2024 – FIN 534 Quiz 1 Question 1 Which of the following statements is CORRECT An

FIN 534 Quiz 1

Question 1 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 2 Which of the following statements is CORRECT?

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.

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.

 

Question 3 Other things held constant, the value of an option depends on the stock’s price, the risk-free rate, and the

Strike price.

Variability of the stock price.

Option’s time to maturity.

All of the above.

None of the above.

 

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%.

 

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).

 

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

 

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 

$7.33

$7.71

$8.12

$8.55

$9.00

 

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.

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

$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.

 

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.

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.

 

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

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.

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 

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.

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 

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 thefirm’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 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.

rs> re> WACC >rd.

WACC > re >rs> rd.

rd> re >rs> WACC.

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?

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 

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 wouldbe 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?

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 over time because its stock price should be increasing.

The CEO’s recommendation would maximize the firm’s intrinsic value.