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10 Cards in this Set

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How to value stock using dividend growth model ?
Value = Dividend / (RROR - Div Growth rate)
Which of the following Covenats obliges the borrower to repay the bonds if a large quantity of common stock is held by a single investor and the bond rating is downgraded?


A- Poison put clause
B- Cross-default clause
C- Affirmative covenant
D- Negative pledge clause
A is correct.
A call option gives the holder the right to purchase an asset at a specified price, called the ________ price, before some specified date. The purchase price of the option is called the ________, while the exercise price of the option minus the current stock price is known as ________. Finally, the difference between the actual call price and its intrinsic value is known as the ________ of the option.



A- Exercise; premium; intrinsic value; time value
B- Exercise; cost; time value; intrinsic value
C- Strike; premium; market value; intrinsic value
D- Strike; cost; intrinsic value; exercise value
The Exercise or Strike price of an option is the specified price at which the holder of a call option has a right to purchase the asset. The purchase price of the option is known as the premium and the difference between the exercise price and the current stock price is know as the Intrinsic Value of the option. The difference between the current price of the option and its intrinsic value is the Time Value of the option.
An investment strategy that exploits divergences between actual futures prices and their theoretically correct parity value is known as which of the following?


A- Program trading
B- Index arbitrage
C- Arbitrage pricing theory
D- Both program trading and index arbitrage
B is correct.

Index arbitrage involves the following: if the futures price is too high, short the futures contract and buy the stocks (and vice versa) in the portfolio to exploit the divergence between the actual futures price and its theoretically correct value.

Program trading is the coordinated purchase and/or sale of an entire portfolio of stock. It is essential to implementing index arbitrage but is not index arbitrage.

Arbitrage pricing theory is a theory that attempts to determine which systematic factors affect security returns.
Datacomp Industries, which has no current debt, has a beta of .95 for its common stock. Management is considering a change in the capital structure to 30% debt and 70% equity. This change would increase the beta on the stock to 1.05, and the after-tax cost of debt will be 7.5%. The expected return on equity is 16%, and the risk-free rate is 6%. Should Datacomp's management proceed with the capital structure change?


A- No, because the cost of equity capital will increase
B- Yes, because the cost of equity capital will decrease
C- Yes, because the weighted-average cost of capital will decrease
D- No, because the weighted-average cost of capital will increase
C is correct.

Even though the beta increases in the next scenario, only 70% of the capital is equity and the rest is debt, with an after-tax cost of capital of 7.5%. Thus, moving to this debt structure would lower Datacomp's weighted-average cost of capital. Present WACC =

6 + .95 (16-6) = 15.5%

Proposed WACC
Cost of Equity =
6 + 1.05 (16 - 6) =
16.5%

WACC = 0.7(16.5) + .30(7.5) = 11.55 + 2.25 = 13.8%
Future value is best described as

A. The value of a dollar-in at a future time adjusted for any compounding effect
B. The sum of dollars-in discounted to time zero.
C. The sum of dollars-out discounted to time zero.
D. The value of a dollar-in at a future time adjusted for any compounding effect and the value of a dollar-out at a future time adjusted for any compounding effect.
D is correct.

The future value of a dollar is its value at a time in the future given its present value. The future value of a dollar is affected both by the discount rate and the time at which the dollar is received. Hence, both dollars-in and dollars-out in the future may be adjusted for the discount rate and any compounding that may occur.
All of the following must be disclosed regarding financial instruments with off-balance-sheet risk of accounting loss, Except the:


A- accounting loss incurred if any party to the instrument failed completely to perform, and the collateral proved to be of no value.
B- face or contract amount.
C- instrument's nature and terms, including credit risk, market risk, cash requirements, and related accounting policies.
D- amount by which earnings per share would change if the accounting loss were to occur.
D is correct.

The following items must be disclosed regarding financial instruments with off-balance-sheet risk of accounting loss:

* Accounting loss incurred if any party to the instrument failed completely to perform and the collateral proved to be of no value.
* Face or contract amount
* Instrument's nature and terms, including credit risk, market risk, cash requirements, and related accounting policies.
* Entity's policy for requiring collateral it accepts, and a description of collateral on instruments presently held
Kruse Corporation made a rights offering to its existing stockholders. Each stockholder received one right for each share of common stock owned.

A stockholder will have to surrender five rights plus $8 to receive one new common share. Kruse Corporation's common stock is selling for $14 per share during the rights-on period.

The theoretical value of one stock purchase right in the rights-on period is:


A- $1.00.
B- $1.20.
C- $2.80.
D- 1.60
A is correct.

The value of a stock right is the difference in the market value of the stock between the rights-on period (when rights can be exercised) and the ex-rights period (when rights are not exercised). The rights-on price of the stock is given at $14.

To figure the ex-rights price, we look at the change in the holdings of one shareholder for simplicity. Before surrendering 5 rights, one shareholder has to hold at least 5 common shares. At $14 per share, a shareholder's total investment in Kruse is 5 × $14 = $70. After exercise of the rights for an additional share, the shareholder has invested $8 more into the company for a total investment of $78 in 6 common shares. The value of the common shares is now $78 ÷ 6 = $13 per share, ex-rights. The difference between the $14 per share rights-on and the $13 per share ex-rights is the value of one right at $1.
Interest rate swaps:


A- involve investors swapping fixed-rate securities for floating-rate securities.
B- involve investors trading interest payments or cash flows from different securities without actually trading the securities directly.
C- involve investors swapping interest rate futures for interest rate options to reduce interest rate risk.
D- can do nothing to help reduce interest rate risk but are effective in reducing default risk.
B is correct.
Which of the following is not a capital instrument for long-term financing?

A- Capital lease
B- Issuance of a bond
C- Issuance of a 1-year note payable
D- Issuance of preferred stock
C is correct.