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? 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. Which of the following statements is CORRECT? Answer 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? Answer -$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 Answer 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? Answer 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? Answer 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? Answer 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? Answer 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? Answer 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? Answer 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? Answer 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 preferred stock? Answer 7.81% 8.22% 8.65% 9.10% 9.56% 13. 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. Answer The lower the WACC used to calculate a project's NPV, the lower the calculated NPV will be. If a project's NPV is less than zero, then its IRR must be less than the WACC. If a project's NPV is greater than zero, then its IRR must be less than zero. The NPV of a relatively low-risk project should be found using a relatively high WACC. 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. 14. The WACC for two mutually exclusive projects that are being considered is 8%. Project K has an IRR of 20% while Project R's IRR is 15%. The projects have the same NPV at the 8% current WACC. However, you believe that money costs and thus your WACC will also increase. You also think that the projects will not be funded until the WACC has increased, and their cash flows will not be affected by the change in economic conditions. Under these conditions, which of the following statements is CORRECT? Answer You should delay a decision until you have more information on the projects, even if this means that a competitor might come in and capture this market. You should recommend Project R, because at the new WACC it will have the higher NPV. You should recommend Project K, because at the new WACC it will have the higher NPV. You should recommend Project K because it has the higher IRR and will continue to have the higher IRR even at the new WACC. You should reject both projects because they will both have negative NPVs under the new conditions. 15. Assume a project has normal cash flows. All else equal, which of the following statements is CORRECT? Answer A project's NPV increases as the WACC declines. A project's MIRR is unaffected by changes in the WACC. A project's regular payback increases as the WACC declines. A project's discounted payback increases as the WACC declines. A project's IRR increases as the WACC declines. 16. Which of the following statements is NOT a disadvantage of the regular payback method? Answer Ignores cash flows beyond the payback period. Does not directly account for the time value of money. Does not provide any indication regarding a project's liquidity or risk. Does not take account of differences in size among projects. Lacks an objective, market-determined benchmark for making decisions. 17. Which of the following statements is CORRECT? Answer One defect of the IRR method is that it does not take account of the time value of money. One defect of the IRR method is that it does not take account of the cost of capital. One defect of the IRR method is that it values a dollar received today the same as a dollar that will not be received until sometime in the future. One defect of the IRR method is that it assumes that the cash flows to be received from a project can be reinvested at the IRR itself, and that assumption is often not valid. One defect of the IRR method is that it does not take account of cash flows over a project's full life. 18. Which of the following statements is CORRECT? Answer One drawback of the regular payback is that this method does not take account of cash flows beyond the payback period. If a project's payback is positive, then the project should be accepted because it must have a positive NPV. The regular payback ignores cash flows beyond the payback period, but the discounted payback method overcomes this problem. One drawback of the discounted payback is that this method does not consider the time value of money, while the regular payback overcomes this drawback. The shorter a project's payback period, the less desirable the project is normally considered to be by this criterion. 19. Which of the following is NOT a relevant cash flow and thus should not be reflected in the analysis of a capital budgeting project? Answer Shipping and installation costs. Cannibalization effects. Opportunity costs. Sunk costs that have been expensed for tax purposes. Changes in net working capital. 20. Which of the following rules is CORRECT for capital budgeting analysis? Answer Only incremental cash flows, which are the cash flows that would result if a project is accepted, are relevant when making accept/reject decisions. Sunk costs are not included in the annual cash flows, but they must be deducted from the PV of the project's other costs when reaching the accept/reject decision. A proposed project's estimated net income as determined by the firm's accountants, using generally accepted accounting principles (GAAP), is discounted at the WACC, and if the PV of this income stream exceeds the project's cost, the project should be accepted. If a product is competitive with some of the firm's other products, this fact should be incorporated into the estimate of the relevant cash flows. However, if the new product is complementary to some of the firm's other products, this fact need not be reflected in the analysis. The interest paid on funds borrowed to finance a project must be included in estimates of the project's cash flows. 21. When evaluating a new project, firms should include in the projected cash flows all of the following EXCEPT: Answer Previous expenditures associated with a market test to determine the feasibility of the project, provided those costs have been expensed for tax purposes. The value of a building owned by the firm that will be used for this project. A decline in the sales of an existing product, provided that decline is directly attributable to this project. The salvage value of assets used for the project that will be recovered at the end of the project's life. Changes in net working capital attributable to the project. 22. Which of the following should be considered when a company estimates the cash flows used to analyze a proposed project? Answer Since the firm's director of capital budgeting spent some of her time last year to evaluate the new project, a portion of her salary for that year should be charged to the project's initial cost. The company has spent and expensed $1 million on R&D associated with the new project. The company spent and expensed $10 million on a marketing study before its current analysis regarding whether to accept or reject the project. The firm would borrow all the money used to finance the new project, and the interest on this debt would be $1.5 million per year. The new project is expected to reduce sales of one of the company's existing products by 5%. 23. Which of the following statements is CORRECT? Answer An example of an externality is a situation where a bank opens a new office, and that new office causes deposits in the bank's other offices to increase. The NPV method automatically deals correctly with externalities, even if the externalities are not specifically identified, but the IRR method does not. This is another reason to favor the NPV. Both the NPV and IRR methods deal correctly with externalities, even if the externalities are not specifically identified. However, the payback method does not. Identifying an externality can never lead to an increase in the calculated NPV. An externality is a situation where a project would have an adverse effect on some other part of the firm's overall operations. If the project would have a favorable effect on other operations, then this is not an externality. 24. Which of the following statements is CORRECT? Answer In a capital budgeting analysis where part of the funds used to finance the project would be raised as debt, failure to include interest expense as a cost when determining the project's cash flows will lead to a downward bias in the NPV. The existence of any type of "externality" will reduce the calculated NPV versus the NPV that would exist without the externality. If one of the assets to be used by a potential project is already owned by the firm, and if that asset could be sold or leased to another firm if the new project were not undertaken, then the net after-tax proceeds that could be obtained should be charged as a cost to the project under consideration. If one of the assets to be used by a potential project is already owned by the firm but is not being used, then any costs associated with that asset is a sunk cost and should be ignored. In a capital budgeting analysis where part of the funds used to finance the project would be raised as debt, failure to include interest expense as a cost when determining the project's cash flows will lead to an upward bias in the NPV 25. Spontaneous funds are generally defined as follows: Answer A forecasting approach in which the forecasted percentage of sales for each item is held constant. Funds that a firm must raise externally through short-term or long-term borrowing and/or by selling new common or preferred stock. Funds that arise out of normal business operations from its suppliers, employees, and the government, and they include immediate increases in accounts payable, accrued wages, and accrued taxes. The amount of cash raised in a given year minus the amount of cash needed to finance the additional capital expenditures and working capital needed to support the firm's growth. Assets required per dollar of sales. 26. A company expects sales to increase during the coming year, and it is using the AFN equation to forecast the additional capital that it must raise. Which of the following conditions would cause the AFN to increase? Answer The company increases its dividend payout ratio. The company begins to pay employees monthly rather than weekly. The company's profit margin increases. The company decides to stop taking discounts on purchased materials. The company previously thought its fixed assets were being operated at full capacity, but now it learns that it actually has excess capacity. 27. North Construction had $850 million of sales last year, and it had $425 million of fixed assets that were used at only 60% of capacity. What is the maximum sales growth rate North could achieve before it had to increase its fixed assets? Answer 54.30% 57.16% 60.17% 63.33% 66.67% 28. Which of the following statements is CORRECT? Answer If a firm's assets are growing at a positive rate, but its retained earnings are not increasing, then it would be impossible for the firm's AFN to be negative. If a firm increases its dividend payout ratio in anticipation of higher earnings, but sales and earnings actually decrease, then the firm's actual AFN must, mathematically, exceed the previously calculated AFN. Higher sales usually require higher asset levels, and this leads to what we call AFN. However, the AFN will be zero if the firm chooses to retain all of its profits, i.e., to have a zero dividend payout ratio. Dividend policy does not affect the requirement for external funds based on the AFN equation. The sustainable growth rate is the maximum achievable growth rate without the firm having to raise external funds. In other words, it is the growth rate at which the firm's AFN equals zero. 29. Which of the following statements is CORRECT? Answer When fixed assets are added in large, discrete units as a company grows, the assumption of constant ratios is more appropriate than if assets are relatively small and can be added in small increments as sales grow. Firms whose fixed assets are "lumpy" frequently have excess capacity, and this should be accounted for in the financial forecasting process. For a firm that uses lumpy assets, it is impossible to have small increases in sales without expanding fixed assets. There are economies of scale in the use of many kinds of assets. When economies occur the ratios are likely to remain constant over time as the size of the firm increases. The Economic Ordering Quantity model for establishing inventory levels demonstrates this relationship. When we use the AFN equation, we assume that the ratios of assets and liabilities to sales (A0*/S0 and L0*/S0) vary from year to year in a stable, predictable manner. 30. Which of the following statements is CORRECT? Answer Suppose a firm is operating its fixed assets at below 100% of capacity, but it has no excess current assets. Based on the AFN equation, its AFN will be larger than if it had been operating with excess capacity in both fixed and current assets. If a firm retains all of its earnings, then it cannot require any additional funds to support sales growth. Additional funds needed (AFN) are typically raised using a combination of notes payable, long-term debt, and common stock. Such funds are non-spontaneous in the sense that they require explicit financing decisions to obtain them. If a firm has a positive free cash flow, then it must have either a zero or a negative AFN. Since accounts payable and accrued liabilities must eventually be paid off, as these accounts increase, AFN as calculated by the AFN equation must also increase. PART 2 1. Which of the following is NOT normally regarded as being a barrier to hostile takeovers? Answer Targeted share repurchases. Shareholder rights provisions. Restricted voting rights. Poison pills. Abnormally high executive compensation. 2. Which of the following is NOT normally regarded as being a good reason to establish an ESOP? Answer To enable the firm to borrow at a below-market interest rate. To make it easier to grant stock options to employees. To help prevent a hostile takeover. To help retain valued employees. To increase worker productivity. 3. Which of the following statements is correct? Answer If a company has an established clientele of investors who prefer a high dividend payout, and if management wants to keep stockholders happy, it should not follow the strict residual dividend policy. If a firm follows a strict residual dividend policy, then, holding all else constant, its dividend payout ratio will tend to rise whenever the firm's investment opportunities improve. If Congress eliminates taxes on capital gains but leaves the personal tax rate on dividends unchanged, this would motivate companies to increase their dividend payout ratios. Despite its drawbacks, following the residual dividend policy will tend to stabilize actual cash dividends, and this will make it easier for firms to attract a clientele that prefers high dividends, such as retirees. One advantage of dividend reinvestment plans is that they enable investors to avoid paying taxes on the dividends they receive. 4. Grandin Inc. is evaluating its dividend policy. It has a capital budget of $625,000, and it wants to maintain a target capital structure of 60% debt and 40% equity. The company forecasts a net income of $475,000. If it follows the residual dividend policy, what is its forecasted dividend payout ratio? Answer 40.61% 42.75% 45.00% 47.37% 49.74% 5. Poff Industries' stock currently sells for $120 a share. You own 100 shares of the stock. The company is contemplating a 2-for-1 stock split. Which of the following best describes what your position will be after such a split takes place? Answer You will have 200 shares of stock, and the stock will trade at or near $60 a share. You will have 100 shares of stock, and the stock will trade at or near $60 a share. You will have 50 shares of stock, and the stock will trade at or near $120 a share. You will have 50 shares of stock, and the stock will trade at or near $60 a share. You will have 200 shares of stock, and the stock will trade at or near $120 a share. 6. Consider two very different firms, M and N. Firm M is a mature firm in a mature industry. Its annual net income and net cash flows are both consistently high and stable. However, M's growth prospects are quite limited, so its capital budget is small relative to its net income. Firm N is a relatively new firm in a new and growing industry. Its markets and products have not stabilized, so its annual operating income fluctuates considerably. However, N has substantial growth opportunities, and its capital budget is expected to be large relative to its net income for the foreseeable future. Which of the following statements is correct? Answer Firm M probably has a higher dividend payout ratio than Firm N. If the corporate tax rate increases, the debt ratio of both firms is likely to decline. The two firms are equally likely to pay high dividends. Firm N is likely to have a clientele of shareholders who want to receive consistent, stable dividend income. Firm M probably has a lower debt ratio than Firm N. 7. If a firm adheres strictly to the residual dividend policy, then if its optimal capital budget requires the use of all earnings for a given year (along with new debt according to the optimal debt/total assets ratio), then the firm should pay Answer no dividends to common stockholders. dividends only out of funds raised by the sale of new common stock. dividends only out of funds raised by borrowing money (i.e., issue debt). dividends only out of funds raised by selling off fixed assets. no dividends except out of past retained earnings. 8. The capital budget of Creative Ventures Inc. is $1,000,000. The company wants to maintain a target capital structure that is 30% debt and 70% equity. The company forecasts that its net income this year will be $800,000. If the company follows a residual dividend policy, what will be its total dividend payment? Answer $100,000 $200,000 $300,000 $400,000 $500,000 9. In the real world, dividends Answer are usually more stable than earnings. fluctuate more widely than earnings. tend to be a lower percentage of earnings for mature firms. are usually changed every year to reflect earnings changes, and these changes are randomly higher or lower, depending on whether earnings increased or decreased. are usually set as a fixed percentage of earnings, e.g., at 40% of earnings, so if EPS = $2.00, then DPS will equal $0.80. Once the percentage is set, then dividend policy is on "automatic pilot" and the actual dividend depends strictly on earnings. 10. Which of the following statements is CORRECT? Answer The capital structure that minimizes the interest rate on debt also maximizes the expected EPS. The capital structure that minimizes the required return on equity also maximizes the stock price. The capital structure that minimizes the WACC also maximizes the price per share of common stock. The capital structure that gives the firm the best credit rating also maximizes the stock price. The capital structure that maximizes expected EPS also maximizes the price per share of common stock. 11. Which of the following events is likely to encourage a company to raise its target debt ratio, other things held constant? Answer An increase in the personal tax rate. An increase in the company's operating leverage. The Federal Reserve tightens interest rates in an effort to fight inflation. The company's stock price hits a new high. An increase in the corporate tax rate. 12. Which of the following would increase the likelihood that a company would increase its debt ratio, other things held constant? Answer An increase in the corporate tax rate. An increase in the personal tax rate. The Federal Reserve tightens interest rates in an effort to fight inflation. The company's stock price hits a new low. An increase in costs incurred when filing for bankruptcy. 13. Which of the following statements is CORRECT? Answer The capital structure that maximizes the stock price is also the capital structure that maximizes earnings per share. The capital structure that maximizes the stock price is also the capital structure that maximizes the firm's times interest earned (TIE) ratio. Increasing a company's debt ratio will typically reduce the marginal costs of both debt and equity financing; however, this still may raise the company's WACC. If Congress were to pass legislation that increases the personal tax rate but decreases the corporate tax rate, this would encourage companies to increase their debt ratios. The capital structure that maximizes the stock price is also the capital structure that minimizes the weighted average cost of capital (WACC). 14. Companies HD and LD have identical tax rates, total assets, and basic earning power ratios, and their basic earning power exceeds their before-tax cost of debt, rd. However, Company HD has a higher debt ratio and thus more interest expense than Company LD. Which of the following statements is CORRECT? Answer Company HD has a lower ROA than Company LD. Company HD has a lower ROE than Company LD. The two companies have the same ROA. The two companies have the same ROE. Company HD has a higher net income than Company LD. 15. Daylight Solutions is considering a recapitalization that would increase its debt ratio and increase its interest expense. The company would issue new bonds and use the proceeds to buy back shares of its common stock. The company's CFO thinks the plan will not change total assets or operating income, but that it will increase earnings per share (EPS). Assuming the CFO's estimates are correct, which of the following statements is CORRECT? Answer If the plan reduces the WACC, the stock price is also likely to decline. Since the plan is expected to increase EPS, this implies that net income is also expected to increase. If the plan does increase the EPS, the stock price will automatically increase at the same rate. Under the plan there will be more bonds outstanding, and that will increase their liquidity and thus lower the interest rate on the currently outstanding bonds. Since the proposed plan increases Daylight's financial risk, the company's stock price still might fall even if EPS increases. 16. Which of the following statements is CORRECT? Answer The capital structure that minimizes a firm's weighted average cost of capital is also the capital structure that maximizes its stock price. The capital structure that minimizes the firm's weighted average cost of capital is also the capital structure that maximizes its earnings per share. If a firm finds that the cost of debt is less than the cost of equity, increasing its debt ratio must reduce its WACC. Other things held constant, if corporate tax rates declined, then the Modigliani-Miller tax-adjusted tradeoff theory would suggest that firms should increase their use of debt. A firm can use retained earnings without paying a flotation cost. Therefore, while the cost of retained earnings is not zero, its cost is generally lower than the after-tax cost of debt. 17. Which of the following items should a company report directly in its monthly cash budget? Answer Cash proceeds from selling one of its divisions. Accrued interest on zero coupon bonds that it issued. New shares issued in a stock split. New shares issued in a stock dividend. Its monthly depreciation expense. 18. Which of the following will cause an increase in net working capital, other things held constant? Answer A cash dividend is declared and paid. Merchandise is sold at a profit, but the sale is on credit. Long-term bonds are retired with the proceeds of a preferred stock issue. Missing inventory is written off against retained earnings. 19. Which of the following statements is most consistent with efficient inventory management? The firm has a Answer low incidence of production schedule disruptions. below average total assets turnover ratio. relatively high current ratio. relatively low DSO. below average inventory turnover ratio. 20. A lockbox plan is Answer used to identify inventory safety stocks. used to slow down the collection of checks our firm writes. used to speed up the collection of checks received. used primarily by firms where currency is used frequently in transactions, such as fast food restaurants, and less frequently by firms that receive payments as checks. used to protect cash, i.e., to keep it from being stolen. 21. Other things held constant, which of the following would tend to reduce the cash conversion cycle? Answer Place larger orders for raw materials to take advantage of price breaks. Take all discounts that are offered. Continue to take all discounts that are offered and pay on the net date. Offer longer payment terms to customers. Carry a constant amount of receivables as sales decline. 22. A lockbox plan is most beneficial to firms that Answer have widely dispersed manufacturing facilities. have a large marketable securities portfolio and cash to protect. receive payments in the form of currency, such as fast food restaurants, rather than in the form of checks. have customers who operate in many different parts of the country. have suppliers who operate in many different parts of the country. 23. In Japan, 90-day securities have a 4% annualized return and 180-day securities have a 5% annualized return. In the United States, 90-day securities have a 4% annualized return and 180-day securities have an annualized return of 4.5%. All securities are of equal risk, and Japanese securities are denominated in terms of the Japanese yen. Assuming that interest rate parity holds in all markets, which of the following statements is most CORRECT? Answer The yen-dollar spot exchange rate equals the yen-dollar exchange rate in the 180-day forward market. The yen-dollar exchange rate in the 90-day forward market equals the yen-dollar exchange rate in the 180-day forward market. The spot rate equals the 90-day forward rate. The spot rate equals the 180-day forward rate. The yen-dollar spot exchange rate equals the yen-dollar exchange rate in the 90-day forward market. 24. If 1.64 Canadian dollars can purchase one U.S. dollar, how many U.S. dollars can you purchase for one Canadian dollar? Answer 0.37 0.61 1.00 1.64 3.28 25. Suppose Yates Inc., a U.S. exporter, sold a consignment of antique American muscle-cars to a Japanese customer at a price of 143.5 million yen, when the exchange rate was 140 yen per dollar. In order to close the sale, Yates agreed to make the bill payable in yen, thus agreeing to take some exchange rate risk for the transaction. The terms were net 6 months. If the yen fell against the dollar such that one dollar would buy 154.4 yen when the invoice was paid, what dollar amount would Yates actually receive after it exchanged yen for U.S. dollars? Answer $1,075,958 $1,025,000 $1,000,000 $975,610 $929,404 26. Suppose that 1 British pound currently equals 1.62 U.S. dollars and 1 U.S. dollar equals 1.62 Swiss francs. What is the cross exchange rate between the pound and the franc? Answer 1 British pound equals 3.2400 Swiss francs 1 British pound equals 2.6244 Swiss francs 1 British pound equals 1.8588 Swiss francs 1 British pound equals 1.0000 Swiss francs 1 British pound equals 0.3810 Swiss francs 27. Suppose a carton of hockey pucks sell in Canada for 105 Canadian dollars, and 1 Canadian dollar equals 0.71 U.S. dollars. If purchasing power parity (PPP) holds, what is the price of hockey pucks in the United States? Answer $14.79 $63.00 $74.55 $85.88 $147.88 28. Suppose one U.S. dollar can purchase 144 yen today in the foreign exchange market. If the yen depreciates by 8.0% tomorrow, how many yen could one U.S. dollar buy tomorrow? Answer 155.5 yen 144.0 yen 133.5 yen 78.0 yen 72.0 yen 29. Suppose a foreign investor who holds tax-exempt Eurobonds paying 9% is considering investing in an equivalent-risk domestic bond in a country with a 28% withholding tax on interest paid to foreigners. If 9% after-tax is the investor's required return, what before-tax rate would the domestic bond need to pay to provide the required after-tax return? Answer 9.00% 10.20% 11.28% 12.50% 13.75% 30. In 1985, a given Japanese imported automobile sold for 1,476,000 yen, or $8,200. If the car still sold for the same amount of yen today but the current exchange rate is 144 yen per dollar, what would the car be selling for today in U.S. dollars? Answer $5.964 $8,200 $10,250 $12,628 $13,525
Solution Description

 

PART 1

1. 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. Which of the following statements is CORRECT?

Answer

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?

Answer

-$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

Answer

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?

Answer

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?

Answer

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?

Answer

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?

Answer

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?

Answer

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?

Answer

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?

Answer

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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