12. A European call option on a stock has a strike price of $75.
The underlying stock is
currently trading at $80. The option premium is $8. What is the intrinsic value of the
option?
A. $5
B. $8
C. $3
D. $0
Answer: A. $5
Explanation: Explanation: The intrinsic value of a call option is the amount by which the underlying
stock's price is higher than the strike price. It represents the value an investor could realize by
exercising the option immediately.
Formula: Intrinsic Value (Call) = Max(0, Stock Price - Strike Price)
Intrinsic Value = Max(0, $80 - $75)
Intrinsic Value = Max(0, $5) = $5.
The option premium ($8) is composed of this intrinsic value ($5) and the time value ($3). The time
value reflects the possibility that the stock price will increase further before the option expires.
13. A company issues a 10-year, 8% semiannual coupon bond with a par value of
$1,000. If the market interest rate (yield to maturity) for similar bonds is 6%, what is the
price of the bond?
A. $1,000.00
B. $1,148.77
C. $875.38
D. $1,170.60
Answer: B. $1,148.77
Explanation: Explanation: The price of a bond is the present value of its future cash flows (coupon
payments and par value) discounted at the market interest rate.
Since it's a semiannual bond:
- Number of periods (n) = 10 years * 2 = 20 periods.
- Market interest rate per period (i) = 6% / 2 = 3%.
- Coupon payment per period (PMT) = ($1,000 * 8%) / 2 = $40.
- Par Value (FV) = $1,000.
We need to calculate the Present Value (PV) of the annuity of coupon payments and the PV of the
par value.
1. PV of coupon payments = $40 * PVIFA(3%, 20) = $40 * [ (1 - (1+0.03)^-20) / 0.03 ] = $40 *
14.8775 = $595.10.
2. PV of par value = $1,000 * PVIF(3%, 20) = $1,000 / (1.03)^20 = $1,000 * 0.55367 = $553.67.
3. Bond Price = PV of coupons + PV of par value = $595.10 + $553.67 = $1,148.77.
Since the coupon rate (8%) is higher than the market rate (6%), the bond sells at a premium (above
par value).
14. Which of the following statements is most accurate regarding the payback period
method for capital budgeting?
A. It is generally preferred over NPV because it is conceptually sounder.
B. It ignores the time value of money and cash flows beyond the payback period.
C. It considers all cash flows over the project's entire life.
D. A shorter payback period always means a higher NPV.
Answer: B. It ignores the time value of money and cash flows beyond the payback period.
Explanation: Explanation: The payback period is the time it takes for a project's cumulative cash
inflows to equal its initial investment. Its primary weaknesses are:
1. It does not discount cash flows, thereby ignoring the time value of money (a dollar today is worth
more than a dollar tomorrow).
2. It completely ignores any cash flows, whether positive or negative, that occur after the payback
period has been reached. This can lead to rejecting projects with high long-term profitability.
Because of these flaws, it is considered conceptually inferior to methods like NPV and IRR, though it
is often used as a secondary measure of liquidity and risk.
15. A firm's optimal capital structure is the mix of debt and equity that:
A. Maximizes earnings per share (EPS).
B. Maximizes the firm's stock price.
C. Minimizes the cost of debt.
D. Maximizes the firm's revenue.
Answer: B. Maximizes the firm's stock price.
Explanation: Explanation: The primary goal of financial management is to maximize shareholder
wealth, which is reflected in the company's stock price. The optimal capital structure is the specific
mix of debt, preferred stock, and common equity that minimizes the company's Weighted Average
Cost of Capital (WACC). By minimizing the WACC, the firm maximizes its overall value, which in turn
maximizes its stock price. While maximizing EPS is a common goal, it can sometimes be achieved
by taking on excessive risk (leverage), which could lower the stock price. Therefore, maximizing the
stock price is the ultimate objective.
