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TEST BANK FINANCIAL MANAGEMENT 14TH EDITION BRIGHAM

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  • ISBN-10 ‏ : ‎ 9390555671
  • ISBN-13 ‏ : ‎ 978-9390555673

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SKU:tb1002155

TEST BANK FINANCIAL MANAGEMENT 14TH EDITION BRIGHAM

CHAPTER 8—FINANCIAL OPTIONS AND APPLICATIONS IN CORPORATE FINANCE

TRUE/FALSE

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

ANS: T PTS: 1 DIF: Difficulty: Easy
OBJ: LO: 8-1 NAT: BUSPROG: Reflective Thinking STA: DISC: Derivatives
LOC: TBA TOP: Options KEY: Bloom’s: Knowledge

2. The strike price is the price that must be paid for a share of common stock when it is bought by exercising a warrant.

ANS: T PTS: 1 DIF: Difficulty: Easy
OBJ: LO: 8-1 NAT: BUSPROG: Reflective Thinking STA: DISC: Derivatives
LOC: TBA TOP: Strike price KEY: Bloom’s: Knowledge

3. The exercise value is the positive difference between the current price of the stock and the strike price. The exercise value is zero if the stock’s price is below the strike price.

ANS: T PTS: 1 DIF: Difficulty: Easy
OBJ: LO: 8-1 NAT: BUSPROG: Reflective Thinking STA: DISC: Derivatives
LOC: TBA TOP: Exercise value KEY: Bloom’s: Knowledge

4. The exercise value is also called the strike price, but this term is generally used when discussing convertibles rather than financial options.

ANS: F PTS: 1 DIF: Difficulty: Easy
OBJ: LO: 8-1 NAT: BUSPROG: Reflective Thinking STA: DISC: Derivatives
LOC: TBA TOP: Exercise value KEY: Bloom’s: Knowledge

5. As the price of a stock rises above the strike price, the value investors are willing to pay for a call option increases because both (1) the immediate capital gain that can be realized by exercising the option and (2) the likely exercise value of the option when it expires have both increased.

ANS: T PTS: 1 DIF: Difficulty: Easy
OBJ: LO: 8-1 NAT: BUSPROG: Reflective Thinking STA: DISC: Derivatives
LOC: TBA TOP: Option time value KEY: Bloom’s: Knowledge

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

ANS: F PTS: 1 DIF: Difficulty: Easy
OBJ: LO: 8-1 NAT: BUSPROG: Reflective Thinking STA: DISC: Derivatives
LOC: TBA TOP: Option pricing KEY: Bloom’s: Knowledge

7. If the market is in equilibrium, then an option must sell at a price that is exactly equal to the difference between the stock’s current price and the option’s strike price.

ANS: F PTS: 1 DIF: Difficulty: Easy
OBJ: LO: 8-1 NAT: BUSPROG: Reflective Thinking STA: DISC: Derivatives
LOC: TBA TOP: Option pricing KEY: Bloom’s: Knowledge

8. Since investors tend to dislike risk and like certainty, the more volatile a stock, the less valuable will be an option to purchase the stock, other things held constant.

ANS: F PTS: 1 DIF: Difficulty: Easy
OBJ: LO: 8-1 NAT: BUSPROG: Reflective Thinking STA: DISC: Derivatives
LOC: TBA TOP: Option pricing KEY: Bloom’s: Knowledge

9. Because of the time value of money, the longer before an option expires, the less valuable the option will be, other things held constant.

ANS: F PTS: 1 DIF: Difficulty: Easy
OBJ: LO: 8-1 NAT: BUSPROG: Reflective Thinking STA: DISC: Derivatives
LOC: TBA TOP: Option pricing KEY: Bloom’s: Knowledge

10. If we define the “premium” on an option to be the difference between the price at which an option sells and the exercise value (or the difference between the stock’s current market price and the strike price), then we would expect the premium to increase as the stock price increases, other things held constant.

ANS: F
See Figure 81, which shows that the premium becomes smaller and smaller as the price of the stock increases. One factor that produces this result is the fact that the amount of leverage inherent in the option diminishes as the stock price increases.

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 8-1
NAT: BUSPROG: Reflective Thinking STA: DISC: Derivatives
LOC: TBA TOP: Option pricing KEY: Bloom’s: Knowledge

11. Because of the put-call parity relationship, under equilibrium conditions a put option on a stock must sell at exactly the same price as a call option on the stock, provided the strike prices for the put and call are the same.

ANS: F
Recognize that if a stock is selling far above the strike price, the call option will be quite valuable, but the put option will be worth very little because the probability is low that the stock’s market price will fall below the put’s strike price.

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 8-6
NAT: BUSPROG: Reflective Thinking STA: DISC: Derivatives
LOC: TBA TOP: Put-call parity KEY: Bloom’s: Knowledge

12. If a company announces a change in its dividend policy from a zero target payout ratio to a 100% payout policy, this action could be expected to increase the value of long-term options (say 5-year options) on the firm’s stock.

ANS: F
Dividends do not enter into the OPM pricing formula. We would expect the stock of a firm that retains all of its earnings to grow over time due to the reinvestment of its earnings, whereas a firm that retains zero earnings should not grow much if any. Therefore, the value of the firm’s long-term options should decline if it announces a change from a zero to a 100% payout policy.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 8-6
NAT: BUSPROG: Reflective Thinking STA: DISC: Derivatives
LOC: TBA TOP: Put-call parity KEY: Bloom’s: Comprehension

MULTIPLE CHOICE

13. An option that gives the holder the right to sell a stock at a specified price at some future time is
a. a put option.
b. an out-of-the-money option.
c. a naked option.
d. a covered option.
e. a call option.

ANS: A PTS: 1 DIF: Difficulty: Easy
OBJ: LO: 8-1 NAT: BUSPROG: Analytic STA: DISC: Derivatives
LOC: TBA TOP: Option terms KEY: Bloom’s: Comprehension
MSC: TYPE: Multiple Choice: Conceptual

14. Other things held constant, the value of an option depends on the stock’s price, the risk-free rate, and the
a. Variability of the stock price.
b. Option’s time to maturity.
c. Strike price.
d. All of the above.
e. None of the above.

ANS: D PTS: 1 DIF: Difficulty: Easy
OBJ: LO: 8-1 NAT: BUSPROG: Analytic STA: DISC: Derivatives
LOC: TBA TOP: Option value KEY: Bloom’s: Comprehension
MSC: TYPE: Multiple Choice: Conceptual

15. Which of the following statements is most correct, holding other things constant, for XYZ Corporation’s traded call options?
a. The higher the strike price on XYZ’s options, the higher the option’s price will be.
b. Assuming the same strike price, an XYZ call option that expires in one month will sell at a higher price than one that expires in three months.
c. If XYZ’s stock price stabilizes (becomes less volatile), then the price of its options will increase.
d. If XYZ pays a dividend, then its option holders will not receive a cash payment, but the strike price of the option will be reduced by the amount of the dividend.
e. The price of these call options is likely to rise if XYZ’s stock price rises.

ANS: E PTS: 1 DIF: Difficulty: Easy
OBJ: LO: 8-1 NAT: BUSPROG: Analytic STA: DISC: Derivatives
LOC: TBA TOP: Option concepts KEY: Bloom’s: Comprehension
MSC: TYPE: Multiple Choice: Conceptual

16. BLW Corporation is considering the terms to be set on the options it plans to issue to its executives. Which of the following actions would decrease the value of the options, other things held constant?
a. The exercise price of the option is increased.
b. The life of the option is increased, i.e., the time until it expires is lengthened.
c. The Federal Reserve takes actions that increase the risk-free rate.
d. BLW’s stock price becomes more risky (higher variance).
e. BLW’s stock price suddenly increases.

ANS: A PTS: 1 DIF: Difficulty: Easy
OBJ: LO: 8-1 NAT: BUSPROG: Analytic STA: DISC: Derivatives
LOC: TBA TOP: Option concepts KEY: Bloom’s: Comprehension
MSC: TYPE: Multiple Choice: Conceptual

17. Which of the following statements is CORRECT?
a. Call options give investors the right to sell a stock at a certain strike price before a specified date.
b. Options typically sell for less than their exercise value.
c. LEAPS are very short-term options that were created relatively recently and now trade in the market.
d. An option holder is not entitled to receive dividends unless he or she exercises their option before the stock goes ex dividend.
e. Put options give investors the right to buy a stock at a certain strike price before a specified date.

ANS: D PTS: 1 DIF: Difficulty: Easy
OBJ: LO: 8-1 NAT: BUSPROG: Analytic STA: DISC: Derivatives
LOC: TBA TOP: Miscellaneous option concepts KEY: Bloom’s: Comprehension
MSC: TYPE: Multiple Choice: Conceptual

18. An investor who writes standard call options against stock held in his or her portfolio is said to be selling what type of options?
a. Put
b. Naked
c. Covered
d. Out-of-the-money
e. In-the-money

ANS: C PTS: 1 DIF: Difficulty: Moderate
OBJ: LO: 8-1 NAT: BUSPROG: Analytic STA: DISC: Derivatives
LOC: TBA TOP: Options KEY: Bloom’s: Analysis
MSC: TYPE: Multiple Choice: Conceptual

19. Cazden Motors’ stock is trading at $30 a share. Call options on the company’s stock are also available, some with a strike price of $25 and some with a strike price of $35. Both options expire in three months. Which of the following best describes the value of these options?
a. The options with the $25 strike price will sell for less than the options with the $35 strike price.
b. The options with the $25 strike price have an exercise value greater than $5.
c. The options with the $35 strike price have an exercise value greater than $0.
d. If Cazden’s stock price rose by $5, the exercise value of the options with the $25 strike price would also increase by $5.
e. The options with the $25 strike price will sell for $5.

ANS: D PTS: 1 DIF: Difficulty: Moderate
OBJ: LO: 8-1 NAT: BUSPROG: Analytic STA: DISC: Derivatives
LOC: TBA TOP: Option value KEY: Bloom’s: Analysis
MSC: TYPE: Multiple Choice: Conceptual

20. Braddock Construction Co.’s stock is trading at $20 a share. Call options that expire in three months with a strike price of $20 sell for $1.50. Which of the following will occur if the stock price increases 10%, to $22 a share?
a. The price of the call option will increase by more than $2.
b. The price of the call option will increase by less than $2, and the percentage increase in price will be less than 10%.
c. The price of the call option will increase by less than $2, but the percentage increase in price will be more than 10%.
d. The price of the call option will increase by more than $2, but the percentage increase in price will be less than 10%.
e. The price of the call option will increase by $2.

ANS: C PTS: 1 DIF: Difficulty: Moderate
OBJ: LO: 8-1 NAT: BUSPROG: Analytic STA: DISC: Derivatives
LOC: TBA TOP: Option value KEY: Bloom’s: Analysis
MSC: TYPE: Multiple Choice: Conceptual

21. Which of the following statements is CORRECT?
a. Call options generally sell at a price greater than their exercise value, and the greater the exercise value, the higher the premium on the option is likely to be.
b. Call options generally sell at a price below their exercise value, and the greater the exercise value, the lower the premium on the option is likely to be.
c. Call options generally sell at a price below their exercise value, and the lower the exercise value, the lower the premium on the option is likely to be.
d. Because of the put-call parity relationship, under equilibrium conditions a put option on a stock must sell at exactly the same price as a call option on the stock.
e. If the underlying stock does not pay a dividend, it does not make good economic sense to exercise a call option prior to its expiration date, even if this would yield an immediate profit.

ANS: E PTS: 1 DIF: Difficulty: Moderate
OBJ: LO: 8-6 NAT: BUSPROG: Analytic STA: DISC: Derivatives
LOC: TBA TOP: Miscellaneous option concepts KEY: Bloom’s: Analysis
MSC: TYPE: Multiple Choice: Conceptual

22. Which of the following statements is CORRECT?
a. Call options generally sell at a price less than their exercise value.
b. If a stock becomes riskier (more volatile), call options on the stock are likely to decline in value.
c. Call options generally sell at prices above their exercise value, but for an in-the-money option, the greater the exercise value in relation to the strike price, the lower the premium on the option is likely to be.
d. Because of the put-call parity relationship, under equilibrium conditions a put option on a stock must sell at exactly the same price as a call option on the stock.
e. If the underlying stock does not pay a dividend, it makes good economic sense to exercise a call option as soon as the stock’s price exceeds the strike price by about 10%, because this permits the option holder to lock in an immediate profit.

ANS: C
Answer c is correct. See Figure 81 and the related discussion.

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 8-6
NAT: BUSPROG: Analytic STA: DISC: Derivatives
LOC: TBA TOP: Miscellaneous option concepts KEY: Bloom’s: Analysis
MSC: TYPE: Multiple Choice: Conceptual

23. Which of the following statements is CORRECT?
a. As the stock’s price rises, the time value portion of an option on a stock increases because the difference between the price of the stock and the fixed strike price increases.
b. Issuing options provides companies with a low cost method of raising capital.
c. The market value of an option depends in part on the option’s time to maturity and also on the variability of the underlying stock’s price.
d. The potential loss on an option decreases as the option sells at higher and higher prices because the profit margin gets bigger.
e. An option’s value is determined by its exercise value, which is the market price of the stock less its striking price. Thus, an option can’t sell for more than its exercise value.

ANS: C PTS: 1 DIF: Difficulty: Challenging
OBJ: LO: 8-1 NAT: BUSPROG: Analytic STA: DISC: Derivatives
LOC: TBA TOP: Options KEY: Bloom’s: Analysis
MSC: TYPE: Multiple Choice: Conceptual

24. Suppose you believe that Basso Inc.’s stock price is going to increase from its current level of $22.50 sometime during the next 5 months. For $3.10 you can buy a 5-month call option giving you the right to buy 1 share at a price of $25 per share. If you buy this option for $3.10 and Basso’s stock price actually rises to $45, what would your pre-tax net profit be?
a. $3.10
b. $16.90
c. $17.75
d. $22.50
e. $25.60

ANS: B
The call option will be exercised only if the final price is above the strike price. If the final price is below the strike price, there will simply be a loss equal to the cost of the option.

Strike price: $25.00 No. of options: 1
Final price: $45.00 Option cost: $3.10

Profit per share = Final price  Strike price = $45  $25 or zero: $20.00

Total profit = Profit/option  No. of options  Cost of options = $16.90

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 8-1
NAT: BUSPROG: Analytic STA: DISC: Derivatives
LOC: TBA TOP: Call options KEY: Bloom’s: Application
MSC: TYPE: Multiple Choice: Problem

25. Suppose you believe that Florio Company’s stock price is going to decline from its current level of $82.50 sometime during the next 5 months. For $5.10 you could buy a 5-month put option giving you the right to sell 1 share at a price of $85 per share. If you bought this option for $5.10 and Florio’s stock price actually dropped to $60, what would your pre-tax net profit be?
a. $5.10
b. $19.90
c. $20.90
d. $22.50
e. $27.60

ANS: B
The put option will be exercised only if the final price is below the strike price. If the final price exceeds the strike price, there will simply be a loss equal to the cost of the option.

Strike price: $85.00 No. of options: 1
Final price: $60.00 Option cost: $5.10

Profit per share = Strike price  Final price = $85  $60 or zero: $25.00

Total profit = Profit/option  No. of options  Cost of options = $19.90

PTS: 1 DIF: Difficulty: Easy OBJ: LO: 8-1
NAT: BUSPROG: Analytic STA: DISC: Derivatives
LOC: TBA TOP: Put options KEY: Bloom’s: Application
MSC: TYPE: Multiple Choice: Problem

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