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.