There is much overlap between Chapters 24 and 25, so the Need to Absorb will be similar for both chapters.  Before you start on Chapter 24, be sure to read the outline for Chapter 25.

Chapter 24

All page numbers are references to Fundamentals of Corporate Finance, 12th edition by Ross, Westerfield, and Jordan (McGraw Hill, 2019)

Things to Absorb

You need to understand both the math and the implications of Chapters 24 and 25.  There are four possible option scenarios, long call, short call, long put, short put.   Persons who are long have rights, persons who are short have obligations.  For all four scenarios, you should be able to compute the value at expiration.  You will need to value a call or put using the one-period binomial model (called the Simple Model on pages 799-804) and compute any of the five inputs to the put-call parity model.  Know the definitions and terms related to options, such as put, call, long, short, in-the-money, at-the-money, out-of-the-money, strike, exercise price, real option, etc.  For the implications, understand the concept of Strategic NPV = Passive NPV + Value of Real Options - Cost of Real Options.  Be able to recognize some of the common real options such as convertible bonds, employee stock options, equity as a call option, put options embedded in risky bonds, option to expand, the option to abandon, and the timing (a.k.a., wait and learn) option, etc.  For these options, and other real life situation be able to identify who is long, who is short, type of option, underlying asset, exercise price, and sometimes the premium.  I will not ask you to value the Black-Scholes Option Pricing Model on the Final Exam, but could ask you to value on a quiz.  I want you to know the five inputs to the Black Scholes Model and their implications for option valuation.  Just as our book does not use the term binominal model, it does not use the term decision tree.  However, there are problems that use decision trees that you should be able to value (see end of chapter Problems 14-16).  My guess is that the Final Exam problems for these two chapters will have option value at expiration, put-call parity, one-period binomial valuation, as well as recognizing real options.

Things to Read

You will need to read Chapters 24 and 25 in order to be prepared for the Chapter quiz.   The Chapter 24 and 25 End of Chapter Problem's Solutions and Spreadsheets are available under Content.

Things to Do

Make 100 on the Chapter Quiz.  Spend time understanding the math of chapters 24 and 25.  Spend time learning to recognize and describe real options, especially those described in the two chapters.  If you have not done so already, you should download my handout on real options, A useful handout on Real Options. Be able to answer Concepts Review 1-8, 10-15, Questions and Problems 1-5, 7-11, 13-16, 20, and 22.  I give links to other useful materials below in the Chapter 25 descriptions.  Examples of Exam level Questions and Problems include 2-5, 7, 8, 10, 11, and 14.  Do enough calculations that you feel comfortable valuing options at expirations, using the one-period binomial model, and valuing any of the five inputs to the put-call parity model.  If you do not see a needed calculation in the Chapter 24 audios, look in the Chapter 25 audios.

• Read the Chapter 24 Summary on Page 820 and Chapter 25 Summary on pages 854-855, then read the Chapter 24 Introduction on page 790-791. Watch the Chapter Overview Lecture video. The video is both the Absorb, Read, Do and an extended discussion of the concepts in the chapter. The PowerPoints for all of this chapter's videos are located here.
• After viewing the Chapter Lecture video, you should be able to answer most of the end of chapter Concepts Review Questions.
• Read pages 790-801. Watch the video on Option Terms, and Fundamentals of Option Valuation. Be able to answer end of chapter Questions 1-3.
• Read the rest of the Chapter. Watch the video on Balance Sheet Expressed as Options and Types of Real and Embedded Real Options. Be able to the remaining suggested end of chapter questions, with a focus on 2-5, 7, 8, 10, 11, and 14.
• Below are some of audio solutions.  If you do not see a solution you need here, look in the Chapter 25 material.
• Modern Artifacts can produce keepsakes that will be sold for $80 each. Nondepreciation fixed costs are $1,000 per year and variable costs are $60 per unit. If the project requires an initial investment of $3,000 and is expected to last for 5 years and the firm pays no taxes, what are the accounting break-even levels of sales? The initial investment will be depreciated straight-line over 5 years to a final value of zero, and the discount rate is 10%. | Review Audio Answer
• Modern Artifacts can produce keepsakes that will be sold for $80 each. Nondepreciation fixed costs are $1,000 per year and variable costs are $60 per unit. If the project requires an initial investment of $3,000 and is expected to last for 5 years and the firm pays no taxes, what are the economic break-even levels of sales? The initial investment will be depreciated straight-line over 5 years to a final value of zero, and the discount rate is 10%. | Review Audio Answer
• Valuing an Abandonment Option as a difference in NPVs. You are considering a project that costs $1050. If the product is a success (probability of success = 0.5), cash flows will be $200 per year in perpetuity. If it is a failure, the cash flows will be $0 per year in perpetuity. Assume a discount rate of 10%. Round all answers to the nearest dollar.
• What is the expected NPV of the project?
• At the end of the first year, you will learn more about the economic viability of the project. If the project is a failure, the firm will sell off its assets for a scrap value of $500. What is the NPV of the project given the additional information?
• What is the value to the company of the abandonment option?
• Take the Chapter 24 Quiz.