FIN534 WEEK 11PART 1

Question 1
Which of the following statements is most
correct, holding other things constant, for XYZ Corporation’s traded call
options?
The higher the strike price on XYZ’s options, the
higher the option’s price will be.
Assuming the same strike price, an XYZ call option
that expires in one month will sell at a higher price than one that expires in
three months.
If XYZ’s stock price stabilizes (becomes less
volatile), then the price of its options will increase.
If XYZ pays a dividend, then its option holders will
not receive a cash payment, but the strike price of the option will be reduced
by the amount of the dividend
The price of these call options is likely to rise if
XYZ’s stock price rises
Question 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
Question 3
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.
Question 4
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.
Question 5
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.
Question 6
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
Strike price
All of the above
None of the above

Question 7
As a consultant to Basso Inc., you have been
provided with the following data: D1 = $0.67; P0 = $27.50; and g = 8.00%
(constant). What is the cost of common from reinvested earnings based on the
DCF approach?
9.42%
9.91%
10.44%
10.96%
11.51%
Question 8
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.
Question 9
Which of the following statements is CORRECT?
The percentage flotation cost associated with
issuing new common equity is typically smaller than the flotation cost for new
debt.
The WACC as used in capital budgeting is an estimate
of the cost of all the capital a company has raised to acquire its assets.
There is an “opportunity cost” associated
with using reinvested earnings, hence they are not “free.”
The WACC as used in capital budgeting would be
simply the after-tax cost of debt if the firm plans to use only debt to finance
its capital budget during the coming year.
The WACC as used in capital budgeting is an estimate
of a company’s before-tax cost of capital.

Question 10
To help them estimate the company’s cost of
capital, Smithco has hired you as a consultant. You have been provided with the
following data: D1 = $1.45; P0 = $22.50; and g = 6.50% (constant). Based on the
DCF approach, what is the cost of common from reinvested earnings?
11.10%
11.68%
12.30%
12.94%
13.59%
Question 11
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.
Question 12
Suppose Acme Industries correctly estimates
its WACC at a given point in time and then uses that same cost of capital to
evaluate all projects for the next 10 years, then the firm will most likely
become less risky over time, and this will maximize
its intrinsic value.
accept too many low-risk projects and too few
high-risk projects.
become more risky and also have an increasing WACC.
Its intrinsic value will not be maximized.
continue as before, because there is no reason to
expect its risk position or value to change over time as a result of its use of
a single cost of capital.
become riskier over time, but its intrinsic value
will be maximized
Question 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
A project’s regular IRR is found by compounding the
cash inflows at the WACC to find the present value (PV), then discounting the
TV to find the IRR.
If a project’s IRR is smaller than the WACC, then
its NPV will be positive.
A project’s IRR is the discount rate that causes the
PV of the inflows to equal the project’s cost.
If a project’s IRR is positive, then its NPV must
also be positive.
A project’s regular IRR is found by compounding the
initial cost at the WACC to find the terminal value (TV), then discounting the
TV at the WACC.
Question 14
Assume a project has normal cash flows. All
else equal, which of the following statements is CORRECT?
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.
Question 15
The WACC for two mutually exclusive projects
that are being considered is 12%. Project K has an IRR of 20% while Project R’s
IRR is 15%. The projects have the same NPV at the 12% current WACC. Interest
rates are currently high. However, you believe that money costs and thus your
WACC will soon decline. You also think that the projects will not be funded
until the WACC has decreased, and their cash flows will not be affected by the
change in economic conditions. Under these conditions, which of the following
statements is CORRECT?
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 R because it will have
both a higher IRR and a higher NPV under the new conditions.
You should reject both projects because they will
both have negative NPVs under the new
conditions.
Question 16
Which of the following statements is CORRECT?
The discounted payback method recognizes all cash
flows over a project’s life, and it also adjusts these cash flows to account
for the time value of money.
The regular payback method was, years ago, widely
used, but virtually no companies even calculate the payback today.
The regular payback is useful as an indicator of a
project’s liquidity because it gives managers an idea of how long it will take
to recover the funds invested in a project.
The regular payback does not consider cash flows
beyond the payback year, but the discounted payback overcomes this defect.
The regular payback method recognizes all cash flows
over a project’s life.
Question 17
Which of the following statements is CORRECT?
If a project has “normal” cash flows, then
its MIRR must be positive.
If a project has “normal” cash flows, then
it will have exactly two real IRRs.
The definition of “normal” cash flows is
that the cash flow stream has one or more negative cash flows followed by a
stream of positive cash flows and then one negative cash flow at the end of the
project’s life.
If a project has “normal” cash flows, then
it can have only one real IRR, whereas a project with “nonnormal”
cash flows might have more than one real IRR.
If a project has “normal” cash flows, then
its IRR must be positive.
Question 18
Which of the following statements is CORRECT?
The NPV method assumes that cash flows will be
reinvested at the risk-free rate, while the IRR method assumes reinvestment at
the IRR.
The NPV method assumes that cash flows will be reinvested
at the WACC, while the IRR method assumes reinvestment at the risk-free rate.
The NPV method does not consider all relevant cash
flows, particularly cash flows beyond the payback period.
The IRR method does not consider all relevant cash
flows, particularly cash flows beyond the payback period.
The NPV method assumes that cash flows will be
reinvested at the WACC, while the IRR method assumes reinvestment at the IRR.
Question 19
Which of the following statements is CORRECT?
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
Question 20
The CFO of Cicero Industries plans to
calculate a new project’s NPV by estimating the relevant cash flows for each
year of the project’s life (i.e., the initial investment cost, the annual
operating cash flows, and the terminal cash flow), then discounting those cash
flows at the company’s overall WACC. Which one of the following factors should
the CFO be sure to INCLUDE in the cash flows when estimating the relevant cash
flows?
All sunk costs that have been incurred relating to
the project.
All interest expenses on debt used to help finance
the project.
The investment in working capital required to
operate the project, even if that investment will be recovered at the end of
the project’s life.
Sunk costs that have been incurred relating to the
project, but only if those costs were incurred prior to the current year.
Effects of the project on other divisions of the
firm, but only if those effects lower the project’s own direct cash flows.
Question 21
A firm is considering a new project whose risk
is greater than the risk of the firm’s average project, based on all methods
for assessing risk. In evaluating this project, it would be reasonable for
management to do which of the following?
Increase the estimated NPV of the project to reflect
its greater risk.
Reject the project, since its acceptance would
increase the firm’s risk.
Ignore the risk differential if the project would
amount to only a small fraction of the firm’s total assets.
Increase the cost of capital used to evaluate the
project to reflect its higher-than-average risk.
Increase the estimated IRR of the project to reflect
its greater risk.
Question 22
Which of the following statements is CORRECT?
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.
Question 23
Which of the following statements is CORRECT?
A sunk cost is any cost that was expended in the
past but can be recovered if the firm decides not to go forward with the
project.
A sunk cost is a cost that was incurred and expensed
in the past and cannot be recovered if the firm decides not to go forward with
the project.
Sunk costs were formerly hard to deal with but now
that the NPV method is widely used, it is possible to simply include sunk costs
in the cash flows and then calculate the PV of the project.
A good example of a sunk cost is a situation where
Home Depot opens a new store, and that leads to a decline in sales of one of
the firm’s existing stores.
A sunk cost is any cost that must be expended in
order to complete a project and bring it into operation.
Question 24
Which one of the following would NOT result in
incremental cash flows and thus should NOT be included in the capital budgeting
analysis for a new product?
Revenues from an existing product would be lost as a
result of customers switching to the new product.
Shipping and installation costs associated with a
machine that would be used to produce the new product.
The cost of a study relating to the market for the
new product that was completed last year. The results of this research were
positive, and they led to the tentative decision to go ahead with the new
product. The cost of the research was incurred and expensed for tax purposes
last year.
It is learned that land the company owns and would
use for the new project, if it is accepted, could be sold to another firm.
Using some of the firm’s high-quality factory floor
space that is currently unused to produce the proposed new product. This space
could be used for other products if it is not used for the project under
consideration.
Question 25
Which of the following statements is CORRECT?
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.
Question 26
The term “additional funds needed
(AFN)” is generally defined as follows:

Funds that a firm must raise externally from
non-spontaneous sources, i.e., by borrowing or by selling new stock to support
operations.
The amount of assets required per dollar of sales.
The amount of internally generated cash in a given
year minus the amount of cash needed to acquire the new assets needed to
support growth.
A forecasting approach in which the forecasted
percentage of sales for each balance sheet account is held constant.
Funds that are obtained automatically from routine
business transactions.
Question 27
Last year National Aeronautics had a FA/Sales
ratio of 40%, comprised of $250 million of sales and $100 million of fixed
assets. However, its fixed assets were used at only 75% of capacity. Now the
company is developing its financial forecast for the coming year. As part of
that process, the company wants to set its target Fixed Assets/Sales ratio at
the level it would have had had it been operating at full capacity. What target
FA/Sales ratio should the company set?
28.5%
30.0%
31.5%
33.1%
34.7%
Question 28
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?
54.30%
57.16%
60.17%
63.33%
66.67%
Question 29
Spontaneous funds are generally defined as
follows:
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.
Question 30
Last year Baron Enterprises had $350 million
of sales, and it had $270 million of fixed assets that were used at 65% of
capacity last year. In millions, by how much could Baron’s sales increase
before it is required to increase its fixed assets?
$170.09
$179.04
$188.46
$197.88
$207.78