most important characteristic of an option
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most important characteristic of an option
Exam 2 BA 620
Deadline: Dec 3, 2019
Name: Thomas Griffin
- What is a financial option? What is the single most important characteristic of an option? ( 5 pts)
A financial option is a contract which its holder the right to buy (or sell) an asset at a predetermined price within a specified period of time. An option’s most important characteristic is that it does not obligate its owner to take any action; it merely gives the owner the right to buy or sell an asset.
- Consider Triple Play’s call option with a $25 strike price. The following table contains historical values for this option at different stock prices:
Stock Price Call Option Price
$25 $ 3.00
- a) Create a table which shows (1) stock price, (2) strike price, (3) exercise value, (4) option price, and (5) the time value. (10 pts)
Stock Price Strike Price Exercise value Call Option Time value 25 25 0 3 3 30 25 5 7.5 2.5 35 25 10 12 2 40 25 15 16.5 1.5 45 25 20 21 1 50 25 25 25.5 0.5
- b) What happens to the option’s time value as the stock price rises? Why? (5 pts)
Options time value falls as the stock price increase because:
- Time value is very important, because it erodes such that it disappears completely at option expiration. Thus, an option’s worth at expiration is only the amount it is in the money. The more an option is in the money, the higher its value.
- When the option is deep in the money the price difference is itself quite higher to outweigh time value of options.
- Quinlan Enterprises stock trades for $52.50 per share. It is expected to pay a $2.50 dividend at year end (D1 = $2.50), and the dividend is expected to grow at a constant rate of 5.50% a year. The before-tax cost of debt is 7.50%, and the tax rate is 25%. The target capital structure consists of 45% debt and 55% common equity.
- a) What is the company’s WACC if all the equity used is from reinvested earnings? (10 pts)
- b) What four common mistakes in estimating the WACC should be avoided? (10 pts)
- Carolina Company is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and are not repeatable.
Year 0 1 2 3 4
CFS −$1,050 $675 $650
CFL −$1,050 $360 $360 $360 $360
- a) If the decision is made by choosing the project with the higher IRR, how much value will be forgone? (15 pts)
- b) What is the underlying cause of ranking conflicts between NPV and IRR? (5 pts)
- a) Distinguish among beta (or market) risk, within-firm (or corporate) risk, and stand-alone risk for a project being considered for inclusion in a firm’s capital budget. (10 pts)
Stand-alone risk is the project’s risk if it is held as a lone asset. It disregards the fact that it is but one asset within the firm’s portfolio of assets and the firm is but one stock in a typical investor’s portfolio of stocks. stand-alone risk is measured by the variability of the project’s expected return.
- b) In theory, market risk should be the only “relevant” risk. However, companies focus as much on stand-alone risk as on market risk. What are the reasons for the focus on stand-alone risk? (10 pts)
It is often difficult to quantify market risk, on the other hand, we can usually get a good idea of a project’s stand-alone risk, and that risk is normally correlated with market risk: the higher the stand-alone risk the higher the market risk is likely to be. therefore, firms tent to focus on stand-alone risk, then deal with corporate and market risk by making subjective, judgmental modifications to the calculated stand-alone risk.
- Century Roofing is thinking of opening a new warehouse, and the key data are shown below. The company owns the building that would be used, and it could sell it for $100,000 after taxes if it decides not to open the new warehouse. The equipment for the project would be depreciated by the straight-line method over the project’s 3-year life, after which it would be worth nothing and thus it would have a zero salvage value. No new working capital would be required, and revenues and other operating costs would be constant over the project’s 3-year life. What is the project’s NPV? (Hint: Cash flows are constant in Years 1-3.) (20 pts)
Project cost of capital (r) 10.0% Opportunity cost $100,000 Net equipment cost (depreciable basis) $65,000 Straight-line deprec. rate for equipment 33.333% Sales revenues, each year $123,000 Operating costs (excl. deprec.), each year $25,000 Tax rate 25%