Fundamentals of Corporate Finance 3e Test Bank
Chapter 20: Options and Corporate Finance
1.
A put option with a strike price of $20 is expiring today. The stock is currently selling at
$25. Based on this information, the put option should not be exercised.
A)
True
B)
False
Ans:
A
2.
A stock is selling for $50 today. A call option on the stock with a strike price of $50 is
set to expire next month. If the price of the stock goes down tomorrow we would
expect the price of the call option to go down as well.
A)
True
B)
False
Ans:
A
3.
A call option can sometimes be priced higher than the underlying asset.
A)
True
B)
False
Ans:
B
Fundamentals of Corporate Finance 3e Test Bank
4.
Neither a call nor a put option can have a negative price.
A)
True
B)
False
Ans:
A
5.
The current price of an asset is $75. A put option on the asset with a strike price of
$100 expires one year from now. It is possible, without arbitrage, for this put option to
be priced at $24 today.
A)
True
B)
False
Ans:
A
6.
If the risk-free rate of interest increases, all else being equal, we would expect the value
of a call option to increase.
A)
True
B)
False
Ans:
A
Fundamentals of Corporate Finance 3e Test Bank
7.
In the binomial pricing model, an option is priced using a replicating portfolio that
typically consists of a risk-free bond and the asset underlying the option.
A)
True
B)
False
Ans:
A
8.
To price an option using the binomial pricing model, it is important that we know the
probability that the asset will increase in value.
A)
True
B)
False
Ans:
B
9.
When using the binomial pricing model to price an option, the volatility of the value of
the underlying asset is represented by the difference between the two possible future
values of the underlying asset.
A)
True
B)
False
Ans:
A
Fundamentals of Corporate Finance 3e Test Bank
10.
Consider a call option on a stock with a strike price of $60. If the stock price at
expiration is $50, the payoff from the call option is $10.
A)
True
B)
False
Ans:
B
11.
Consider a put option on a stock with a strike price of $60. If the stock price at
expiration is $50, the payoff from the put option is $10.
A)
True
B)
False
Ans:
A
Payoff = $60 – $50
Fundamentals of Corporate Finance 3e Test Bank
12.
Suppose you have sold a put option on a stock with a strike price of $25 and assume the
current price of the stock is $25. If the stock price at expiration is $30, your payoff will
be –$5.
A)
True
B)
False
Ans:
B
The value of put option to the owner is $0 when the value of underlying asset is greater
than or equal to the strike price. Since the stock price at expiration is $30 which is
greater than the strike price of $25. The payoff value would be equal to $0.
13.
A portfolio consisting of one put option and one call option, both with the same
exercise price is a good investment strategy for investors who don’t know whether an
asset’s value is likely to go up or down, but think that the volatility of the asset will
increase.
A)
True
B)
False
Ans:
A
14.
If a firm adds financial options to its debt securities, it will increase the interest expense
to the firm.
A)
True
B)
False
Ans:
B
Fundamentals of Corporate Finance 3e Test Bank
15.
If a project has a positive NPV, then the real options that affect the project are not
important to estimating the value of the project.
A)
True
B)
False
Ans:
B
16.
The option to defer investment can be characterized as the flexibility to wait and learn
more information about a project before committing resources to the project.
A)
True
B)
False
Ans:
A
17.
The management’s ability to choose to terminate a project is like a put option.
A)
True
B)
False
Ans:
A
Fundamentals of Corporate Finance 3e Test Bank
18.
After taking into account the value of real options, it is possible that some projects with
a negative NPV should be pursued.
A)
True
B)
False
Ans:
A
19.
A company is negotiating for the option to develop a platinum mine. Under the terms of
the option contract, the company would be able to purchase the development rights to
the mine one year from now for an exercise price specified today. If, during the
negotiations over the option contract, the volatility of the price of platinum increases,
the company should expect to pay a higher price for the development option.
A)
True
B)
False
Ans:
A
20.
The option to abandon a project can decrease its value.
A)
True
B)
False
Ans:
B
Fundamentals of Corporate Finance 3e Test Bank
21.
Ecofren Thermostats Co. sells equipment to residential and commercial customers. It is
considering whether or not to develop a new line of smart thermostats. The discounted
cash flows from smart thermostat sales are not likely to cover the development costs.
However, the company has decided to pursue the project anyway. If the commercial
technology is successful, it might be applied to a new line of very profitable residential
thermostats. This is an example of the option to make follow-on investments.
A)
True
B)
False
Ans:
A
22.
Consider a firm with a single loan. There are no interest payments on the loan, but the
principal and interest are all due in two years. It is uncertain whether the cash flow the
company will produce will be enough to pay off the debt. The payoff to stockholders in
this company resembles a call option.
A)
True
B)
False
Ans:
A
Fundamentals of Corporate Finance 3e Test Bank
23.
Consider a company that is likely to go bankrupt in the next year. The bondholders may
encourage the company to pursue risky negative-NPV projects in hopes that the firm
will avoid financial distress.
A)
True
B)
False
Ans:
B
24.
Consider a company that is likely to go bankrupt in the next year. Stockholders may
wish to pursue negative-NPV projects, even if there is no additional value to the project
from real options.
A)
True
B)
False
Ans:
A
25.
By designing compensation plans with performance bonuses, stock-based
compensation, and stock options, corporate boards are attempting to make the payoff
function for managers look similar to the payoff function for stockholders.
A)
True
B)
False
Ans:
A
Fundamentals of Corporate Finance 3e Test Bank
26.
Financial options can be used to hedge risks such as interest rates and foreign exchange
rates.
A)
True
B)
False
Ans:
A
27.
Suppose the current spot price of wheat is $25 a bushel. A wheat farmer expects to
produce 1,000 bushels at the end of the season, and she wants to ensure that she gets at
least $19 a bushel. If a put option on 1,000 bushels of wheat with a strike price of $20
and an expiration date at the end of the season is selling for $1,000, the farmer can
purchase the put option to guarantee she gets $19 a bushel.
A)
True
B)
False
Ans:
A
Put option will guarantee $20,000 minus the put option premium of $1,000
She will get $19,000 for 1,000 bushels or $19 per bushel
Fundamentals of Corporate Finance 3e Test Bank
28.
Suppose the current spot price of corn is $20 a bushel. A corn farmer expects to
produce 2,000 bushels at the end of the season, and she wants to ensure that she gets at
least $18 per bushel. Call options on 1,000 bushels of corn with a strike price of $15
and an expiration date at the end of the season are selling for $3,000. By selling call
options on her corn crop, the farmer can guarantee that she gets at least $18 per bushel.
A)
True
B)
False
Ans:
B
29.
Hedging is the process of using financial instruments such as options, forwards, futures,
and swaps to reduce the financial risks faced by a firm.
A)
True
B)
False
Ans:
A
30.
Harmostrax Co. has a defined-benefit pension plan for its employees. To fund the plan,
the company makes periodic contributions to a stock investment fund. If the stock
market declines significantly, the company would have to make additional
contributions to make up for lost revenue. The company could hedge its risk of a
market downturn by periodically purchasing put options on the stock market.
A)
True
B)
False
Fundamentals of Corporate Finance 3e Test Bank
31.
A small soybean farmer wants to hedge the price risk of his next crop, but he is
financially constrained. He can’t raise capital by either borrowing money or selling his
current assets. Instead, he sells call options on his soybean crop with a strike price of
$14 per bushel at a premium of $0.50 a bushel. Using the proceeds from selling the
call options, he buys put options on his soybean crop with a strike price of $11.00 per
bushel at a premium of $0.35 per bushel. Assume the risk-free interest rate is 0
percent. By taking these derivative positions, the farmer has guaranteed that he will
earn somewhere between $14.15 and $11.15 per bushel.
A)
B)
Ans:
Fundamentals of Corporate Finance 3e Test Bank
32.
An investor (the buyer) purchases a call option from a seller. On the expiration date of a
call option:
A)
the buyer has the obligation to buy the underlying asset and the seller has the
obligation to sell it.
B)
the buyer has the right to buy the underlying asset and the seller has the
obligation to sell it.
C)
the buyer has the obligation to sell the underlying asset and the seller has the right
to buy it.
D)
the buyer has the right to sell the underlying asset and the seller has the right to
buy it.
Ans:
B
33.
An investor (the buyer) purchases a put option from a seller. On the expiration date of a
put option:
A)
the buyer has the obligation to sell the underlying asset and the seller has the right
to buy it.
B)
the buyer has the obligation to sell the underlying asset and the seller has the
obligation to buy it.
C)
the buyer has the right to sell the underlying asset and the seller has the obligation
to buy it.
D)
the buyer has the right to buy the underlying asset and the seller has the right to
sell it.
Fundamentals of Corporate Finance 3e Test Bank
34.
Which of the following statements is true of a call option?
A)
The value of a call option can never be positive.
B)
The value of a call option can be more than the value of the underlying asset.
C)
The value of a call option can never be worth less than the current value of the
asset minus present value of the strike price.
D)
The value of a call option can be worth more than the strike price.
Ans:
C
35.
Which of the following statements is true of a put option?
A)
The value of a put option can be negative.
B)
The value of a put option can be worth more than the underlying asset.
C)
The value of a put option can be less than the present value of the strike price
minus the current value of the underlying asset.
D)
The value of a put option increases when the stock price increases.
Ans:
B
Fundamentals of Corporate Finance 3e Test Bank
36.
Suppose you own a call option on a stock with a strike price of $20 that expires today.
The price of the underlying stock is $15. If you exercise the option and immediately
sell the stock:
A)
you will earn $5.
B)
you will lose $5.
C)
you will lose $15.
D)
you will earn $15.
Ans:
B
37.
Suppose you own a put option on a stock with a strike price of $35 that expires today.
The price of the underlying stock is $25. If you purchase the stock and exercise the put
option:
A)
you will earn $10.
B)
you will lose $10.
C)
you will earn $25.
D)
you will lose $25.
Ans:
A
Fundamentals of Corporate Finance 3e Test Bank
38.
Consider an option that gives the owner the right to buy a stock for $20 only on the
third Friday of May, next year. The option being described is:
A)
an American call option.
B)
a European put option.
C)
an American put option.
D)
a European call option.
Ans:
D
39.
Consider an American and a European call option on a dividend-paying stock, with
otherwise identical features (same strike price, etc.). Which of the following
statements is true?
A)
The American call option will never be worth less than the European call option.
B)
The European call option will never be worth less than the American call option.
C)
Both European call and American call option should always have the same
value.
D)
The American option can be exercised only on specific dates during the life of
the option.
Ans:
Fundamentals of Corporate Finance 3e Test Bank
40.
The option payoff function is the relationship:
A)
between the value of an option and the value of a firm.
B)
between the value of an option and the price of the underlying asset.
C)
between the call premium and the value of an option.
D)
between the call premium and the price of underlying asset.
Ans:
41.
Which of the following changes, when considered individually, will increase the value
of a call option?
A)
The value of the underlying asset becomes more volatile
B)
The price of the underlying asset goes down
C)
Getting closer to the expiration date (the passage of time)
D)
A higher strike price
Ans:
A
42.
Which of the following changes, when considered individually, will increase the value
of a put option?
A)
An increase in the risk-free interest rate
B)
Lower volatility of the price of the underlying asset
C)
A higher strike price
D)
The option is nearing its expiration date.
Ans:
C
Fundamentals of Corporate Finance 3e Test Bank
43.
What happens to the value of call and put options if the volatility of the price of
underlying asset decreases?
A)
Put options will be worth more, call options will be worth less.
B)
Put options will be worth less, call options will be worth more.
C)
Both call and put options will be worth more.
D)
Both call and put options will be worth less.
Ans:
D
44.
If the price of the underlying asset increases, what happens to the value of call and put
options?
A)
Put options will be worth more, call options will be worth less.
B)
Put options will be worth less, call options will be worth more.
C)
Both call and put options will be worth more.
D)
Both call and put options will be worth less.
Ans:
B
45.
With everything else constant, as the expiration date gets closer, what happens to the
value of call and put options?
A)
Call option will be worth more, put options will be worth less.
B)
Call option will be worth less, put options will be worth more.
C)
Both call and put options will be worth more.
D)
Both call and put options will be worth less.
Fundamentals of Corporate Finance 3e Test Bank
46.
With everything else held constant, what happens to the value of call and put options if
the risk-free interest rate increases?
A)
Call options will be worth more, put options will be worth less.
B)
Call options will be worth less, put options will be worth more.
C)
Both call and put options will be worth less.
D)
Both call and put options will be worth more.
Ans:
A
47.
The management at PhoneUn considered the option to abandon when building their
new manufacturing plant. The design of the plant allows it to be easily converted to
manufacture other types of large machinery. If its new line of cars is poorly received,
its plant should be easy to sell to another manufacturing company. In this example, the
price at which they expect to sell the plant if things go poorly resembles:
A)
the premium of a put option on the plant.
B)
the premium of a call option on the plant.
C)
the strike price of a put option on the plant.
D)
the strike price of a call option the plant.
Ans:
C
Fundamentals of Corporate Finance 3e Test Bank
48.
Frost1 Motors is very likely to enter financial distress. Without a dramatic change of
events over the next couple of years, the company will be unable to pay its lenders, who
will then gain control of the company’s assets. A group of stockholders has pressured
the company’s management to begin manufacturing and selling one of the company’s
concept cars in the hope that it will be a big hit. Concept cars are prototypes that are
developed to test new ideas and to show off at auto shows. Although elements of
concept cars are often incorporated into product lines, rushing a concept car into
production is very risky. The best estimates about the concept car make it appear to be a
negative-NPV project. This is a good example of:
A)
the dividend payout problem.
B)
the underinvestment problem.
C)
the asset substitution problem.
D)
the agency cost of equity.
Ans:
C
49.
Why would the managers of a firm bundle options with stock in an IPO?
A)
To increase the supply of outstanding shares in order to attract more investors
B)
To promote the dilution of common stockholders’ control on assets
C)
To reduce the number of common shares that must be sold at the IPO price in
order to raise the amount of money that the firm needs
D)
To bring down the earnings per share of common stockholders
Ans:
C