FIN534/FIN 534 WEEK 11PART 1 (SOLUTION 100%)

Question 1

Which of the following statements is most correct, holding other things constant, for XYZ Corporation’s traded call options?

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

The price of these call options is likely to rise if XYZ’s stock price rises

Question 2

Suppose you believe that Florio Company’s stock price is going to decline from its current level of $82.50 sometime during the next 5 months. For $5.10 you could buy a 5-month put option giving you the right to sell 1 share at a price of $85 per share. If you bought this option for $5.10 and Florio’s stock price actually dropped to $60, what would your pre-tax net profit be?

-$5.10

$19.90

$20.90

$22.50

$27.60

Question 3

Which of the following statements is CORRECT?

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.

Question 4

Which of the following statements is CORRECT?

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.

Question 5

An option that gives the holder the right to sell a stock at a specified price at some future time is

a put option.

an out-of-the-money option.

a naked option.

a covered option.

a call option.

Question 6

Other things held constant, the value of an option depends on the stock’s price, the risk-free rate, and the

Variability of the stock price

Option’s time to maturity

Strike price

Strike price

All of the above

None of the above

 

Question 7

As a consultant to Basso Inc., you have been provided with the following data: D1 = $0.67; P0 = $27.50; and g = 8.00% (constant). What is the cost of common from reinvested earnings based on the DCF approach?

9.42%

9.91%

10.44%

10.96%

11.51%

Question 8

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?

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.

Question 9

Which of the following statements is CORRECT?

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.

 

Question 10

To help them estimate the company’s cost of capital, Smithco has hired you as a consultant. You have been provided with the following data: D1 = $1.45; P0 = $22.50; and g = 6.50% (constant). Based on the DCF approach, what is the cost of common from reinvested earnings?

11.10%

11.68%

12.30%

12.94%

13.59%

Question 11

Which of the following statements is CORRECT?

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.

Question 12

Suppose Acme Industries 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 likely

become less risky over time, and this will 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.

become riskier over time, but its intrinsic value will be maximized

Question 13

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

A project’s regular IRR is found by compounding the cash inflows at the WACC to find the present value (PV), then discounting the TV to find the IRR.

If a project’s IRR is smaller than the WACC, then its NPV will be positive.

A project’s IRR is the discount rate that causes the PV of the inflows to equal the project’s cost.

If a project’s IRR is positive, then its NPV must also be positive.

A project’s regular IRR is found by compounding the initial cost at the WACC to find the terminal value (TV), then discounting the TV at the WACC.

Question 14

Assume a project has normal cash flows. All else equal, which of the following statements is CORRECT?

A project’s NPV increases as the WACC declines.

A project’s MIRR is unaffected by changes in the WACC.

A project’s regular payback increases as the WACC declines.

A project’s discounted payback increases as the WACC declines.

A project’s IRR increases as the WACC declines.

Question 15

The WACC for two mutually exclusive projects that are being considered is 12%. Project K has an IRR of 20% while Project R’s IRR is 15%. The projects have the same NPV at the 12% current WACC. Interest rates are currently high. However, you believe that money costs and thus your WACC will soon decline. You also think that the projects will not be funded until the WACC has decreased, and their cash flows will not be affected by the change in economic conditions. Under these conditions, which of the following statements is CORRECT?

You should delay a decision until you have more information on the projects, even if this means that a competitor might come in and capture this market.

You should recommend Project R, because at the new WACC it will have the higher NPV.

You should recommend Project K, because at the new WACC it will have the higher NPV.

You should recommend Project R because it will have both a higher IRR and a higher NPV under the new conditions.

You should reject both projects because they will both have negative NPVs under the new

conditions.

Question 16

Which of the following statements is CORRECT?

The discounted payback method recognizes all cash flows over a project’s life, and it also adjusts these cash flows to account for the time value of money.

The regular payback method was, years ago, widely used, but virtually no companies even calculate the payback today.

The regular payback is useful as an indicator of a project’s liquidity because it gives managers an idea of how long it will take to recover the funds invested in a project.

The regular payback does not consider cash flows beyond the payback year, but the discounted payback overcomes this defect.

The regular payback method recognizes all cash flows over a project’s life.

Question 17

Which of the following statements is CORRECT?

If a project has “normal” cash flows, then its MIRR must be positive.

If a project has “normal” cash flows, then it will have exactly two real IRRs.

The definition of “normal” cash flows is that the cash flow stream has one or more negative cash flows followed by a stream of positive cash flows and then one negative cash flow at the end of the project’s life.

If a project has “normal” cash flows, then it can have…

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