FIN 534 FINAL EXAM PART 1

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?

 [removed] -\$5.10 [removed] \$19.90 [removed] \$20.90 [removed] \$22.50 [removed] \$27.60

Question 2

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 binomial model, what is the option’s value? (Hint: Use daily compounding.)

 [removed] \$2.43 [removed] \$2.70 [removed] \$2.99 [removed] \$3.29 [removed] \$3.62

Question 3

Which of the following statements is CORRECT?

 [removed] 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. [removed] 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. [removed] Issuing options provides companies with a low cost method of raising capital. [removed] 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. [removed] The potential loss on an option decreases as the option sells at higher and higher prices because the profit margin gets bigger.

Question 4

Which of the following statements is most correct, holding other things constant, for XYZ Corporation’s traded call options?

 [removed] The higher the strike price on XYZ’s options, the higher the option’s price will be. [removed] 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. [removed] If XYZ’s stock price stabilizes (becomes less volatile), then the price of its options will increase. [removed] 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. [removed] The price of these call options is likely to rise if XYZ’s stock price rises.

Question 5

Braddock Construction Co.’s 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?

 [removed] The price of the call option will increase by more than \$2. [removed] The price of the call option will increase by less than \$2, and the percentage increase in price will be less than 10%. [removed] The price of the call option will increase by less than \$2, but the percentage increase in price will be more than 10%. [removed] The price of the call option will increase by more than \$2, but the percentage increase in price will be less than 10%. [removed] The price of the call option will increase by \$2.

Question 6

Which of the following statements is CORRECT?

 [removed] Call options generally sell at a price less than their exercise value. [removed] If a stock becomes riskier (more volatile), call options on the stock are likely to decline in value. [removed] 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. [removed] 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. [removed] 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.

Question 7

Which of the following statements is CORRECT? Assume a company’s target capital structure is 50% debt and 50% common equity.

 [removed] The WACC is calculated on a before-tax basis. [removed] The WACC exceeds the cost of equity. [removed] The cost of equity is always equal to or greater than the cost of debt. [removed] The cost of reinvested earnings typically exceeds the cost of new common stock. [removed] The interest rate used to calculate the WACC is the average after-tax cost of all the company’s outstanding debt as shown on its balance sheet.

Question 8

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?

 [removed] 9.42% [removed] 9.91% [removed] 10.44% [removed] 10.96% [removed] 11.51%

Question 9

Which of the following statements is CORRECT?

 [removed] 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. [removed] 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. [removed] A firm’s cost of reinvesting earnings is the rate of return stockholders require on a firm’s common stock. [removed] 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. [removed] 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.

Question 10

Which of the following statements is CORRECT?

 [removed] The percentage flotation cost associated with issuing new common equity is typically smaller than the flotation cost for new debt. [removed] 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. [removed] There is an “opportunity cost” associated with using reinvested earnings, hence they are not “free.” [removed] 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. [removed] The WACC as used in capital budgeting is an estimate of a company’s before-tax cost of capital.

Question 11

Which of the following statements is CORRECT?

 [removed] The tax-adjusted cost of debt is always greater than the interest rate on debt, provided the company does in fact pay taxes. [removed] 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. [removed] 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. [removed] Higher flotation costs tend to reduce the cost of equity capital. [removed] 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.

Question 12

Which of the following statements is CORRECT?

 [removed] All else equal, an increase in a company’s stock price will increase its marginal cost of reinvested earnings (not newly issued stock), rs. [removed] All else equal, an increase in a company’s stock price will increase its marginal cost of new common equity, re. [removed] Since the money is readily available, the after-tax cost of reinvested earnings (not newly issued stock) is usually much lower than the after-tax cost of debt. [removed] If a company’s tax rate increases but the YTM on its noncallable bonds remains the same, the after-tax cost of its debt will fall. [removed] When calculating the cost of preferred stock, a company needs to adjust for taxes, because preferred stock dividends are deductible by the paying corporation.

Question 13

Which of the following statements is CORRECT?

 [removed] Projects with “normal” cash flows can have two or more real IRRs. [removed] Projects with “normal” cash flows must have two changes in the sign of the cash flows, e.g., from negative to positive to negative. If there are more than two sign changes, then the cash flow stream is “nonnormal.” [removed] The “multiple IRR problem” can arise if a project’s cash flows are “normal.” [removed] Projects with “nonnormal” cash flows are almost never encountered in the real world. [removed] Projects with “normal” cash flows can have only one real IRR.

Question 14

Assume a project has normal cash flows. All else equal, which of the following statements is CORRECT?

 [removed] A project’s NPV increases as the WACC declines. [removed] A project’s MIRR is unaffected by changes in the WACC. [removed] A project’s regular payback increases as the WACC declines. [removed] A project’s discounted payback increases as the WACC declines. [removed] A project’s IRR increases as the WACC declines.

Question 15

Which of the following statements is CORRECT?

 [removed] The IRR method can never be subject to the multiple IRR problem, while the MIRR method can be. [removed] One reason some people prefer the MIRR to the regular IRR is that the MIRR is based on a generally more reasonable reinvestment rate assumption. [removed] The higher the WACC, the shorter the discounted payback period. [removed] The MIRR method assumes that cash flows are reinvested at the crossover rate. [removed] The MIRR and NPV decision criteria can never conflict.

Question 16

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?

 [removed] 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. [removed] You should recommend Project R, because at the new WACC it will have the higher NPV. [removed] You should recommend Project K, because at the new WACC it will have the higher NPV. [removed] You should recommend Project K because it has the higher IRR and will continue to have the higher IRR even at the new WACC. [removed] You should reject both projects because they will both have negative NPVs under the new conditions.

Question 17

Which of the following statements is CORRECT?

 [removed] One drawback of the regular payback is that this method does not take account of cash flows beyond the payback period. [removed] If a project’s payback is positive, then the project should be accepted because it must have a positive NPV. [removed] The regular payback ignores cash flows beyond the payback period, but the discounted payback method overcomes this problem. [removed] 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. [removed] The shorter a project’s payback period, the less desirable the project is normally considered to be by this criterion.

Question 18

Projects S and L are both normal projects with an initial cost of \$10,000, followed by a series of positive cash inflows. Project S’s undiscounted net cash flows total \$20,000, while L’s total undiscounted flows are \$30,000. At a WACC of 10%, the two projects have identical NPVs. Which project’s NPV is more sensitive to changes in the WACC?

 [removed] Project L. [removed] Both projects are equally sensitive to changes in the WACC since their NPVs are equal at all costs of capital. [removed] Neither project is sensitive to changes in the discount rate, since both have NPV profiles that are horizontal. [removed] The solution cannot be determined because the problem gives us no information that can be used to determine the projects’ relative IRRs. [removed] Project S.

Question 19

Which of the following statements is CORRECT?

 [removed] In comparing two projects using sensitivity analysis, the one with the steeper lines would be considered less risky, because a small error in estimating a variable such as unit sales would produce only a small error in the project’s NPV. [removed] The primary advantage of simulation analysis over scenario analysis is that scenario analysis requires a relatively powerful computer, coupled with an efficient financial planning software package, whereas simulation analysis can be done efficiently using a PC with a spreadsheet program or even with just a calculator. [removed] Sensitivity analysis is a type of risk analysis that considers both the sensitivity of NPV to changes in key input variables and the probability of occurrence of these variables’ values. [removed] As computer technology advances, simulation analysis becomes increasingly obsolete and thus less likely to be used as compared to sensitivity analysis. [removed] Sensitivity analysis as it is generally employed is incomplete in that it fails to consider the probability of occurrence of the key input variables.

Question 20

Which of the following statements is CORRECT?

 [removed] 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. [removed] The existence of any type of “externality” will reduce the calculated NPV versus the NPV that would exist without the externality. [removed] 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. [removed] 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. [removed] 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 21

Which of the following factors should be included in the cash flows used to estimate a project’s NPV?

 [removed] Interest on funds borrowed to help finance the project. [removed] The end-of-project recovery of any working capital required to operate the project. [removed] Cannibalization effects, but only if those effects increase the project’s projected cash flows. [removed] Expenditures to date on research and development related to the project, provided those costs have already been expensed for tax purposes. [removed] All costs associated with the project that have been incurred prior to the time the analysis is being conducted.

Question 22

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?

 [removed] A new product will generate new sales, but some of those new sales will be from customers who switch from one of the firm’s current products. [removed] A firm must obtain new equipment for the project, and \$1 million is required for shipping and installing the new machinery. [removed] A firm has spent \$2 million on R&D associated with a new product. These costs have been expensed for tax purposes, and they cannot be recovered regardless of whether the new project is accepted or rejected. [removed] A firm can produce a new product, and the existence of that product will stimulate sales of some of the firm’s other products. [removed] A firm has a parcel of land that can be used for a new plant site or be sold, rented, or used for agricultural purposes.

Question 23

Which of the following procedures best accounts for the relative risk of a proposed project?

 [removed] Adjusting the discount rate downward if the project is judged to have above-average risk. [removed] Reducing the NPV by 10% for risky projects. [removed] Picking a risk factor equal to the average discount rate. [removed] Ignoring risk because project risk cannot be measured accurately. [removed] Adjusting the discount rate upward if the project is judged to have above-average risk.

Question 24

Puckett Inc. risk-adjusts its WACC to account for project risk. It uses a WACC of 8% for below-average risk projects, 10% for average-risk projects, and 12% for above-average risk projects. Which of the following independent projects should Puckett accept, assuming that the company uses the NPV method when choosing projects?

 [removed] Project B, which has below-average risk and an IRR = 8.5%. [removed] Project C, which has above-average risk and an IRR = 11%. [removed] Without information about the projects’ NPVs we cannot determine which project(s) should be accepted. [removed] All of these projects should be accepted. [removed] Project A, which has average risk and an IRR = 9%.

Question 25

Spontaneous funds are generally defined as follows:

 [removed] A forecasting approach in which the forecasted percentage of sales for each item is held constant. [removed] Funds that a firm must raise externally through short-term or long-term borrowing and/or by selling new common or preferred stock. [removed] 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. [removed] 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. [removed] Assets required per dollar of sales

Question 26

Which of the following assumptions is embodied in the AFN equation?

 [removed] Accounts payable and accruals are tied directly to sales. [removed] Common stock and long-term debt are tied directly to sales. [removed] Fixed assets, but not current assets, are tied directly to sales. [removed] Last year’s total assets were not optimal for last year’s sales. [removed] None of the firm’s ratios will change.

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?

 [removed] 28.5% [removed] 30.0% [removed] 31.5% [removed] 33.1% [removed] 34.7%

Question 28

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?

 [removed] The company increases its dividend payout ratio. [removed] The company begins to pay employees monthly rather than weekly. [removed] The company’s profit margin increases. [removed] The company decides to stop taking discounts on purchased materials. [removed] The company previously thought its fixed assets were being operated at full capacity, but now it learns that it actually has excess capacity.

Question 29

F. Marston, Inc. has developed a forecasting model to estimate its AFN for the upcoming year. All else being equal, which of the following factors is most likely to lead to an increase of the additional funds needed (AFN)?

 [removed] A switch to a just-in-time inventory system and outsourcing production. [removed] The company reduces its dividend payout ratio. [removed] The company switches its materials purchases to a supplier that sells on terms of 1/5, net 90, from a supplier whose terms are 3/15, net 35. [removed] The company discovers that it has excess capacity in its fixed assets. [removed] A sharp increase in its forecasted sales.

Question 30

The capital intensity ratio is generally defined as follows:

 [removed] The percentage of liabilities that increase spontaneously as a percentage of sales. [removed] The ratio of sales to current assets. [removed] The ratio of current assets to sales. [removed] The amount of assets required per dollar of sales, or A0*/S0. [removed] Sales divided by total assets, i.e., the total assets turnover ratio.

VERSION 2

Question 1

Which of the following statements is CORRECT?

 [removed] 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. [removed] 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. [removed] 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. [removed] 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. [removed] 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 2

Which of the following statements is CORRECT?

 [removed] 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. [removed] 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. [removed] 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. [removed] 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. [removed] 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

Question 3

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?

 [removed] \$7.33 [removed] \$7.71 [removed] \$8.12 [removed] \$8.55 [removed] \$9.00

Question 4

Other things held constant, the value of an option depends on the stock’s price, the risk-free rate, and the

 [removed] Variability of the stock price. [removed] Option’s time to maturity. [removed] Strike price. [removed] All of the above. [removed] None of the above.

Question 5

Which of the following statements is CORRECT?

 [removed] 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. [removed] 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. [removed] Issuing options provides companies with a low cost method of raising capital. [removed] 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. [removed] The potential loss on an option decreases as the option sells at higher and higher prices because the profit margin gets bigger

Question 6

Cazden Motors’ stock is trading at \$30 a share. Call options on the company’s stock are also available, some with a strike price of \$25 and some with a strike price of \$35. Both options expire in three months. Which of the following best describes the value of these options?

 [removed] The options with the \$25 strike price will sell for less than the options with the \$35 strike price. [removed] The options with the \$25 strike price have an exercise value greater than \$5. [removed] The options with the \$35 strike price have an exercise value greater than \$0. [removed] If Cazden’s stock price rose by \$5, the exercise value of the options with the \$25 strike price would also increase by \$5. [removed] The options with the \$25 strike price will sell for \$5

Question 7

Which of the following statements is CORRECT?

 [removed] All else equal, an increase in a company’s stock price will increase its marginal cost of reinvested earnings (not newly issued stock), rs. [removed] All else equal, an increase in a company’s stock price will increase its marginal cost of new common equity, re. [removed] Since the money is readily available, the after-tax cost of reinvested earnings (not newly issued stock) is usually much lower than the after-tax cost of debt. [removed] If a company’s tax rate increases but the YTM on its noncallable bonds remains the same, the after-tax cost of its debt will fall. [removed] When calculating the cost of preferred stock, a company needs to adjust for taxes, because preferred stock dividends are deductible by the paying corporation.

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?

 [removed] Increase the percentage of debt in the target capital structure. [removed] Increase the proposed capital budget. [removed] Reduce the amount of short-term bank debt in order to increase the current ratio. [removed] Reduce the percentage of debt in the target capital structure. [removed] Increase the dividend payout ratio for the upcoming year.

Question 9

Which of the following statements is CORRECT?

 [removed] WACC calculations should be based on the before-tax costs of all the individual capital components. [removed] Flotation costs associated with issuing new common stock normally reduce the WACC. [removed] If a company’s tax rate increases, then, all else equal, its weighted average cost of capital will decline. [removed] An increase in the risk-free rate will normally lower the marginal costs of both debt and equity financing. [removed] A change in a company’s target capital structure cannot affect its WACC

Question 10

Adams Inc. has the following data: rRF = 5.00%; RPM = 6.00%; and b = 1.05. What is the firm’s cost of common from reinvested earnings based on the CAPM?

 [removed] 11.30% [removed] 11.64% [removed] 11.99% [removed] 12.35% [removed] 12.72%

Question 11

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?

 [removed] The flotation costs associated with issuing new common stock increase. [removed] The company’s beta increases. [removed] Expected inflation increases. [removed] The flotation costs associated with issuing preferred stock increase. [removed] The market risk premium declines.

Question 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?

 [removed] 7.81% [removed] 8.22% [removed] 8.65% [removed] 9.10% [removed] 9.56%

Question 13

Suppose a firm relies exclusively on the payback method when making capital budgeting decisions, and it sets a 4-year payback regardless of economic conditions. Other things held constant, which of the following statements is most likely to be true?

 [removed] It will accept too many long-term projects and reject too many short-term projects (as judged by the NPV). [removed] The firm will accept too many projects in all economic states because a 4-year payback is too low. [removed] The firm will accept too few projects in all economic states because a 4-year payback is too high. [removed] If the 4-year payback results in accepting just the right set of projects under average economic conditions, then this payback will result in too few long-term projects when the economy is weak. [removed] It will accept too many short-term projects and reject too many long-term projects (as judged by the NPV).

Question 14

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.

 [removed] The lower the WACC used to calculate a project’s NPV, the lower the calculated NPV will be. [removed] If a project’s NPV is less than zero, then its IRR must be less than the WACC. [removed] If a project’s NPV is greater than zero, then its IRR must be less than zero. [removed] The NPV of a relatively low-risk project should be found using a relatively high WACC. [removed] 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

Question 15

Which of the following statements is CORRECT?

 [removed] If a project has “normal” cash flows, then its MIRR must be positive. [removed] If a project has “normal” cash flows, then it will have exactly two real IRRs. [removed] 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. [removed] 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. [removed] If a project has “normal” cash flows, then its IRR must be positive

Question 16

Projects S and L are both normal projects with an initial cost of \$10,000, followed by a series of positive cash inflows. Project S’s undiscounted net cash flows total \$20,000, while L’s total undiscounted flows are \$30,000. At a WACC of 10%, the two projects have identical NPVs. Which project’s NPV is more sensitive to changes in the WACC?

 [removed] Project L. [removed] Both projects are equally sensitive to changes in the WACC since their NPVs are equal at all costs of capital. [removed] Neither project is sensitive to changes in the discount rate, since both have NPV profiles that are horizontal. [removed] The solution cannot be determined because the problem gives us no information that can be used to determine the projects’ relative IRRs. [removed] Project S.

Question 17

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.

 [removed] 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. [removed] If a project’s IRR is smaller than the WACC, then its NPV will be positive. [removed] A project’s IRR is the discount rate that causes the PV of the inflows to equal the project’s cost. [removed] If a project’s IRR is positive, then its NPV must also be positive. [removed] 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 18

Which of the following statements is CORRECT?

 [removed] The IRR method can never be subject to the multiple IRR problem, while the MIRR method can be. [removed] One reason some people prefer the MIRR to the regular IRR is that the MIRR is based on a generally more reasonable reinvestment rate assumption. [removed] The higher the WACC, the shorter the discounted payback period. [removed] The MIRR method assumes that cash flows are reinvested at the crossover rate. [removed] The MIRR and NPV decision criteria can never conflict.

Question 19

While developing a new product line, Cook Company spent \$3 million two years ago to build a plant for a new product. It then decided not to go forward with the project, so the building is available for sale or for a new product. Cook owns the building free and clear¾there is no mortgage on it. Which of the following statements is CORRECT?

 [removed] If the building could be sold, then the after-tax proceeds that would be generated by any such sale should be charged as a cost to any new project that would use it. [removed] This is an example of an externality, because the very existence of the building affects the cash flows for any new project that Rowell might consider. [removed] Since the building was built in the past, its cost is a sunk cost and thus need not be considered when new projects are being evaluated, even if it would be used by those new projects. [removed] If there is a mortgage loan on the building, then the interest on that loan would have to be charged to any new project that used the building. [removed] Since the building has been paid for, it can be used by another project with no additional cost. Therefore, it should not be reflected in the cash flows for any new project

Question 20

Which of the following statements is CORRECT?

 [removed] 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. [removed] The existence of any type of “externality” will reduce the calculated NPV versus the NPV that would exist without the externality. [removed] 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. [removed] 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. [removed] 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 21

Which of the following statements is CORRECT?

 [removed] Only incremental cash flows are relevant in project analysis, the proper incremental cash flows are the reported accounting profits, and thus reported accounting income should be used as the basis for investor and managerial decisions. [removed] It is unrealistic to believe that any increases in net working capital required at the start of an expansion project can be recovered at the project’s completion. Working capital like inventory is almost always used up in operations. Thus, cash flows associated with working capital should be included only at the start of a project’s life. [removed] If equipment is expected to be sold for more than its book value at the end of a project’s life, this will result in a profit. In this case, despite taxes on the profit, the end-of-project cash flow will be greater than if the asset had been sold at book value, other things held constant. [removed] Changes in net working capital refer to changes in current assets and current liabilities, not to changes in long-term assets and liabilities. Therefore, changes in net working capital should not be considered in a capital budgeting analysis. [removed] If an asset is sold for less than its book value at the end of a project’s life, it will generate a loss for the firm, hence its terminal cash flow will be negative.

Question 22

Which of the following is NOT a relevant cash flow and thus should not be reflected in the analysis of a capital budgeting project?

 [removed] Shipping and installation costs. [removed] Cannibalization effects. [removed] Opportunity costs. [removed] Sunk costs that have been expensed for tax purposes. [removed] Changes in net working capital.

Question 23

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?

 [removed] Increase the estimated NPV of the project to reflect its greater risk. [removed] Reject the project, since its acceptance would increase the firm’s risk. [removed] Ignore the risk differential if the project would amount to only a small fraction of the firm’s total assets. [removed] Increase the cost of capital used to evaluate the project to reflect its higher-than-average risk. [removed] Increase the estimated IRR of the project to reflect its greater risk

Question 24

Which of the following should be considered when a company estimates the cash flows used to analyze a proposed project?

 [removed] 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. [removed] The company has spent and expensed \$1 million on R&D associated with the new project. [removed] The company spent and expensed \$10 million on a marketing study before its current analysis regarding whether to accept or reject the project. [removed] 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. [removed] The new project is expected to reduce sales of one of the company’s existing products by 5%.

Question 25

Spontaneous funds are generally defined as follows:

 [removed] A forecasting approach in which the forecasted percentage of sales for each item is held constant. [removed] Funds that a firm must raise externally through short-term or long-term borrowing and/or by selling new common or preferred stock. [removed] 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. [removed] 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. [removed] Assets required per dollar of sales

Question 26

The capital intensity ratio is generally defined as follows:

 [removed] The percentage of liabilities that increase spontaneously as a percentage of sales. [removed] The ratio of sales to current assets. [removed] The ratio of current assets to sales. [removed] The amount of assets required per dollar of sales, or A0*/S0. [removed] Sales divided by total assets, i.e., the total assets turnover ratio

Question 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?

 [removed] 54.30% [removed] 57.16% [removed] 60.17% [removed] 63.33% [removed] 66.67%

Question 28

Which of the following statements is CORRECT?

 [removed] 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. [removed] 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. [removed] 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. [removed] Dividend policy does not affect the requirement for external funds based on the AFN equation. [removed] 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

Question 29

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?

 [removed] 28.5% [removed] 30.0% [removed] 31.5% [removed] 33.1% [removed] 34.7%

Question 30

F. Marston, Inc. has developed a forecasting model to estimate its AFN for the upcoming year. All else being equal, which of the following factors is most likely to lead to an increase of the additional funds needed (AFN)?

 [removed] A switch to a just-in-time inventory system and outsourcing production. [removed] The company reduces its dividend payout ratio. [removed] The company switches its materials purchases to a supplier that sells on terms of 1/5, net 90, from a supplier whose terms are 3/15, net 35. [removed] The company discovers that it has excess capacity in its fixed assets. [removed] A sharp increase in its forecasted sales

VERSION 3

Question 1

Cazden Motors’ stock is trading at \$30 a share. Call options on the company’s stock are also available, some with a strike price of \$25 and some with a strike price of \$35. Both options expire in three months. Which of the following best describes the value of these options?

 [removed] The options with the \$25 strike price will sell for less than the options with the \$35 strike price. [removed] The options with the \$25 strike price have an exercise value greater than \$5. [removed] The options with the \$35 strike price have an exercise value greater than \$0. [removed] If Cazden’s stock price rose by \$5, the exercise value of the options with the \$25 strike price would also increase by \$5. [removed] The options with the \$25 strike price will sell for \$5.

Question 2

Which of the following statements is CORRECT?

 [removed] Call options generally sell at a price less than their exercise value. [removed] If a stock becomes riskier (more volatile), call options on the stock are likely to decline in value. [removed] 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. [removed] 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. [removed] 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.

Question 3

Which of the following statements is CORRECT?

 [removed] 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. [removed] 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. [removed] 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. [removed] 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. [removed] 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

Other things held constant, the value of an option depends on the stock’s price, the risk-free rate, and the

 [removed] Variability of the stock price. [removed] Option’s time to maturity. [removed] Strike price. [removed] All of the above. [removed] None of the above.

Question 5

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?

 [removed] -\$5.10 [removed] \$19.90 [removed] \$20.90 [removed] \$22.50 [removed] \$27.60

Question 6

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?

 [removed] \$7.33 [removed] \$7.71 [removed] \$8.12 [removed] \$8.55 [removed] \$9.00

Question 7

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?

 [removed] 11.10% [removed] 11.68% [removed] 12.30% [removed] 12.94% [removed] 13.59%

Question 8

Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting?

 [removed] Accounts payable. [removed] Common stock “raised” by reinvesting earnings. [removed] Common stock raised by new issues. [removed] Preferred stock. [removed] Long-term debt

Question 9

Which of the following statements is CORRECT?

 [removed] When calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on preferred stock are deductible by the paying corporation. [removed] 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. [removed] 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. [removed] Higher flotation costs reduce investors’ expected returns, and that leads to a reduction in a company’s WACC. [removed] When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation

Question 10

Which of the following statements is CORRECT?

 [removed] WACC calculations should be based on the before-tax costs of all the individual capital components. [removed] Flotation costs associated with issuing new common stock normally reduce the WACC. [removed] If a company’s tax rate increases, then, all else equal, its weighted average cost of capital will decline. [removed] An increase in the risk-free rate will normally lower the marginal costs of both debt and equity financing. [removed] A change in a company’s target capital structure cannot affect its WACC.

Question 11

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?

 [removed] Increase the percentage of debt in the target capital structure. [removed] Increase the proposed capital budget. [removed] Reduce the amount of short-term bank debt in order to increase the current ratio. [removed] Reduce the percentage of debt in the target capital structure. [removed] Increase the dividend payout ratio for the upcoming year

Question 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?

 [removed] 7.81% [removed] 8.22% [removed] 8.65% [removed] 9.10% [removed] 9.56%

Question 13

Which of the following statements is CORRECT?

 [removed] One defect of the IRR method is that it does not take account of the time value of money. [removed] One defect of the IRR method is that it does not take account of the cost of capital. [removed] 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. [removed] 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. [removed] One defect of the IRR method is that it does not take account of cash flows over a project’s full life.

Question 14

Which of the following statements is NOT a disadvantage of the regular payback method?

 [removed] Ignores cash flows beyond the payback period. [removed] Does not directly account for the time value of money. [removed] Does not provide any indication regarding a project’s liquidity or risk. [removed] Does not take account of differences in size among projects. [removed] Lacks an objective, market-determined benchmark for making decisions

Question 15

Which of the following statements is CORRECT?

 [removed] To find the MIRR, we first compound cash flows at the regular IRR to find the TV, and then we discount the TV at the WACC to find the PV. [removed] The NPV and IRR methods both assume that cash flows can be reinvested at the WACC. However, the MIRR method assumes reinvestment at the MIRR itself. [removed] If two projects have the same cost, and if their NPV profiles cross in the upper right quadrant, then the project with the higher IRR probably has more of its cash flows coming in the later years. [removed] If two projects have the same cost, and if their NPV profiles cross in the upper right quadrant, then the project with the lower IRR probably has more of its cash flows coming in the later years. [removed] For a project with normal cash flows, any change in the WACC will change both the NPV and the IRR.

Question 16

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.

 [removed] The lower the WACC used to calculate a project’s NPV, the lower the calculated NPV will be. [removed] If a project’s NPV is less than zero, then its IRR must be less than the WACC. [removed] If a project’s NPV is greater than zero, then its IRR must be less than zero. [removed] The NPV of a relatively low-risk project should be found using a relatively high WACC. [removed] 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.

Question 17

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.

 [removed] A project’s regular IRR is found by discounting the cash inflows at the WACC to find the present value (PV), then compounding this PV to find the IRR. [removed] If a project’s IRR is greater than the WACC, then its NPV must be negative. [removed] To find a project’s IRR, we must solve for the discount rate that causes the PV of the inflows to equal the PV of the project’s costs. [removed] To find a project’s IRR, we must find a discount rate that is equal to the WACC. [removed] A project’s regular IRR is found by compounding the cash inflows at the WACC to find the terminal value (TV), then discounting this TV at the WACC.

Question 18

Which of the following statements is CORRECT?

 [removed] 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. [removed] The regular payback method was, years ago, widely used, but virtually no companies even calculate the payback today. [removed] 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. [removed] The regular payback does not consider cash flows beyond the payback year, but the discounted payback overcomes this defect. [removed] The regular payback method recognizes all cash flows over a project’s life.

Question 19

Which of the following statements is CORRECT?

 [removed] 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. [removed] 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. [removed] 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. [removed] 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. [removed] A sunk cost is any cost that must be expended in order to complete a project and bring it into operation

Question 20

Which of the following statements is CORRECT?

 [removed] 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. [removed] 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. [removed] Both the NPV and IRR methods deal correctly with externalities, even if the externalities are not specifically identified. However, the payback method does not. [removed] Identifying an externality can never lead to an increase in the calculated NPV. [removed] 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 21

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?

 [removed] A new product will generate new sales, but some of those new sales will be from customers who switch from one of the firm’s current products. [removed] A firm must obtain new equipment for the project, and \$1 million is required for shipping and installing the new machinery. [removed] A firm has spent \$2 million on R&D associated with a new product. These costs have been expensed for tax purposes, and they cannot be recovered regardless of whether the new project is accepted or rejected. [removed] A firm can produce a new product, and the existence of that product will stimulate sales of some of the firm’s other products. [removed] A firm has a parcel of land that can be used for a new plant site or be sold, rented, or used for agricultural purposes.

Question 22

Puckett Inc. risk-adjusts its WACC to account for project risk. It uses a WACC of 8% for below-average risk projects, 10% for average-risk projects, and 12% for above-average risk projects. Which of the following independent projects should Puckett accept, assuming that the company uses the NPV method when choosing projects?

 [removed] Project B, which has below-average risk and an IRR = 8.5%. [removed] Project C, which has above-average risk and an IRR = 11%. [removed] Without information about the projects’ NPVs we cannot determine which project(s) should be accepted. [removed] All of these projects should be accepted. [removed] Project A, which has average risk and an IRR = 9%.

Question 23

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?

 [removed] Revenues from an existing product would be lost as a result of customers switching to the new product. [removed] Shipping and installation costs associated with a machine that would be used to produce the new product. [removed] 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. [removed] 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. [removed] 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 24

Which of the following statements is CORRECT?

 [removed] Only incremental cash flows are relevant in project analysis, the proper incremental cash flows are the reported accounting profits, and thus reported accounting income should be used as the basis for investor and managerial decisions. [removed] It is unrealistic to believe that any increases in net working capital required at the start of an expansion project can be recovered at the project’s completion. Working capital like inventory is almost always used up in operations. Thus, cash flows associated with working capital should be included only at the start of a project’s life. [removed] If equipment is expected to be sold for more than its book value at the end of a project’s life, this will result in a profit. In this case, despite taxes on the profit, the end-of-project cash flow will be greater than if the asset had been sold at book value, other things held constant. [removed] Changes in net working capital refer to changes in current assets and current liabilities, not to changes in long-term assets and liabilities. Therefore, changes in net working capital should not be considered in a capital budgeting analysis. [removed] If an asset is sold for less than its book value at the end of a project’s life, it will generate a loss for the firm, hence its terminal cash flow will be negative

Question 25

Which of the following statements is CORRECT?

 [removed] 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. [removed] 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. [removed] 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. [removed] Dividend policy does not affect the requirement for external funds based on the AFN equation. [removed] 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.

Question 26

Which of the following is NOT one of the steps taken in the financial planning process?

 [removed] Monitor operations after implementing the plan to spot any deviations and then take corrective actions. [removed] Determine the amount of capital that will be needed to support the plan. [removed] Develop a set of forecasted financial statements under alternative versions of the operating plan in order to analyze the effects of different operating procedures on projected profits and financial ratios. [removed] Consult with key competitors about the optimal set of prices to charge, i.e., the prices that will maximize profits for our firm and its competitors. [removed] Forecast the funds that will be generated internally. If internal funds are insufficient to cover the required new investment, then identify sources from which the required external capital can be raised.

Question 27

Which of the following statements is CORRECT?

 [removed] 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. [removed] Firms whose fixed assets are “lumpy” frequently have excess capacity, and this should be accounted for in the financial forecasting process. [removed] For a firm that uses lumpy assets, it is impossible to have small increases in sales without expanding fixed assets. [removed] 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. [removed] 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.

Question 28

Spontaneous funds are generally defined as follows:

 [removed] A forecasting approach in which the forecasted percentage of sales for each item is held constant. [removed] Funds that a firm must raise externally through short-term or long-term borrowing and/or by selling new common or preferred stock. [removed] 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. [removed] 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. [removed] Assets required per dollar of sales

Question 29

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?

 [removed] 28.5% [removed] 30.0% [removed] 31.5% [removed] 33.1% [removed] 34.7%

Question 30

Which of the following statements is CORRECT?