Multiple choice questions on stocks, derivatives and capital budgeting.

1. An option which gives the holder the right to sell a stock at a specified price at some time in the future is called a(n)

a)    Call option.

b)   Put option.

c)    Out-of-the-money option.

d)   Naked option.

e)    Covered option.

2. Warnes Motors' stock is trading at $20 a share. Call options that expire in three months with an exercise price of $20 have a price of $1.50. Which of the following will occur if the stock price increases 10 percent to $22 a share?

a)    The price of the call option will increase by $2.

b)   The price of the call option will increase by more than $2.

c)    The price of the call option will increase by less than $2, and the percentage increase in price will be less than 10 percent.

d)   The price of the call option will increase by less than $2, but the percentage increase in price will be more than 10 percent.

e)    The price of the call option will increase by more than $2, but the percentage increase in price will be less than 10 percent.

3. Clueless Corporation never considers abandonment options or growth options when estimating its optimal capital budget. What impact does this policy have on the company's optimal capital budget?

a)    Its estimated capital budget is too small because it fails to consider abandonment and growth options.

b)   Its estimated capital budget is too large because it fails to consider abandonment and growth options.

c)    Failing to consider abandonment options makes the optimal capital budget too large, but failing to consider growth options makes the optimal capital budget too small, so it is unclear what impact this policy has on the overall capital budget.

d)   Failing to consider abandonment options makes the optimal capital budget too small, but failing to consider growth options makes the optimal capital budget too large, so it is unclear what impact this policy has on the overall capital budget.

e)    Neither abandonment nor growth options should have an effect on the company's optimal capital budget.

4. Consider the following project data:

(1)A $500 feasibility study will be conducted at t = 0.(2)If the study indicates potential, the firm will spend $1,000 at t = 1 to build a prototype. The best estimate now is that there is an 80 percent chance that the study will indicate potential, and a 20 percent chance that it will not.(3)If reaction to the prototype is good, the firm will spend $10,000 to build a production plant at t = 2. The best estimate now is that there is a 60 percent chance that the reaction to the prototype will be good, and a 40 percent chance that it will be poor.(4)If the plant is built, there is a 50 percent chance of a t = 3 cash inflow of $16,000 and a 50 percent chance of a $13,000 cash inflow.

If the appropriate cost of capital is 10 percent, what is the project's expected NPV?

a)    -$35

b)   -$12

c)    $0

d)   $12

e)    $35

5. Refer to Diplomat.com. Based on this information what is the project's net present value?

Diplomat.com

Diplomat.com is considering a project that has an up-front cost of $3 million and produces an expected cash flow of $500,000 at the end of each of the next five years. The project's cost of capital is 10 percent.

a)    -$875,203

b)   -$506,498

c)    $54,307

d)   -$1,104,607

e)    $105,999

6. Which of the following statements is not correct?

a)    The corporate valuation model can be used even for a company that does not pay dividends.

b)   The corporate valuation model discounts free cash flows by the required return on equity.

c)    The corporate valuation model can be used to find the value of a division.

d)   An important step in applying the corporate valuation model is forecasting the pro forma financial statements.

e)    Free cash flows must grow at a constant rate in order to find the horizon, or terminal, value.

7. A company forecasts free cash flow in one year to be -$10 million and free cash flow in two years to be $20 million. After the second year, free cash flow will grow at a constant rate of 4 percent per year forever. If the overall cost of capital is 14 percent, what is the current value of operations, to the nearest million?

a)    $150 million

b)   $167 million

c)    $200 million

d)   $208 million

e)    $228 million

8. Using the corporate valuation model, the value of a company's operations is $400 million. The company's balance sheet shows $20 million in short-term investments that are unrelated to operations. The balance sheet also shows $50 million in accounts payable, $90 million in notes payable, $30 million in long-term debt, $40 million in preferred stock, and $100 million in total common equity. If the company has 10 million shares of stock, what is your best estimate for the stock price per share?

a)    $10

b)   $21

c)    $24

d)   $26

e)    $42