# BEC 2 - Fin Valuation 2

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1. What is the generalized formula to calculate the value of a call option?
• Value = Stock price - PV of strike price
• Because we're taking the PV, the higher the discount rate the lower the PV
2. When do the following options have value (1) call, (2) put
• Call: When the spot price is more than the strike price
• Put: When the spot price is less than the strike price
3. When you purchase an option, the option should be treated as an [asset / liability].
As an asset, with a value of greater than or equal to \$0. At no time is it a liability.
4. What factors increase the value for a call option using the Black-Schols method?
• The greater the difference (spread) between the stock price and the exercise price.
• The greater the volatility of the stock, the more you are apt to receive for the call option, and the less you are apt to pay.
• The higher the risk-free rate
• The more time you have to exercise the option
5. Explain the Black-Schols method in high-level terms. What factors increase the value of the option?
• What we get when exercising the option = stock price x a probability that we're actually going to exercise the option.
• How much it costs us to exercise = strike price x a probability that we're actually going to exercise the option.
• The [....] the greater the probability we'll exercise the option (which increases the option's value)
• (1) higher the risk free rate
• (2) greater the % spread between the spot price & the strike price
• (3) greater the volatility (level of risk) of the stock (price fluctuation)
• (4) longer the time we have to exercise the option
6. What assumptions underlie the Black-Scholes model
• Stock prices behave randomly
• The risk-free rate is constant over the option's life
• The stock price volatility is constant over the option's life
• The stock pays no dividends
• The options are European-style (one single exercise date; American-style offers an exercise period [range])
7. What are the limitations of the Black-Scholes model
• The results may differ considerably from real prices
• Assumes instant and cost-less trading (which doesn't actually happen)
• It underestimates extreme price movements
• It cannot be used with American-style options because of the exercise time range (instead of a precise date).
8. What assumptions underlie the Binomial model
• There exists a perfectly efficient stock market
• The security price will move up or down at certain points in time (discrete) during the life of the option (called a node)
• We must be able to predict the percentage increase and decrease at those nodes.
9. What are the benefits of the Binomial model
• It can be used over a period of time, and thus can be used for the American-style options
• It can be used for stocks that pay dividends
10. WHITE BOARD: A \$1,000 face value bond maturing in 3 years pays annual interest of 4%. What is the bond's price if the market rate at the time of issuance is 5%.
• \$972.77
• Year 1: \$38.10
• Year 2: \$36.28
• Year 3: \$898.39 (don't forget to include the bond's principal in this calculation)
11. True/False: When valuing a bond, you may use a different discount rate for each year until the bond's maturity.
True
12. What are the methods used to value tangible assets?
• "Stay CALM"
• Cost: Original cost. It may be reduced by accumulated depreciation to reflect current utility (aka book value)
• Appraisal Value: by a professional appraiser, but still subjective and less reliable.
• Liquidation Value: what price would be obtained if the asset absolutely had to be sold now. Usually the lowest value.
• Market Value: one of these two methods
• ** Replacement Cost = what it would cost to replace the asset in today's market
• ** Net Realizable Value = what it could be sold for in the marketplace - selling costs
• ** Or use the average of the two
13. What are the methods to value intangible assets?