Econ 282 Theory of Investment Finance
Extra Exercises, Chapters 13, 15, 16
November 5, 2023
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Equity Valuation
1. Tri-coat Paints has a current market value of $41 per share with earnings of $3.64.
What is the present value of its growth opportunities (PVGO) if the required return is
9%?
2. Deployment Specialists pays a current (annual) dividend of $1 and is expected to grow
at 20% for two years and then at 4% thereafter. If the required return for Deployment
Specialists is 8.5%, what is the intrinsic value of its stock?
3. Phoebe’s investment club wants to buy the stock of either NewSoft, Inc. or Capital
Corp. Phoebe prepared the following table and you have been asked to hlep her
interpret the data, based on your forecast for a healthy economy and a strong stock
market over the next 12 months.
Newsoft’s shares have higher PE and P/B ratios than those of Capital Corp. Briefly
discuss why the disparity in ratios may not indicate that NewSoft’s shares are overvalued relative to the shares of Capital Corp. Answer the question in terms of the
two ratios, and assume that there have been no extraordinary events affecting either
company.
4. Janet Ludlow’s firm requires all its analysts to use the DDM and the CAPM to value
stocks. Using these measures, Ludlow has valued QuickBrush Company at $63 per
share. She now must value SmileWhite Corporation.
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(a) Calculate the required rate of return for SmileWhite using the information in the
following table:
With Risk-free rate = 4.5% and expected market return = 14.5%.
(b) Assume that SmileWhite has an intrinsic value of $28.89. Give an recommendation of (whether to choose) QuickBrush or SmileWhite stock for purchase.
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Option Markets
1. You establish a straddle on Fincorp using September call and put options with a strike
price of $80. The call premium is $7.00 and the put premium is $8.50.
(a) What is the most you can lose on this position?
(b) What will be your profit or loss if Fincorp is selling for $88 in September?
(c) At what stock prices will you break even on the straddle?
2. In what ways is owning a corporate bond similar to writing a put option? A call
option?
3. You buy a share of stock, write a one-year call option with X = $10, and buy a
one-year put option with X = $10. Your net outlay to establish the entire portfolio is
$9.50. What is the payoff of your portfolio? What must be the risk-free interest rate?
Assume the stock pays no dividends.
4. Multiple choice practice:
Which one(s) of the following statements about the value of a call option at expiration
is(are) false?
(a) A short position in a call option will result in a loss if the stock price substantially
exceeds the exercise price.
(b) The value of a long position equals zero or the stock price minus the exercise
price, whichever is higher.
(c) The value of a long position equals zero or the exercise price minus the stock
price, whichever is higher.
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(d) A short position in a call option has a zero value for all stock prices equal to or
less than the exercise price.
5. You write a call option with X = $50 and buy a call with X = $60. The options are
on the same stock and have the same expiration date. One of the calls sells for $3; the
other sells for $9. (Which option should sell for a higher price?)
(a) Draw the payoff and profit graph for this strategy at the option expiration date.
Show the payoff table too.
(b) What is the break-even point for this strategy?
(c) Are you bullish or bearish on the stock?
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Option Valuation
1. Should the rate of return of a call option on a long-term Treasury bond be more or less
sensitive to changes in interest rates than the rate of return of the underlying bond?
2. All else being equal, is a put option on a high-beta stock worth more than one on a
low-beta stock? The firms have identical firm-specific risk.
3. You are very bullish (optimistic) on stock EFG, much more so than the rest of the
market. Which portfolio strategy will give you the bigger dollar profit if your bullish
forecast turns out to be correct? Explain your answer.
Choice A: 10 EFG call options contracts (for 100 shares each), with X = 50
Choice B: 1000 shares of EFG stock.
4. Washington considers a put option with a delta of -0.65. If the price of the underlying
asset decreases by $6, what is the best estimate of the change in option price?
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