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Corporate Finance II

Problem Set 4

Work done by:

Alexandra Pop, nº 45165

Fabiana Raquel Pires Severiano, nº 45245

Joana Sofia Azevedo Pereira, nº 45236

Raquel Marques Faquinha, nº 45219


Problem 1:

a) In order to obtain the value of a European Call option (one year), we need to
take into account the following expression:
𝑂𝐶 = [𝑁(𝑑1 )×𝑃] − [𝑁(𝑑2 )×𝑃𝑉(𝐸𝑋)]

Data: P = 35
EX = 50 Rf = 0.03
σ = 0.2 T=1

We need to calculate:
PV(EX) = 50 x e-1*0.03 = 48.522277
ln(35/48.522277) 0.2√1
d1 = + = -1.53337
0.2√1 2

N(d1) = 0.062592
d2 = -1.53337 – 0.2√1 = -1.73337
N(d2) = 0.041515

Using the Black - Scholes formula, the value of Call is:


𝑶𝒄 = [0.062592 x 35] – [0.041515 x 48.522277] = 0.176332

Multiplyng for 100 shares of XYZ Corporation, the total value of Call is:
0.176332 x 100 = $17.63

b) When σ goes from0,2 to 0.5:

PV(EX) = 50 x e-1*0.03 = 48.522277

ln(35/48.522277) 0.5√1
d1 = + = -0.40335
0.5√1 2

N(d1) = 0.343345

d2 = -0.40335 – 0.5√1 = -0.90335

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N(d2) = 0.18317

Using the Black - Scholes formula, the value of Call is:


𝑶𝒄 = [0.343345 x 35] – [0.18317 x 48.522277] = 3.129259

Multiplyng for 100 shares of XYZ Corporation, the total value of Call is:

3.129259 x 100 = $312.93

When maturity goes from 0 to 3 years:

PV(EX) = 50 x e-3*0.03 = 45.696559

ln(35/45.696559) 0.2√3
d1 = + = -0.34446
0.2√3 2

N(d1) = 0.365251

d2 = -0.34446 – 0.2√3 = -0.69087

N(d2) = 0.244824

Using the Black - Scholes formula, the value of Call is:


𝑶𝒄 = [0.365251 x 35] – [0.244824 x 45.696559] = 1.59616

Multiplyng for 100 shares of XYZ Corporation, the total value of Call is:

1.59616 x 100 = $159.616

When exercise price goes from $50 to $25:

PV(EX) = 25 x e-1*0.03 = 24.261138

ln(35/24.261138) 0.2√1
d1 = + = 1.932361
0.2√1 2

N(d1) = 0.973343

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d2 = 1.932361 – 0.2√1 = 1.732361

N(d2) = 0.958395

Using the Black - Scholes formula, the value of Call is:


𝑶𝒄 = [0.973343 x 35] – [0.958395 x 24.261138] = 10.81523

Multiplyng for 100 shares of XYZ Corporation, the total value of Call is:

10.81523 x 100 = $1081.52

When exercise price goes from $50 to $35:

PV(EX) = 35 x e-1*0.03 = 33.965594

ln(35/33.965594) 0.2√1
d1 = + = 0.25
0.2√1 2

N(d1) = 0.598706

d2 = 0.25 – 0.2√1 = 0.05

N(d2) = 0.519939

Using the Black - Scholes formula, the value of Call is:


𝑶𝒄 = [0.598706 x 35] – [0.519939 x 33.965594] = 3.294691

Multiplyng for 100 shares of XYZ Corporation, the total value of Call is:

3.294691 x 100 = $329.47

When stock price goes from $35 to $60:

PV(EX) = 50x e-1*0.03 = 48.522277

ln(60/48.522277) 0.2√1
d1 = + = 1.161608
0.2√1 2

N(d1) = 0.877303

2
d2 = 1.161608 – 0.2√1 = 0.961608

N(d2) = 0.831877

Using the Black - Scholes formula, the value of Call is:


𝑶𝒄 = [0.877303 x 60] – [0.831877 x 48.522277] = 12.27361

Multiplyng for 100 shares of XYZ Corporation, the total value of Call is:

12.27361 x 100 = $1227.361

When risk-free rate goes from 3% to 6%:

PV(EX) = 50x e-1*0.06 = 47.088227

ln(35/47.088227) 0.2√1
d1 = + = -1.38337
0.2√1 2

N(d1) = 0.083275

d2 = -1.38337 – 0.2√1 = -1.58337

N(d2) = 0.056668

Using the Black - Scholes formula, the value of Call is:


𝑶𝒄 = [0.083275 x 35] – [0.056668 x 47.088227] = 0.246227

Multiplyng for 100 shares of XYZ Corporation, the total value of Call is:

0.246227 x 100 = $24.62274

Assuming that we are comparing the values obtained with an option whose
exercise price = $50, σ = 0.2, r = 3%, t = 1 and stock price = $35, we find that the value
increases when the distance until maturity increases, as well as when volatility
increases. The call option goes from $0.18 to $1.60 and $3.13, respectively.
Regarding the following situations, we find that when the exercise price goes up
to $25 (ceteris paribus), the value of our option increased to $10.82. The same happens

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when in the third situation presented, the exercise price becomes $35, passing the call
value to be $3.29.
In the event that the stock price increases from $60, we see that there is an
increase in the value of our call, as well as when the value of the risk-free rate increases,
presenting the following values: $12.27 and $0.25, respectively.
Given the above conclusions, we can verify that there are variables that influence
the behavior of call options. These values when:
1) the value of the exercise price decreases;
2) the value of the stock increases;
3) the volatility of the option increases;
4) the risk-free rate increases;
5) the distance to maturity is increasing (more risk, more associated value).

c) If the value of a European call is 0.176332, so the Put price is:


Put price = Oc – P + PV(EX) = 0.176332 – 35 + 48.522277 = 13.69861

The value of Put Price on 100 shares of XYZ corporation is:


13.69861 x 100 = $1369.86

d) When σ goes to 0.5:


If the value of a European call is 3.129259, so the Put price is:
Put price = Oc – P + PV(EX) = 3.129259 – 35 + 48.522277 = 16.65154

The value of Put Price on 100 shares of XYZ corporation is:


16.65154 x 100 = $1665.15

When maturity goes to 3:


If the value of a European call is 1.59616, so the Put price is:
Put price = Oc – P + PV(EX) = 1.59616 – 35 + 45.696559 = 12.292772

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The value of Put Price on 100 shares of XYZ corporation is:
12.292772 x 100 = $1229.28

When exercise price goes to $25:


If the value of a European call is 10.81523, so the Put price is:
Put price = Oc – P + PV(EX) = 10.81523 – 35 + 24.261138 = 0.076364

The value of Put Price on 100 shares of XYZ corporation is:


0.076364 x 100 = $7.64

When exercise price goes to $35:


If the value of a European call is 3.294691, so the Put price is:
Put price = Oc – P + PV(EX) = 3.294691 – 35 + 33.965594 = 2.260285

The value of Put Price on 100 shares of XYZ corporation is:


2.260285 x 100 = $226.03

When stock price goes to $60:


If the value of a European call is 12.27361, so the Put price is:
Put price = Oc – P + PV(EX) = 12.27361 – 60 + 48.522277 = 0.795882

The value of Put Price on 100 shares of XYZ corporation is:


0.795882 x 100 = $79.59

When risk-free rate goes to 6%:


If the value of a European call is 0.246227, so the Put price is:
Put price = Oc – P + PV(EX) = 0.246227 – 35 + 47.088227 = 12.33445

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The value of Put Price on 100 shares of XYZ corporation is:
12.33445 x 100 = $1233.45

Given that we are calculating the value of the Put option, associated with the Call
option value, the base values are the same (exercise price = $50, σ = 0.2, r = 3%, t = 1
and stock price = $35). In this way, we verify that the behavior of the Put option will only
be equal to the Call option, when the volatility increases, that is, its value will increase,
going from $13.70 to $16.65.
In all other cases, the value of Put option will decrease: when the distance to
maturity increases, the Put option will have a value of $12.29; when the exercise price
decreases to $25 it has a value of $0.08, whereas when the exercise price is $35, Put
option has a value of $2.26; In the event that the share price increases to $60, the value
of the put option will be $0.80; and finally, if the risk-free rate increases to 6%, Put option
will present a value of $12.33.
In short, we can verify that, as there are variables that influence the behavior of
call options, there are also variables that will induce the behavior of put options. These
devalues when:
1) the value of the exercise price decreases;
2) the value of the stock increases;
3) the volatility of the option shows a decrease;
4) the risk-free rate increases;
5) the distance to maturity is increasing (more risk, more associated value).

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Problem 2

The first two years of the Project Alpha are presented in the following tree:

a) In order to obtain the Net Present Value of our investment, it is necessary to


take into account the following expression:
NPV = PV (Inflows) – PV (Outflows)
So, if we invest $100 today and only consider the phase 1 cash flows, we obtain as
value of Alpha’s phase 1:
0,5 𝑥 120+0,5 𝑥 80
NPVphase 1 = -100 + = −100 + 90.91 = −$9.09
1.10

The value of Alpha’s phase 1 is -$9.09.

As the value of the project at this phase is negative, it does not seem to us that
any investment should be made.

b) If we are at time zero, once and for all, the phase 2 opportunity would be:

100 0,25 𝑥 (144+2𝑥96+64)


NPV with phase 2 = − + = −$8.26
1.10 1.102

The value of Alpha’s is -$8.26.

As the value of the project at this phase is negative, it does not seem to us that
any investment should be made.

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c) If we consider whether or not to invest in phase 2, the total value of the alpha
project is represented by the following expression
100 100 0,50 × (144+96)
NPV = [ − 100 + 1.10] + 0.5 × [− + ] = −$4.96
1.10 1.102

Taking into account the result obtained, it does not seem to us that the first
investment of $ 100 should be made, because the NPV will be negative.

d) The first two years of the Project Omega are presented in the following tree:

So, if we invest $100 today and only consider the phase 1 cash flows, we obtain as
value of Omega phase 1:
0,5 𝑥 140+0,5 𝑥 60
NPV phase 1 = -100 + = −100 + 90.91 = −$9.09
1.10

100 0,25 𝑥 (196+2𝑥84+36)


NPV with phase 2 = − + = −$8.26
1.10 1.102

As can be seen, the NPV values obtained do not differ from those obtained in item
a) and b), since they do not differ in the expected value.

100 100 0,50 𝑥 (196+84)


NPV = [ − 100 + 1.10] + 0.5 𝑥 [− + ] = $3.31
1.10 1.102

In relation to the resolution of the proposed statement, we see that the total value
of the Omega project is different ($3.31Project Omega > -$4.96Project Alpha) since the values
obtained depend on the volatility of the project in question (volatility differs from
project to project). Therefore, the first investment of $ 100 must be made.

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e) As we can see, both projects have a basic structure and the same risk system,
varying only one issue of cash flows (inflows obtained at the moment 1 different as well
as percentage of gain). Given the above statement, we can conclude that the option to
invest in one project and not the other is related to payoffs volatility.
When analyzing the structure of the payoffs obtained in the Alpha Project, we find
that it is not interesting since in all our options we have always obtained a negative
value, that is, a loss. In our perspective, the first case analyzed seems to be riskier, the
second being the most valuable since, when we wait and study the situation before
investing the first $ 100, the NPV of the Omega project is positive.
Regarding the possibility of financing both projects and taking into account that
investors are risk averse, the amount invested in Alpha would be lower than the amount
invested in Omega. This decision is based on obtaining superior returns when we make
the first investment in Omega. Although it does not seem to us so attractive to invest in
Alpha, it may acquire value in the market and change the structure of cash flows.
In conclusion, let's not forget that we are looking at our options based on a
discount rate that is used by the industry in question (with an approach that values the
expansion option) rather than a risk-free rate. Thus, the problem in question should be
solved with a risk-free discount rate (approaching the probability of neutral risk).

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