# Multiple choice

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

a.Strike price.

b.Variability of the stock price.

c.Option's time to maturity.

d.All of the above.

e.None of the above.

2. Which of the following statements is CORRECT?

a.Put options give investors the right to buy a stock at a certain strike price before a specified date.

b.Call options give investors the right to sell a stock at a certain strike price before a specified date.

c.Options typically sell for less than their exercise value.

d.LEAPS are very short-term options that were created relatively recently and now trade in the market.

e.An option holder is not entitled to receive dividends unless he or she exercises their option before the stock goes ex dividend

3.An investor who writes standard call options against stock held in his or her portfolio is said to be selling what type of options?

a.In-the-money

b.Put

c.Naked

d.Covered

e.Out-of-the-money

4.Which of the following statements is CORRECT?

a.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.

b.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.

c.Issuing options provides companies with a low cost method of raising capital.

d.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.

e.The potential loss on an option decreases as the option sells at higher and higher prices because the profit margin gets bigger.

5. 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?

a.ï?$310.25

b.$1,689.75

c.$1,774.24

d.$1,862.95

e.$1,956.10

6. 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?

a.$7.33

b.$7.71

c.$8.12

d.$8.55

e.$9.00

6.Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC)?

a.Long-term debt.

b.Accounts payable.

c.Retained earnings.

d.Common stock.

e.Preferred stock

7.Schalheim Sisters Inc. has always paid out all of its earnings as dividends, and hence 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. Its target capital structure consists of common stock, preferred stock, and debt. Which of the following events would reduce the WACC?

a.The market risk premium declines.

b.The flotation costs associated with issuing new common stock increase.

c.The company's beta increases.

d.Expected inflation increases.

e.The flotation costs associated with issuing preferred stock increase.

7.Nelson Enterprises, an all-equity firm, has a beta of 2.0. Nelson's chief financial officer is evaluating a project with an expected return of 21%, before any risk adjustment. The risk-free rate is 7%, and the market risk premium is 6%. The project being evaluated is riskier than Nelson's average project, in terms of both its beta risk and its total risk. Which of the following statements is CORRECT?

a.The project should definitely be accepted because its expected return (before any risk adjustments) is greater than its required return.

b.The project should definitely be rejected because its expected return (before risk adjustment) is less than its required return.

c.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.

d.The accept/reject decision depends on the firm's risk-adjustment policy. If Nelson's policy is to increase the required return on a riskier-than-average project to 3% over rS, then it should reject the project.

e.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.

8. Which of the following statements is CORRECT?

a.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.

b.We should use historical measures of the component costs from prior financings when estimating a company's WACC for capital budgeting purposes.

c.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.

d.Its cost of retained earnings is the rate of return stockholders require on a firm's common stock.

e.The component cost of preferred stock is expressed as rp(1 ï? T), because preferred stock dividends are treated as fixed charges, similar to the treatment of interest on debt.

9. Crary Consolidated has 2 divisions of equal size: a computer division and a restaurant division. Its CFO believes that stand-alone restaurant companies typically have a WACC of 8%, while stand-alone computer companies typically have a 12% WACC. He also believes that Crary's restaurant and computer divisions have the same risk as their typical peers. Consequently, Crary estimates that its composite, or corporate, WACC is 10%. A consultant has suggested using an 8% hurdle rate for the restaurant division and a 12% hurdle rate for the computer division. However, Crary's CFO disagrees, and he has assigned a 10% WACC to all projects in both divisions. Which of the following statements is CORRECT?

a.While Crary's decision not to use risk-adjusted WACCs will result in its accepting more projects in the computer division and fewer projects in its restaurant division than if it followed the consultant's recommendation, this should not affect the firm's intrinsic value.

b.Crary's decision not to adjust for risk means, in effect, that it is favoring the restaurant division. Therefore, that division is likely to become a larger part of the consolidated company over time.

c.Crary's decision not to adjust for risk means that the company will accept too many projects in the computer business and too few projects in the restaurant business. This will lead to a reduction in the firm's intrinsic value over time.

d.Crary's decision to not risk adjust means that the company will accept too many projects in the restaurant business and too few projects in the computer business. This will lead to a reduction in its intrinsic value over time.

e.Crary's decision not to risk adjust means that the company will accept too many projects in the computer business and too few projects in the restaurant business. This may affect the firm's capital structure but it will not affect its intrinsic value.

10. Which of the following statements is CORRECT?

a.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.

b.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.

c.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 not maximize the firm's intrinsic value.

d.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.

e.The bond-yield-plus-risk-premium approach is the most sophisticated and objective method for estimating a firm's cost of equity capital.

11. Hettenhouse Company's perpetual preferred stock sells for $102.50 per share, and it pays a $9.50 annual dividend. If the company were to sell a new preferred issue, it would incur a flotation cost of 4.00% of the price paid by investors. What is the company's cost of preferred stock for use in calculating the WACC?

9.27%

9.65%

10.04%

10.44%

10.86%

12. To help finance a major expansion, Delano Development Company sold a noncallable bond several years ago that now has 15 years to maturity. This bond has a 10.25% annual coupon, paid semiannually, it sells at a price of $1,025, and it has a par value of $1,000. If Delano's tax rate is 40%, what component cost of debt should be used in the WACC calculation?

5.11%

5.37%

5.66%

5.96%

6.25%

13.Kovach Lumber Company hired you to help estimate its cost of capital. You were provided with the following data: D1 = $1.10; P0 = $27.50; g = 6.00% (constant); and F = 5.00%. What is the cost of equity raised by selling new common stock?

9.41%

9.80%

10.21%

10.62%

11.04%

14. Roxie Epoxy's balance sheet shows a total of $50 million long-term debt with a coupon rate of 8.00% and a yield to maturity of 7.00%. This debt currently has a market value of $55 million. The balance sheet also shows that that the company has 20 million shares of common stock, and the book value of the common equity (common stock plus retained earnings) is $65 million. The current stock price is $8.25 per share; stockholders' required return, rs, is 10.00%; and the firm's tax rate is 40%. Based on market value weights, and assuming the firm is currently at its target capital structure, what WACC should Roxie use to evaluate capital budgeting projects?

7.26%

7.48%

7.88%

8.21%

8.55%

15. 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.A project's NPV is found by compounding the cash inflows at the IRR to find the terminal value (TV), then discounting the TV at the WACC.

b.The lower the WACC used to calculate it, the lower the calculated NPV will be.

c.If a project's NPV is less than zero, then its IRR must be less than the WACC.

d.If a project's NPV is greater than zero, then its IRR must be less than zero.

e. The NPV of a relatively low risk project should be found using a relatively high WACC.

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

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

c. If a project's IRR is greater than the WACC, then its NPV must be negative.

d. To find a project's IRR, we must solve for the discount rate that causes the PV of the inflows to equal the PV of the project's costs.

e. To find a project's IRR, we must find a discount rate that is equal to the WACC.

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

a.The project's IRR increases as the WACC declines.

b.The project's NPV increases as the WACC declines.

c.The project's MIRR is unaffected by changes in the WACC.

d.The project's regular payback increases as the WACC declines.

e.The project's discounted payback increases as the WACC declines.

#### Solution Preview

1. d.All of the above.

All these factors affect the price

2. e.An option holder is not entitled to receive dividends unless he or she exercises their option before the stock goes ex dividend

Since the option holders is not the owner of the stock, there are no dividends till the stock is purchased by exercising the option

3. d.Covered

Since you own the stock also you have covered the risk

4. d.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.

These are parameters on which the option price is based

5. Profit = (45-25) X 100 shares - 310.25 = $1,689.75

6. We are given

V= Value of call option = $7.20

P, Price = $50

X, strike price = $55

Risk free rate, rRF = 6%

Time t ...

#### Solution Summary

The solution explains some multiple choice questions in finance