Which of the following statements is CORRECT?AnswerIf the underlying stock does not pay a dividend, it makes good economic sense to exercise a call option as soon as the stock?s price exceeds the strike price by about 10%, because tpermits the option holder to lock in an immediate profit.Call options generally sell at a price less than their exercise value.If a stock becomes riskier (more volatile), call options on the stock are likely to decline in value.Call options generally sell at prices above their exercise value, but for an in-the-money option, the greater the exercise value in relation to the strike price, 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.2 pointsQuestion 2Warner Motors? 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?AnswerThe price of the call option will increase by $2.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%.2 pointsQuestion 3Which of the following statements is CORRECT?AnswerAn 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.2 pointsQuestion 4The current price of a stock is $22, and at the end of one year its price will be either $27 or $17. The annual risk-free rate is 6.0%, based on daily compounding. A 1-year call option on the stock, with an exercise price of $22, is available. Based on the binominal model, what is the option?s value?Answer$2.43$2.70$2.99$3.29$3.62 2 pointsQuestion 5Suppose you believe that Delva Corporation?s stock price is going to decline from its current level of $82.50 sometime during the next 5 months. For $510.25 you could buy a 5-month put option giving you the right to sell 100 shaat a price of $85 per share. If you bought toption for $510.25 and Delva?s stock price actually dropped to $60, what would your pre-tax net profit be?Answer-$510.25$1,989.75$2,089.24$2,193.70$2,303.382 pointsQuestion 6Other things held constant, the value of an option depends on the stock?s price, the risk-free rate, and theAnswerStrike price.Variability of the stock price.Option?s time to maturity.All of the above.None of the above. 2 pointsQuestion 7Which of the following statements is CORRECT?AnswerIf 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 twould 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.2 pointsQuestion 8An investor who writes standard call options against stock held in or her portfolio is said to be selling what type of options?AnswerIn-the-moneyPutNakedCoveredOut-of-the-money 2 pointsQuestion 9Call options on XYZ Corporation?s common stock trade in the market. Which of the following statements is most correct, holding other things constant?AnswerThe price of thcall options is likely to rise if XYZ?s stock price rises.The higher the strike price on XYZ?s options, the higher the option?s price will be.Assuming the same strike price, an XYZ call option that expiin one month will sell at a higher price than one that expiin three months.If XYZ?s stock price stabilizes (becomes less volatile), then the price of its options will increase.If XYZ pays a dividend, then its option holders will not receive a cash payment, but the strike price of the option will be reduced by the amount of the dividend.2 pointsQuestion 10Suppose you believe that Johnson Company?s stock price is going to increase from its current level of $22.50 sometime during the next 5 months. For $310.25 you can buy a 5-month call option giving you the right to buy 100 shaat a price of $25 per share. If you buy toption for $310.25 and Johnson?s stock price actually rises to $45, what would your pre-tax net profit be?Answer-$310.25$1,689.75$1,774.24$1,862.95$1,956.10 2 pointsQuestion 11Deeble Construction Co.?s stock is trading at $30 a share. Call options on the company?s stock are also available, some with a strike price of $25 and some with a strike price of $35. Both options expire in three months. Which of the following best describes the value of thoptions?AnswerThe options with the $25 strike price will sell for $5.The options with the $25 strike price will sell for less than the options with the $35 strike price.The options with the $25 strike price have an exercise value greater than $5.The options with the $35 strike price have an exercise value greater than $0.If Deeble?s stock price rose by $5, the exercise value of the options with the $25 strike price would also increase by $5. 2 pointsQuestion 12Which of the following statements is CORRECT?AnswerIf 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 twould 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.2 pointsQuestion 13GCC Corporation is planning to issue options to its key employees, and it is now discussing the terms to be set on those options. Which of the following actions would decrease the value of the options, other things held constant?AnswerGCC?s stock price suddenly increases.The exercise price of the option is increased.The life of the option is increased, i.e., the time until it expiis lengthened.The Federal Reserve takes actions that increase the risk-free rate.GCC?s stock price becomes more risky (higher variance). 2 pointsQuestion 14Which of the following statements is CORRECT?AnswerPut options give investors the right to buy a stock at a certain strike price before a specified date.Call options give investors the right to sell a stock at a certain strike price before a specified date.Options typically sell for less than their exercise value.LEAPS are very short-term options that were created relatively recently and now trade in the market.An option holder is not entitled to receive dividends unless he or she exercises their option before the stock goes ex dividend.2 pointsQuestion 15An option that gives the holder the right to sell a stock at a specified price at some future time isAnswera call option.a put option.an out-of-the-money option.a naked option.a covered option. 2 pointsQuestion 16Which of the following statements is CORRECT?AnswerThe WACC is calculated using before-tax costs for all components.The after-tax cost of debt usually exceeds the after-tax cost of equity.For a given firm, the after-tax cost of debt is always more expensive than the after-tax cost of non-convertible preferred stock.Retained earnings that were generated in the past and are reported on the firm?s balance sheet are available to finance the firm?s capital budget during the coming year.The WACC that should be used in capital budgeting is the firm?s marginal, after-tax cost of capital.2 pointsQuestion 17Which of the following statements is CORRECT?AnswerThe cost of capital used to evaluate a project should be the cost of the specific type of financing used to fund that project, i.e., it is the after-tax cost of debt if debt is to be used to finance the project or the cost of equity if the project will be financed with equity.The after-tax cost of debt that should be used as the component cost when calculating the WACC is the average after-tax cost of all the firm?s outstanding debt.Suppose some of a publicly-traded firm?s stockholders are not diversified; they hold only the one firm?s stock. In tcase, the CAPM approach will result in an estimated cost of equity that is too low in the sense that if it is used in capital budgeting, projects will be accepted that will reduce the firm?s intrinsic value.The cost of equity is generally harder to measure than the cost of debt because there is no stated, contractual cost number on which to base the cost of equity.The bond-yield-plus-risk-premium approach is the most sophisticated and objective method for estimating a firm?s cost of equity capital.2 pointsQuestion 18Which of the following statements is CORRECT?AnswerThe bond-yield-plus-risk-premium approach to estimating the cost of common equity involves adding a risk premium to the interest rate on the company?s own long-term bonds. The size of the risk premium for bonds with different ratings is published daily in The Wall Street Journal.The WACC is calculated using a before-tax cost for debt that is equal to the interest rate that must be paid on new debt, along with the after-tax costs for common stock and for preferred stock if it is used.An increase in the risk-free rate is likely to reduce the marginal costs of both debt and equity.The relevant WACC can change depending on the amount of funds a firm raises during a given year. Moreover, the WACC at each level of funds raised is a weighted average of the marginal costs of each capital component, with the weights based on the firm?s target capital structure.Beta measumarket risk, which is generally the most relevant risk measure for a publicly-owned firm that seeks to maximize its intrinsic value. However, tis not true unless all of the firm?s stockholders are well diversified.2 pointsQuestion 19Which of the following statements is CORRECT?AnswerSince the costs of internal and external equity are related, an increase in the flotation cost required to sell a new issue of stock will increase the cost of retained earnings.Since its stockholders are not directly responsible for paying a corporation?s income taxes, corporations should focus on before-tax cash flows when calculating the WACC.An increase in a firm?s tax rate will increase the component cost of debt, provided the YTM on the firm?s bonds is not affected by the change in the tax rate.When the WACC is calculated, it should reflect the costs of new common stock, retained earnings, preferred stock, long-term debt, short-term bank loans if the firm normally finances with bank debt, and accounts payable if the firm normally has accounts payable on its balance sheet.If a firm has been suffering accounting losses that are expected to continue into the foreseeable future, and therefore its tax rate is zero, then it is possible for the after-tax cost of preferred stock to be less than the after-tax cost of debt.2 pointsQuestion 20Which of the following statements is CORRECT?AnswerThe discounted cash flow method of estimating the cost of equity cannot be used unless the growth rate, g, is expected to be constant forever.If the calculated beta underestimates the firm?s true investment risk?i.e., if the forward-looking beta that investors think exists exceeds the historical beta?then the CAPM method based on the historical beta will produce an estimate of rs and thus WACC that is too high.Beta measumarket risk, which is, theoretically, the most relevant risk measure for a publicly-owned firm that seeks to maximize its intrinsic value. Tis true even if not all of the firm?s stockholders are well diversified.An advantage shared by both the DCF and CAPM methods when they are used to estimate the cost of equity is that they are both ?objective? as opposed to ?subjective,? hence little or no judgment is required.The specific risk premium used in the CAPM is the same as the risk premium used in the bond-yield-plus-risk-premium approach.2 pointsQuestion 21When working with the CAPM, which of the following factors can be determined with the most precision?AnswerThe market risk premium (RPM).The beta coefficient, bi, of a relatively safe stock.The most appropriate risk-free rate, rRF.The expected rate of return on the market, rM.The beta coefficient of ?the market,? which is the same as the beta of an average stock.2 pointsQuestion 22Which of the following statements is CORRECT?AnswerThe WACC as used in capital budgeting is an estimate of a company?s before-tax cost of capital.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 retained 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.2 pointsQuestion 23Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting?AnswerLong-term debt.Accounts payable.Retained earnings.Common stock.Preferred stock.2 pointsQuestion 24Which of the following statements is CORRECT?AnswerWhen calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation.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, twill increase the cost of equity used to calculate the WACC, but only if the company does not have enough retained 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.2 pointsQuestion 25Norris Enterprises, an all-equity firm, has a beta of 2.0. The chief financial officer is evaluating a project with an expected return of 14%, before any risk adjustment. The risk-free rate is 5%, and the market risk premium is 4%. The project being evaluated is riskier than an average project, in terms of both its beta risk and its total risk. Which of the following statements is CORRECT?AnswerThe project should definitely be accepted because its expected return (before any risk adjustments) is greater than its required return.The project should definitely be rejected because its expected return (before risk adjustment) is less than its required return.Riskier-than-average projects should have their expected returns increased to reflect their higher risk. Clearly, twould make the project acceptable regardless of the amount of the adjustment.The accept/reject decision depends on the firm?s risk-adjustment policy. If Norris? policy is to increase the required return on a riskier-than-average project to 3% over rS, then it should reject the project.Capital budgeting projects should be evaluated solely on the basis of their total risk. Thus, insufficient information has been provided to make the accept/reject decision.2 pointsQuestion 26Duval Inc. uses only equity capital, and it has two equally-sized divisions. Division A?s cost of capital is 10.0%, Division B?s cost is 14.0%, and the corporate (composite) WACC is 12.0%. All of Division A?s projects are equally risky, as are all of Division B?s projects. However, the projects of Division A are less risky than those of Division B. Which of the following projects should the firm accept?AnswerA Division B project with a 13% return.A Division B project with a 12% return.A Division A project with an 11% return.A Division A project with a 9% return.A Division B project with an 11% return.2 pointsQuestion 27Which of the following statements is CORRECT?The component cost of preferred stock is expressed as rp(1 ? T). Tfollows because preferred stock dividends are treated as fixed charges, and as such they can be deducted by the issuer for tax purposes.A cost should be assigned to retained earnings due to the opportunity cost principle, which refers to the fact that the firm?s stockholders would themselves expect to earn a return on earnings that were distributed rather than retained and reinvested.No cost should be assigned to retained earnings because the firm does not have to pay anything to raise them. They are generated as cash flows by operating assets that were raised in the past; hence, they are ?free.?Suppose a firm has been losing money and thus is not paying taxes, and tsituation is expected to persist into the foreseeable future. In tcase, the firm?s before-tax and after-tax costs of debt for purposes of calculating the WACC will both be equal to the interest rate on the firm?s currently outstanding debt, provided that debt was issued during the past 5 years.If a firm has enough retained earnings to fund its capital budget for the coming year, then there is no need to estimate either a cost of equity or a WACC.Question 28Which of the following statements is CORRECT?Although some methods used to estimate the cost of equity are subject to severe limitations, the CAPM is a simple, straightforward, and reliable model that consistently produces accurate cost of equity estimates. In particular, academics and corporate finance people generally agree that its key inputs?beta, the risk-free rate, and the market risk premium?can be estimated with little error.The DCF model is generally preferred by academics and financial executives over other models for estimating the cost of equity. Tis because of the DCF model?s logical appeal and also because accurate estimates for its key inputs, the dividend yield and the growth rate, are easy to obtain.The bond-yield-plus-risk-premium approach to estimating the cost of equity may not always be accurate, but it has the advantage that its two key inputs, the firm?s own cost of debt and its risk premium, can be found by using standardized and objective procedures.Surveys indicate that the CAPM is the most widely used method for estimating the cost of equity. However, other methods are also used because CAPM estimates may be subject to error, and people like to use different methods as checks on one another. If all of the methods produce similar results, tincreases the decision maker?s confidence in the estimated cost of equity.The DCF model is preferred by academics and finance practitioners over other cost of capital models because it correctly recognizes that the expected return on a stock consists of a dividend yield plus an expected capital gains yield.2 pointsQuestion 29If a typical U.S. company correctly estimates its WACC at a given point in time and then uses that same cost of capital to evaluate all projects for the next 10 years, then the firm will most likelybecome riskier over time, but its intrinsic value will be maximized.become less risky over time, and twill maximize its intrinsic value.accept too many low-risk projects and too few high-risk projects.become more risky and also have an increasing WACC. Its intrinsic value will not be maximized.continue as before, because there is no reason to expect its risk position or value to change over time as a result of its use of a single cost of capital.Question 30For a typical firm, which of the following sequences is CORRECT? All rates are after taxes, and assume that the firm operates at its target capital structure.rs > re > rd > WACC.re >rs> WACC > rd.WACC > re >rs > rd.rd > re >rs> WACC.WACC >rd>rs> re.
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