Financial Management

Question 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 binomial model, what is the option's value? (Hint: Use daily compounding.)
$2.43
$2.70
$2.99
$3.29
$3.62
Payoff range: 27 - 17 = 10

Question 2
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?
-$5.10
$19.90
$20.90
$22.50
$27.60

Question 3
Which of the following statements is CORRECT?
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.
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 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?
-$3.10
$16.90
$17.75
$22.50
$25.60

Question 5
Which of the following statements is CORRECT?
Call options give investors the right to sell a stock at a certain strike price before a specified date.
Options typically sell for less than their exercise value.
LEAPS are very short-term options that were created relatively recently and now trade in the market.
An option holder is not entitled to receive dividends unless he or she exercises their option before the stock goes ex dividend.
Put options give investors the right to buy a stock at a certain strike price before a specified date.

Question 6
An option that gives the holder the right to sell a stock at a specified price at some future time is
a put option.
an out-of-the-money option.
a naked option.
a covered option.
a call option.

Question 7
Which of the following statements is CORRECT?
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 reinvested 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.
When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation.

Question 8
You have been hired as a consultant by Feludi Inc.'s CFO, who wants you to help her estimate the cost of capital. You have been provided with the following data: rRF = 4.10%; RPM = 5.25%; and b = 1.30. Based on the CAPM approach, what is the cost of common from reinvested earnings?
9.67%
9.97%
10.28%
10.60%

Question 9
Which of the following statements is CORRECT?
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.
The WACC is calculated using before-tax costs for all components

Question 10
Perpetual preferred stock from Franklin Inc. sells for $97.50 per share, and it pays an $8.50 annual dividend. If the company were to sell a new preferred issue, it would incur a flotation cost of 4.00% of the price paid by investors. What is the company's cost of preferred stock for use in calculating the WACC?
8.72%
9.08%
9.44%
9.82%
10.22%

Question 11
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?
11.30%
11.64%
11.99%
12.35%
12.72%

Question 12
Which of the following statements is CORRECT? Assume a company's target capital structure is 50% debt and 50% common equity.
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 reinvested earnings typically exceeds the cost of new common stock.
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 13
Which of the following statements is CORRECT?
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 14
The WACC for two mutually exclusive projects that are being considered is 12%. Project K has an IRR of 20% while Project R's IRR is 15%. The projects have the same NPV at the 12% current WACC. Interest rates are currently high. However, you believe that money costs and thus your WACC will soon decline. You also think that the projects will not be funded until the WACC has decreased, and their cash flows will not be affected by the change in economic conditions. Under these conditions, which of the following statements is CORRECT?
You should delay a decision until you have more information on the projects, even if this means that a competitor might come in and capture this market.
You should recommend Project R, because at the new WACC it will have the higher NPV.
You should recommend Project K, because at the new WACC it will have the higher NPV.
You should recommend Project R because it will have both a higher IRR and a higher NPV under the new conditions.
You should reject both projects because they will both have negative NPVs under the new conditions.

Question 15
Which of the following statements is CORRECT?
For mutually exclusive projects with normal cash flows, the NPV and MIRR methods can never conflict, but their results could conflict with the discounted payback and the regular IRR methods.
Multiple IRRs can exist, but not multiple MIRRs. This is one reason some people favor the MIRR over the regular IRR.
If a firm uses the discounted payback method with a required payback of 4 years, then it will accept more projects than if it used a regular payback of 4 years.
The percentage difference between the MIRR and the IRR is equal to the project's WACC.
The NPV, IRR, MIRR, and discounted payback (using a payback requirement of 3 years or less) methods always lead to the same accept/reject decisions for independent projects

Question 16
Assume a project has normal cash flows. All else equal, which of the following statements is CORRECT?
A project's NPV increases as the WACC declines.
A project's MIRR is unaffected by changes in the WACC.
A project's regular payback increases as the WACC declines.
A project's discounted payback increases as the WACC declines.
A project's IRR increases as the WACC declines.

Question 17
Which of the following statements is CORRECT?
One defect of the IRR method versus the NPV is that the IRR does not take account of the time value of money.
One defect of the IRR method versus the NPV is that the IRR does not take account of the cost of capital.
One defect of the IRR method versus the NPV is that the IRR 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 versus the NPV is that the IRR does not take proper account of differences in the sizes of projects.
One defect of the IRR method versus the NPV is that the IRR does not take account of cash flows over a project's full life.

Question 18
Which of the following statements is CORRECT?
If a project has "normal" cash flows, then its MIRR must be positive.
If a project has "normal" cash flows, then it will have exactly two real IRRs.
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.
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.
If a project has "normal" cash flows, then its IRR must be positive.

Question 19
Which of the following statements is CORRECT?
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
The CFO of Cicero Industries plans to calculate a new project's NPV by estimating the relevant cash flows for each year of the project's life (i.e., the initial investment cost, the annual operating cash flows, and the terminal cash flow), then discounting those cash flows at the company's overall WACC. Which one of the following factors should the CFO be sure to INCLUDE in the cash flows when estimating the relevant cash flows?
All sunk costs that have been incurred relating to the project.
All interest expenses on debt used to help finance the project.
The investment in working capital required to operate the project, even if that investment will be recovered at the end of the project's life.
Sunk costs that have been incurred relating to the project, but only if those costs were incurred prior to the current year.
Effects of the project on other divisions of the firm, but only if those effects lower the project's own direct cash flows.

Question 21
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?
Project B, which has below-average risk and an IRR = 8.5%.
Project C, which has above-average risk and an IRR = 11%.
Without information about the projects' NPVs we cannot determine which project(s) should be accepted.
All of these projects should be accepted.
Project A, which has average risk and an IRR = 9%.

Question 22
Collins Inc. is investigating whether to develop a new product. In evaluating whether to go ahead with the project, which of the following items should NOT be explicitly considered when cash flows are estimated?
The project will utilize some equipment the company currently owns but is not now using. A used equipment dealer has offered to buy the equipment.
The company has spent and expensed for tax purposes $3 million on research related to the new detergent. These funds cannot be recovered, but the research may benefit other projects that might be proposed in the future.
The new product will cut into sales of some of the firm's other products.
If the project is accepted, the company must invest $2 million in working capital. However, all of these funds will be recovered at the end of the project's life.
The company will produce the new product in a vacant building that was used to produce another product until last year. The building could be sold, leased to another company, or used in the future to produce another of the firm's products.

Question 23
Which of the following procedures best accounts for the relative risk of a proposed project?
Adjusting the discount rate downward if the project is judged to have above-average risk.
Reducing the NPV by 10% for risky projects.
Picking a risk factor equal to the average discount rate.
Ignoring risk because project risk cannot be measured accurately.
Adjusting the discount rate upward if the project is judged to have above-average risk.

Question 24
Which of the following is NOT a relevant cash flow and thus should not be reflected in the analysis of a capital budgeting project?
Shipping and installation costs.
Cannibalization effects.
Opportunity costs.
Sunk costs that have been expensed for tax purposes.
Changes in net working capital

Question 25
Which of the following statements is CORRECT?
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 26
A company expects sales to increase during the coming year, and it is using the AFN equation to forecast the additional capital that it must raise. Which of the following conditions would cause the AFN to increase?
The company increases its dividend payout ratio.
The company begins to pay employees monthly rather than weekly.
The company's profit margin increases.
The company decides to stop taking discounts on purchased materials.
The company previously thought its fixed assets were being operated at full capacity, but now it learns that it actually has excess capacity.

Question 27
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)?
A switch to a just-in-time inventory system and outsourcing production.
The company reduces its dividend payout ratio.
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.
The company discovers that it has excess capacity in its fixed assets.
A sharp increase in its forecasted sales.

Question 28
The term "additional funds needed (AFN)" is generally defined as follows:
Funds that a firm must raise externally from non-spontaneous sources, i.e., by borrowing or by selling new stock to support operations.
The amount of assets required per dollar of sales.
The amount of internally generated cash in a given year minus the amount of cash needed to acquire the new assets needed to support growth.
A forecasting approach in which the forecasted percentage of sales for each balance sheet account is held constant.
Funds that are obtained automatically from routine business transactions.

Question 29
The Besnier Company had $250 million of sales last year, and it had $75 million of fixed assets that were being operated at 80% of capacity. In millions, how large could sales have been if the company had operated at full capacity?
$312.5
$328.1
$344.5
$361.8
$379.8

Question 30
Which of the following statements is CORRECT?
The AFN equation for forecasting funds requirements requires only a forecast of the firm's balance sheet. Although a forecasted income statement may help clarify the results, income statement data are not essential because funds needed relate only to the balance sheet.
Dividends are paid with cash taken from the accumulated retained earnings account, hence dividend policy does not affect the AFN forecast.
A negative AFN indicates that retained earnings and spontaneous liabilities are far more than sufficient to finance the additional assets needed.
If the ratios of assets to sales and spontaneous liabilities to sales do not remain constant, then the AFN equation will provide more accurate forecasts than the forecasted financial statements method.
Any forecast of financial requirements involves determining how much money the firm will need, and this need is determined by adding together increases in assets and spontaneous liabilities and then subtracting operating income.