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ACCA Strategic Professional · Advanced Financial Management · The role and responsibility of senior financial executive/advisor

Zeta plc has 10 million shares at a market price of $5.00. Management receives options over 1 million shares at an exercise price of $5.00. Two strategies exist: Strategy A is safe and adds $2 million to equity value. Strategy B is risky: 50% chance it adds $10 million and 50% chance it reduces value by $4 million. Ignoring option time value, which statement best describes how the option scheme could influence the decision?

Management favour Strategy B, because options pay off on the upside but cannot lose value below zero on the downside. B's expected value ($3m) also exceeds A's ($2m), so the asymmetric option payoff encourages risk taking.

  1. AManagement favour Strategy B because options gain from upside but lose nothing on downside, even though expected value of B ($3m) exceeds A only modestlyCorrect
  2. BManagement favour Strategy A because options reward certain gains
  3. CManagement are indifferent because options have the same payoff under both strategies
  4. DManagement favour Strategy A because the expected value of B is lower

Explanation

Expected value of B is 0.5×10 + 0.5×(−4) = $3m versus $2m for A. Share price after the good outcome rises by $1.00 (10m/10m), giving options an intrinsic value of $1m, while the bad outcome leaves them worthless (out of the money) rather than negative. This asymmetric payoff encourages risk taking. The statement that B has lower expected value is wrong as $3m exceeds $2m.

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