Homework answers / question archive / Week 10 The Rountree ditch-digging firm has $2,000 of extra cash

Week 10 The Rountree ditch-digging firm has $2,000 of extra cash

Finance

Share With

Week 10

1. The Rountree ditch-digging firm has $2,000 of extra cash. Brian, the CFO, is thinking about what to do with the money. He can put it into treasuries for three years currently yielding 6 percent or pay it out to shareholders now. Of course, shareholders themselves also have access to the Treasury market. Most of the equity investors in Rountree ditch-digging are poor and pay only a 15 percent personal tax rate. The tax rate on dividends is 18 percent. The corporate tax rate is 32 percent. How much money will shareholders have after three years under each of Brian’s alternatives, and what should he do?

Part 2: Multiple Choice

2. Financial leverage impacts the performance of the firm by
   1. Increasing the volatility of the firm's EBIT
   2. Decreasing the volatility of the firm's EBIT
   3. Decreasing the volatility of the firm's net income
   4. Increasing the volatility of the firm's net income
   5. None of the above
3. The dividend-irrelevance proposition of Miller and Modigliani depends on which relationship between investment policy and dividend policy?
   1. Investment policy does not influence or matter for the dividend decision.
   2. Only after dividend policy is set can investment decisions can be made.
   3. Investment policy must be set before the dividend decision, and so it cannot be changed by dividend policy.
   4. Dividend policy is irrelevant so there is no relationship between investment policy and dividend policy.
   5. Miller and Modigliani were concerned only about capital structure.
4. If both dividends and capital gains are currently taxed at the same ordinary income tax rate, the effect of the tax is different because
   1. Capital gains are actually taxed, whereas dividends are taxed on paper only.
   2. Dividends are actually taxed, whereas capital gains are taxed on paper only.
   3. Dividends are taxable when distributed, whereas capital gains are deferred until the stock is sold.
   4. Capital gains are taxable when distributed, whereas dividends are deferred until the stock is sold.
   5. Both A and C.
5. An out-of-the-money call option is one that
   1. Has an exercise price below the current market price of the underlying security
   2. Should not be exercised
   3. Has an exercise price above the current market price of the underlying security
   4. Both A and B
   5. Both B and C
6. The writer of an option is also known as the __________ who is obligated to __________.
   1. holder; sell shares in a call option
   2. Owner; buy shares in a put option
   3. seller; sell shares in a call option
   4. seller; buy shares in a put option
   5. Both C and D

Part 3: Option Strategies

Design a portfolio of put and/or call options and/or stocks and/or bonds that has the

following payoff diagram at maturity (exactly one year from now):

Specify exactly what instruments you will buy or sell or write, and find the total cost of the portfolio at initiation (that is, determine the initial cash flows to the investment strategy). Assume that the annual standard deviation of returns for the stock is 20 percent, the risk free rate is 5 percent, and maturity is exactly one year from now. The stock price is currently $35.