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Derivatives, mergers, multinational finance

1. The value of an option depends on the stock's price, the risk-free rate, and the

a. Exercise price.
b. Variability of the stock price.
c. Option's time to maturity.
d. All of the above.
e. None of the above.

2. An option which gives the holder the right to sell a stock at a specified price at some time in the future is called a(n)

a. Call option.
b. Put option.
c. Out-of-the-money option.
d. Naked option.
e. Covered option.

3. There are call options on the common stock of XYZ Corporation. Which of the following best describes the factors affecting the value of these call options?

a. The price of the call options is likely to rise if XYZ's stock price rises.
b. The higher the strike price on the call option, the higher the call option price.
c. Assuming the same strike price, a call option which expires in one month will sell for a higher price than a call option which expires in three months.
d. All of the answers above are correct.
e. None of the answers above is correct.

4. Which of the following statements is correct?

a. Put options give investors the right to buy a stock at a certain exercise price before a specified date.
b. Call options give investors the right to sell a stock at a certain exercise price before a specified date.
c. Options typically sell for less than their exercise value.
d. LEAPS are very short-term options which have begun trading on the exchanges in recent years.
e. Option holders are not entitled to receive dividends unless they choose to exercise their option.

5. An investor who writes call options against stock held in his or her portfolio is said to be selling ___________ options.

a. in-the-money
b. put
c. naked
d. covered
e. out-of-the-money

6. Suppose you believe that Du Pont'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 $83.00 per share. If you bought a 100-share contract for $510.25 and Du Pont's stock price actually dropped to $63.00, you would make

a. $1,950.00
b. $1,439.75
c. $1,489.75
d. $2,000.00
e. $2,435.00

7. Which of the following statements about interest rate and reinvestment rate risk is correct?

a. Variable, or floating rate, securities have a high degree of interest rate (price) risk.
b. Price risk occurs because fixed-rate debt securities lose value when interest rates rise, while reinvestment rate risk is the risk of earning less than expected when interest payments or debt principal are reinvested.
c. Price risk can be eliminated by purchasing zero coupon bonds.
d. Reinvestment rate risk can be eliminated by purchasing variable, or floating, rate bonds.
e. All of the statements above are correct.

8. A commercial bank estimates that its net income suffers whenever interest rates increase. The bank is looking to use derivatives to reduce its interest rate risk. Which of the following strategies best protects the bank against rising interest rates?

a. Buying inverse floaters.
b. Entering into an interest rate swap where the bank receives a fixed payment stream, and in return agrees to make payments that float with market interest rates.
c. Purchase principal only (PO) strips that decline in value whenever interest rates rise.
d. Enter into a short hedge where the bank agrees to sell interest rate futures.
e. Sell some of the banks floating rate loans and use the proceeds to make fixed rate loans.

9. Company A can issue floating rate debt at LIBOR + 1 percent and can issue fixed rate debt at 9 percent. Company B can issue floating rate debt at LIBOR + 1.4 percent and can issue fixed rate debt at 9.4 percent. Suppose A issues floating rate debt and B issues fixed rate debt. They engage in the following swap: A will make a fixed 7.95 percent payment to B, and B will make a floating rate payment equal to LIBOR to A. What are the resulting net payments of A and B?

a. A pays a fixed rate of 9 percent, B pays LIBOR + 1.5 percent.
b. A pays a fixed rate of 8.95 percent, B pays LIBOR + 1.45 percent.
c. A pays LIBOR plus 1 percent, B pays a fixed rate of 9.4 percent.
d. A pays a fixed rate of 7.95 percent, B pays LIBOR.
e. None of the answers above is correct.

10. Deeble Construction Co.'s stock is trading at $30 a share. There are also call options on the company's stock, some with an exercise price of $25 and some with an exercise price of $35. All options expire in three months. Which of the following best describes the value of these options?

a. The options with the $25 exercise price will sell for $5.
b. The options with the $25 exercise price will sell for less than the options with the $35 exercise price.
c. The options with the $25 exercise price have an exercise value greater than $5.
d. The options with the $35 exercise price have an exercise value greater than $0.
e. If Deeble's stock price rose by $5, the exercise value of the options with the $25 exercise price would also increase by $5.

11. Which of the following are not ways in which risk management can increase the value of a company?

a. Risk management can increase debt capacity.
b. Risk management can help a firm maintain its optimal capital budget.
c. Risk management can reduce the expected costs of financial distress.
d. Risk management can help firms minimize taxes.
e. Risk management can allow managers to maximize their bonuses.

12. A swap is a method for reducing financial risk. Which of the following statements about swaps, if any, is incorrect?

a. A swap involves the exchange of cash payment obligations.
b. The earliest swaps were currency swaps, in which companies traded debt denominated in different currencies, say dollars and pounds.
c. Swaps are generally arranged by a financial intermediary, who may or may not take the position of one of the counterparties.
d. A problem with swaps is the lack of standardized contracts, which limits the development of a secondary market.
e. All of the statements above are correct.

13. Which of the following statements is most correct?

a. One advantage of forward contracts is that they are default free.
b. Futures contracts generally trade on an organized exchange and are marked to market daily.
c. Goods are never delivered under forward contracts, but are almost always delivered under futures contracts.
d. Answers a and c are correct.
e. None of the answers above is correct.

14. Suppose the December CBOT Treasury bond futures contract has a quoted price of 80-07. If annual interest rates go up by 1 percentage point, what is the gain or loss on the futures contract (assume $1,000 par value)?

a. Loss of $78
b. Gain of $78
c. Loss of $145
d. Gain of $145
e. None of the above

15. Firms use defensive tactics to fight off undesired mergers. These tactics include

a. Raising antitrust issues.
b. Taking poison pills.
c. Getting a white knight to bid for the firm.
d. Repurchasing their own stock.
e. All of the above.

16. Which of the following statements is most correct?

a. Tax considerations often play a part in mergers. If one firm has excess cash, purchasing another firm exposes the purchasing firm to additional taxes. Thus, firms with excess cash rarely undertake mergers.
b. The smaller the synergistic benefits of a particular merger, the greater the incentive to bargain in negotiations, and the higher the probability that the merger will be completed.
c. Since mergers are frequently financed by debt more than equity, financial economies which imply a lower cost of debt or greater debt capacity are rarely a relevant rationale for mergers.
d. Managers who purchase other firms often assert that the new combined firm will enjoy benefits from diversification such as more stable earnings. However, since shareholders are free to diversify their own holdings at lower cost, such a rationale is generally not a valid motive for publicly held firms.

17. Which of the following statements is most correct?

a. A firm acquiring another firm in a horizontal merger will not have its required rate of return affected because the two firms will have similar betas.
b. Financial theory says that the choice of how to pay for a merger is really irrelevant because, although it may affect the firm's capital structure, it will not affect the firm's overall required rate of return.
c. The basic rationale for any financial merger is synergy and thus, development of pro-forma cash flows is the single most important part of the analysis.
d. In most mergers, the benefits of synergy and the price premium the acquirer pays over market price are summed and then divided equally between the shareholders of the acquiring and target firms.
e. The primary rationale for any operating merger is synergy, but it is also possible that mergers can include aspects of both operating and financial mergers.

18. American Hardware, a national hardware chain, is considering purchasing a smaller chain, Eastern Hardware. American's analysts project that the merger will result in incremental net cash flows with a present value of $72.52 million, and they have determined that the appropriate discount rate for valuing Eastern is 16 percent. Eastern has 4 million shares outstanding. Eastern's current price is $16.25. What is the maximum price per share that American should offer?

a. $16.25
b. $16.97
c. $17.42
d. $18.13
e. $19.00

19. A parent holding company sells shares in its subsidiary such that the parent now owns only 65 percent of the subsidiary and thus, the tax returns of the parent and its subsidiary can't be consolidated. The parent receives annual dividends from the subsidiary of $2,500,000. If the parent's marginal tax rate is 34 percent and if the exclusion on intercompany dividends is 70 percent, what is the effective tax rate on the intercompany dividends and what are the net dividends received?

a. 10.2%; $2,245,000
b. 10.2%; $2,135,000
c. 23.8%; $1,905,000
d. 10.2%; $1,750,000
e. 34.0%; $1,650,000

20. American Pizza, a national pizza chain, is considering purchasing a smaller chain, Eastern Pizza. American's analysts project that the merger will result in incremental net cash flows of $2 million in Year 1, $4 million in Year 2, $5 million in Year 3, and $117 million in Year 4. (The Year 4 cash flow includes a terminal value of $107 million.) The acquisition would be made immediately, if it is undertaken. Eastern's post-merger beta is estimated to be 2.0, and its post-merger tax rate would be 34 percent. The risk-free rate is 8 percent, and the market risk premium is 4 percent. What is the appropriate discount rate for valuing the acquisition?

a. 17%
b. 16%
c. 15%
d. 14%
e. 12%

21. Which of the following are reasons why companies move into international operations?

a. To take advantage of lower production costs in regions of inexpensive labor.
b. To develop new markets for their finished products.
c. To better serve their primary customers.
d. Because important raw materials are located abroad.
e. All of the above.

22. Multinational financial management requires that

a. The effects of changing currency values be included in financial analyses.
b. Legal and economic differences be considered in financial decisions.
c. Political risk be excluded from multinational corporate financial analyses.
d. All of the above.
e. Only a and b above.

23. If the inflation rate in the United States is greater than the inflation rate in Sweden, other things held constant, the Swedish currency will

a. Appreciate against the U.S. dollar.
b. Depreciate against the U.S. dollar.
c. Remain unchanged against the U.S. dollar.
d. Appreciate against other major currencies.
e. Appreciate against the dollar and other major currencies.

24. If one Swiss franc can purchase $0.71 U.S. dollars, how many Swiss francs can one U.S. dollar buy?

a. 0.71
b. 1.41
c. 1.00
d. 2.81
e. 0.50

25. If the spot rate of the French franc is 5.51 francs per dollar and the 180-day forward rate is 5.97 francs per dollar, then the forward rate for the French franc is selling at a ________________ to the spot rate.

a. premium of 8%
b. premium of 18%
c. discount of 18%
d. discount of 8%
e. premium of 16%

26. Hockey skates sell in Canada for 105 Canadian dollars. Currently, 1 Canadian dollar equals 0.71 U.S. dollars. If purchasing power parity (PPP) holds, what is the price of hockey skates in the United States?

a. $ 14.79
b. $ 71.00
c. $ 74.55
d. $ 85.88
e. $147.88

27. Pit Row Auto, a national autoparts chain, is considering purchasing a smaller chain, Southern Auto. Pit Row's analysts project that the merger will result in the following incremental free cash flows, tax shields, and horizon values:

Year 1 2 3 4
Free cash flow $1 $3 $3 $7
Unlevered horizon value 75
Tax shield 1 1 2 3
Horizon value of tax shield 32

Assume all cash flows occur at the end of the year. Southern is currently financed with 30% debt at a rate of 10%. The acquisition would be made immediately, if it is undertaken and Southern would retain its current $15 million in debt and issue new debt in order to continue targeting a 30% debt level. The interest rate will remain the same. Southern's pre-merger beta is estimated to be 2.0, and its post-merger tax rate would be 34 percent. The risk-free rate is 8 percent, and the market risk premium is 4 percent. What is the value of Southern Auto's equity to Pit Row Auto?

a. $53.40 million
b. $61.96 million
c. $64.64 million
d. $76.96 million
e. $79.64 million

Multiple part:

(The following information applies to the next four questions. 14 - 16 )

Magiclean Corporation is considering an acquisition of Dustvac Company. Dustvac has a capital structure consisting of $5 million (market value) in 11% bonds and $10 million (market value) of common stock. Dustvac's pre-merger beta is 1.36. Magiclean's beta is 1.02 and both it and Dustvac face a 40 percent tax rate. Magiclean's capital structure is 40 percent debt and 60 percent equity. The free cash flows from Dustvac are estimated to be $3.0 million for each of the next four years and a horizon value of $10.0 million in Year 4. Tax savings are estimated to be $1 million for each of the next 4 years and a horizon value of $5 million in Year 4. Additionally, new debt would be issued to finance the acquisition and retire the old debt, and this new debt would have an interest rate of 8%. Currently, the risk-free rate is 6.0 percent and the market risk premium is 4.0 percent.

28. What Dustvac's pre-merger WACC?

a. 9.02%
b. 9.50%
c. 9.83%
d. 10.01%
e. 11.29%

29. What discount rate should you use to discount the free cash flows and interest tax savings?

a. 10.01%
b. 10.06%
c. 11.29%
d. 11.44%
e. 13.49%

30. What is the value of Dustvac's equity to Magiclean? (Round your answer to the closest thousand dollars.)

a. $17,019,000
b. $17,109,000
c. $17,916,000
d. $22,111,000
e. $22,916,000

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1. The value of an option depends on the stock's price, the risk-free rate, and the

a. Exercise price.
b. Variability of the stock price.
c. Option's time to maturity.
d. All of the above.
e. None of the above.

Answer: d. All of the above.

"There are six factors that influence the price of a stock option: 1) The current security price 2) The exercise price 3) Time to maturity 4) Volatility of the underlying asset's price 5) Risk-free interest rate and 6) Dividends expected during life of the option
"

2. An option which gives the holder the right to sell a stock at a specified price at some time in the future is called a(n)

a. Call option.
b. Put option.
c. Out-of-the-money option.
d. Naked option.
e. Covered option.

Answer: b. Put option.
Call options give the owner the right to buy the undelying asset, put option give the owner the right to sell the underlying asset.

3. There are call options on the common stock of XYZ Corporation.  Which of the following best describes the factors affecting the value of these call options?

a. The price of the call options is likely to rise if XYZ's stock price rises.
b. The higher the strike price on the call option, the higher the call option price.
c. Assuming the same strike price, a call option which expires in one month will sell for a higher price than a call option which expires in three months.
d. All of the answers above are correct.
e. None of the answers above is correct.

Answer: a. The price of the call options is likely to rise if XYZ's stock price rises.

Call option - as the price of the asset increases the option is more profitable.
The higher the strike price on the call option, the lower is the call option price.
Put and call options become more valuable as the time to expiration increases.

4. Which of the following statements is correct?

a. Put options give investors the right to buy a stock at a certain exercise price before a specified date.
b. Call options give investors the right to sell a stock at a certain exercise price before a specified date.
c. Options typically sell for less than their exercise value.
d. LEAPS are very short-term options which have begun trading on the exchanges in recent years.
e. Option holders are not entitled to receive dividends unless they choose to exercise their option.

Answer: e. Option holders are not entitled to receive dividends unless they choose to exercise their option.

Holders of equity call options are not entitled to receive the cash dividend paid to owners of the underlying stock, unless they exercise the calls prior to the ex dividend date
Call options give the owner the right to buy the undelying asset, put option give the owner the right to sell the underlying asset.
LEAPS (Long-Term Equity Anticipation Securities) are long term options. These are Publicly traded options contracts with expiration dates that are longer than one year.

5. An investor who writes call options against stock held in his or her portfolio is said to be selling ___________ options.

a. in-the-money
b. put
c. naked
d. covered
e. out-of-the-money

Answer: d. covered

A covered option is an option contract backed by the shares underlying the option.

6. Suppose you believe that Du Pont'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 $83.00 per share. If you bought a 100-share contract for $510.25 and Du Pont's stock price actually dropped to $63.00, you would make

a. $1,950.00
b. $1,439.75
c. $1,489.75
d. $2,000.00
e. $2,435.00

Answer: c. $1,489.75
Payoff at expiration= $2,000.00 =100*(83-63)
Less premium paid= $510.25
Profit= $1,489.75

7. Which of the following statements about interest rate and reinvestment rate risk is correct?

a. Variable, or floating rate, securities have a high degree of interest rate (price) risk.
b. Price risk occurs because fixed-rate debt securities lose value when interest rates rise, while reinvestment rate risk is the risk of earning less than expected when interest payments or debt principal are reinvested.
c. Price risk can be eliminated by purchasing zero coupon bonds.
d. Reinvestment rate risk can be eliminated by purchasing variable, or floating, rate bonds.
e. All of the statements above are correct.

Answer: b. Price risk occurs because fixed-rate debt securities lose value when interest rates rise, while reinvestment rate risk is the risk of earning less than expected when interest payments or debt principal are reinvested.

"Price risk: The risk that bond prices will decrease.
Reinvestment rate risk: The uncertainty about future or target date portfolio value that results from the need to reinvest bond coupons at yields not known in advance.
"

8. A commercial bank estimates that its net income suffers whenever interest rates increase.  The bank is looking to use derivatives to reduce its interest rate risk.  Which of the following strategies best protects the bank against rising interest rates?

a. Buying inverse floaters.
b. Entering into an interest rate swap where the bank receives a fixed payment stream, and in return agrees to make payments that float with market interest rates.
c. Purchase principal only (PO) strips that decline in value whenever interest rates rise.
d. Enter into a short hedge where the bank agrees to sell interest rate futures.
e. Sell some of the banks floating rate loans and use the proceeds to make fixed rate loans.

Answer: d. Enter into a short hedge where the bank agrees to sell interest rate futures.

When interest rate increases the interest rate future price will decrease. Since, we are short on futures we will gain when the futures price decreases.

An inverse floater, is a type of bond or other type of debt instrument whose coupon rate has an inverse relationship to short-term interest rates With an inverse floater, as interest rates rise the coupon rate falls. When short-term interest rates rise, the value of the bond can drop ...

Solution Summary

Answers multiple choice questions on derivatives, mergers, multinational finance.

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