Question 1
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.
2 points
Question 2
Which of the following statements is CORRECT?
Answer
Put options give investors the right to buy a stock at a certain strike price before a specified date.
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.
2 points
Question 3
Other things held constant, the value of an option depends on the stock's price, the risk-free rate,
and the
Answer
Strike price.
Variability of the stock price.
Option's time to maturity.
All of the above.
None of the above.
2 points
Question 4
Warner Motors’ stock is trading at $20 a share. Call options that expire in three months with a
strike price of $20 sell for $1.50. Which of the following will occur if the stock price increases
10%, to $22 a share?
Answer
The price of the call option will increase by $2.
The price of the call option will increase by more than $2.
The price of the call option will increase by less than $2, and the percentage increase in price
will be less than 10%.
The price of the call option will increase by less than $2, but the percentage increase in price will
be more than 10%.
The price of the call option will increase by more than $2, but the percentage increase in price
will be less than 10%.
2 points
Question 5
GCC Corporation is planning to issue options to its key employees, and it is now discussing the
terms to be set on those options. Which of the following actions would decrease the value of the
options, other things held constant?
Answer
GCC’s stock price suddenly increases.
The exercise price of the option is increased.
The life of the option is increased, i.e., the time until it expires is lengthened.
The Federal Reserve takes actions that increase the risk-free rate.
GCC’s stock price becomes more risky (higher variance).
2 points
Question 6
An investor who writes standard call options against stock held in his or her portfolio is said to
be selling what type of options?
Answer
In-the-money
Put
Naked
Covered
Out-of-the-money
2 points
Question 7
The current price of a stock is $50, the annual risk-free rate is 6%, and a 1-year call option with a
strike price of $55 sells for $7.20. What is the value of a put option, assuming the same strike
price and expiration date as for the call option?
Answer
$7.33
$7.71
$8.12
$8.55
$9.00
2 points
Question 8
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 points
Question 9
Suppose you believe that Johnson Company's stock price is going to increase from its current
level of $22.50 sometime during the next 5 months. For $310.25 you can buy a 5-month call
option giving you the right to buy 100 shares at a price of $25 per share. If you buy this option
for $310.25 and Johnson's stock price actually rises to $45, what would your pre-tax net profit
be?
Answer
-$310.25
$1,689.75
$1,774.24
$1,862.95
$1,956.10
2 points
Question 10
Call options on XYZ Corporation’s common stock trade in the market. Which of the following
statements is most correct, holding other things constant?
Answer
The price of these call options is likely to rise if XYZ’s stock price rises.
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.
2 points
Question 11
Which of the following statements is CORRECT?
Answer
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.
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.
2 points
Question 12
Suppose you believe that Delva Corporation's stock price is going to decline from its current
level of $82.50 sometime during the next 5 months. For $510.25 you could buy a 5-month put
option giving you the right to sell 100 shares at a price of $85 per share. If you bought this option
for $510.25 and Delva's stock price actually dropped to $60, what would your pre-tax net profit
be?
Answer
-$510.25
$1,989.75
$2,089.24
$2,193.70
$2,303.38
2 points
Question 13
An option that gives the holder the right to sell a stock at a specified price at some future time is
Answer
a call option.
a put option.
an out-of-the-money option.
a naked option.
a covered option.
2 points
Question 14
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 points
Question 15
The current price of a stock is $22, and at the end of one year its price will be either $27 or $17.
The annual risk-free rate is 6.0%, based on daily compounding. A 1-year call option on the stock,
with an exercise price of $22, is available. Based on the binominal model, what is the option's
value?
Answer
$2.43
$2.70
$2.99
$3.29
$3.62
2 points
Question 16
Which of the following statements is CORRECT?
Answer
The WACC is calculated using before-tax costs for all components.
The after-tax cost of debt usually exceeds the after-tax cost of equity.
For a given firm, the after-tax cost of debt is always more expensive than the after-tax cost of
non-convertible preferred stock.
Retained earnings that were generated in the past and are reported on the firm’s balance sheet are
available to finance the firm’s capital budget during the coming year.
The WACC that should be used in capital budgeting is the firm’s marginal, after-tax cost of
capital.
2 points
Question 17
Which of the following is NOT a capital component when calculating the weighted average cost
of capital (WACC) for use in capital budgeting?
Answer
Long-term debt.
Accounts payable.
Retained earnings.
Common stock.
Preferred stock.
2 points
Question 18
Which of the following statements is CORRECT?
Answer
The discounted cash flow method of estimating the cost of equity cannot be used unless the
growth rate, g, is expected to be constant forever.
If the calculated beta underestimates the firm’s true investment risk--i.e., if the forward-looking
beta that investors think exists exceeds the historical beta--then the CAPM method based on the
historical beta will produce an estimate of rs and thus WACC that is too high.
Beta measures market risk, which is, theoretically, the most relevant risk measure for a publiclyowned firm that seeks to maximize its intrinsic value. This is true even if not all of the firm’s
stockholders are well diversified.
An advantage shared by both the DCF and CAPM methods when they are used to estimate the
cost of equity is that they are both "objective" as opposed to "subjective," hence little or no
judgment is required.
The specific risk premium used in the CAPM is the same as the risk premium used in the bondyield-plus-risk-premium approach.
2 points
Question 19
Which of the following statements is CORRECT? Assume that the firm is a publicly-owned
corporation and is seeking to maximize shareholder wealth.
Answer
If a firm has a beta that is less than 1.0, say 0.9, this would suggest that the expected returns on
its assets are negatively correlated with the returns on most other firms’ assets.
If a firm’s managers want to maximize the value of their firm’s stock, they should, in theory,
concentrate on project risk as measured by the standard deviation of the project’s expected future
cash flows.
If a firm evaluates all projects using the same cost of capital, and the CAPM is used to help
determine that cost, then its risk as measured by beta will probably decline over time.
Projects with above-average risk typically have higher than average expected returns. Therefore,
to maximize a firm’s intrinsic value, its managers should favor high-beta projects over those with
lower betas.
Project A has a standard deviation of expected returns of 20%, while Project B’s standard
deviation is only 10%. A’s returns are negatively correlated with both the firm’s other assets and
the returns on most stocks in the economy, while B’s returns are positively correlated. Therefore,
Project A is less risky to a firm and should be evaluated with a lower cost of capital.
2 points
Question 20
Duval Inc. uses only equity capital, and it has two equally-sized divisions. Division A’s cost of
capital is 10.0%, Division B’s cost is 14.0%, and the corporate (composite) WACC is 12.0%. All
of Division A’s projects are equally risky, as are all of Division B's projects. However, the
projects of Division A are less risky than those of Division B. Which of the following projects
should the firm accept?
Answer
A Division B project with a 13% return.
A Division B project with a 12% return.
A Division A project with an 11% return.
A Division A project with a 9% return.
A Division B project with an 11% return.
2 points
Question 21
Norris Enterprises, an all-equity firm, has a beta of 2.0. The chief financial officer is evaluating a
project with an expected return of 14%, before any risk adjustment. The risk-free rate is 5%, and
the market risk premium is 4%. The project being evaluated is riskier than an average project, in
terms of both its beta risk and its total risk. Which of the following statements is CORRECT?
Answer
The project should definitely be accepted because its expected return (before any risk
adjustments) is greater than its required return.
The project should definitely be rejected because its expected return (before risk adjustment) is
less than its required return.
Riskier-than-average projects should have their expected returns increased to reflect their higher
risk. Clearly, this would make the project acceptable regardless of the amount of the adjustment.
The accept/reject decision depends on the
firm's risk-adjustment policy. If Norris' policy is to increase the required return on a riskier-thanaverage project to 3% over rS, then it should reject the project.
Capital budgeting projects should be evaluated solely on the basis of their total risk. Thus,
insufficient information has been provided to make the accept/reject decision.
2 points
Question 22
Which of the following statements is CORRECT?
Answer
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.
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 retained 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 retained 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.
2 points
Question 23
For a typical firm, which of the following sequences is CORRECT? All rates are after taxes, and
assume that the firm operates at its target capital structure.
Answer
rs> re > rd > WACC.
re> rs > WACC >rd.
WACC > re > rs> rd.
rd> re > rs > WACC.
WACC > rd > rs >re.
2 points
Question 24
Which of the following statements is CORRECT?
Answer
The cost of capital used to evaluate a project should be the cost of the specific type of financing
used to fund that project, i.e., it is the after-tax cost of debt if debt is to be used to finance the
project or the cost of equity if the project will be financed with equity.
The after-tax cost of debt that should be used as the component cost when calculating the WACC
is the average after-tax cost of all the firm’s outstanding debt.
Suppose some of a publicly-traded firm’s
stockholders are not diversified; they hold only the one firm’s stock. In this case, the CAPM
approach will result in an estimated cost of equity that is too low in the sense that if it is used in
capital budgeting, projects will be accepted that will reduce the firm’s intrinsic value.
The cost of equity is generally harder to measure than the cost of debt because there is no stated,
contractual cost number on which to base the cost of equity.
The bond-yield-plus-risk-premium approach is the most sophisticated and objective method for
estimating a firm’s cost of equity capital.
2 points
Question 25
Safeco Company and Risco Inc are identical in size and capital structure. However, the riskiness
of their assets and cash flows are somewhat different, resulting in Safeco having a WACC of
10% and Risco a WACC of 12%. Safeco is considering Project X, which has an IRR of 10.5%
and is of the same risk as a typical Safeco project. Risco is considering Project Y, which has an
IRR of 11.5% and is of the same risk as a typical Risco project.
Now assume that the two companies merge and form a new company, Safeco/Risco Inc.
Moreover, the new company's market risk is an average of the pre-merger companies' market
risks, and the merger has no impact on either the cash flows or the risks of Projects X and Y.
Which of the following statements is CORRECT?
Answer
If the firm evaluates these projects and all other projects at the new overall corporate WACC, it
will probably become riskier over time.
If evaluated using the correct post-merger WACC, Project X would have a negative NPV.
After the merger, Safeco/Risco would have a corporate WACC of 11%. Therefore, it should
reject Project X but accept Project Y.
Safeco/Risco’s WACC, as a result of the merger, would be 10%.
After the merger, Safeco/Risco should
select Project Y but reject Project X. If the firm does this, its corporate WACC will fall to 10.5%.
2 points
Question 26
Which of the following statements is CORRECT?
Answer
When calculating the cost of debt, a company needs to adjust for taxes, because interest
payments are deductible by the paying corporation.
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 retained 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.
2 points
Question 27
Which of the following statements is CORRECT?
Answer
The WACC as used in capital budgeting is an estimate of a company’s before-tax cost of capital.
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 retained 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.
2 points
Question 28
Schalheim Sisters Inc. has always paid out all of its earnings as dividends; hence, the firm has no
retained earnings. 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 market risk premium declines.
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.
2 points
Question 29
Which of the following statements is CORRECT?
Answer
The bond-yield-plus-risk-premium approach to estimating the cost of common equity involves
adding a risk premium to the interest rate on the company’s own long-term bonds. The size of
the risk premium for bonds with different ratings is published daily in The Wall Street Journal.
The WACC is calculated using a before-tax cost for debt that is equal to the interest rate that
must be paid on new debt, along with the after-tax costs for common stock and for preferred
stock if it is used.
An increase in the risk-free rate is likely to reduce the marginal costs of both debt and equity.
The relevant WACC can change depending on the amount of funds a firm raises during a given
year. Moreover, the WACC at each level of funds raised is a weighted average of the marginal
costs of each capital component, with the weights based on the firm’s target capital structure.
Beta measures market risk, which is generally the most relevant risk measure for a publiclyowned firm that seeks to maximize its intrinsic value. However, this is not true unless all of the
firm’s stockholders are well diversified.
2 points
Question 30
The MacMillen Company has equal amounts of low-risk, average-risk, and high-risk projects.
The firm's overall WACC is 12%. The CFO believes that this is the correct WACC for the
company’s average-risk projects, but that a lower rate should be used for lower-risk projects and
a higher rate for higher-risk projects. The CEO disagrees, on the grounds that even though
projects have different risks, the WACC used to evaluate each project should be the same
because the company obtains capital for all projects from the same sources. If the CEO’s position
is accepted, what is likely to happen over time?
Answer
The company will take on too many high-risk projects and reject too many low-risk projects.
The company will take on too many low-risk projects and reject too many high-risk projects.
Things will generally even out over time, and, therefore, the firm’s risk should remain constant
over time.
The company’s overall WACC should decrease
over time because its stock price should be increasing.
The CEO’s recommendation would maximize the firm’s intrinsic value.