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Because no flotation costs are required to obtain capital as reinvested earnings, the cost of reinvested earnings is generally lower than the after-tax cost of debt. If a company assigns the same cost of capital to all of its projects regardless of each project's risk, then the company is likely to reject some safe projects that it actually should accept and to accept some risky projects that it should reject. Which of the following statements is CORRECT ? Answer The tax-adjusted cost of debt is always greater than the interest rate on debt, provided the company does in fact pay taxes. Common stock “raised” by reinvesting earnings. Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting ? Answer Accounts payable. What is the company's cost of preferred stock for use in calculating the WACC ? Answer 8.72% 9.08% 9.44% 9.82% 10.22% 8. 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. sells for $97.50 per share, and it pays an $8.50 annual dividend. Perpetual preferred stock from Franklin Inc. Put options give investors the right to buy a stock at a certain strike price before a specified date. An option holder is not entitled to receive dividends unless he or she exercises their option before the stock goes ex dividend. LEAPS are very short-term options that were created relatively recently and now trade in the market. Options typically sell for less than their exercise value. Which of the following statements is CORRECT ? Answer Call options give investors the right to sell a stock at a certain strike price before a specified date. The potential loss on an option decreases as the option sells at higher and higher prices because the profit margin gets bigger. 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. Issuing options provides companies with a low cost method of raising capital. 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. Thus, an option can't sell for more than its exercise value. Which of the following statements is CORRECT ? Answer An option's value is determined by its exercise value, which is the market price of the stock less its striking price. Other things held constant, the value of an option depends on the stock's price, the risk-free rate, and the Answer Variability of the stock price. 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 ? Answer -$3.10 $16.90 $17.75 $22.50 $25.60 4.
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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. 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. If the underlying stock does not pay a dividend, it makes good economic sense to exercise a call option as soon as the stock's price exceeds the strike price by about 10%, because this permits the option holder to lock in an immediate profit. 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. Call options generally sell at prices above their exercise value, but for an in-the-money option, the greater the exercise value in relation to the strike price, the lower the premium on the option is likely to be. If a stock becomes riskier (more volatile), call options on the stock are likely to decline in value. Which of the following statements is CORRECT ? Answer Call options generally sell at a price less than their exercise value. 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. 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 greater than their exercise value, and the greater the exercise value, the higher the premium on the option is likely to be. Which of the following statements is CORRECT ? Answer 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.