1. FIN 534 Week 1 Quiz 1
(30 questions with answers) 99,99 % Scored
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Question 1
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.
2 points
Question 2
Which of the following statements is CORRECT?
Answer
Put 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.

2. 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 points
Question 3
Other things held constant, the value of an option depends on the stock's price,
the risk-free rate, and the
Answer
Strike price.
Variability of the stock price.
Option's time to maturity.
All of the above.
None of the above.
2 points
Question 4
Warner 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?
Answer
The 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%.

3. 2 points
Question 5
GCC 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?
Answer
GCC’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 points
Question 6
An investor who writes standard call options against stock held in his or her
portfolio is said to be selling what type of options?
Answer
In-the-money
Put
Naked
Covered
Out-of-the-money
2 points
Question 7
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

4. $7.33
$7.71
$8.12
$8.55
$9.00
2 points
Question 8
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.
2 points
Question 9
Suppose 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 shares at a
price of $25 per share. If you buy this option for $310.25 and Johnson's stock
price actually rises to $45, what would your pre-tax net profit be?
Answer
-$310.25

5. $1,689.75
$1,774.24
$1,862.95
$1,956.10
2 points
Question 10
Call options on XYZ Corporation’s common stock trade in the market. Which of
the following statements is most correct, holding other things constant?
Answer
The 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 will
sell 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 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 points
Question 11
Which of the following statements is CORRECT?
Answer
If 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 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 to
decline in value.

6. 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 points
Question 12
Suppose 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 shares at a price of
$85 per share. If you bought this option 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
$2,303.38
2 points
Question 13
An option that gives the holder the right to sell a stock at a specified price at some
future time is
Answer
a call option.
a put option.
an out-of-the-money option.
a naked option.
a covered option.

7. 2 points
Question 14
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.
2 points
Question 15
The 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 points
Question 16

8. Which of the following statements is CORRECT?
Answer
The 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 points
Question 17
Which of the following is NOT a capital component when calculating the weighted
average cost of capital (WACC) for use in capital budgeting?
Answer
Long-term debt.
Accounts payable.
Retained earnings.
Common stock.
Preferred stock.
2 points
Question 18
Which of the following statements is CORRECT?
Answer
The discounted cash flow method of estimating the cost of equity cannot be used
unless the growth rate, g, is expected to be constant forever.

9. 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 measures market risk, which is, theoretically, the most relevant risk measure
for a publicly-owned firm that seeks to maximize its intrinsic value. This is 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 points
Question 19
Which of the following statements is CORRECT? Assume that the firm is a
publicly-owned corporation and is seeking to maximize shareholder wealth.
Answer
If a firm has a beta that is less than 1.0, say 0.9, this would suggest that the
expected returns on its assets are negatively correlated with the returns on most
other 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 of
the project’s expected future cash flows.
If a firm evaluates all projects using the same cost of capital, and the CAPM is
used to help determine that cost, then its risk as measured by beta will probably
decline over time.
Projects with above-average risk typically have higher than average expected
returns. Therefore, to maximize a firm’s intrinsic value, its managers should favor
high-beta projects over those with lower betas.
Project A has a standard deviation of expected returns of 20%, while Project B’s
standard deviation is only 10%. A’s returns are negatively correlated with both the
firm’s other assets and the returns on most stocks in the economy, while B’s
returns are positively correlated. Therefore, Project A is less risky to a firm and
should be evaluated with a lower cost of capital.
2 points

10. Question 20
Duval 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?
Answer
A 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 points
Question 21
Norris 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?
Answer
The 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, this would 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.

11. 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 points
Question 22
Which of the following statements is CORRECT?
Answer
In the WACC calculation, we must adjust the cost of preferred stock (the market
yield) to reflect the fact that 70% of the dividends received by corporate investors
are excluded from their taxable income.
We should use historical measures of the component costs from prior financings
that are still outstanding when estimating a company’s WACC for capital
budgeting purposes.
The cost of new equity (re) could possibly be lower than the cost of retained
earnings (rs) if the market risk premium, risk-free rate, and the company’s beta all
decline by a sufficiently large amount.
A firm’s cost of retained earnings is the rate of return stockholders require on a
firm’s common stock.
The component cost of preferred stock is expressed as rp(1 - T), because
preferred stock dividends are treated as fixed charges, similar to the treatment of
interest on debt.
2 points
Question 23
For 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.
Answer
rs> re >rd> WACC.
re>rs> WACC >rd.
WACC > re >rs> rd.
rd> re >rs> WACC.

12. WACC >rd>rs>re.
2 points
Question 24
Which of the following statements is CORRECT?
Answer
The 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 this case,
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 points
Question 25
Safeco 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 is
considering Project X, which has an IRR of 10.5% and is of the same risk as a
typical 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 company's market risk is an average of the
pre-merger companies' market risks, and the merger has no impact on either the
cash flows or the risks of Projects X and Y. Which of the following statements is
CORRECT?

13. Answer
If the firm evaluates these projects and all other projects at the new overall
corporate WACC, it will probably become riskier over time.
If evaluated using the correct post-merger WACC, Project X would have a
negative 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 should
select Project Y but reject Project X. If the firm does this, its corporate WACC will
fall to 10.5%.
2 points
Question 26
Which of the following statements is CORRECT?
Answer
When 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, this will 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 points
Question 27

14. Which of the following statements is CORRECT?
Answer
The 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 points
Question 28
Schalheim 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 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 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 points
Question 29
Which of the following statements is CORRECT?

15. Answer
The 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 measures market risk, which is generally the most relevant risk measure for
a publicly-owned firm that seeks to maximize its intrinsic value. However, this is
not true unless all of the firm’s stockholders are well diversified.
2 points
Question 30
The MacMillen Company has equal amounts of low-risk, average-risk, and high-
risk projects. The firm's overall WACC is 12%. The CFO believes that this is the
correct WACC for the company’s average-risk projects, but that a lower rate
should 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 different
risks, the WACC used to evaluate each project should be the same because the
company obtains capital for all projects from the same sources. If the CEO’s
position is accepted, what is likely to happen over time?
Answer
The 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 should
remain constant over time.
The company’s overall WACC should decrease

16. over time because its stock price should be increasing.
The CEO’s recommendation would maximize the firm’s intrinsic value.