OPTIONS AND CORPORATE FINANCE:
EXTENSIONS AND APPLICATIONS
Answers to Concepts Review and Critical Thinking Questions
One of the purposes to give stock options to CEOs (instead of cash) is to tie the performance of the
firm’s stock with the compensation of the CEO. In this way, the CEO has an incentive to increase
Most businesses have the option to abandon under bad conditions and the option to expand under
Virtually all projects have embedded options, which are ignored in NPV calculations and likely leads
As the volatility increases, the value of an option increases. As the volatility of coal and oil increases,
the option to burn either increases. However, if the prices of coal and oil are highly correlated, the
value of the option would decline. If coal and oil prices both increase at the same time, the option to
switch becomes less valuable since the company will likely save less money.
The advantage is that the value of the land may increase if you wait. Additionally, if you wait, the
best use of the land other than sale may become more valuable.
The company has an option to abandon the mine temporarily, which is an American put. If the
option is exercised, which the company is doing by not operating the mine, it has an option to reopen
the mine when it is profitable, which is an American call. Of course, if the company does reopen the
mine, it has another option to abandon the mine again, which is an American put.
Your colleague is correct, but the fact that an increased volatility increases the value of an option is
an important part of option valuation. All else the same, a call option on a venture that has a higher
volatility will be worth more since the upside potential is greater. Even though the downside is also
greater, with an option, the downside is irrelevant since the option will not be exercised and will
expire worthless no matter how low the asset falls. With a put option, the reverse is true in that the
option becomes more valuable the further the asset falls, and if the asset increases in value, the
option is allowed to expire.
Real option analysis is not a technique that can be applied in isolation. The value of the asset in real
option analysis is calculated using traditional cash flow techniques, and then real options are applied
to the resulting cash flows.
Insurance is a put option. Consider your homeowner’s insurance. If your house were to burn down,
you would receive the value of the policy from your insurer. In essence, you are selling your burned
house (“putting”) to the insurance company for the value of the policy (the strike price).