An option that gives the holder the right to sell a stock

Question

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%