FIN 534 FINAL EXAM PART 1

FIN 534 FINAL EXAM PART 1
Question 1
BLW Corporation is considering the terms to be set on the options it plans to issue to its executives. Which of the following actions would decrease the value of the options, other things held constant?

Question 2
 	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?

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?
		
Question 4
 	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?

Question 5
 	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?

Question 6
         Which of the following statements is most correct, holding other things constant, for XYZ Corporation's traded call options?

Question 7
 Which of the following statements is CORRECT?
Answer
 
	a) When calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on preferred stock are deductible by the paying corporation.
 
	b) 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.
 
	c) 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.
 
	d) Higher flotation costs reduce investors' expected returns, and that leads to a reduction in a company's WACC.
 
	e) When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation.

Question 8
 
Suppose Acme Industries correctly estimates its WACC at a given point in time and then uses that same cost of capital to evaluate all projects for the next 10 years, then the firm will most likely
Answer	
 
	become less risky over time, and this will maximize its intrinsic value.
 
	accept too many low-risk projects and too few high-risk projects.
 
	become more risky and also have an increasing WACC. Its intrinsic value will not be maximized.
 
	continue as before, because there is no reason to expect its risk position or value to change over time as a result of its use of a single cost of capital.
 
	become riskier over time, but its intrinsic value will be maximized.

Question 9
 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.
 
	because preferred stock dividends are treated as fixed charges, similar to the treatment of interest on debt.The component cost of preferred stock is expressed as rp(1 
 
	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
 	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?

Question 11
 	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.

Question 12
 	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?
		
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?
			
Question 14
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.

Question 15
 
Which of the following statements is CORRECT?
Answer
 
	The payback method is generally regarded by academics as being the best single method for evaluating capital budgeting projects.
 
	The discounted payback method is generally regarded by academics as being the best single method for evaluating capital budgeting projects.
 
	The net present value method (NPV) is generally regarded by academics as being the best single method for evaluating capital budgeting projects.
 
	The modified internal rate of return method (MIRR) is generally regarded by academics as being the best single method for evaluating capital budgeting projects.
 
	The internal rate of return method (IRR) is generally regarded by academics as being the best single method for evaluating capital budgeting projects.

Question 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.

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.
Answer
             a. The lower the WACC used to calculate it, the lower the calculated NPV will be.
             b. 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.
           .c. If a project's NPV is less than zero, then its IRR must be less than the WACC.
             d. If a project's NPV is greater than zero, then its IRR must be less than zero.
            e. The NPV of a relatively low-risk project should be found using a relatively high WACC
			
Question 18
 	
Which of the following statements is CORRECT?
Answer
 
	The NPV method assumes that cash flows will be reinvested at the risk-free rate, while the IRR method assumes reinvestment at the IRR.
 
	The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the risk-free rate.
 
	The NPV method does not consider all relevant cash flows, particularly cash flows beyond the payback period.
 
	The IRR method does not consider all relevant cash flows, particularly cash flows beyond the payback period.
 
	The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the IRR.

Question 19
 
Which of the following statements is CORRECT?
Answer
 
	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.
 
	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.
 
	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.
 
	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.
 
	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 20
 
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.


Question 21
       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			
         a. Opportunity costs.
         b. Shipping and installation costs for machinery acquired.
         c. Cannibalization effects.
         d. Changes in net operating working capital.
         e. Sunk costs that have been expensed for tax purposes

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?

Question 23
Which of the following procedures does the text say is used most frequently by businesses when they do capital budgeting analyses?
Answer
        a) The firm's corporate, or overall, WACC is used to discount all project cash flows to find the projects' NPVs. Then, depending on how risky different projects are judged to be, the calculated NPVs are scaled up or down to adjust for differential risk.
       b) Differential project risk cannot be accounted for by using "risk-adjusted discount rates" because it is highly subjective and difficult to justify. It is better to not risk adjust at all.
        c) Other things held constant, if returns on a project are thought to be positively correlated with the returns on other firms in the economy, then the project's NPV will be found using a lower discount rate than would be appropriate if the project's returns were negatively correlated.
          d) Monte Carlo simulation uses a computer to generate random sets of inputs, those inputs are then used to determine a trial NPV, and a number of trial NPVs are averaged to find the project's expected NPV. Sensitivity and scenario analyses, on the other hand, require much more information regarding the input variables, including probability distributions and correlations among those variables. This makes it easier to implement a simulation analysis than a scenario or sensitivity analysis, hence simulation is the most frequently used procedure.
           e) DCF techniques were originally developed to value passive investments (stocks and bonds). However, capital budgeting projects are not passive investments--managers can often take positive actions after the investment has been made that alter the cash flow stream. Opportunities for such actions are called real options. Real options are valuable, but this value is not captured by conventional NPV analysis. Therefore, a project's real options must be considered separately.
			
Question 24
 	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?
Question 25
 
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.


Question 26
 
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.

Question 27
 
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.

Question 28
Last year Baron Enterprises had $350 million of sales, and it had $270 million of fixed assets that were used at 65% of capacity last year. In millions, by how much could Baron's sales increase before it is required to increase its fixed assets?

Question 29
The capital intensity ratio is generally defined as follows:
Answer			
	Sales divided by total assets, i.e., the total assets turnover ratio.

       The percentage of liabilities that increase spontaneously as a percentage of sales.

      The ratio of sales to current assets.

      The ratio of current assets to sales.

      The amount of assets required per dollar of sales, or A0*/S0.		

Question 30
 	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?