Which of the following statements is CORRECT?
Answer
An option's value is determined by its exercise value, which is the market price of the stock less its striking price. Thus, an option can't sell for more than its exercise value.
As the stock’s price rises, the time value portion of an option on a stock increases because the difference between the price of the stock and the fixed strike price increases.
Issuing options provides companies with a low cost method of raising capital.
The market value of an option depends in part on the option's time to maturity and also on the variability of the underlying stock's price.
The potential loss on an option decreases as the option sells at higher and higher prices because the profit margin gets bigger.
Which of the following statements is CORRECT?
Answer
Call options generally sell at a price greater than their exercise value, and the greater the exercise value, the higher the premium on the option is likely to be.
Call options generally sell at a price below their exercise value, and the greater the exercise value, the lower the premium on the option is likely to be.
Call options generally sell at a price below their exercise value, and the lower the exercise value, the lower the premium on the option is likely to be.
Because of the put-call parity relationship, under equilibrium conditions a put option on a stock must sell at exactly the same price as a call option on the stock.
If the underlying stock does not pay a dividend, it does not make good economic sense to exercise a call option prior to its expiration date, even if this would yield an immediate profit
3
Suppose you believe that Basso Inc.'s stock price is going to increase from its current level of $22.50 sometime during the next 5 months. For $3.10 you can buy a 5-month call option giving you the right to buy 1 share at a price of $25 per share. If you buy this option for $3.10 and Basso's stock price actually rises to $45, what would your pre-tax net profit be?
Answer
-$3.10
$16.90
$17.75
$22.50
$25.60
The current price of a stock is $50, the annual risk-free rate is 6%, and a 1-year call option with a strike price of $55 sells for $7.20. What is the value of a put option, assuming the same strike price and expiration date as for the call option?
Answer
$7.33
$7.71
$8.12
$8.55
$9.00
Question 5
Which of the following statements is CORRECT?
Answer
If the underlying stock does not pay a dividend, it does not make good economic sense to exercise a call option prior to its expiration date, even if this would yield an immediate profit.
Call options generally sell at a price greater than their exercise value, and the greater the exercise value, the higher the premium on the option is likely to be.
Call options generally sell at a price below their exercise value, and the greater the exercise value, the lower the premium on the option is likely to be.
Call options generally sell at a price below their exercise value, and the lower the exercise value, the lower the premium on the option is likely to be.
Because of the put-call parity relationship, under equilibrium conditions a put option on a stock must sell at exactly the same price as a call option on the stock.
Braddock Construction Co.'s stock is trading at $20 a share. Call options that expire in three months with a strike price of $20 sell for $1.50. Which of the following will occur if the stock price increases 10%, to $22 a share?
Answer
The price of the call option will increase by more than $2.
The price of the call option will increase by less than $2, and the percentage increase in price will be less than 10%.
The price of the call option will increase by less than $2, but the percentage increase in price will be more than 10%.
The price of the call option will increase by more than $2, but the percentage increase in price will be less than 10%.
The price of the call option will increase by $2.
Question 7
Which of the following statements is CORRECT?
Answer
When calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on preferred stock are deductible by the paying corporation.
Because of tax effects, an increase in the risk-free rate will have a greater effect on the after-tax cost of debt than on the cost of common stock as measured by the CAPM.
If a company's beta increases, this will increase the cost of equity used to calculate the WACC, but only if the company does not have enough reinvested earnings to take care of its equity financing and hence must issue new stock.
Higher flotation costs reduce investors' expected returns, and that leads to a reduction in a company's WACC.
When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation
With its current financial policies, Flagstaff Inc. will have to issue new common stock to fund its capital budget. Since new stock has a higher cost than reinvested earnings, Flagstaff would like to avoid issuing new stock. Which of the following actions would REDUCE its need to issue new common stock?
Answer
Increase the percentage of debt in the target capital structure.
Increase the proposed capital budget.
Reduce the amount of short-term bank debt in order to increase the current ratio.
Reduce the percentage of debt in the target capital structure.
Increase the dividend payout ratio for the upcoming year.
Which of the following statements is CORRECT? Assume a company's target capital structure is 50% debt and 50% common equity.
Answer
The WACC is calculated on a before-tax basis.
The WACC exceeds the cost of equity.
The cost of equity is always equal to or greater than the cost of debt.
The cost of reinvested earnings typically exceeds the cost of new common stock.
The interest rate used to calculate the WACC is the average after-tax cost of all the company's outstanding debt as shown on its balance sheet.
10
Which of the following statements is CORRECT?
Answer
The percentage flotation cost associated with issuing new common equity is typically smaller than the flotation cost for new debt.
The WACC as used in capital budgeting is an estimate of the cost of all the capital a company has raised to acquire its assets.
There is an "opportunity cost" associated with using reinvested earnings, hence they are not "free."
The WACC as used in capital budgeting would be simply the after-tax cost of debt if the firm plans to use only debt to finance its capital budget during the coming year.
The WACC as used in capital budgeting is an estimate of a company's before-tax cost of capital.
Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting?
Answer
Accounts payable.
Common stock “raised” by reinvesting earnings.
Common stock raised by new issues.
Preferred stock.
Long-term debt.
Burnham Brothers Inc. has no retained earnings since it has always paid out all of its earnings as dividends. This same situation is expected to persist in the future. The company uses the CAPM to calculate its cost of equity, and its target capital structure consists of common stock, preferred stock, and debt. Which of the following events would REDUCE its WACC?
Answer
The flotation costs associated with issuing new common stock increase.
The company's beta increases.
Expected inflation increases.
The flotation costs associated with issuing preferred stock increase.
The market risk premium declines.
Which of the following statements is CORRECT?
Answer
For mutually exclusive projects with normal cash flows, the NPV and MIRR methods can never conflict, but their results could conflict with the discounted payback and the regular IRR methods.
Multiple IRRs can exist, but not multiple MIRRs. This is one reason some people favor the MIRR over the regular IRR.
If a firm uses the discounted payback method with a required payback of 4 years, then it will accept more projects than if it used a regular payback of 4 years.
The percentage difference between the MIRR and the IRR is equal to the project's WACC.
The NPV, IRR, MIRR, and discounted payback (using a payback requirement of 3 years or less) methods always lead to the same accept/reject decisions for independent projects.
Which of the following statements is CORRECT?
Answer
The payback method is generally regarded by academics as being the best single method for evaluating capital budgeting projects.
The discounted payback method is generally regarded by academics as being the best single method for evaluating capital budgeting projects.
The net present value method (NPV) is generally regarded by academics as being the best single method for evaluating capital budgeting projects.
The modified internal rate of return method (MIRR) is generally regarded by academics as being the best single method for evaluating capital budgeting projects.
The internal rate of return method (IRR) is generally regarded by academics as being the best single method for evaluating capital budgeting projects
14
Which of the following statements is CORRECT?
Answer
The payback method is generally regarded by academics as being the best single method for evaluating capital budgeting projects.
The discounted payback method is generally regarded by academics as being the best single method for evaluating capital budgeting projects.
The net present value method (NPV) is generally regarded by academics as being the best single method for evaluating capital budgeting projects.
The modified internal rate of return method (MIRR) is generally regarded by academics as being the best single method for evaluating capital budgeting projects.
The internal rate of return method (IRR) is generally regarded by academics as being the best single method for evaluating capital budgeting projects
Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows.
Answer
The lower the WACC used to calculate a project's NPV, the lower the calculated NPV will be.
If a project's NPV is less than zero, then its IRR must be less than the WACC.
If a project's NPV is greater than zero, then its IRR must be less than zero.
The NPV of a relatively low-risk project should be found using a relatively high WACC.
A project's NPV is found by compounding the cash inflows at the IRR to find the terminal value (TV), then discounting the TV at the WACC.
Which of the following statements is CORRECT?
Answer
One defect of the IRR method versus the NPV is that the IRR does not take account of the time value of money.
One defect of the IRR method versus the NPV is that the IRR does not take account of the cost of capital.
One defect of the IRR method versus the NPV is that the IRR values a dollar received today the same as a dollar that will not be received until sometime in the future.
One defect of the IRR method versus the NPV is that the IRR does not take proper account of differences in the sizes of projects.
One defect of the IRR method versus the NPV is that the IRR does not take account of cash flows over a project's full life.
Projects S and L are both normal projects with an initial cost of $10,000, followed by a series of positive cash inflows. Project S's undiscounted net cash flows total $20,000, while L's total undiscounted flows are $30,000. At a WACC of 10%, the two projects have identical NPVs. Which project's NPV is more sensitive to changes in the WACC?
Answer
Project L.
Both projects are equally sensitive to changes in the WACC since their NPVs are equal at all costs of capital.
Neither project is sensitive to changes in the discount rate, since both have NPV profiles that are horizontal.
The solution cannot be determined because the problem gives us no information that can be used to determine the projects' relative IRRs.
Project S.
Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows.
Answer
A project's regular IRR is found by discounting the cash inflows at the WACC to find the present value (PV), then compounding this PV to find the IRR.
If a project's IRR is greater than the WACC, then its NPV must be negative.
To find a project's IRR, we must solve for the discount rate that causes the PV of the inflows to equal the PV of the project's costs.
To find a project's IRR, we must find a discount rate that is equal to the WACC.
A project's regular IRR is found by compounding the cash inflows at the WACC to find the terminal value (TV), then discounting this TV at the WACC.
Which of the following statements is CORRECT?
Answer
In a capital budgeting analysis where part of the funds used to finance the project would be raised as debt, failure to include interest expense as a cost when determining the project's cash flows will lead to a downward bias in the NPV.
The existence of any type of "externality" will reduce the calculated NPV versus the NPV that would exist without the externality.
If one of the assets to be used by a potential project is already owned by the firm, and if that asset could be sold or leased to another firm if the new project were not undertaken, then the net after-tax proceeds that could be obtained should be charged as a cost to the project under consideration.
If one of the assets to be used by a potential project is already owned by the firm but is not being used, then any costs associated with that asset is a sunk cost and should be ignored.
In a capital budgeting analysis where part of the funds used to finance the project would be raised as debt, failure to include interest expense as a cost when determining the project's cash flows will lead to an upward bias in the NPV.
Which of the following rules is CORRECT for capital budgeting analysis?
Answer
Only incremental cash flows, which are the cash flows that would result if a project is accepted, are relevant when making accept/reject decisions.
Sunk costs are not included in the annual cash flows, but they must be deducted from the PV of the project's other costs when reaching the accept/reject decision.
A proposed project's estimated net income as determined by the firm's accountants, using generally accepted accounting principles (GAAP), is discounted at the WACC, and if the PV of this income stream exceeds the project's cost, the project should be accepted.
If a product is competitive with some of the firm's other products, this fact should be incorporated into the estimate of the relevant cash flows. However, if the new product is complementary to some of the firm's other products, this fact need not be reflected in the analysis.
The interest paid on funds borrowed to finance a project must be included in estimates of the project's cash flows.
Which of the following should be considered when a company estimates the cash flows used to analyze a proposed project?
Answer
Since the firm's director of capital budgeting spent some of her time last year to evaluate the new project, a portion of her salary for that year should be charged to the project's initial cost.
The company has spent and expensed $1 million on R&D associated with the new project.
The company spent and expensed $10 million on a marketing study before its current analysis regarding whether to accept or reject the project.
The firm would borrow all the money used to finance the new project, and the interest on this debt would be $1.5 million per year.
The new project is expected to reduce sales of one of the company's existing products by 5%.
2 points
When evaluating a new project, firms should include in the projected cash flows all of the following EXCEPT:
Answer
Previous expenditures associated with a market test to determine the feasibility of the project, provided those costs have been expensed for tax purposes.
The value of a building owned by the firm that will be used for this project.
A decline in the sales of an existing product, provided that decline is directly attributable to this project.
The salvage value of assets used for the project that will be recovered at the end of the project's life.
Changes in net working capital attributable to the project.
Which of the following statements is CORRECT?
Answer
In comparing two projects using sensitivity analysis, the one with the steeper lines would be considered less risky, because a small error in estimating a variable such as unit sales would produce only a small error in the project's NPV.