of year 2 of:

NPVEnd of year 2 = (1,400 $32)/1.145 = $39,126.64

The NPV of this project today is:

AACSB: AnalyticBloom's: AnalysisDifficulty: ChallengeLearning Objective: 24-5Section: 24.6Topic: Option to abandon

24-76


85. Patience is reviewing a project with projected sales of 4,200 units a year, a cash flow of $28 a unit, and a four-year project life. Assume all operating cash flows occur on the last day of each year. The initial cost of the project is $247,000. The relevant discount rate is 13 percent. Patience has the option to abandon the project after two years at which time she feels she could sell the project's assets for $110,000. At what level of annual sales, starting in year 3, should she be willing to abandon this project? A. 2,119 unitsB. 2,355 unitsC. 2,367 unitsD. 2,516 unitsE. 2,667 units

AACSB: AnalyticBloom's: AnalysisDifficulty: IntermediateLearning Objective: 24-5Section: 24.6Topic: Option to abandon

86. You own a convertible bond with a face value of $1,000 and a market value of $1,034. The bond can be converted into 14 shares of stock. What is the conversion price? A. $71.43B. $72.00C. $72.67D. $73.86E. $74.33

Conversion price = $1,000/14 = $71.43

AACSB: AnalyticBloom's: ApplicationDifficulty: BasicLearning Objective: 24-6Section: 24.7Topic: Convertible bonds

24-77


87. You own nine convertible bonds. These bonds have a 7 percent coupon, a $1,000 face value, and mature in 6 years. The bonds are convertible into shares of common stock at a conversion price of $25. How many shares of stock will you receive if you convert all of your bonds? A. 285B. 300C. 350D. 360E. 400

Number of shares = ($1,000/$25) 9 = 360 shares


88. A convertible bond has a face value of $5,000 and a conversion price of $80. The bond has a 6 percent coupon, pays interest semi-annually, and matures in 12 years. Similar bonds are yielding 7.5 percent. The current price of the stock is $41.20 per share. What is the conversion value of this bond? A. $1,680B. $2,415C. $2,575D. $4,651E. $5,000

Conversion value = ($5,000/$80) $41.20 = $2,575


24-78


89. A convertible bond has a face value of $1,000 and a conversion price of $12.50. The bond has a 6 percent coupon, pays interest semi-annually, and matures in 12 years. Similar bonds are yielding 9 percent. The current price of the stock is $13.40 per share. What is the straight bond value? A. $782.57B. $781.82C. $827.74D. $832.09E. $843.47


24-79


90. Kurt owns a convertible bond that matures in three years. The bond has a 7.5 percent coupon and pays interest semi-annually. The face value of the bond is $1,000 and the conversion price is $25. Similar bonds have a market return of 9.25 percent. The current price of the stock is $26.50 per share. What is the straight bond value? A. $948.20B. $955.05C. $972.80D. $987.78E. $991.15


91. Lucinda owns a convertible bond that matures in six years. The bond has a 9 percent coupon and pays interest annually. The face value of the bond is $1,000 and the conversion price is $22. Similar bonds have a market return of 8.75 percent. The current price of the stock is $21.60 per share. What is the conversion value of this bond? A. $835.60B. $848.40C. $942.11D. $981.82E. $1,000.00

Conversion value = ($1,000/$22) $21.60 = $981.82


24-80


Essay Questions

92. Circle Stores stock is priced at $28 a share. A $40 call on this stock has five months until expiration and a call price of $0.15. Why would an investor purchase a call that is so far out of the money?

Students should discuss the impact of time to maturity on option values. They should point out that with five months left to maturity, there is a chance that the option could finish in the money, especially if the stock price is volatile. A low option price per share such as $0.15, means that an investment in an option contract will be quite inexpensive. However, investors apparently don't have a strong feeling the stock will reach $40 by share by the expiration date, or the option price would be much higher.

Feedback: Refer to section 24.3

AACSB: Reflective thinkingBloom's: AnalysisDifficulty: BasicLearning Objective: 24-2Section: 24.3Topic: Option value

93. What are the basic similarities and basic differences between warrants and call options?

Both warrants and call options grant their owners the right to purchase shares of stock at a prespecified price. Warrants are issued by corporations while call options are issued by investors. Warrants are usually attached to privately placed loans or bonds. Warrants can be detached from the debt security and traded separately. Call options are traded separately from the underlying stock.


AACSB: Reflective thinkingBloom's: KnowledgeDifficulty: BasicLearning Objective: 24-1 and 24-6Section: 24.7Topic: Warrants, calls, and convertibles

24-81


94. What are the upper and lower bounds for an American call option? Explain what would happen in each case if the bound was violated.

The upper bound on a call is the stock price. If the call price exceeded the stock price, you would be paying more for the option to buy an asset than the asset itself costs. The lower bounds are: C 0 if S - E < 0 and C (S - E) if (S - E) 0. In the first case, if the exercise price exceeds the stock price, the call is out of the money and it will either be worthless or have some time value. In the second case, if the call is in the money, the call must be worth at least the difference between the asset's value and the exercise price. If the call was worth less than this value, rational investors would purchase calls, immediately exercise them, and then sell the stock at the current price, completing an arbitrage.


AACSB: Reflective thinkingBloom's: AnalysisDifficulty: IntermediateLearning Objective: 24-2Section: 24.2Topic: Option pricing bounds

95. Explain the rationale behind the idea that equity is a call option on a firm's assets. When would a shareholder allow this call to expire?

The analogy only works for leveraged firms. At maturity of the firm's debt, the stockholders have the option to either pay the creditors the face value of the debt or turn the firm's assets over to the firm's creditors. If the firm's assets are worth less than the face value of the debt, the stockholders will not exercise the call, that is, they will let the creditors have the assets and the firm will be liquidated.


AACSB: Reflective thinkingBloom's: ComprehensionDifficulty: BasicLearning Objective: 24-4Section: 24.5Topic: Equity as a call option

24-82


96. Call options are frequently attached to bonds, making them callable at the option of the issuer. Consider a firm that just issued two sets of bonds: One is callable, has a 7 percent coupon rate, 15 years to maturity, and cannot be called during the first three years; the second is noncallable, has a 7 percent coupon rate, 15 years to maturity, and is identical to the first bond in every way except for the call option. Suppose the noncallable bonds are sold for $1,000 each. Will the callable bonds sell for more or less than $1,000? Who "purchases" the option in this case and who "sells" it?

The callable bond will sell for less than par. The bond issuer buys the option and the bondholder writes it. If the callable bonds sell for $950 each, the call option will be worth the difference between the two bond prices, or $50 per bond.


AACSB: Reflective thinkingBloom's: ComprehensionDifficulty: BasicLearning Objective: 24-6Section: 24.7Topic: Callable bonds

97. Explain how the floor and the ceiling prices for a convertible bond are determined.

The floor, or minimum, value of a bond is the bond's straight bond value. The ceiling, or maximum, value is theoretically unlimited since there is no upper limit on a bond's conversion value.


AACSB: Reflective thinkingBloom's: KnowledgeDifficulty: BasicLearning Objective: 24-6Section: 24.7Topic: Convertible bonds


24-83


98. T-bills currently yield 6.3 percent. Stock in Pinta Manufacturing is currently selling for $46 per share. There is no possibility that the stock will be worth less than $39 per share in one year. What is the value of a call option on this stock if the exercise price is $22 per share? A. $21.40B. $22.00C. $24.00D. $25.30E. $25.70

C0 = $46 - [$22/(1 + 0.063)] = $25.30

AACSB: AnalyticBloom's: ApplicationDifficulty: BasicEOC #: 24-1Learning Objective: 24-2Section: 24.2Topic: Option value

99. The price of Time Squared Corp. stock will be either $80 or $95 at the end of the year. Call options are available with one year to expiration. T-bills currently yield 6 percent and the current price of Time Squared Corp. stock is $85. What is the value of a call option if the exercise price is $75 per share? A. $14.25B. $15.06C. $18.78D. $24.25E. $25.06

C0 = $85 - [$75/(1 + 0.06)] = $14.25


24-84


100. The price of Dimension, Inc. stock will be either $65 or $85 at the end of the year. Call options are available with one year to expiration. T-bills currently yield 5 percent. Suppose the current price of Dimension stock is $70. What is the value of the call option if the exercise price is $70 per share? A. $6.07B. $8.48C. $11.58D. $15.39E. $17.62

$70 = [($85 - $65)/($85 - $70)]C0 + $65/(1 + 0.05); C0 = $6.07


101. Rackin Pinion Corporation's assets are currently worth $1,260. In one year, they will be worth either $1,200 of $1,610. The risk-free interest rate is 5 percent. Suppose Rackin Pinion has an outstanding debt issue with a face value of $1,200. What is the current value of the firm's debt? A. $60.00B. $114.14C. $1,142.86D. $1,263.19E. $1,504.20

E0 = $1,260 - [$1,200/(1 + 0.05)] = $117.14D0 = $1,260 - $117.14 = $1,142.86

AACSB: AnalyticBloom's: AnalysisDifficulty: BasicEOC #: 24-7Learning Objective: 24-4Section: 24.5Topic: Equity as an option

24-85


102. Buckeye Industries has a bond issue with a face value of $1,000 that is coming due in one year. The value of Buckeye's assets is currently $1,200. Jim Tressell, the CEO, believes that the assets in the firm will be worth either $600 or $1,700 in a year. The going rate on one-year T-bills is 6 percent. What is the current value of the firm's debt? A. $601.18B. $796.57C. $844.24D. $878.78E. $911.03

$1,200 = [($1,700 - $600)/($1,700 - $1,000)] E0 + [$600/(1 + 0.06)] = $403.43D0 = $1,200 - $403.43 = $796.57

AACSB: AnalyticBloom's: AnalysisDifficulty: BasicEOC #: 24-8Learning Objective: 24-4Section: 24.5Topic: Equity as an option

103. A $1,000 convertible debenture has a conversion price for common stock of $85 per share. The common stock is selling at $92 a share. What is the conversion value of this bond? A. $920.00B. $923.91C. $1,000.00D. $1,082.35E. $1,092.00

Conversion value = ($1,000/$85)($92) = $1,082.35

AACSB: AnalyticBloom's: ApplicationDifficulty: BasicEOC #: 24-9Learning Objective: 24-6Section: 24.7Topic: Conversion value

24-86


104. A bond with 10 detachable warrants has just been offered for sale at $1,000. The bond matures in 15 years and has an annual coupon of $80. Each warrant gives the owner the right to purchase two shares of stock in the company at $14 per share. Ordinary bonds (with no warrants) of similar quality are priced to yield 11 percent. What is the value of one warrant? A. $7.00B. $13.58C. $14.00D. $16.67E. $21.57

Total warrant value = $1,000 - $784.27 = $215.73Price per warrant = $215.73/10 = $21.57

AACSB: AnalyticBloom's: ApplicationDifficulty: BasicEOC #: 24-12Learning Objective: 24-6Section: 24.7Topic: Warrant values

24-87


105. Your company is deciding when to invest in a new machine. The new machine will increase cash flow by $240,000 per year. You believe the technology used in the machine has a 10-year life; in other words, no matter when you purchase the machine, it will be obsolete 10 years from today. The machine is currently priced at $1,200,000. The cost of the machine will decline by $120,000 per year until it reaches $720,000, where it will remain. Your required return is 8 percent. In which year should you purchase the machine? A. Year 0B. Year 1C. Year 2D. Year 3E. Year 4

The company should purchase the machine today when the NPV is the highest.

AACSB: AnalyticBloom's: AnalysisDifficulty: BasicEOC #: 24-13Learning Objective: 24-5Section: 24.6Topic: Option to wait

24-88


106. We are examining a new project. We expect to sell 9,000 units per year at $45 net cash flow apiece for the next 20 years. In other words, the annual operating cash flow is projected to be $45 9,000 = $405,000. The relevant discount rate is 14 percent, and the initial investment required is $1,730,000. After the first year, the project can be dismantled and sold for $1,350,000. If expected sales are revised based on the first year's performance, it would make sense to abandon the investment if the sales are less than which of the following number of units? A. 4,580 unitsB. 4,620 unitsC. 4,750 unitsD. 4,810 unitsE. 5,020 units

$1,350,000 = ($45)(Q)(PVIFA14%, 19); Q = 4,580 unitsAbandon the project if Q < 4,580 units because the NPV of abandoning the project is greater than the NPV of the future cash flows.

AACSB: AnalyticBloom's: AnalysisDifficulty: IntermediateEOC #: 24-14Learning Objective: 24-5Section: 24.6Topic: Abandonment value

24-89


107. We are examining a new project. We expect to sell 8,000 units per year at $80 net cash flow apiece for the next 15 years. In other words, the annual operating cash flow is projected to be $80 8,000 = $640,000. The relevant discount rate is 16 percent, and the initial investment required is $2,740,000. The project can be dismantled after the first year and sold for $2,130,000. Suppose you think it is likely that expected sales will be revised upward to 9,600 units if the first year is a success and revised downward to 3,000 units if the first year is not a success. Suppose the scale of the project can be doubled in one year in the sense that twice as many units can be produced and sold. Naturally, expansion would be desirable only if the project is a success. This implies that if the project is a success, projected sales after expansion will be 19,200. Assume that success and failure are equally likely. Note that abandonment is still an option if the project is a failure. What is the value of the option to expand? A. $1,774,328B. $1,809,941C. $1,828,406D. $1,848,920E. $1,872,312

The gain from the option to expand is the present value of the cash flows from the additional units sold, so:Gain from option to expand = $80(9,600)(PVIFA16%, 14) = $4,199,062.39We need to find the value of the option to expand times the likelihood of expansion. We also need to find the value of the option to expand today, so:Option value = (0.50)($4,199,062.39)/1.16 = $1,809,941

AACSB: AnalyticBloom's: EvaluationDifficulty: IntermediateEOC #: 24-16Learning Objective: 24-5Section: 24.6Topic: Abandonment and expansion

24-90