Test bank corporate finance 8e ros chap014

Chapter 014 Options and Corporate Finance Multiple Choice Questions A contract that grants its owner the right to buy or sell a specified asset at an agreed-upon price on or before a given date is called a(n): A option b invoice c exercise d swap e straddle SECTION: 14.1 TOPIC: OPTION TYPE: DEFINITIONS Exercising an option is the act of: a buying the right to either buy or sell an asset at a specified price for a stated period of time b purposely allowing an option to expire C buying or selling the underlying asset via the option contract d purchasing a second option to exactly offset an option which you currently own e purchasing shares of stock in the open market to offset an option position SECTION: 14.1 TOPIC: EXERCISING THE OPTION TYPE: DEFINITIONS The fixed price in an option contract at which the holder can buy or sell the underlying asset is called the option's: a opening price b intrinsic value C strike price d market price e time value SECTION: 14.1 TOPIC: STRIKE PRICE TYPE: DEFINITIONS 14-1 Chapter 014 Options and Corporate Finance The last day on which an option can be exercised is the _ date a ex-payment b ex-option c opening D expiration e intrinsic SECTION: 14.1 TOPIC: EXPIRATION DATE TYPE: DEFINITIONS An option that may be exercised at any time before it expires is called a(n) _ option a flexible b portable c daily d European E American SECTION: 14.1 TOPIC: AMERICAN OPTIONS TYPE: DEFINITIONS An option that may be exercised only on the expiration date is called a(n) _ option A European b American c inflexible d dated e pointed SECTION: 14.1 TOPIC: EUROPEAN OPTIONS TYPE: DEFINITIONS 14-2 Chapter 014 Options and Corporate Finance A call option is the _ an asset at a fixed price during a stated period of time a right to sell B right to buy c obligation to sell d obligation to buy e obligation to trade SECTION: 14.1 TOPIC: CALL OPTION TYPE: DEFINITIONS A put option is the _ an asset at a fixed price during a stated period of time A right to sell b right to buy c obligation to sell d obligation to buy e obligation to trade SECTION: 14.1 TOPIC: PUT OPTION TYPE: DEFINITIONS The value of an option if it were about to expire is called the _ value a strike b upper c deadline d time E intrinsic SECTION: 14.2 TOPIC: INTRINSIC VALUE TYPE: DEFINITIONS 14-3 Chapter 014 Options and Corporate Finance 10 The right granted to a company employee which enables that employee to buy shares of stock in the company at a set price for a fixed period of time is called a(n): A employee stock option b company bonus option c employee grant d employee exercise option e company benefits option SECTION: 14.6 TOPIC: EMPLOYEE STOCK OPTION TYPE: DEFINITIONS 11 An option based on an underlying asset such as a building or land is called a _ option a financial b liquid c fixed D real e tangible SECTION: 14.4 TOPIC: REAL OPTION TYPE: DEFINITIONS 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 SECTION: 14.6 TOPIC: INVESTMENT TIMING DECISION TYPE: DEFINITIONS 14-4 Chapter 014 Options and Corporate Finance 13 Managerial options are: a choices managers can make given today's circumstances b various rights that a manager has today given the calls owned by the firm c choices that are independent of all future events D opportunities that managers can exploit if certain things happen in the future e various methods a manager can utilize to produce a specific product SECTION: 14.6 TOPIC: MANAGERIAL OPTIONS TYPE: DEFINITIONS 14 When a person takes into account the managerial options implicit in a project, that person is conducting: a financial planning B contingency planning c asset management reviews d a prospective evaluation e strategic evaluations SECTION: 14.6 TOPIC: CONTINGENCY PLANNING TYPE: DEFINITIONS 15 Options for future, related business products or strategies are referred to as _ options a financial B strategic c expansion d real e managerial SECTION: 14.6 TOPIC: STRATEGIC OPTIONS TYPE: DEFINITIONS 14-5 Chapter 014 Options and Corporate Finance 16 A security that gives the holder the right to purchase shares of stock at a fixed price over a specified period of time is called a(n): a convertible bond B warrant c initial public offering d seasoned equity offering e put SECTION: 14.7 TOPIC: WARRANT TYPE: DEFINITIONS 17 A bond that can be exchanged for a fixed number of shares of stock over a specified period of time is called a _ bond a secured b warranted C convertible d junk e callable SECTION: 14.7 TOPIC: CONVERTIBLE BOND TYPE: DEFINITIONS 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 SECTION: 14.7 TOPIC: CONVERSION PRICE TYPE: DEFINITIONS 14-6 Chapter 014 Options and Corporate Finance 19 The number of shares of stock received for each bond that is converted is called the: a conversion premium b straight bond value c conversion value d conversion price E conversion ratio SECTION: 14.7 TOPIC: CONVERSION RATIO TYPE: DEFINITIONS 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 SECTION: 14.7 TOPIC: CONVERSION PREMIUM TYPE: DEFINITIONS 21 The value a convertible bond would have if it could not be converted into common stock is called the: a conversion premium B straight bond value c conversion value d conversion price e conversion ratio SECTION: 14.7 TOPIC: STRAIGHT BOND VALUE TYPE: DEFINITIONS 14-7 Chapter 014 Options and Corporate Finance 22 The value a convertible bond would have if it were to be immediately converted into common stock is called the: a conversion premium b straight bond value C conversion value d conversion price e conversion ratio SECTION: 14.7 TOPIC: CONVERSION VALUE TYPE: DEFINITIONS 23 Which one of the following statements correctly describes your situation as the holder of an American 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 SECTION: 14.1 TOPIC: AMERICAN OPTION TYPE: CONCEPTS 24 Max opted to exercise his July option on June 11 and as a result received $4,600 in cash Max must have owned a (an): a warrant b American call C American put d European call e European put SECTION: 14.1 TOPIC: AMERICAN OPTION TYPE: CONCEPTS 14-8 Chapter 014 Options and Corporate Finance 25 Maria opted to exercise her December option at the end of October and paid $2,600 at that time to acquire 100 shares of stock Maria probably owned an: A American call b American put c European call d European put e European convertible bond SECTION: 14.1 TOPIC: AMERICAN OPTION TYPE: CONCEPTS 26 Jessica owns an option which gives her the right to purchase shares of TRU-LUV stock at a price of $57.50 a share Currently, TRU-LUV is selling for $62.60 Jessica would like to realize her profits but is not permitted to exercise the option for another three weeks Jessica must own a(n): a warrant b American call c American put D European call e European put SECTION: 14.1 TOPIC: EUROPEAN OPTION TYPE: CONCEPTS 14-9 Chapter 014 Options and Corporate Finance 27 What is the key 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 each month 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 SECTION: 14.1 TOPIC: EUROPEAN OPTION TYPE: CONCEPTS 14-10 Chapter 014 Options and Corporate Finance 72 Three weeks ago, you purchased a November 25 put option on Kepner stock at an option price of $1.20 The market price of the stock three weeks ago was $24.30 Today, the stock is selling at $24.80 a share and the November 25 put is priced at $.60 What is the intrinsic value of your put contract? a $100 b $20 c $0 D $20 e $60 Contract intrinsic value = ($25.00 $24.80) 100 = $20 AACSB TOPIC: ANALYTIC SECTION: 14.2 TOPIC: INTRINSIC VALUE TYPE: PROBLEMS 73 You own a call option on Beaker Glass stock that expires in one year The exercise price is $35 The current price of the stock is $38.20 and the risk-free rate of return is 4.7 percent Assume the option will finish in the money What is the current value of the call option? a $0 b $1.49 c $3.97 D $4.77 e $5.46 C0 = $38.20 [$35 (1 + 047)] = $4.77 AACSB TOPIC: ANALYTIC SECTION: 14.2 TOPIC: CALL OPTION VALUE TYPE: PROBLEMS 14-34 Chapter 014 Options and Corporate Finance 74 You currently own a one-year call option on Caspian Way stock The current stock price is $38.70 and the risk-free rate of return is 3.85 percent Your option has a strike price of $37.50 and you assume the option will finish in the money What is the current value of your call option? a $1.20 B $2.59 c $3.07 d $5.13 e $7.27 C0 = $38.70 [$37.50 (1 + 0385)] = $2.59 AACSB TOPIC: ANALYTIC SECTION: 14.2 TOPIC: CALL OPTION VALUE TYPE: PROBLEMS 75 The common stock of New Horizon Homes is selling for $68.70 a share U.S Treasury bills are currently yielding 4.65 percent What is the current value of a one-year call option on this stock if the exercise price is $67.50 and you assume the option will finish in the money? a $0 b $1.20 c $3.00 D $4.20 e $5.40 C0 = $68.70 [$67.50 (1 + 0465)] = $4.20 AACSB TOPIC: ANALYTIC SECTION: 14.2 TOPIC: CALL OPTION VALUE TYPE: PROBLEMS 14-35 Chapter 014 Options and Corporate Finance 76 The common stock of Trynor's, Inc is currently priced at $37.90 a share One year from now, the stock price is expected to be either $38 or $43 a share The risk-free rate of return is 3.5 percent What is the current value of one call option on this stock if the exercise price is $40? a $0.64 B $0.71 c $0.77 d $0.82 e $0.91 Number of options needed = ($43 $38) (3 0) = 1.66667; $37.90 = (1.66667 C0) + [$38 (1 + 035)]; $37.90 = 1.66667C0 + $36.71498; 1.66667C0 = 1.18502; C0 = $.71 AACSB TOPIC: ANALYTIC SECTION: 14.3 TOPIC: CALL OPTION VALUE TYPE: PROBLEMS 77 You own one call option with an exercise price of $55 on Doo Little stock The stock is currently selling for $55.20 a share but is expected to sell for either $54 or $62 a share in one year The risk-free rate of return is percent and the inflation rate is 2.5 percent What is the current option price if the option expires one year from now? a $0.55 b $0.79 c $1.67 D $2.43 e $2.72 Number of options needed = ($62 $54) (7 0) = 1.142857; $55.20 = (1.142857 [$54 (1 + 03)]; $55.20 = 1.142857C0 + $52.427184; 1.142857C0 = 2.772816; C0 = $2.426214 = $2.43 AACSB TOPIC: ANALYTIC SECTION: 14.3 TOPIC: CALL OPTION VALUE TYPE: PROBLEMS 14-36 C0) + Chapter 014 Options and Corporate Finance 78 The assets of Bill's Boats are currently worth $47,600 These assets are expected to be worth either $45,000 or $53,000 one year from now The company has a pure discount bond outstanding with a $50,000 face value and a maturity date of one year The risk-free rate is percent What is the value of the equity in this firm? (Round your answer to the nearest whole dollar.) a $767 b $948 C $1,624 d $2,120 e $2,419 Number of options needed = ($53,000 $45,000) ($3,000 $0) = 2.66667; $47,600 = (2.66667 C0) + ($45,000 / 1.04); $47,600 = 2.66667C0 + $43,269.23077; 2.66667C0 = $4,330.76923; C0 = $1,624 (rounded) AACSB TOPIC: ANALYTIC SECTION: 14.5 TOPIC: EQUITY AS A CALL OPTION TYPE: PROBLEMS 79 Ted's Welding Shop has a pure discount bond with a face value of $5,000 that matures in one year The risk-free rate of return is 4.5 percent The assets of the business are expected to be worth either $4,800 or $5,200 in one year Currently, these assets are worth $4,750 What is the current value of the bond? a $4,006.13 b $4,166.67 c $4,268.11 D $4,671.65 e $4,784.69 Number of options needed = ($5,200 $4,800) ($200 $0) = 2; $4,750 = 2C0 + ($4,800 / 1.045); 2C0 + $4,593.30 = $4,750; 2C0 = $156.70; C0 = $78.35; Value of debt = $4,750 $78.35 = $4,671.65 AACSB TOPIC: ANALYTIC SECTION: 14.5 TOPIC: EQUITY AS A CALL OPTION TYPE: PROBLEMS 14-37 Chapter 014 Options and Corporate Finance 80 Richardson's Auto Wrecking has total assets of $2,810 These assets are expected to increase in value to either $2,900 or $3,200 by next year The company has a pure discount bond outstanding with a face value of $3,000.This bond matures in one year Currently, U.S Treasury bills are yielding 4.8 percent What is the value of the equity in this firm? a $190.00 b $52.60 C $28.55 d $47.08 e $121.89 Number of options needed = ($3,200 $2,900) ($200 $0) = 1.5; $2,810 = 1.5C0 + ($2,900 / 1.048); $2,810 = 1.5C0 + $2,767.18; 1.5C0 = $42.82; C0 = $28.55 AACSB TOPIC: ANALYTIC SECTION: 14.5 TOPIC: EQUITY AS A CALL OPTION 81 You are considering a project which has been assigned a discount rate of 12 percent If you start the project today, you will incur an initial cost of $2,500 and will receive cash inflows of $1,550 a year for two years If you wait one year to start the project, the initial cost will rise to $2,725 and the cash flows will increase to $1,700 a year for two years What is the value of the option to wait? A $12.64 b $19.46 c $28.51 d $30.49 e $34.68 AACSB TOPIC: ANALYTIC SECTION: 14.6 TOPIC: OPTION TO WAIT TYPE: PROBLEMS 14-38 Chapter 014 Options and Corporate Finance 82 Bloom's Flowers is considering a project that has an initial cost today of $6,500 The project has a two-year life with cash inflows of $4,800 a year Should Bloom's decide to wait one year to commence this project, the initial cost will increase by percent and the cash inflows will increase to $5,500 a year What is the value of the option to wait if the applicable discount rate is 13 percent? a $399.19 B $457.33 c $609.18 d $712.67 e $804.20 AACSB TOPIC: ANALYTIC SECTION: 14.6 TOPIC: OPTION TO WAIT TYPE: PROBLEMS 14-39 Chapter 014 Options and Corporate Finance 83 Your firm is considering a project with a four-year life and an initial cost of $162,000.The discount rate for the project is 13 percent The firm expects to sell 3,500 units a year The cash flow per unit is $22 The firm will have the option to abandon this project after one year at which time they expect they could sell the project for $89,000 At what level of sales should the firm be willing to abandon this project? a 837 units b 1,154 units c 1,468 units D 1,713 units e 2,108 units AACSB TOPIC: ANALYTIC SECTION: 14.6 TOPIC: OPTION TO ABANDON TYPE: PROBLEMS 14-40 Chapter 014 Options and Corporate Finance 84 Your firm is considering a project with a six-year life and an initial cost of $85,000.The discount rate for the project is 11.5 percent The firm expects to sell 1,400 units a year The cash flow per unit is $16 The firm will have the option to abandon this project after two years at which time they expect they could sell the project for $45,000 You are interested in knowing how the project will perform if the sales forecast for years four and five of the project are revised such that there is a 50/50 chance that the sales will be either 800 or 1,800 units a year What is the net present value of this project given your sales forecasts? A $13,627 b $14,709 c $15,088 d $16,192 e $16,887 Level to abandon = $45,000 = 27.21953Q; Q = 1,653 units At 800 units, you will abandon the project and receive $45,000 At 1,800 units, you will continue the project and the NPV will be: AACSB TOPIC: ANALYTIC SECTION: 14.6 TOPIC: OPTION TO ABANDON TYPE: PROBLEMS 14-41 Chapter 014 Options and Corporate Finance 85 Roger is reviewing a project with projected sales of 3,400 units a year, a cash flow of $23 a unit and a four-year project life The initial cost of the project is $268,000 The relevant discount rate is 14 percent Roger has the option to abandon the project after two years at which time he feels he could sell the project for $130,000 At what level of sales should he be willing to abandon the project? a 1,419 units b 1,847 units c 1,967 units d 2,816 units E 3,433 units AACSB TOPIC: ANALYTIC SECTION: 14.6 TOPIC: OPTION TO ABANDON TYPE: PROBLEMS 86 You own one convertible bond with a face value of $1,000 and a market value of $1,069 The bond can be converted into 12.5 shares of stock What is the conversion price? a $74.48 B $80.00 c $85.52 d $92.00 e $94.33 Conversion price = $1,000 12.5 = $80 AACSB TOPIC: ANALYTIC SECTION: 14.7 TOPIC: CONVERTIBLE BONDS TYPE: PROBLEMS 14-42 Chapter 014 Options and Corporate Finance 87 You own seven convertible bonds These bonds have a percent coupon, a $1,000 face value, and mature in years The bonds are convertible into shares of common stock at a conversion price of $22.50 How many shares of stock will you receive if you convert all of your bonds? a 285.00 shares b 294.48 shares c 300.00 shares d 308.50 shares E 311.11 shares Number of shares = $1,000 $22.50 = 311.11 shares AACSB TOPIC: ANALYTIC SECTION: 14.7 TOPIC: CONVERTIBLE BONDS TYPE: PROBLEMS 88 A convertible bond has a face value of $1,000 and a conversion price of $40 The bond has a percent coupon and pays interest semi-annually The bond matures in 12 years Similar bonds are yielding percent The current price of the stock is $37.38 What is the conversion value of this bond? a $495.20 b $654.83 C $934.50 d $1,278.15 e $1,495.20 Conversion value = $1,000 $40 $37.38 = $934.50 AACSB TOPIC: ANALYTIC SECTION: 14.7 TOPIC: CONVERTIBLE BONDS TYPE: PROBLEMS 14-43 Chapter 014 Options and Corporate Finance 89 A convertible bond has a face value of $1,000 and a conversion price of $25 The bond has a percent coupon and pays interest semi-annually The bond matures in 11 years Similar bonds are yielding percent The current price of the stock is $26.70 What is the straight bond value? a $858.07 b $878.18 C $927.74 d $932.09 e $941.08 AACSB TOPIC: ANALYTIC SECTION: 14.7 TOPIC: CONVERTIBLE BONDS TYPE: PROBLEMS 14-44 Chapter 014 Options and Corporate Finance 90 Neal owns a convertible bond that matures in four years The bond has an 8.5 percent coupon and pays interest semi-annually The face value of the bond is $1,000 and the conversion price is $20 Similar bonds have a market return of percent The current price of the stock is $21.10 What is the straight bond value? a $1,003.88 b $1,006.47 c $1,008.92 D $1,016.83 e $1,055.00 AACSB TOPIC: ANALYTIC SECTION: 14.7 TOPIC: CONVERTIBLE BONDS TYPE: PROBLEMS 91 Doug owns a convertible bond that matures in five years The bond has a percent coupon and pays interest annually The face value of the bond is $1,000 and the conversion price is $24 Similar bonds have a market return of 8.25 percent The current price of the stock is $23.15 What is the conversion value of this bond? a $555.60 b $748.40 c $942.11 D $964.58 e $1,000.00 Conversion value = $1000 $24 $23.15 = $964.58 AACSB TOPIC: ANALYTIC SECTION: 14.7 TOPIC: CONVERTIBLE BONDS TYPE: PROBLEMS 14-45 Chapter 014 Options and Corporate Finance Essay Questions 92 Merton Enterprises stock is priced at $74 a share A $90 call on this stock has three months until expiration and a call price of $0.10 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 three 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 premium such as $0.10, 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 $90 by the expiration date, or the option premium would be much higher AACSB TOPIC: REFLECTIVE THINKING SECTION: 14.3 TOPIC: OUT OF THE MONEY CALLS 93 What are the basic differences between warrants, call options, and convertible bonds? Warrants and convertibles are issued by corporations while call options are issued by individuals Warrants are usually privately issued and bundled with a bond Warrants can then be detached from the bond and traded separately in the market Warrants and call options are exercised for cash while convertible bonds are exchanged for shares of stock AACSB TOPIC: REFLECTIVE THINKING SECTION: 14.1 AND 14.7 TOPIC: WARRANTS, CALLS AND CONVERTIBLES 14-46 Chapter 014 Options and Corporate Finance 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 if S E < and C (S E) if (S E) In the first case, if the call 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 TOPIC: REFLECTIVE THINKING SECTION: 14.2 TOPIC: 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 TOPIC: REFLECTIVE THINKING SECTION: 14.5 TOPIC: EQUITY AS A CALL OPTION ON ASSETS 14-47 Chapter 014 Options and Corporate Finance 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 percent coupon rate, 15 years to maturity, and cannot be called during the first three years; the second is noncallable, has a 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 TOPIC: REFLECTIVE THINKING SECTION: 14.7 TOPIC: 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 TOPIC: REFLECTIVE THINKING SECTION: 14.7 TOPIC: CONVERTIBLE BONDS 14-48 ...Chapter 014 Options and Corporate Finance The last day on which an option can be exercised is the _ date a ex-payment b ex-option... pointed SECTION: 14.1 TOPIC: EUROPEAN OPTIONS TYPE: DEFINITIONS 14-2 Chapter 014 Options and Corporate Finance A call option is the _ an asset at a fixed price during a stated period of time a... intrinsic SECTION: 14.2 TOPIC: INTRINSIC VALUE TYPE: DEFINITIONS 14-3 Chapter 014 Options and Corporate Finance 10 The right granted to a company employee which enables that employee to buy shares