# FIN 534/ FIN 534 FINAL EXAM PART 1 & 2 2015 - 94567

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PART 1

1. 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.

2. 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.

3. 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

4. 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.

All of the above.

None of the above.

5. 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.

6. Which of the following statements is CORRECT?

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.

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

7. Perpetual preferred stock from Franklin Inc. sells for \$97.50 per share, and it pays an \$8.50 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?

8.72%

9.08%

9.44%

9.82%

10.22%

8. Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting?

Accounts payable.

Common stock “raised” by reinvesting earnings.

Common stock raised by new issues.

Preferred stock.

Long-term debt

9. Which of the following statements is CORRECT?

The tax-adjusted cost of debt is always greater than the interest rate on debt, provided the company does in fact pay taxes.

If a company assigns the same cost of capital to all of its projects regardless of each project's risk, then the company is likely to reject some safe projects that it actually should accept and to accept some risky projects that it should reject.

Because no flotation costs are required to obtain capital as reinvested earnings, the cost of reinvested earnings is generally lower than the after-tax cost of debt.

Higher flotation costs tend to reduce the cost of equity capital.

Since debt capital can cause a company to go bankrupt but equity capital cannot, debt is riskier than equity, and thus the after-tax cost of debt is always greater than the cost of equity.

10. Burnham Brothers Inc. has no retained earnings since it has always paid out all of its earnings as dividends. 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?

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.

The market risk premium declines.

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. A company's perpetual preferred stock currently sells for \$92.50 per share, and it pays an \$8.00 annual dividend. If the company were to sell a new preferred issue, it would incur a flotation cost of 5.00% of the issue price. What is the firm's cost of pre

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