Options

Question 1

What type of options do we assume that we use

Answer 1

European

Question 2

What is the difference between payoff and profit

Answer 2

Payoff does not take into account the money we paid for the option

Question 3

What is the time value of an option

Answer 3

Time value is difference between the market value
and the intrinsic value of an option

Question 4

5 Capital structure examples of agency cost of debt

Answer 4

Refusing to Contribute Equity Capital ( underinvestment)
Risk Shifting (or ‘Asset Substitution’)
Cash In & Run (increase dividends)
Playing for Time (reluctant liquidation)
Bait & Switch (increase leverage)

Question 5

in the option value of debt and equity what do we model as a put option

Answer 5

we model limited liability as a put because, limited liability involves an ability to cut of damages when something bad happens. This is similar to a put which is a type of insurance against losses when the stock declines

Question 6

Why is limited liability preferable to unlimited liability

Answer 6

Too high monitoring costs for shareholders
Increase in the company’s cost of capital, shareholders having unlimited liability increases their risk therefore their expected returns are higher.
Downward pressure on the stock and faster bankruptcy, unlimited liability shareholders are more likely to dump shares
Less incentives to undertake risky positive NPV project
Market values will depend more on the financing methods of the
firm, rather than its fundamentals.