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<strong>FIN
534 Final Exam Part 1 and Part 2 Solution</strong>
<strong>Version
1</strong>
<strong>Part
1</strong>
1. Which
of the following statements is CORRECT?
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.
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.
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
3.
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.
4. 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.
5. An
investor who writes standard call options against stock held in his or her
portfolio is said to be selling what type of options?
Put
Naked
Covered
Out-of-the-money
In-the-money
6.
Suppose you believe that Basso Inc.'s stock price is going to increase from its
current level of $22.50 sometime during the next 5 months. For $3.10 you can
buy a 5-month call option giving you the right to buy 1 share at a price of $25
per share. If you buy this option for $3.10 and Basso's stock price actually rises
to $45, what would your pre-tax net profit be?
-$3.10
$16.90
$17.75
$22.50
$25.60
7. 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.
8. Which
of the following statements is CORRECT?
All else
equal, an increase in a company's stock price will increase its marginal cost
of reinvested earnings (not newly issued stock), rs.
All else
equal, an increase in a company's stock price will increase its marginal cost
of new common equity, re.
Since
the money is readily available, the after-tax cost of reinvested earnings (not
newly issued stock) is usually much lower than the after-tax cost of debt.
If a
company's tax rate increases but the YTM on its noncallable bonds remains the
same, the after-tax cost of its debt will fall.
When
calculating the cost of preferred stock, a company needs to adjust for taxes,
because preferred stock dividends are deductible by the paying corporation.
9. 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.
10.
Which of the following statements is CORRECT? Assume a company's target capital
structure is 50% debt and 50% common equity.
The WACC
is calculated on a before-tax basis.
The WACC
exceeds the cost of equity.
The cost
of equity is always equal to or greater than the cost of debt.
The cost
of reinvested earnings typically exceeds the cost of new common stock.
The
interest rate used to calculate the WACC is the average after-tax cost of all
the company's outstanding debt as shown on its balance sheet.
11.
Which of the following statements is CORRECT?
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 reinvested 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 reinvesting 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.
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.
12.
Which of the following statements is CORRECT?
WACC
calculations should be based on the before-tax costs of all the individual
capital components.
Flotation
costs associated with issuing new common stock normally reduce the WACC.
If a
company's tax rate increases, then, all else equal, its weighted average cost
of capital will decline.
An
increase in the risk-free rate will normally lower the marginal costs of both
debt and equity financing.
A change
in a company's target capital structure cannot affect its WACC.
13.
Which of the following statements is CORRECT?
The IRR
method can never be subject to the multiple IRR problem, while the MIRR method
can be.
One
reason some people prefer the MIRR to the regular IRR is that the MIRR is based
on a generally more reasonable reinvestment rate assumption.
The
higher the WACC, the shorter the discounted payback period.
The MIRR
method assumes that cash flows are reinvested at the crossover rate.
The MIRR
and NPV decision criteria can never conflict.
14.
Which of the following statements is CORRECT?
To find
the MIRR, we first compound cash flows at the regular IRR to find the TV, and
then we discount the TV at the WACC to find the PV.
The NPV
and IRR methods both assume that cash flows can be reinvested at the WACC.
However, the MIRR method assumes reinvestment at the MIRR itself.
If two
projects have the same cost, and if their NPV profiles cross in the upper right
quadrant, then the project with the higher IRR probably has more of its cash
flows coming in the later years.
If two
projects have the same cost, and if their NPV profiles cross in the upper right
quadrant, then the project with the lower IRR probably has more of its cash
flows coming in the later years.
For a
project with normal cash flows, any change in the WACC will change both the NPV
and the IRR.
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