Advanced corporate finance

Final revision
1.Options
1. For Parts A through c, determine the payoffs of calls and puts under the conditions given.
A. The underlying is a stock index and is at 5,601.19 when the options expire. The multiplier is 500. The
exercise price is
i. 5,500
ii. 6,000
B. The underlying is a bond and is at $1.035 per $1 par when the options expire. The contract is on
$100,000 face value of bonds. The exercise price is
i. $1.00
ii. $1.05
C. The underlying is a 90-day interest rate and is at 9 percent when the options expire. The notional
principal is $50 million. The exercise rate is
i. 8 percent
ii. 10.5 percent
1. If an investor paid $5 for a put option with an exercise price of $ 60 that is in the money $2, the price of
the underlying is closest to:
A) $ 53.
B) $ 58.
C) $62.
2. Analyst 1: The combination of a long asset, long put, and short call will result in a risk free position.
Analyst 2: The combination of a long call, long put, and short asset will result in a risk free position.
Which analyst’s statement is most likely correct?
A. Analyst 1.
B. Analyst 2.
C. Both.
3. The premium for the HD May call option with the strike price of 20.00 is $3.90 where the premium for
the HD April call option with the same strike price is $3.60. The difference between the prices of the two
options is because of different intrinsic values. (true or false)
4. if S=99, X=100, r=10%, c=7.50,p=4.25, T=0.5 years. Show that there is an arbitrage opportunity.
How can you take advantage of this opportunity?
Sol: S+P = 103.25 where C+X/(1+r)^T =102.85 that means put-call parity doesn’t hold so there is
an arbitrage opportunity. We can take advantage of this by buying the fiduciary call (long position)
and selling the protective put(short position)
5. American calls should be exercised early if:
A. the underlying has reached its expected maximum price.
B. the underlying has a lower expected return than the risk free rate.
C. there is a dividend or other cash payment on the underlying.
 ii. REAL OPTIONS
1. True or false?
a. Decision trees can help identify and describe real options.
b. The option to expand increases PV.
c. High abandonment value decreases PV.
d. If a project has positive NPV, the firm should always invest immediately.
Solution
a. True
b. True
c. False. Just as the option to expand has value, the option to terminate also raises the present
value of the project.
d. False. The optimal date to undertake an investment is the one that maximizes its contribution
to the firm today.

2. Describe the real option in each of the following cases:

a. Deutsche Metall postpones a major plant expansion. The expansion has positive NPV on a
discounted-cash-flow basis but top management wants to get a better fix on product demand before
proceeding.
b. Western Telecom commits to production of digital switching equipment specially designed for the
European market. The project has a negative NPV, but it is justified on strategic grounds by the need
for a strong market position in the rapidly growing, and potentially very profitable, market.
c. Western Telecom vetoes (has the right to cancel) a fully integrated, automated production line for
the new digital switches. It relies on standard, less-expensive equipment. The automated production
line is more efficient overall, according to a discounted-cash-flow calculation.
Solution
a. Timing option
b. Expansion option
c. Abandonment option

1. A firm has a two-year real option to invest in a project that has a present value of $400 million with an
exercise price (in year 2) of $600 million. Calculate the value of the option given that N(d1) = 0.6 and
N(d2) = 0.4. Assume that the risk-free interest rate is 6% per year.
A. $26.4 million
B. zero
C. $239.59 million
D. $13.58 million
C = 400(0.6) - (0.4)(600)/(1.06^2) = 26.4.
 Petroleum Inc. owns a lease to extract crude oil from sea. It is considering the construction of a deep-sea oil
rig at a cost of $50 million (C0). The construction costs are expected to remain constant. The price of oil P
is $40/bbl., and extraction costs are $25/bbl. The rig can extract a quantity of oil, Q = 300,000 bbl. per year
forever. (For tractability, assume that all first-year production occurs at the end of the first year.) Assume
that the cost of capital and the risk-free rate are both 6% per year. (Ignore taxes.)
2. Calculate the NPV from investing today.
A. +40 million
B. +75 million
C. +25 million
D. +150 million
3. Suppose that the oil price is uncertain and can be either $60/bbl. or $30/bbl. next year with equal
probability. Calculate the expected NPV of the project if it is postponed by one year.
A. +50 million
B. -25 million
C. +59 million
D. +47 million
4. Suppose that the oil price is uncertain and can be $60/bbl. or $30/bbl. next year with equal probability.
Then the value of the option to postpone the project by one year equals:
A. +34 million
B. +25 million
C. +59 million
D. -13 million
5. A project is worth $12 million today without an abandonment option. Suppose the value of the project is
either $18 million one year from today (if product demand is high) or $8 million (if product demand is
low). It is possible to sell off the project for $10 million if product demand is low. Calculate the value of
the abandonment option if the discount rate is 5% per year.
A. $1.03 million
B. $0.88 million
C. $1.90 million
D. $5.14 million
6. The NPV of a new video game, Dexa 1, is -1.5M after discounting all expected cash flows. However, if
high demand in the market evolves, Dexa 2 is a possible follow-on opportunity in two years. In two years it
will cost 10M to start Dexa 2, which will produce 9M of cash flow in year 2. N(d1) = 0.5785 and N(d2) =
0.1755. The annual interest rate is 11% and equals the risk-free rate. What is the Dexa 1 APV?
A. $1.95 M
B. $1.30 M
C. $2.28 M
D. $2.80 M
7. The owner of a pro-football team expects the team to be worth either $270 million next year or $120 million,
depending on whether or not she gets the city to build a new stadium. There is a 60% chance she will get a
new stadium. There is a buyer willing to pay $175 million for the team right now. However, the buyer will
keep his offer open—until the stadium issue is resolved—if offered some form of compensation. Given a
discount rate of 7%, how much should she be willing to pay the potential buyer for a one-year option to sell
the team (round to the nearest $1 million)?
A. 0
B. $21 million
C. $42 million
D. $55 million
 Put option value = a one-year option to sell the team = [(0.6 × 0) + (0.4 × (175 - 120))]/1.07 = 20.56.
iii. LEASING
1. If the after-tax present value of buying equipment and using it for six years is $100,000, calculate the
break-even after-tax yearly lease payment (seven payments) using a 7% real discount rate. (Assume that
lease payments are made at the beginning of the year and zero inflation.)
A. $14,286
B. $17,341
C. $18,555
D. $19,607
2. You have shopped for a new car, and the best purchase price you can get is $15,000. You have been
offered a lease with 36 month-end payments of $249 and a residual value of $7,500. The interest rate that
the bank would charge you to borrow money is 9% (APR). What is the NPV of the lease arrangement?
(Ignore taxes.)
A. $1,439
B. $1,380
C. $406
D. $1,338
NPV = 15,000 - PV(249, 36 monthly payments at 0.75%) - PV (7500 at 0.75%, 36 months); N =
36, I = 0.75, PMT = 249, FV = 7,500; Compute PV = $13,561; NPV = 15,000 - 13561 = +1439.
8. Your firm is considering leasing a new photocopier. The lease lasts for nine years. The lease calls for 10
payments of $1,000 per year with the first payment occurring immediately. The copier would cost $8,100
to buy and would be depreciated using the straight-line method to zero salvage over nine years. The firm
can borrow at a rate of 8%. The corporate tax rate is 30%. What is the NPV of the lease?
A. -$1,039.78
B. $6,610.22
C. $686.00
D. $360.00
4. A computer costs $500,000 and is depreciated for tax purposes straight-line over years 1 through 5. Assume
that it has zero salvage value at the end of five years. The user wishes to lease the computer by making six
annual lease payments, the first of which is due immediately. If taxes are paid without delay and the rate of
interest is 10%, what is the minimum acceptable lease payment for a lessor who pays tax at 35%?
A. $71,905
B. $105,798
C. $123,455
D. need more information to solve
Set the NPV of the transaction equal to zero and solve:
0 = + 500,000 - [0.65(L)] - [0.65L + (100,000)(0.35)][4.1557];
-500,000 + [0.65(L)] = -2.7012(L) - 145,450;
(3.3512)L = 354,550; L = 354,550/3.3512 = 105,798.
5. Assume the initial financing provided by a lease is $500,000 and the present value of the cash outflow
attributable to the lease is $525,000. Then the net value of the lease is:
A. $25,000
B. -$25,000
C. $1,025,000
D. $500,000
500,000 - 525,000 = -25,000.