FIN 534 Week 1 Quiz 1 (30 questions with answers) 99,99 % Scored PLEASE DOWNLOAD HEREQuestion 1Which of the following statements is CORRECT?AnswerAn options value is determined by its exercise value, which is the market price ofthe stock less its striking price. Thus, an option cant sell for more than itsexercise value.As the stock’s price rises, the time value portion of an option on a stock increasesbecause the difference between the price of the stock and the fixed strike priceincreases.Issuing options provides companies with a low cost method of raising capital.The market value of an option depends in part on the options time to maturity andalso on the variability of the underlying stocks price.The potential loss on an option decreases as the option sells at higher and higherprices because the profit margin gets bigger.2 pointsQuestion 2Which of the following statements is CORRECT?AnswerPut options give investors the right to buy a stock at a certain strike price before aspecified date.Call options give investors the right to sell a stock at a certain strike price before aspecified date.Options typically sell for less than their exercise value.
LEAPS are very short-term options that were created relatively recently and nowtrade in the market.An option holder is not entitled to receive dividends unless he or she exercisestheir option before the stock goes ex dividend.2 pointsQuestion 3Other things held constant, the value of an option depends on the stocks price,the risk-free rate, and theAnswerStrike price.Variability of the stock price.Options time to maturity.All of the above.None of the above.2 pointsQuestion 4Warner Motors’ stock is trading at $20 a share. Call options that expire in threemonths with a strike price of $20 sell for $1.50. Which of the following will occur ifthe 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 percentageincrease in price will be less than 10%.The price of the call option will increase by less than $2, but the percentageincrease in price will be more than 10%.The price of the call option will increase by more than $2, but the percentageincrease in price will be less than 10%.
2 pointsQuestion 5GCC Corporation is planning to issue options to its key employees, and it is nowdiscussing the terms to be set on those options. Which of the following actionswould 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 expires is lengthened.The Federal Reserve takes actions that increase the risk-free rate.GCC’s stock price becomes more risky (higher variance).2 pointsQuestion 6An investor who writes standard call options against stock held in his or herportfolio is said to be selling what type of options?AnswerIn-the-moneyPutNakedCoveredOut-of-the-money2 pointsQuestion 7The current price of a stock is $50, the annual risk-free rate is 6%, and a 1-yearcall option with a strike price of $55 sells for $7.20. What is the value of a putoption, assuming the same strike price and expiration date as for the call option?Answer
$7.33$7.71$8.12$8.55$9.002 pointsQuestion 8Which of the following statements is CORRECT?AnswerIf the underlying stock does not pay a dividend, it does not make good economicsense to exercise a call option prior to its expiration date, even if this would yieldan immediate profit.Call options generally sell at a price greater than their exercise value, and thegreater 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 greaterthe 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 theexercise value, the lower the premium on the option is likely to be.Because of the put-call parity relationship, under equilibrium conditions a putoption on a stock must sell at exactly the same price as a call option on the stock.2 pointsQuestion 9Suppose you believe that Johnson Companys stock price is going to increasefrom its current level of $22.50 sometime during the next 5 months. For $310.25you can buy a 5-month call option giving you the right to buy 100 shares at aprice of $25 per share. If you buy this option for $310.25 and Johnsons stockprice actually rises to $45, what would your pre-tax net profit be?Answer-$310.25
$1,689.75$1,774.24$1,862.95$1,956.102 pointsQuestion 10Call options on XYZ Corporation’s common stock trade in the market. Which ofthe following statements is most correct, holding other things constant?AnswerThe price of these call 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 expires in one month willsell at a higher price than one that expires in three months.If XYZ’s stock price stabilizes (becomes less volatile), then the price of its optionswill 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 11Which of the following statements is CORRECT?AnswerIf the underlying stock does not pay a dividend, it makes good economic sense toexercise a call option as soon as the stock’s price exceeds the strike price byabout 10%, because this permits 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 todecline 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, thelower the premium on the option is likely to be.Because of the put-call parity relationship, under equilibrium conditions a putoption on a stock must sell at exactly the same price as a call option on the stock.2 pointsQuestion 12Suppose you believe that Delva Corporations stock price is going to decline fromits current level of $82.50 sometime during the next 5 months. For $510.25 youcould buy a 5-month put option giving you the right to sell 100 shares at a price of$85 per share. If you bought this option for $510.25 and Delvas stock priceactually 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 13An option that gives the holder the right to sell a stock at a specified price at somefuture time isAnswera call option.a put option.an out-of-the-money option.a naked option.a covered option.
2 pointsQuestion 14Which of the following statements is CORRECT?AnswerIf the underlying stock does not pay a dividend, it does not make good economicsense to exercise a call option prior to its expiration date, even if this would yieldan immediate profit.Call options generally sell at a price greater than their exercise value, and thegreater 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 greaterthe 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 theexercise value, the lower the premium on the option is likely to be.Because of the put-call parity relationship, under equilibrium conditions a putoption on a stock must sell at exactly the same price as a call option on the stock.2 pointsQuestion 15The current price of a stock is $22, and at the end of one year its price will beeither $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 options value?Answer$2.43$2.70$2.99$3.29$3.622 pointsQuestion 16
Which 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 theafter-tax cost of non-convertible preferred stock.Retained earnings that were generated in the past and are reported on the firm’sbalance sheet are available to finance the firm’s capital budget during the comingyear.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 is NOT a capital component when calculating the weightedaverage cost of capital (WACC) for use in capital budgeting?AnswerLong-term debt.Accounts payable.Retained earnings.Common stock.Preferred stock.2 pointsQuestion 18Which of the following statements is CORRECT?AnswerThe discounted cash flow method of estimating the cost of equity cannot be usedunless the growth rate, g, is expected to be constant forever.
If the calculated beta underestimates the firm’s true investment risk--i.e., if theforward-looking beta that investors think exists exceeds the historical beta--thenthe CAPM method based on the historical beta will produce an estimate of rs andthus WACC that is too high.Beta measures market risk, which is, theoretically, the most relevant risk measurefor a publicly-owned firm that seeks to maximize its intrinsic value. This is trueeven if not all of the firm’s stockholders are well diversified.An advantage shared by both the DCF and CAPM methods when they are usedto 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 premiumused in the bond-yield-plus-risk-premium approach.2 pointsQuestion 19Which of the following statements is CORRECT? Assume that the firm is apublicly-owned corporation and is seeking to maximize shareholder wealth.AnswerIf a firm has a beta that is less than 1.0, say 0.9, this would suggest that theexpected returns on its assets are negatively correlated with the returns on mostother firms’ assets.If a firm’s managers want to maximize the value of their firm’s stock, they should,in theory, concentrate on project risk as measured by the standard deviation ofthe project’s expected future cash flows.If a firm evaluates all projects using the same cost of capital, and the CAPM isused to help determine that cost, then its risk as measured by beta will probablydecline over time.Projects with above-average risk typically have higher than average expectedreturns. Therefore, to maximize a firm’s intrinsic value, its managers should favorhigh-beta projects over those with lower betas.Project A has a standard deviation of expected returns of 20%, while Project B’sstandard deviation is only 10%. A’s returns are negatively correlated with both thefirm’s other assets and the returns on most stocks in the economy, while B’sreturns are positively correlated. Therefore, Project A is less risky to a firm andshould be evaluated with a lower cost of capital.2 points
Question 20Duval Inc. uses only equity capital, and it has two equally-sized divisions. DivisionA’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 areall of Division Bs projects. However, the projects of Division A are less risky thanthose 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 21Norris Enterprises, an all-equity firm, has a beta of 2.0. The chief financial officeris evaluating a project with an expected return of 14%, before any riskadjustment. The risk-free rate is 5%, and the market risk premium is 4%. Theproject being evaluated is riskier than an average project, in terms of both its betarisk and its total risk. Which of the following statements is CORRECT?AnswerThe project should definitely be accepted because its expected return (before anyrisk adjustments) is greater than its required return.The project should definitely be rejected because its expected return (before riskadjustment) is less than its required return.Riskier-than-average projects should have their expected returns increased toreflect their higher risk. Clearly, this would make the project acceptableregardless of the amount of the adjustment.The accept/reject decision depends on thefirms risk-adjustment policy. If Norris policy is to increase the required return ona 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 totalrisk. Thus, insufficient information has been provided to make the accept/rejectdecision.2 pointsQuestion 22Which of the following statements is CORRECT?AnswerIn the WACC calculation, we must adjust the cost of preferred stock (the marketyield) to reflect the fact that 70% of the dividends received by corporate investorsare excluded from their taxable income.We should use historical measures of the component costs from prior financingsthat are still outstanding when estimating a company’s WACC for capitalbudgeting purposes.The cost of new equity (re) could possibly be lower than the cost of retainedearnings (rs) if the market risk premium, risk-free rate, and the company’s beta alldecline by a sufficiently large amount.A firm’s cost of retained earnings is the rate of return stockholders require on afirm’s common stock.The component cost of preferred stock is expressed as rp(1 - T), becausepreferred stock dividends are treated as fixed charges, similar to the treatment ofinterest on debt.2 pointsQuestion 23For a typical firm, which of the following sequences is CORRECT? All rates areafter taxes, and assume that the firm operates at its target capital structure.Answerrs> re >rd> WACC.re>rs> WACC >rd.WACC > re >rs> rd.rd> re >rs> WACC.
WACC >rd>rs>re.2 pointsQuestion 24Which of the following statements is CORRECT?AnswerThe cost of capital used to evaluate a project should be the cost of the specifictype of financing used to fund that project, i.e., it is the after-tax cost of debt ifdebt is to be used to finance the project or the cost of equity if the project will befinanced with equity.The after-tax cost of debt that should be used as the component cost whencalculating the WACC is the average after-tax cost of all the firm’s outstandingdebt.Suppose some of a publicly-traded firm’sstockholders are not diversified; they hold only the one firm’s stock. In this case,the CAPM approach will result in an estimated cost of equity that is too low in thesense that if it is used in capital budgeting, projects will be accepted that willreduce the firm’s intrinsic value.The cost of equity is generally harder to measure than the cost of debt becausethere 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 andobjective method for estimating a firm’s cost of equity capital.2 pointsQuestion 25Safeco Company and RiscoInc are identical in size and capital structure.However, the riskiness of their assets and cash flows are somewhat different,resulting in Safeco having a WACC of 10% and Risco a WACC of 12%. Safeco isconsidering Project X, which has an IRR of 10.5% and is of the same risk as atypical Safeco project. Risco is considering Project Y, which has an IRR of 11.5%and is of the same risk as a typical Risco project.Now assume that the two companies merge and form a new company,Safeco/Risco Inc. Moreover, the new companys market risk is an average of thepre-merger companies market risks, and the merger has no impact on either thecash flows or the risks of Projects X and Y. Which of the following statements isCORRECT?
AnswerIf the firm evaluates these projects and all other projects at the new overallcorporate WACC, it will probably become riskier over time.If evaluated using the correct post-merger WACC, Project X would have anegative NPV.After the merger, Safeco/Risco would have a corporate WACC of 11%.Therefore, it should reject Project X but accept Project Y.Safeco/Risco’s WACC, as a result of the merger, would be 10%.After the merger, Safeco/Risco shouldselect Project Y but reject Project X. If the firm does this, its corporate WACC willfall to 10.5%.2 pointsQuestion 26Which of the following statements is CORRECT?AnswerWhen calculating the cost of debt, a company needs to adjust for taxes, becauseinterest 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 deductibleby the paying corporation.Because of tax effects, an increase in the risk-free rate will have a greater effecton the after-tax cost of debt than on the cost of common stock as measured bythe CAPM.If a company’s beta increases, this will increase the cost of equity used tocalculate the WACC, but only if the company does not have enough retainedearnings to take care of its equity financing and hence must issue new stock.Higher flotation costs reduce investors expected returns, and that leads to areduction in a company’s WACC.2 pointsQuestion 27
Which of the following statements is CORRECT?AnswerThe WACC as used in capital budgeting is an estimate of a company’s before-taxcost of capital.The percentage flotation cost associated with issuing new common equity istypically smaller than the flotation cost for new debt.The WACC as used in capital budgeting is an estimate of the cost of all thecapital a company has raised to acquire its assets.There is an “opportunity cost” associated with using retained earnings, hencethey are not “free.”The WACC as used in capital budgeting wouldbe simply the after-tax cost of debt if the firm plans to use only debt to finance itscapital budget during the coming year.2 pointsQuestion 28Schalheim Sisters Inc. has always paid out all of its earnings as dividends; hence,the firm has no retained earnings. This same situation is expected to persist in thefuture. The company uses the CAPM to calculate its cost of equity, and its targetcapital structure consists of common stock, preferred stock, and debt. Which ofthe following events would REDUCE its WACC?AnswerThe market risk premium declines.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.2 pointsQuestion 29Which of the following statements is CORRECT?
AnswerThe bond-yield-plus-risk-premium approach to estimating the cost of commonequity involves adding a risk premium to the interest rate on the company’s ownlong-term bonds. The size of the risk premium for bonds with different ratings ispublished daily in The Wall Street Journal.The WACC is calculated using a before-tax cost for debt that is equal to theinterest rate that must be paid on new debt, along with the after-tax costs forcommon 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 debtand equity.The relevant WACC can change depending on the amount of funds a firm raisesduring a given year. Moreover, the WACC at each level of funds raised is aweighted average of the marginal costs of each capital component, with theweights based on the firm’s target capital structure.Beta measures market risk, which is generally the most relevant risk measure fora publicly-owned firm that seeks to maximize its intrinsic value. However, this isnot true unless all of the firm’s stockholders are well diversified.2 pointsQuestion 30The MacMillen Company has equal amounts of low-risk, average-risk, and high-risk projects. The firms overall WACC is 12%. The CFO believes that this is thecorrect WACC for the company’s average-risk projects, but that a lower rateshould be used for lower-risk projects and a higher rate for higher-risk projects.The CEO disagrees, on the grounds that even though projects have differentrisks, the WACC used to evaluate each project should be the same because thecompany obtains capital for all projects from the same sources. If the CEO’sposition is accepted, what is likely to happen over time?AnswerThe company will take on too many high-risk projects and reject too many low-risk projects.The company will take on too many low-risk projects and reject too many high-risk projects.Things will generally even out over time, and, therefore, the firm’s risk shouldremain constant over time.The company’s overall WACC should decrease
over time because its stock price should be increasing.The CEO’s recommendation would maximize the firm’s intrinsic value.