# Call option value

Which of the following is correct?

a. NPV will be higher if sunk costs are included in a project's cash flows

b. A good example of a sunk cost is a situation where a company builds a restaurant and that results in lower sales by another of its restaurants.

c. A good example of a sunk cost is a situation where a company builds a restaurant and closes another of its restaurants.

d. A good example of a sunk cost is a situation where a company evaluated a site for a new restaurant last year, expensed the cost on its income statement, and now builds the restaurant

e. none of the above

TUNDRA Corporation's stock sells for $50 per share. A call option on the stock has a strike price of $55. A put option on the stock also has a strike price of $55. Which of the following is correct?

a. The call option is in-the-money

b. The put option is in-the-money

c. Both the call option and the put option are out-of-the money

d. The call option has a value of $5

e. none of the above

A firm plans to purchase equipment for $1.5 million. It will cost 200,000 to modify it for use in the firm's facility. The equipment is in the 3-year MACRS class. Calculate depreciation expense for Year 3.

a. $222,150

b. $251,770

c. $566,667

d. $500,000

e. none of the above

A proposed project is much riskier than average. The best way to account for its added risk is:

a. Ignoring it because project risk cannot be measured accurately.

b. Decreasing the discount rate to account for the higher risk

c. Increasing the discount rate to account for the higher risk

d. Reducing the NPV by 5% to account for the higher risk

e. none of the above

A company needs to decide whether to invest in a project now or wait a year until better information is available. The project has a positive expected NPV, but it could be negative if cash flows are less than expected. No competitors are likely to invest in a similar project if the company decides to wait. Which of the following best describes the issues the company is facing in making its decision?

The more uncertainty about the future cash flows, the more reason to go ahead with the project today.

a. NPV should be even higher by waiting a year, since it is positive today.

b. The project should be adopted now to lock in the expected positive NPV.

c. Waiting would probably reduce the project's risk

d. none of the above

A stock is currently selling for $25. A 6-month call option on the stock has a strike price of $30 and sells for $0.50. Calculate the exercise value of the option?

a. $0.00

b. $4.50

c. $5.00

d. $24.50

e. none of the above

Which of the following is not a real option?

a. The option to switch the type of vehicle manufactured in a plant

b. The option to expand into a foreign country

c. The option to buy shares of stock if its price goes up.

d. The option to abandon a project.

e. none of the above

The current price of a stock is $22, and at the end of one year its price will be either $27 or $17. The annual risk-free rate is 6.0%, based on daily compounding. A 1-year call option on the stock, with an exercise price of $22, is available. Based on the binominal model, what is the option's value?

a. $2.99

b. $2.70

c. $2.43

d. $3.29

e. $3.62

A company purchases equipment for $5 million, incurs shipping costs of $30,000 and installation costs of $50,000. It also requires additional net working capital of $100,000. What is the depreciable base?

a. $5,000,000

b. $5,180,000

c. $5,080,000

d. $5,030,000

e. none of the above

Which of the following is an example of a real option?

a. An option to buy stock at a specified price for a specified period of time

b. An option to sell stock at a specified price for a specified period of time

c. An option to invest in a project today or to wait a year.

d. An option to buy either an American or European option

e. none of the above

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#### Solution Summary

The current price of a stock is $22, and at the end of one year its price will be either $27 or $17. The annual risk-free rate is 6.0%, based on daily compounding. A 1-year call option on the stock, with an exercise price of $22, is available. Based on the binominal model, what is the option's value?

Option strategies: straddle, butterfly spread, CONDOR, writing covered calls, writing puts, vertical bull spread

1. Suppose you buy 100 shares of ABC at $79.25 and simultaneously write a March 80 Straddle at the prices given below. Make a spreadsheet and draw a profit/loss diagram and label all significant points for this strategy.

March 80 call at $1.625

March 80 put at $3.50

2. XYZ Inc.'s JUN 300 calls ($4 1/4 each), JUN 305 calls ($2 1/2), and JUN 310 calls ($1) are all available to you. You are required to construct a butterfly spread and show (a) the maximum possible gain and (b) the maximum possible loss and the break-even point. What is the gain or loss if, at expiration, the underlying security sells for exactly $302?

3. Look at the situation in question 2 again. Now assume that you also have a JUN 315 call ($0.50) available to you. If you short a CONDOR using the calls-only strategy, what is (a) the maximum possible gain and (b) the maximum possible loss and the break-even point. What is the gain or loss if, at expiration, the underlying security sells for exactly $302?

4. Explain why writing covered calls and writing puts are generally equivalent strategies. Show with an example.

5. Using the following prices, answer the questions listed below.

CALLS PUTS

EP FEB MAY AUG FEB MAY AUG

JJ 25 3 4 1/4 5 1/2 2 2 1/2 3 3/4

27 1/2 30 1 1 7/8 2 1/2 3 1/8 3 3/4 4 5/8

27 1/2 35 1/8 3/4 1 1/4 7 1/2 8 8

a. Using MAY 30/35 construct a vertical bull spread using calls and puts.

b. Show the maximum profit/loss under both strategies.

c. Suppose at expiration the JJ stock sells for $33 1/4. What is the percentage return on your investment? Ignore transaction costs.