Question 1

What are agency costs in corporate finance, and how do they relate to options?

Accepted Answer

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Question 2

Trerec Co. is a privately-owned oil drilling and refinery company with a significant amount of debt. Most of the company's cash flows come from the financially stable refinery unit of the business. With only the assets in place, the company is very likely to avoid financial distress for the foreseeable future. Avoiding financial distress is very important to the owners, who founded the company. The company is considering a new positive-NPV oil drilling project. Because of the nature of oil prices, the project is very risky. At any oil price above $115, the project would add value to the company. However, if oil prices were to fall below $95 the losses could push the entire business into financial distress. Assume the risk-free interest rate is 0 percent. Which of the following strategies would allow the firm to pursue the positive NPV project while hedging the oil price risk?

Accepted Answer

Purchasing put options with a strike price of $130 would allow the firm to hedge against the risk of falling oil prices. If oil prices do fall below $95, the firm can exercise the option and sell the oil at the higher strike price of $130, reducing the impact of the losses on the new drilling project. Selling call options, as in option B, would expose the firm to unlimited losses if oil prices rise above $130. Purchasing call options, as in option A, would provide some protection against rising oil prices but would not hedge against the risk of falling oil prices. Selling put options, as in option D, would expose the firm to unlimited losses if oil prices fall below $130.

Question 3

Neunlay Inc., is a manufacturer of residential air conditioning equipment. Air conditioning equipment requires a lot of copper. In six months the company will purchase its copper supply for the next two years. Management is very concerned about the volatility of copper prices. Assume the risk-free rate of interest is 0 percent. Which of the following transactions will ensure the company does not have to pay more than $6,100 per ton of copper six months from now?

Accepted Answer

Purchasing a call option allows Neunlay Inc. to buy copper at a set price ($6,000 per ton) regardless of how high the market price goes. The premium of $100 per ton is the cost for this right, making the maximum effective price $6,100 per ton.

Question 4

Consider a corn farmer who expects to produce 55,000 bushels of corn at the end of this season. To hedge the risk associated with corn prices, the farmer purchases put options to cover his entire crop. The put options have a strike price of $8.50 per bushel and a premium of $0.40 per bushel. He also sells an equal amount of call options with a strike price of $8.50 per bushel and a premium of $0.53 a bushel. Which of the following statements is correct?

Accepted Answer

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Question 5

Consider a lease agreement recently offered by a car dealership. The agreement gives the customer the right to use a new SUV for four years in exchange for payments of $650 per month. At the end of the lease, the customer can choose to purchase the SUV for $18,000. What sort of option does this resemble?

Accepted Answer

This resembles a call option on the SUV with a strike price of $18,000 because at the end of the lease, the customer has the option to purchase the SUV for $18,000, which is the strike price. The customer can choose to exercise this option or not, depending on the market value of the SUV at the time.

Question 6

When we consider the value of a call option that has not expired, we must:

Accepted Answer

When considering the value of a call option that has not expired, we must compare the current value of the underlying asset with the present value of the exercise price, discounted at the risk-free rate. This is because the option holder has the right to buy the underlying asset at the exercise price, and this value needs to be discounted to account for the time value of money. Option A is incorrect because it mentions the present value of the cash flow by underlying asset, which is not relevant to the value of the call option. Option C is incorrect because it mentions the nominal rate, which does not account for inflation, and Option D is incorrect because it mentions compounding, which is not relevant to the present value calculation.

Question 7

Name the factors that affect the value of a call option and explain the direction of the effects.

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Question 8

You're brought in to consult on a project for Sanpharm Corp., which is considering whether or not to build a new high-tech manufacturing facility. Give four examples of real options that you would consider when evaluating the project.

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Question 9

Calculate the value of put option with the given information. Value of the call option is $6.2, Exercise price is $58, risk-free rate of interest is 5.5%, time before the option expires is one year and the current value of underlying assets is $52. Consider the value for 'e' as 2.71828.

Accepted Answer

Using the put-call parity formula: P = C + X/(e^(rT)) - S, where P is the put option price, C is the call option price, X is the exercise price, r is the risk-free rate, T is the time to expiration, and S is the current stock price. Substituting the given values, P = 6.2 + 58/(2.71828^(0.055)) - 52 = $9.10.

Question 10

Which of the following is true of a call option?

Accepted Answer

The value of a call option prior to expiration includes not only its intrinsic value (the value if exercised immediately) but also its time value, which accounts for the potential of the underlying asset's price to increase before expiration. This means the option's market price can be higher than its immediate exercise value, making choice C correct. Choices A, B, and D are incorrect because a call option's value can indeed be $0 or more (not always less), it can be lower than the value of the underlying asset (since it might have no intrinsic value if out of the money), and it is the buyer, not the seller, who is protected from price volatility through the right to buy at a predetermined price.

Question 11

Describe the difference between American call options and American put options. Include in your answer a description of the option premium, the option strike price, the expiration date, and the payoff function.

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Quiz 20: Options and Corporate Finance