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Name: Homework #2 FIN 4504 Equity and Capital Markets Instructor: Cem Demiroglu Fall 2004 DUE DATE:

September 28, 2004 (Tuesday) Multiple Choice Questions 1.

Firm A has $1,000 cash at hand and $1,200 worth of debt that will mature in a month. There are two projects available to the firm. Both projects require an investment outlay of $1,000. Project 1 pays off $900 with probability 0.4 and $1,100 with probability 0.6. Project 2 pays off $500 with probability 0.9 and $1,250 with probability 0.1. The pay offs of both projects will be due just before the debt matures. What will the management of Firm B do? BBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBB Invest in Project 1 B) Invest in Project 2 C) Do nothing D) None of the above 2. A) B) C) D) 3. A) B) C) D) 4. A) B) C) D) 5. A) B) C) D) 6. A) B) C) D) _____ computes over 50 country indexes. Dow Jones The Federal Reserve NASDAQ MSCI __________ is a true statement. Dividends on preferred stocks are tax-deductible Common dividends are paid before preferred dividends Preferred stockholders have voting power Preferred dividends are usually cumulative In a futures contract, the short position is taken by the person who __________. commits to delivering the commodity commits to purchasing the commodity plays between second base and third base uses his margin __________ is a true statement regarding the Dow Jones Industrial Average. It is a value-weighted average of 30 large industrial stocks It is a price-weighted average of 30 large industrial stocks It is a price-weighted average of 100 large stocks traded on the New York Stock Exchange It is a value-weighted average of all stocks traded on the New York Stock Exchange A __________ gives its holder the right to sell an asset for a specified exercise price on or before a specified expiration date. call option futures contract put option none of the above

7. A) B) C) D) 8. A) B) C) D) 9. A) B) C) D) 10. A) B) C) D) 11. A) B) C) D) 12. A) B) C) D) 13. A) B) C) D)

A __________ gives its holder the right to buy an asset for a specified exercise price on or before a specified expiration date. call option futures contract put option none of the above __________ market-value weighted. The New York Stock Exchange Composite index is The Standard & Poor's Composite 500 Stock index is The Wilshire 5000 index is All of the above are In the event of the firm's bankruptcy, __________. the firm's stockholders are personally liable for the firm's obligations the most shareholders can lose is their original investment in the firm's stock common shareholders are the first in line to receive their claims on the firm's assets bondholders have claim to what is left from the liquidation of the firm's assets after paying shareholders Which one of the following is one of the common characteristics of common and preferred stocks? Control rights Seniority of claims to corporate assets and income Tax consequences for investors All of the above Preferred stock is like equity in that _____. it promises to pay a fixed stream of income each year it has voting power regarding the firm's management the firm has a contractual obligation to pay the dividend each period none of the above Preferred stock is like long-term debt in that _____. it gives the holder voting power regarding the firm's management it promises to pay to its holder a fixed stream of income each year the dividend is a tax-deductible expense for the firm all of the above Which of the following most closely approximates the performance of a buy and hold portfolio strategy? an equally weighted index a price weighted index a value weighted index weights are not a factor in this situation

14.

If the market prices of the 30 stocks in the Dow Jones Industrial Average all change by the same dollar amount on a given day (ignoring the stock splits), which stock will have the greatest impact

A) B) C) D) 15. A) B) C) D) 16. A) B) C) D) 17. A) B) C) D) 18. A) B) C) D) 19. A) B) C) D) 20. A) B) C) D)

on the average? the one with the highest price the one with the lowest price all 30 stocks will have the same impact the answer cannot be determined by the information given Purchase of a futures contract involves __________ . the right to buy an item at a specified price the right to sell an item at a specified price the obligation to buy an item at a specified price the obligation to sell an item at a specified price Ownership of a put option entitles the owner to the __________ to ___________ a specific stock, on or before a specific date, at a specific price. right, buy right, sell obligation, buy obligation, sell Futures and options are sometimes referred to as __________ . derivative assets integral assets contingent claims more than one of the above The price which the owner of a call option must pay in order to purchase the stock named in the option contract is called the __________ . purchase price exercise price strike price More than one of the above Ownership of a call option entitles the owner to the __________ to __________ a specific stock, on or before a specific date, at a specific price right, buy right, sell obligation, buy obligation, sell Which of the following are not characteristic of common stock ownership? residual claimant unlimited liability voting rights all of the above are characteristics of stock ownership

21. A) B) C)

Derivative securities can be based on _____. currencies common stocks home mortgages

D) 22. A) B) C) D) 23. A) B) C) D) 24. A) B) C) D) 25. A) B) C) D) 26. A) B) C) D) 27. A) B) C) D)

all of the above Why are derivatives potentially dangerous? They involve leverage. They are used to hedge. They are a tool for risk management There are more than 1200 different derivatives on the market. What are business firms most likely to use derivative securities for? hedging speculating doing calculus problems none of the above Why do put options with exercise prices lower than the price of the underlying stock sell for positive prices? The holder can exercise the option immediately, sell the stock, and make a profit. The holder can buy the stock, exercise the option immediately, and make a profit. At some point in the future, the holder may be able to buy the stock, exercise the option, and make a profit. None of the above. Three stocks have share prices of $5, $7, and $3. What is the value of a price-weighted index of the three stocks? 15 5 105 indeterminate Underwriting is one of the services provided by _________________. the SEC investment bankers publicly traded companies FDIC Under firm commitment underwriting the _________________ assumes the full risk that the shares cannot be sold to the public at the stipulated offering price. red herring issuing company initial stockholder underwriter

28. A) B) C) D)

Explicit costs of an IPO tend to be around ______________ of the funds raised. 1% 7% 15% 25%

29.

A) B) C) D) 30. A) B) C) D) 31. A) B) C) D) 32. A) B) C) D) 33. A) B) C) D) 34. A) B) C) D)

Barnegat Light sold 200,000 shares in an initial public offering. The underwriter's explicit fees were $70,000. The offering price for the shares was $25, but immediately upon issue, the share price jumped to $41. What is the best estimate of the total cost (direct plus indirect) to Barnegat Light of the equity issue? $ 70,000 $3,200,000 $3,270,000 $8,200,000 Purchases of new issues of stock take place __________. at the desk of the Fed in the primary market in the secondary market none of the above A prospectus is __________. a description of a firm and the security it is issuing a privately placed security the Latin word for prospector none of the above The process of polling potential investors regarding their interest in a forthcoming initial public offering (IPO) is called _________. interest building book building market analysis customer identification The bulk of most initial public offerings (IPOs) of equity securities go to ____________. institutional investors individual investors the firm's current shareholders day traders Initial public offerings (IPOs) are usually ___________ relative to the levels at which their prices stabilize within a few months. over priced correctly priced under priced mispriced but without any particular bias

35. A) B) C) D) 36.

Initial public offerings tend to exhibit __________ performance initially, and __________ performance over the long term. bad; good bad; bad good; good good; bad In a __________ underwriting arrangement, the underwriter assumes the full risk that shares

A) B) C) D) 37. A) B) C) D) 38. A) B) C) D) 39. A) B) C) D) 40. A) B) C) D) 41. A) B) C) D)

cannot be sold to the public at the stipulated offering price. best efforts firm commitment private placement none of the above __________ is a false statement about the function of investment bankers. They act as intermediaries between issuers of stocks and investors They purchase new securities from corporations and sell them to the public They are commercial banks that accept deposits from savers and lend them out to companies They act as advisers to companies in helping them analyze their financial needs and find buyers for their securities According to SEC Rule 415 regarding shelf registration, firms can gradually sell securities to the public for __________ following initial registration. 1 year 2 years 3 years 4 years The average first day return earned on investing in IPOs is __________. 9% 11% 18% 27% Transactions that do not involve the original issue of securities take place in __________. primary markets secondary markets over-the-counter markets institutional markets The ____ requires full disclosure of relevant information relating to the issue of new securities. Insider Trading Act of 1931 Securities Act of 1933 Securities Exchange Act of 1934 none of the above

42. A) B) C) D) 43. A) B)

A follow-on offering is another name for a(n): IPO SEO red herring syndicate The number of dollars earned during the period on behalf of each share of outstanding common stock is known as _______________________. dividends per share earnings per share

C) D) 44. A) B) C) D) 45. A) B) C) D) 46. A) B) C) D) 47. A) B) C) D) 48. A) B) C) D) 49. A) B) C) D) 50. A) B) C) D) 51. A) B) C) D)

return on equity none of the above High P/E ratios tend to indicate that a company will _______, ceteris paribus. grow quickly grow slowly grow at the same speed as an average company not grow Protective covenants are designed to protect __________________ . employees shareholders bondholders suppliers Preferred shareholders claims on assets and income of a firm are ___________ those of creditors and _______________ those of common stockholders. before, before after, before after, after before, after Which has the priority claim on the assets and income of a firm? common stock holders preferred stock holders bondholders none of the above. Which one of the following items is likely to increase earnings per share (EPS) of a corporation? repurchases stock splits dividends new common stock issues Which of the following could force a company into bankruptcy? failure to pay common stockholders failure to pay preferred stockholders failure to pay bondholders none of the above The value of a firm is equal to _______________________ . the value of its equity the value of its debt the total value of its equity and debt its market capitalization Equity and debt are very different in terms of all of the following except: control rights ownership rights taxation of the issuer for distributions they are different in terms of all of the above

52. A) B) C) D) 53. A) B) C) D) 54. A) B) C) D) 55. A) B) C) D) 56.

Which of the following is the main regulator of the financial markets? NYSE NASDAQ CBOE SEC Consider a company with 300 shares outstanding and $15 share price. What happens to the number of shares and the share price after a 1-for-3 stock split? 900 shares, $5 900 shares, $45 100 shares, $5 100 shares, $45 Which one of the following can NOT be considered one of the reasons for repurchases? Paying out free cash flow to investors Increasing debt ratio Fending off hostile takeover threats Signaling overvaluation Which one of the following is NOT a financing instrument for corporations? Bonds Stocks Options All of the above are financing instruments for corporations Which one of the following are the common characteristics of preferred stocks and bonds? I. Control rights II. Rights to force bankruptcy III. Tax consequences for issuers All of the above I and II Only I II and III Which one of the following is NOT one of the stylized facts about IPOs? Increase in direct compensation to underwriters Long-run underperformance High first day returns Allocation of IPO shares to the favored clients of underwriters Which one of the following is NOT one of the reasons why firms go public? Raise funds to finance growth Start filing financial statements at the SEC Provide diversification benefits to insiders All of the above Which one of the following is NOT related to favoritism in IPO share allocations? spinning laddering kick backs front running

A) B) C) D) 57. A) B) C) D) 58. A) B) C) D) 59. A) B) C) D)

60. A) B) C) D) 61. A) B) C) D) 62. A) B) C) D) 63. A) B) C) D) 64. A) B) C) D)

Winners curse occurs when the IPO mechanism is a(n) ______________________ . auction firm commitment offering fixed price offering bookbuilding During the bubble period (1999-2000), the average underpricing of IPO firms jumped from 18% to 65%. Which one of the explains the change in underpricing during the bubble period? The change in the characteristics of firms going public The willingness of issuers to buy influential analyst coverage by underpricing Managements willingness to compensate underwriters for allocation of hot IPO shares to personal accounts. All of the above Which one of the following forms do firms file when they register their IPOs at the SEC? 10K 10Q S-1 424B4 Insiders of a firm are often prohibited from selling their personal shares during the first 180 days after the IPO. This period is called the _______________________ . registration period quiet period lock up period none of the above According to SEC guidelines updated in 2002, the IPO quiet period starts at the _______________________ and ends at __________________ . registration of the IPO, offer date of the IPO registration of the IPO, 40 days after the IPO registration of the IPO, 180 days after the IPO offer date of the IPO, 180 days after the IPO

65. A) B) C) D) 66. A) B) C) D)

Which one of the following is a false statement about IPO quiet period? No analyst can issue a research report before the quiet period expires The firm officially stays under IPO registration during the quiet period Other than the regular announcements, management cannot announce material information during the quiet period. None of the above. During the IPOs, issuing firms grant over allotment (green shoe) options to underwriters, which helps underwriters stabilize the market for the stock in the aftermarket of an IPO. The overallotment option is often equal to ____ of the shares sold during the IPO. 7% 10% 15% 25%

67.

An analyst gathered the following data about stocks A, B, and C, which together form a value weighted index: December 31, Year 1 Stock A B Price $40 $30 Shares Outstanding 10,000 6,000 December 31, Year 2 Price $50 $20 $40 Shares Outstanding 10,000 12,000* 9,000

C $50 9,000 The ending value weighted index (base index=100) is closest to: A) 92.31 B) 93.64 C) 106.80 D) 108.33

68. Which one of the following became famous for his spinning practices during the bubble period? VVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVV Henry Blodget B) Conrad Black C) Garry Meeker D) Frank Quattrone 69. A) B) C) D) Who is the current president of the SEC? Arthur Levitt Alan Greenspan Glenn Hubbard William Donaldson

70. A) B) C) D) 71. A) B) C) D) 72. A) B) C)

Which one of the following was the former president of the NYSE who had to resign after his excessive bonuses and compensations are uncovered by the media? Frank Quattrone Glenn Hubbard Dick Grasso Martha Stewart Which one of the following is one of the book runners of the Google IPO? JP Morgan Chase Deutsche Bank Morgan Stanley ABN Amro What was the underwriter spread in the Google IPO? 2.8% 4.2% 5.6%

D) 73. A) B) C) D) 74. A) B) C) D) 75. A) B) C) D) 76. A) B) C) D) 77. A) B) C) D) 78. A) B) C) D) 79. A) B) C) D) 80. A)

7.0% __________________ requires that dividends cannot be paid on common stock until all current and previously omitted dividends are paid on preferred stock. A residual claim A preferred margin Cumulative provision Liquidation claim Investors assume _________ risk when they buy preferred stock than when they buy corporate bonds. The payment of dividends on preferred stock _________ be omitted without the firm being forced into bankruptcy. more; can less; can more; cannot less; cannot A firm can best avoid the time lag between registering new securities with the SEC and actually selling them by _______________ . proxy voting shelf registration margin call preemptive rights Managers may consider a stock repurchase when their firms stock is _______________, or an equity issue when the stock is ________________ . undervalued; undervalued overvalued; undervalued undervalued; overvalued overvalued; overvalued The largest and most liquid companies trading over-the-counter are ______. listed on pink sheets posted on the OTC Bulletin Board listed on the NASDAQ National Market System listed on the NASDAQ Small Cap Market Initial margin requirements on stocks are set by __________. the Federal Deposit Insurance Corporation the Federal Reserve the New York Stock Exchange the Securities and Exchange Commission __________ is a false statement regarding specialists. On a stock exchange all buy or sell orders are negotiated through a specialist Specialists can not trade for their own accounts Specialists earn income from commissions and spreads in stock prices Specialists stand ready to trade at quoted bid and ask prices Restrictions on trading involving insider information apply to __________. corporate officers and directors

B) C) D) 81. A) B) C) D) 82. A) B) C) D) 83. A) B) C) D) 84. A) B) C) D) 85. A) B) C) D) 86. A) B) C) D) 87. A) B) C) D) 88. A) B) C)

major stockholders relatives of corporate directors and officers all of the above __________ is called the Big Board. The American Stock Exchange The New York Stock Exchange The Pacific Stock Exchange The Tokyo Stock Exchange __________ is a false statement about the NYSE. It is known as the Big Board It is national in scope It is the largest stock exchange in the USA More than 3000 companies are listed on the NYSE The fourth market refers to __________. direct trading between investors in exchange-listed securities without benefit of a broker trading of exchange-listed securities in the over-the-counter market trading of exchange-listed securities on the NYSE or AMEX trading of foreign stock exchange listed securities Which of the following are sources of competition for the New York Stock Exchange? regional exchanges the American Stock Exchange foreign exchanges all of the above The _________ price is the price at which a dealer is willing to purchase a security. bid ask market none of the above The _________ price is the price at which a dealer is willing to sell a security. bid ask market none of the above The difference between the price at which a dealer is willing to buy, and the price at which a dealer is willing to sell, is called the __________. market spread bid-ask spread bid-ask gap market variation The bid-ask spread exists because of ________________. market inefficiencies poor communication the need for dealers to cover expenses and make a modest profit

D) 89. A) B) C) D) 90. A) B) C) D) 92.

none of the above The cost of buying and selling a stock include __________. broker's commissions dealer's bid-asked spread price concessions investors may be forced to make all of the above __________ do not take place in the secondary market. Transactions of new issues of stocks Transactions in the OTC market Transactions on the AMEX Transactions on the NYSE Consider the following limit order book of a specialist. The last trade in the stock occurred at a price of $40.

If a market buy order for 100 shares comes in, at what price will it be filled? A) $39.75 B) $40.50 C) $40.375 D) $40.25 or less 93. A) B) C) D) 94. A) B) C) D) 95. A) B) C) D) 96. A) B) Assume you purchased 200 shares of XYZ common stock on margin at $80 per share from your broker. If the initial margin is 60%, the amount you borrowed from the broker is __________. $4000 $6400 $9600 $16,000 You sold short 200 shares of common stock at $50 per share. The initial margin is 60%. Your initial investment was __________. $4,000 $6,000 $10,000 $16,667 You short-sell 300 shares of MSFT, now selling for $50 per share. What is your maximum possible loss? $50 $150 $10,000 unlimited You short-sell 300 shares of MSFT, now selling for $50 per share. What is your maximum possible gain ignoring transactions cost? $50 $150

L im it B u y O rd e rs P ric e S h ares $ 3 9 .7 5 100 $ 3 9 .5 0 100

L im it S e ll O rd e rs P ric e S h a re s $ 4 0 .2 5 100 $ 4 0 .5 0 100

C) D) 97. A) B) C) D) 98. A) B) C) D)

$15,000 unlimited You short-sell 300 shares of MSFT, now selling for $50 per share. You also place a stop-buy order at $60. What is your maximum possible loss? $50 $150 $3,000 unlimited You purchased 100 shares of ABC common stock on margin at $50 per share. Assume the initial margin is 50% and the maintenance margin is 30%. Below the stock price of __________ you would get a margin call. Assume the stock pays no dividend and ignore interest on margin. $35.71 $42.86 $53.57 $57.14

99. A) B) C) D) 100. A) B) C) D) 101. A) B) C) D) 102. A) B) C) D) 103.

You purchased 300 shares of common stock on margin for $50 per share. The initial margin is 60% and the stock pays no dividend. Your rate of return would be __________ if you sell the stock at $40 per share. Ignore interest on margin. 33% -33% -44% -56% Many exchange-listed securities are also traded in the over-the-counter market. Trading of this sort is said to take place in the ____________. third market fourth market after-market block market __________ often accompany short sales, and are used to limit potential losses from the short position. Limit orders Restricted orders Limit-loss orders Stop-loss buy orders The NASDAQ Stock Market is an example of a primary market a secondary market an over-the-counter market more than one of the above Borrowing a security from your broker in order to sell it, with the intention of repurchasing it later

A) B) C) D) 104. A) B) C) D) 105. A) B) C) D) 106. A) B) C) D) 107. A) B) C) D) 108. A) B) C) D) 109. A) B) C) D) 110. A) B) C) D)

when the price is lower, is called ____________. post-purchasing pre-selling short-selling reverse investing Specialists are obligated to _____________. provide price continuity in the stocks in which they specialize disseminate information regarding the stocks in which they specialize provide retail trading services for the public none of the above Which one of the following statements regarding trading orders is FALSE? A market order is simply an order to buy or sell a stock immediately at the prevailing market prices. A stop-loss order to sell is an order to limit the losses from short selling. If stock ABC is selling at $50, a limit order to buy may instruct the broker to buy the stock if the price falls below $45. none of the above Short squeeze occurs when _____________________. you short a stock on margin. a stock does not allow short sellers. you want to short sell a stock but there are too many shareholders. stock prices are pushed up as a result of a large number of short sellers want out of a stock. The basic difference between going short and long is _____________________. shorts make money when the stock price decreases, longs make money when it increases. shorts borrow the stock, while longs actually own it. short selling means your potential losses are infinite, while longs can only lose their original investments. all of the above. What is a zero plus tick? A transaction that costs a penny over zero. A transaction that is either at the preceding trades price or at a higher price. A transaction that is either at the preceding trades price or at a lower price. None of the above. Which of the following is an advantage of buying on margin? Low risk Leverage Fast execution All of the above Which of the following is one of the risks associated with buying on margin? If price of the stock purchased on margin falls, you lose money faster than an investor who has a long position in the stock. Your brokerage firm may sell some or all of the securities without consulting you. You can lose more money than you originally invested. All of the above

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