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					1.   Which of the following statements is CORRECT?

     a.   If corporate tax rates were decreased while other things were held
          constant, and if the Modigliani-Miller tax-adjusted tradeoff theory
          of capital structure were correct, this would tend to cause
          corporations to decrease their use of debt.
     b.   A change in the personal tax rate should not affect firms’ capital
          structure decisions.
     c.   “Business risk” is differentiated from “financial risk” by the fact
          that financial risk reflects only the use of debt, while business
          risk reflects both the use of debt and such factors as sales
          variability, cost variability, and operating leverage.
     d.   The optimal capital structure is the one that simultaneously (1)
          maximizes the price of the firm’s stock, (2) minimizes its WACC,
          and (3) maximizes its EPS.
     e.   If changes in the bankruptcy code make bankruptcy less costly to
          corporations, then this would likely reduce the debt ratio of the
          average corporation.

     Answer: a

2.   Which of the following statements is CORRECT?

     a.   When a company increases its debt ratio, the costs of equity and
          debt both increase. Therefore, the WACC must also increase.
     b.   The capital structure that maximizes the stock price is generally
          the capital structure that also maximizes earnings per share.
     c.   All else equal, an increase in the corporate tax rate would tend to
          encourage a company to increase its debt ratio.
     d.   Since debt financing raises the firm’s financial risk, increasing a
          company’s debt ratio will always increase its WACC.
     e.   Since debt is cheaper than equity, increasing a company’s debt
          ratio will always reduce its WACC.
      Answer: c

Rollins Corporation is estimating its WACC.        Its target capital
structure is 20 percent debt, 20 percent preferred stock, and 60
percent common equity. Its bonds have a 12 percent coupon, paid
semiannually, a current maturity of 20 years, and sell for $1,000. The
firm could sell, at par, $100 preferred stock which pays a 12 percent
annual dividend, but flotation costs of 5 percent would be incurred.
Rollins' beta is 1.2, the risk-free rate is 10 percent, and the market
risk premium is 5 percent. Rollins is a constant-growth firm which just
paid a dividend of $2.00, sells for $27.00 per share, and has a growth
rate of 8 percent.    The firm's policy is to use a risk premium of 4
percentage points when using the bond-yield-plus-risk-premium method to
find rs. The firm's marginal tax rate is 40 percent.
3.) What is Rollins' cost of common stock (rs) using the CAPM approach?

          a.   13.6%
          b.   14.1%
          c.   16.0%
          d.   16.6%
          e.   16.9%

4.)   A     company has determined that its optimal capital structure
          consists of 40 percent debt and 60 percent equity.      Given the
          following information, calculate the firm's weighted average cost
          of capital.

                                  rd = 6%
                                  Tax rate = 40%
                                  P0 = $25
                                  Growth = 0%
                                  D0 = $2.00


          a.   6.0%
          b.   6.2%
          c.   7.0%
          d.   7.2%
          e.   8.0%


5.) The major contribution of the Miller model is that it demonstrates
      that

          a. personal taxes increase the value of corporate debt.
          b. personal taxes decrease the value of corporate debt.
          c. financial distress and agency costs reduce the         value   of
             corporate debt.
          d. equity costs increase with financial leverage.
          e. debt costs increase with financial leverage.


6.) Which of the following statements concerning capital structure theory
      is false?

          a. The major contribution of Miller's theory is that it
             demonstrates that personal taxes decrease the value of corporate
             debt.
          b. Under MM with zero taxes, financial leverage has no effect on
             firm value.
          c. Under MM with corporate taxes, the value of the levered firm
             exceeds the value of the unlevered firm by the product of the
             tax rate times the market value dollar amount of debt.
          d. Under MM with corporate taxes, rs increases with leverage, and
             this increase is just sufficient to offset the tax benefits of
             debt financing.
          e. Under MM with corporate taxes, the effect of business risk is
             automatically incorporated because rsL is a function of rsU.
The Kimberly Corporation is a zero growth firm with an expected EBIT of
$100,000 and a corporate tax rate of 30 percent. Kimberly uses $500,000
of 12.0 percent debt financing, and the cost of equity to an unlevered
firm in the same risk class is 16.0 percent.

7.)   What is the value of the firm according to MM with corporate taxes?

      a.   $400,000
      b.   $437,500
      c.   $587,500
      d.   $625,000
      e.   $775,000


8.) Which one of the following is NOT an assumption of the
Black-Scholes option pricing model?
     a. The stock underlying the call option provides no
     dividends
     b. There are no transactions costs for buying and selling
     either the stock or the option
     c. The short-term, risk-free rate is known and is constant
     during the life of the option
     d. Short selling is not permitted.

9.) Assuming that the theoretical price of the Black-Scholes
option pricing model is correct, if the actual value of the call
option is less than the theoretical value than the call options
is
     a. undervalued
     b. overvalued
     c. misvalued
     d. irrelevant to engage in any kind of trading.


10. Call options on XYZ Corporation’s common stock trade in the market.
      Which of the following statements is most correct, holding other
      things constant?

      a. The price of these call options is likely to rise if XYZ’s
         stock price rises.
      b. The higher the strike price on XYZ’s options, the higher the
         option’s price will be.
      c. 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.
      d. If XYZ’s stock price stabilizes (becomes less volatile), then
         the price of its options will increase.
      e. 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.
      Answer: a
11. Which of the following statements is CORRECT?

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

12.   Which of the following statements is CORRECT?

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

      Answer: d
13. An analyst wants to use the Black-Scholes model to value call
      options on the stock of Ledbetter Inc. based on the following
      data:

          The price of the stock is $40.
          The strike price of the option is $40.
          The option matures in 3 months (t = 0.25).
          The standard deviation of the stock’s returns is 0.40, and the
           variance is 0.16.
          The risk-free rate is 6%.

      Given this information, the analyst then calculated the following
      necessary components of the Black-Scholes model:

          d1 = 0.175
          d2 = -0.025
          N(d1) = 0.56946
          N(d2) = 0.49003

      N(d1) and N(d2) represent areas under a standard normal
      distribution function. Using the Black-Scholes model, what is
      the value of the call option?

      a.   $2.81
      b.   $3.12
      c.   $3.47
      d.   $3.82
      e.   $4.20

      Answer: c


14.   Which of the following is NOT a capital component when calculating the
      weighted average cost of capital (WACC)?

      a.   Long-term debt.
      b.   Accounts payable.
      c.   Retained earnings.
      d.   Common stock.
      e.   Preferred stock.

      Answer: b
15.   For a typical firm, which of the following sequences is CORRECT? All
      rates are after taxes, and assume the firm operates at its target
      capital structure.

      a. re > rs   >    WACC   > rd.
      b. rs > re   >    rd >   WACC.
      c. WACC >    re   > rs   > rd.
      d. rd > re   >    rs >   WACC.
      e. WACC >    rd   > rs   > re.
      Answer: a
16. Which of the following statements is CORRECT?

a.   A cost should be assigned to retained earnings due to the opportunity
     cost principle, which refers to the fact that the firm’s stockholders
     could themselves earn a return on earnings if they were paid out rather
     than retained and reinvested.
b.   The component cost of preferred stock is expressed as rp(1 - T). This
     follows because preferred stock dividends are treated as fixed charges,
     and as such they can be deducted by the issuer for tax purposes.
c.   No cost should be assigned to retained earnings because the firm does
     not have to pay anything to raise them—they are generated as cash flows
     by operating assets that were raised in the past, hence they are “free.”
d.   Suppose a firm has been losing money and thus is not paying taxes, and
     this situation is expected to persist into the foreseeable future. In
     this case, the firm’s before-tax and after-tax costs of debt will both
     be equal to the interest rate on the firm’s currently outstanding debt,
     provided that debt was issued during the past 5 years.
e.   If a firm has enough retained earnings to fund its capital budget for
     the coming year, then there is no need to estimate either a cost of
     equity or a WACC.

Answer: a

17. Hettenhouse Company’s perpetual preferred stock sells for $102.50 per
share, and it pays a $9.50 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?

a.   9.27%
b.   9.65%
c.   10.04%
d.   10.44%
e.   10.86%

Answer: b

18. Assume that you are a consultant to Magee Inc., and you have been
provided with the following data: rRF = 4.00%; RPM = 5.00%; and b = 1.15.
What is the cost of equity from retained earnings based on the CAPM approach?

 a. 9.75%
 b. 10.04%
 c. 10.34%
 d. 10.65%
 e. 10.97%
Answer: a

				
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