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Tutorial 15021

step by step 1. 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...

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1. 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? $2.43 $2.70  $2.99  $3.29 $3.62

 

2. An option that gives the holder the right to sell a stock at a specified price at some future time is a call option. a put option. an out-of-the-money option. a naked option. a covered option.

 

3. 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? 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%.

 

4. Which of the following statements is CORRECT? If the underlying stock does not pay a dividend, it does not make good economic sense to exercise a call option prior to its expiration date, even if this would yield an immediate profit. Call options generally sell at a price greater than their exercise value, and the greater the exercise value, the higher the premium on the option is likely to be. Call options generally sell at a price below their exercise value, and the greater the exercise value, the lower the premium on the option is likely to be. Call options generally sell at a price below their exercise value, and the lower the exercise value, the lower the premium on the option is likely to be. Because of the put-call parity relationship, under equilibrium conditions a put option on a stock must sell at exactly the same price as a call option on the stock.

 

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5. 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? -$310.25 $1,689.75 $1,774.24 $1,862.95 $1,956.10

 

6. If a typical U.S. company correctly estimates its WACC at a given point in time and then uses that same cost of capital to evaluate all projects for the next 10 years, then the firm will most likely become riskier over time, but its intrinsic value will be maximized. become less risky over time, and this will maximize its intrinsic value. accept too many low-risk projects and too few high-risk projects. become more risky and also have an increasing WACC. Its intrinsic value will not be maximized. continue as before, because there is no reason to expect its risk position or value to change over time as a result of its use of a single cost of capital.

 

7. Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting? Long-term debt. Accounts payable. Retained earnings. Common stock. Preferred stock.

 

8. Which of the following statements is CORRECT? 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.

 

9. Which of the following statements is CORRECT? 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.

 

10. For a company whose target capital structure calls for 50% debt and 50% common equity, which of the following statements is CORRECT? 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. The WACC is calculated on a before-tax basis. The WACC exceeds the cost of equity. The cost of equity is always equal to or greater than the cost of debt. The cost of retained earnings typically exceeds the cost of new common stock.

 

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