Corporate Finance, 3e (Berk/DeMarzo) Chapter 3 Financial Decision Making and the Law of One Price 3.1 Valuing Decisions 1) Due to a pre-e...

Author:
16/17

36 downloads 420 Views 811KB Size

Use the information for the question(s) below. Alaska North Slope Crude Oil (ANS) West Texas Intermediate Crude Oil (WTI)

$71.75/Bbl $73.06/Bbl

As an oil refiner, you are able to produce $76 worth of unleaded gasoline from one barrel of Alaska North Slope (ANS) crude oil. Because of its lower sulfur content, you can produce $77 worth of unleaded gasoline from one barrel of West Texas Intermediate (WTI) crude. 4) Another oil refiner is offering to trade you 10,150 Bbls of Alaska North Slope (ANS) crude oil for 10,000 Bbls of West Texas Intermediate (WTI) crude oil. Assuming you currently have 10,000 Bbls of WTI crude, the added benefit (cost) to you if you take the trade is closest to: A) ($1,400) B) $1,400 C) ($3,908) D) $3,908 Answer: B Explanation: B) Total Benefits No trade and refine WTI crude (base case) 10,000 Bbls × $77 of gasoline/Bbl = $770,000 Trade WTI for ANS crude 10,150 Bbls × $76 of gasoline/Bbl = $771,400 Added Benefits = Total Benefits - Base Case Trade WTI for ANS crude = $771,400 - $770,000 = $1,400 Diff: 2 Section: 3.1 Valuing Decisions Skill: Analytical

2 Copyright © 2014 Pearson Education, Inc.

5) Assuming you currently have 10,000 Bbls of WTI crude, the added benefit (cost) to you if you were to sell the 10,000 Bbls of WTI crude and use the proceeds to purchase and refine ANS crude is closest to: A) ($1,400) B) $1,400 C) ($3,908) D) $3,908 Answer: D Explanation: D) Total Benefits No trade and refine WTI crude (base case) 10,000 Bbls × $77 of gasoline/Bbl = $770,000 Sell WTI and use proceeds to buy ANS 10,000 Bbls WTI × $73.06/Bbl = $730,600 Buy ANS crude $730,600/$71.75/Bbl ANS = 10,182.57 or approx 10,183 Bbls ANS 10,183 Bbls × $76 of gasoline/Bbl = $773,908 Added Benefits = Total Benefits - Base Case Sell WTI and use proceeds to buy ANS = $773,908 - $770,000 = $3,908 Diff: 2 Section: 3.1 Valuing Decisions Skill: Analytical 6) Assuming you just purchased 10,000 Bbls of WTI crude at the current market price, the added benefit (cost) to you if you were to refine this crude oil and sell the unleaded gasoline is closest to: A) $730,600 B) $39,400 C) $770,000 D) -$39,400 Answer: B Explanation: B) Benefits 10,000 Bbls × $77/Bbl = $770,000 Costs 10,000 Bbls × $73.06/Bbl = $730,600 Added Benefit $770,000 - $730,600 = $39,400 Diff: 1 Section: 3.1 Valuing Decisions Skill: Analytical

3 Copyright © 2014 Pearson Education, Inc.

7) Another oil refiner is offering to trade you 10,150 Bbls of Alaska North Slope (ANS) crude oil for 10,000 Bbls of West Texas Intermediate (WTI) crude oil. Assuming you just purchased 10,000 Bbls of WTI crude at the current market price, the added benefit (cost) to you if you take the trade is closest to: A) $730,600 B) $771,400 C) $40,800 D) $43,308 Answer: C Explanation: C) Benefits Trade WTI for ANS crude 10,150 Bbls × $76 of gasoline/Bbl = $771,400 Costs 10,000 Bbls × $73.06/Bbl = $730,600 Added Benefit $771,400 - $730,600 = $40,800 Diff: 2 Section: 3.1 Valuing Decisions Skill: Analytical 8) Assuming you currently have 10,000 Bbls of WTI crude, the added benefits to you if you were to sell the 10,000 Bbls of WTI crude and use the proceeds to purchase and refine ANS crude is closest to: A) $730,600 B) $770,000 C) $40,800 D) $43,308 Answer: D Explanation: D) Total Benefits Sell WTI and use proceeds to buy ANS 10,000 Bbls WTI × $73.06/Bbl = $730,600 Buy ANS crude $730,600/$71.75/Bbl ANS = 10,182.57 or approx 10,183 Bbls ANS 10,183 Bbls × $76 of gasoline/Bbl = $773,908 Total Costs 10,000 Bbls × $73.06/Bbl = $730,600 Added Benefit $773,908 - $730,600 = $43,308 Diff: 2 Section: 3.1 Valuing Decisions Skill: Analytical

4 Copyright © 2014 Pearson Education, Inc.

9) Another oil refiner is offering to trade you 10,150 Bbls of Alaska North Slope (ANS) crude oil for 10,000 Bbls of West Texas Intermediate (WTI) crude oil. Assuming you currently have 10,000 Bbls of WTI crude, what should you do? A) Sell 10,000 Bbls WTI crude on the market and use the proceeds to purchase and refine ANS crude. B) Do nothing, refine the 10,000 Bbls of WTI crude. C) Trade the 10,000 Bbls WTI crude with the other refiner and refine the 10,150 Bbls of ANS crude. D) Trade the 10,000 Bbls WTI crude with the other refiner and then sell the 10,150 Bbls of ANS crude. Answer: A Explanation: A) Sell 10,000 Bbls WTI crude for 10,000 × $73.06 = $730,600 Buy $730,600/$71.75 = 10,182.5 Bbls of ANS, which is higher than 10,150 Bbls ANS Diff: 2 Section: 3.1 Valuing Decisions Skill: Analytical 10) By evaluating cost and benefits using competitive market prices, we can determine whether a decision will make the firm and its investors wealthier. This central concept is called: A) the Law of One Price. B) the Present Value. C) the Valuation Principle. D) the Internal Rate of Return. Answer: C Section: 3.1 Valuing Decisions Skill: Definition

5 Copyright © 2014 Pearson Education, Inc.

Use the information for the question(s) below. Low-Grade Copper Ore High-Grade Copper Ore

$640 per Ton $940 per Ton

Coloma Cooper Incorporated is able to produce $640 worth of copper from one ton of low-grade copper ore. Because of its higher copper content, Coloma can produce $940 worth of copper from one ton of high-grade copper ore. 11) A mining company is offering to trade you 7,250 tons of low-grade copper ore for 5,000 tons of high-grade copper ore. Assuming you currently have 5,000 tons of high-grade ore, what should you do? Answer: Don't trade. Coloma should keep the high grade ore and refine it. See below: Total Benefits No trade and refine high-grade ore (base case) 5,000 tons × $940 of copper/ton = $4,700,000 Trade high-grade for low-grade 7,250 tons × $640 of copper/ton = $4,640,000 Added Benefits = Total Benefits - Base Case = $4,640,000 - $4,700,000 =- $60,000 (added cost) Diff: 2 Section: 3.1 Valuing Decisions Skill: Analytical 12) A company that manufactures copper piping is offering to trade you 5,925 tons of low-grade copper ore for 4,000 tons of high-grade copper ore. Assuming you currently have 4,000 tons of high-grade ore, what are the total benefits and added benefits of taking the trade? Answer: Total Benefits No trade and refine high-grade ore (base case) 4,000 tons × $940 of copper/ton = $3,760,000 Trade high-grade for low-grade 5,925 tons × $640 of copper/ton = $3,792,000 (total benefits) Added Benefits = Total Benefits - Base Case = $3,792,000 - $3,760,000 = $32,000 (added benefit) Diff: 2 Section: 3.1 Valuing Decisions Skill: Analytical

6 Copyright © 2014 Pearson Education, Inc.

3.2 Interest Rates and the Time Value of Money 1) If the risk-free rate of interest (rf ) is 3.5%, then you should be indifferent between receiving $1000 in one-year or: A) $965.00 today. B) $966.18 today. C) $1000.00 today. D) $1035.00 today. Answer: B Explanation: B) $1000/1.035 = $966.183575 Diff: 1 Section: 3.2 Interest Rates and the Time Value of Money Skill: Analytical 2) Suppose you have $1,000 today and the risk-free rate of interest (rf ) is 3.5%. The equivalent value in one year is closest to: A) $965.00 today. B) $966.18 today. C) $1000.00 today. D) $1035.00 today. Answer: D Explanation: D) $1000 × 1.035 = $1035.00 Diff: 1 Section: 3.2 Interest Rates and the Time Value of Money Skill: Analytical 3) A project that you are considering today is expected to provide benefits worth $168,000 in one year. If the risk-free rate of interest (rf ) is 4.5%, then the value of the benefits of this project today are closest to: A) $160,440 B) $160,766 C) $168,000 D) $175,560 Answer: B Explanation: B) $168,000/1.045 = $160,765.55 Diff: 1 Section: 3.2 Interest Rates and the Time Value of Money Skill: Analytical

7 Copyright © 2014 Pearson Education, Inc.

4) Which of the following statements is INCORRECT? A) In general, money today is worth more than money in one year. B) We define the risk-free interest rate, rf for a given period as the interest rate at which money can be borrowed or lent without risk over that period. C) We refer to (1 - rf) as the interest rate factor for risk-free cash flows. D) For most financial decisions, costs and benefits occur at different points in time. Answer: C Diff: 1 Section: 3.2 Interest Rates and the Time Value of Money Skill: Conceptual 5) If the risk-free rate of interest (rf ) is 6%, then you should be indifferent between receiving $250 in one year or A) $235.85 today. B) $250.00 today. C) $265.00 today. D) None of the above Answer: A Explanation: A) Benefit = $250.00/($1.06 in one year/$1.00 today) = $235.85 Diff: 1 Section: 3.2 Interest Rates and the Time Value of Money Skill: Analytical 6) If the risk-free rate of interest (rf ) is 6%, then you should be indifferent between receiving $250 today or A) $235.85 in one year. B) $250.00 in one year. C) $265.00 in one year. D) None of the above Answer: C Explanation: C) $250.00 × (1.06) = $265.00 Diff: 1 Section: 3.2 Interest Rates and the Time Value of Money Skill: Analytical 7) A project you are considering is expected to provide benefits worth $225,000 in one year. If the risk-free rate of interest (rf ) is 8%, then the value of the benefits of this project today are closest to: A) $190,333 B) $208,333 C) $225,000 D) $243,000 Answer: B Explanation: B) $225,000/(1.08) = $208,333 Diff: 1 Section: 3.2 Interest Rates and the Time Value of Money Skill: Analytical 8 Copyright © 2014 Pearson Education, Inc.

8) Suppose you have $500 today and the risk-free interest rate (rf) is 5%. The equivalent value in one year is closest to: A) $475 B) $476 C) $500 D) $525 Answer: D Explanation: D) $500 × (1.05) = $525 Diff: 1 Section: 3.2 Interest Rates and the Time Value of Money Skill: Analytical 9) Suppose you will receive $500 in one year and the risk-free interest rate (rf ) is 5%. The equivalent value today is closest to: A) $475 B) $476 C) $500 D) $525 Answer: B Explanation: B) $500/(1.05) = $476 Diff: 1 Section: 3.2 Interest Rates and the Time Value of Money Skill: Analytical 10) When we express the value of a cash flow or series of cash flows in terms of dollars today, we call it the ________ of the investment. If we express it in terms of dollars in the future, we call it the ________. A) present value; future value B) future value; present value C) ordinary annuity; annuity due D) discount factor; discount rate Answer: A Diff: 1 Section: 3.2 Interest Rates and the Time Value of Money Skill: Definition

9 Copyright © 2014 Pearson Education, Inc.

11) If we use future value rather than present value to decide whether to make an investment: A) we will make a bad decision, since the future value will always be higher if the discount rate is positive. B) we will make a bad decision, since the future value will always be lower if the discount rate is positive. C) we will make the same decision using either future value or present value. D) There is not enough information given to answer the question. Answer: C Diff: 1 Section: 3.2 Interest Rates and the Time Value of Money Skill: Definition 3.3 Present Value and the NPV Decision Rule 1) Rearden Metal needs to order a new blast furnace that will be delivered in one year. The $1,000,000 price for the blast furnace is due in one year when the new furnace is installed. The blast furnace manufacturer offers Rearden Metal a discount of $50,000 if they pay for the furnace now. If the interest rate is 7%, then the NPV of paying for the furnace now is closest to: A) ($15,421) B) $15,421 C) ($46,729) D) $46,729 Answer: A Explanation: A) Solution: $1,000,000/1.07 - $950,000 = -$15,420.56 Diff: 1 Section: 3.3 Present Value and the NPV Decision Rule Skill: Analytical

10 Copyright © 2014 Pearson Education, Inc.

Use the information below to answer the following question(s): The owner of the Krusty Krab is considering selling his restaurant and retiring. An investor has offered to buy the Krusty Krab for $350,000 whenever the owner is ready for retirement. The owner is considering the following three alternatives: 1. Sell the restaurant now and retire. 2. Hire someone to manage the restaurant for the next year and retire. This will require the owner to spend $50,000 now, but will generate $100,000 in profit next year. In one year the owner will sell the restaurant for $350,000. 3. Scale back the restaurant's hours and ease into retirement over the next year. This will require the owner to spend $40,000 on expenses now, but will generate $75,000 in profit at the end of the year. In one year the owner will sell the restaurant for $350,000. 2) If the interest rate is 7%, the NPV of alternative #1 is closest to: A) $350,000 B) $357,000 C) $375,500 D) $400,000 Answer: A Explanation: A) There is no TVM for alternative #1. The NPV = $350,000. Diff: 1 Section: 3.3 Present Value and the NPV Decision Rule Skill: Analytical 3) If the interest rate is 7%, the NPV of alternative #2 is closest to: A) $350,000 B) $357,196 C) $370,561 D) $401,121 Answer: C Explanation: C) NPV = -50,000 + (100,000 + 350,000)/1.07 = $370,561 Diff: 1 Section: 3.3 Present Value and the NPV Decision Rule Skill: Analytical 4) If the interest rate is 7%, the NPV of alternative #3 is closest to: A) $350,000 B) $357,196 C) $370,561 D) $401,121 Answer: B Explanation: B) NPV = -40,000 + (75,000 + 350,000)/1.07 = $357,196 Diff: 1 Section: 3.3 Present Value and the NPV Decision Rule Skill: Analytical 11 Copyright © 2014 Pearson Education, Inc.

5) If the interest rate is 7%, the alternative with the highest NPV is: A) Alternative #1 with an NPV of approximately $350,000 B) Alternative #2 with an NPV of approximately $370,561 C) Alternative #3 with an NPV of approximately $357,196 D) Alternative #2 with an NPV of approximately $380,561 Answer: B Explanation: B) There is no TVM for alternative #1. The NPV = $350,000. Alternative #2: NPV = -50,000 + (100,000 + 350,000)/1.07 = $370,561 Alternative #3: NPV = -40,000 + (75,000 + 350,000)/1.07 = $357,196 Diff: 3 Section: 3.3 Present Value and the NPV Decision Rule Skill: Analytical 6) If the interest rate is 7%, the alternative with the lowest NPV is: A) Alternative #1 with an NPV of approximately $350,000 B) Alternative #2 with an NPV of approximately $370,561 C) Alternative #3 with an NPV of approximately $357,196 D) Alternative #2 with an NPV of approximately $380,561 Answer: A Explanation: A) There is no TVM for alternative #1. The NPV = $350,000. Alternative #2: NPV = -50,000 + (100,000 + 350,000)/1.07 = $370,561 Alternative #3: NPV = -40,000 + (75,000 + 350,000)/1.07 = $357,196 Thus Alternative #1 has the lowest NPV Diff: 3 Section: 3.3 Present Value and the NPV Decision Rule Skill: Analytical 7) Which of the following statements regarding Net Present Value (NPV) is INCORRECT? A) The NPV represents the value of the project in terms of cash today. B) Good projects will have a positive NPV. C) The NPV of a project is the difference between the present value of its benefits and the present value of its costs. D) When faced with a set of alternatives, choose the one with the lowest NPV in order to minimize the preset value of costs. Answer: D Diff: 2 Section: 3.3 Present Value and the NPV Decision Rule Skill: Conceptual

12 Copyright © 2014 Pearson Education, Inc.

Use the following information to answer the question(s) below. The owner of the Krusty Krab is considering selling his restaurant and retiring. An investor has offered to buy the Krusty Krab for $350,000 whenever the owner is ready for retirement. The owner is considering the following three alternatives: 1. Sell the restaurant now and retire. 2. Hire someone to manage the restaurant for the next year and retire. This will require the owner to spend $50,000 now, but will generate $100,000 in profit next year. In one year the owner will sell the restaurant. 3. Scale back the restaurant's hours and ease into retirement over the next year. This will require the owner to spend $40,000 on expenses now, but will generate $75,000 in profit at the end of the year. In one year the owner will sell the restaurant. 8) If the discount rate is 15%, the alternative with the highest NPV is: A) #1 with an NPV of approximately $350,000 B) #2 with an NPV of approximately $341,300 C) #3 with an NPV of approximately $329,570 D) #2 with an NPV of approximately $400,000 E) None of the above Answer: A Explanation: A) NPV #1 = $350,000 (No TVM here) NPV#2 = -50,000 + NPV#3 = -40,000 +

= 341,304

= 329,565

Correct answer is #1 with NPV of 350,000. Diff: 3 Section: 3.3 Present Value and the NPV Decision Rule Skill: Analytical 9) If the discount rate is 15%, the alternative with the lowest NPV is: A) #1 with an NPV of approximately $350,000 B) #2 with an NPV of approximately $341,300 C) #3 with an NPV of approximately $329,570 D) #2 with an NPV of approximately $400,000 E) None of the above Answer: C Explanation: C) NPV #1 = $350,000 (No TVM here) NPV#2 = -50,000 + NPV#3= -40,000 +

= 341,304

= 329,565

Correct answer is #2 with NPV of 329,565. Diff: 3 Section: 3.3 Present Value and the NPV Decision Rule Skill: Analytical

13 Copyright © 2014 Pearson Education, Inc.

10) If the discount rate is 15%, then which alternative should the owner choose: A) #1 B) #2 C) #3 D) either #1 or #2 E) either #1 or #3 Answer: A Explanation: A) NPV #1 = $350,000 (No TVM here) NPV#2 = -50,000 + NPV#3 = -40,000 +

= 341,304

= 329,565

Correct answer is #1 with NPV of 350,000. Diff: 3 Section: 3.3 Present Value and the NPV Decision Rule Skill: Analytical 11) Which of the following statements regarding the NPV decision rule is FALSE? A) Reject projects with a NPV of zero, as accepting them is equivalent to reducing firm value. B) When faced with a set of alternatives, choose the one with the highest NPV. C) Accept those projects with a positive NPV, as accepting them is equivalent to receiving their NPV in cash today. D) Reject those projects with a negative NPV. Answer: A Diff: 2 Section: 3.3 Present Value and the NPV Decision Rule Skill: Conceptual 12) Which of the following formulas regarding NPV is INCORRECT? A) NPV + PV(benefits) = PV(Cost) B) NPV + PV(costs) = PV(benefits) C) NPV = PV(All project cash flows) D) All of the above Answer: A Diff: 2 Section: 3.3 Present Value and the NPV Decision Rule Skill: Conceptual

14 Copyright © 2014 Pearson Education, Inc.

13) You are offered an investment opportunity in which you will receive $23,750 today in exchange for paying $25,000 in one year. Suppose the risk-free interest rate is 6% per year. Should you take this project? The NPV for this project is closest to: A) Yes; NPV = $165 B) No; NPV = $165 C) Yes; NPV = -$165 D) No; NPV = -$165 Answer: A Explanation: A) NPV = 23,750 - 25,000/(1.06) = 165, since NPV > 0 accept the project Diff: 2 Section: 3.3 Present Value and the NPV Decision Rule Skill: Analytical 14) You are offered an investment opportunity in which you will receive $25,000 in one year in exchange for paying $23,750 today. Suppose the risk-free interest rate is 6% per year. Should you take this project? The NPV for this project is closest to: A) Yes; NPV = $165 B) No; NPV = $165 C) Yes; NPV = -$165 D) No; NPV = -$165 Answer: D Explanation: D) NPV = -23,750 + 25,000/1.06 = -165, since NPV < 0 you should reject project Diff: 2 Section: 3.3 Present Value and the NPV Decision Rule Skill: Analytical 15) You have an investment opportunity in Germany that requires an investment of $250,100 today and will produce a cash flow of €208,650 in one year with no risk. Suppose the risk-free rate of interest in Germany is 7% and the current competitive exchange rate is €0.78 to $1.00. What is the NPV of this project? Would you take the project? A) NPV = -$100; No B) NPV = $100; Yes C) NPV = $2,358; Yes D) NPV = $3,650; Yes Answer: A Explanation: A) NPV = -250,100 + (€208,650/1.07) × $1.00/€0.78 = -$100, so since NPV is not > 0, reject Diff: 3 Section: 3.3 Present Value and the NPV Decision Rule Skill: Analytical

15 Copyright © 2014 Pearson Education, Inc.

16) You have an investment opportunity in Germany that requires an investment of $250,000 today and will produce a cash flow of €208,650 in one year with no risk. Suppose the risk-free rate of interest in Germany is 6% and the current competitive exchange rate is €0.78 to $1.00. What is the NPV of this project? Would you take the project? A) NPV = 0; No B) NPV = -$2,358; No C) NPV = $2,358; Yes D) NPV = $13,650; Yes Answer: C Explanation: C) NPV = -250,000 + (€208,650/1.06) × $1.00/€0.78 = $2358, so since NPV > 0, accept Diff: 3 Section: 3.3 Present Value and the NPV Decision Rule Skill: Analytical Use the table for the question(s) below. Project Eenie Meenie Mighty Moe

Cash flow today -10 10 -15 10

Cash flow in one year 15 -8 20 -15

17) If the risk-free interest rate is 10%, then the NPV for Eenie is closest to: A) -3.64 B) 2.73 C) 3.18 D) 3.64 Answer: D Explanation: D) NPV = -10 + 15/1.10 = 3.64 Diff: 1 Section: 3.3 Present Value and the NPV Decision Rule Skill: Analytical 18) If the risk-free interest rate is 10%, then the NPV for Moe is closest to: A) -3.64 B) 2.73 C) 3.18 D) 3.64 Answer: A Explanation: A) NPV = 10 - 15/1.1 = -3.64 Diff: 1 Section: 3.3 Present Value and the NPV Decision Rule Skill: Analytical

16 Copyright © 2014 Pearson Education, Inc.

19) If the risk-free interest rate is 10%, then of the four projects listed, if you could only invest in one project, which on e would you select? A) Eenie B) Meenie C) Mighty D) Moe Answer: A Explanation: A) Eenie has highest NPV NPV Eenie = -10 + 15/1.1 = 3.64 NPV Meenie = 10 - 8/1.1 = 2.73 NPV Mighty = -15 + 20/1.1 = 3.18 NPV Moe = 10 - 15/1.1 = -3.64 Diff: 2 Section: 3.3 Present Value and the NPV Decision Rule Skill: Analytical 20) If the risk-free interest rate is 10%, then of the four projects listed, which project would you never want to invest in? A) Eenie B) Meenie C) Mighty D) Moe Answer: D Explanation: D) Moe has negative NPV NPV Eenie = -10 + 15/1.1 = 3.64 NPV Meenie = 10 - 8/1.1 = 2.73 NPV Mighty = -15 + 20/1.1 = 3.18 NPV Moe = 10 - 15/1.1 = -3.64 Diff: 2 Section: 3.3 Present Value and the NPV Decision Rule Skill: Analytical 21) If the risk-free interest rate is 10%, then of the four projects listed, if could only invest in two of these projects, which two projects would you select? A) Mighty & Eenie B) Mighty & Meenie C) Eenie & Moe D) Eenie & Meenie Answer: A Explanation: A) Eenie & Mighty have the highest NPVs NPV Eenie = -10 + 15/1.1 = 3.64 NPV Meenie = 10 - 8/1.1 = 2.73 NPV Mighty = -15 + 20/1.1 = 3.18 NPV Moe = 10 - 15/1.1 = -3.64 Diff: 3 Section: 3.3 Present Value and the NPV Decision Rule Skill: Analytical 17 Copyright © 2014 Pearson Education, Inc.

22) You have an investment opportunity in the United Kingdom that requires an investment of $500,000 today and will produce a cash flow of £320,000 in one year with no risk. Suppose the risk-free rate of interest in the U.K is 6% and the current competitive exchange rate is $1.70/£. What is the NPV of this project? Would you take the project? Answer: NPV = -500,000 + (£320,000/1.06) × $1.70/£ = $13,208 so since NPV > 0, accept Diff: 2 Section: 3.3 Present Value and the NPV Decision Rule Skill: Analytical Use the table for the question(s) below. Project "alpha" "beta" "gamma" "delta"

Cash flow today -18 15 15 -16

Cash flow in one year 23 -12 -20 21

23) Assume that the risk-free interest rate is 10%. Rank each of the four projects from most desirable to least desirable based upon NPV. Which project would you invest in first? Are there any projects that you wouldn't invest in? Answer: Ranking 1. NPV beta = 15 - 12/1.1 = 4.09 2. NPV delta = -16 + 21/1.1 = 3.09 3. NPV alpha = -18 + 23/1.1 = 2.91 Would never invest in gamma. NPV gamma = 15 - 20/1.1 = -3.18 Diff: 3 Section: 3.3 Present Value and the NPV Decision Rule Skill: Analytical 3.4 Arbitrage and the Law of One Price 1) Which of the following statements regarding arbitrage is the most correct? A) Any situation in which it is possible to make a profit without taking any risk is known as an arbitrage opportunity. B) Any situation in which it is possible to make a profit without making any investment is known as an arbitrage opportunity. C) We call a competitive market in which there are no arbitrage opportunities an arbitrage market. D) The practice of buying and selling equivalent goods in different markets to take advantage of a price difference is known as arbitrage. Answer: D Diff: 2 Section: 3.4 Arbitrage and the Law of One Price Skill: Conceptual 18 Copyright © 2014 Pearson Education, Inc.

2) Which of the following statements regarding the Law of One Price is INCORRECT? A) At any point in time, the price of two equivalent goods trading in different competitive markets will be the same. B) One useful consequence of the Law of One Price is that when evaluating costs and benefits to compute a net present value, we can use any competitive price to determine a cash value, without checking the price in all possible markets. C) If equivalent goods or securities trade simultaneously in different competitive markets, then they will trade for the same price in both markets. D) An important property of the Law of One Price is that it holds even in markets where arbitrage is not possible. Answer: D Diff: 2 Section: 3.4 Arbitrage and the Law of One Price Skill: Conceptual Use the table for the question(s) below. Consider the following prices from a McDonald's Restaurant: Big Mac Sandwich Large Coke Large Fry

$2.99 $1.39 $1.09

3) A McDonald's Big Mac value meal consists of a Big Mac Sandwich, Large Coke, and a Large Fry. Assuming that there is a competitive market for McDonald's food items, at what price must a Big Mac value meal sell to insure the absence of an arbitrage opportunity and uphold the law of one price? A) $4.08 B) $4.38 C) $5.47 D) $5.77 Answer: C Explanation: C) 2.99 + 1.39 + 1.09 = 5.47 Diff: 1 Section: 3.4 Arbitrage and the Law of One Price Skill: Analytical

19 Copyright © 2014 Pearson Education, Inc.

4) A McDonald's Big Mac value meal consists of a Big Mac Sandwich, Large Coke, and a Large Fry. Assume that there is a competitive market for McDonald's food items and that McDonald's sells the Big Mac value meal for $4.79. Does an arbitrage opportunity exists and if so how would you exploit it and how much would you make on one extra value meal? A) Yes, buy extra value meal and then sell Big Mac, Coke, and Fries to make arbitrage profit of $0.68. B) No, no arbitrage opportunity exists. C) Yes, buy Big Mac, Coke, and Fries then sell value meal to make arbitrage profit of $1.09. D) Yes, buy Big Mac, Coke, and Fries then sell value meal to make arbitrage profit of $0.68. Answer: A Explanation: A) Buy value meal and sell Big Mac, Coke and Fries -4.79 + 2.99 + 1.39 + 1.09 = 0.68 (so arbitrage exists) Diff: 2 Section: 3.4 Arbitrage and the law of one">Law of One Price Skill: Analytical 5) Walgreen Company (NYSE: WAG) is currently trading at $48.75 on the NYSE. Walgreen Company is also listed on NASDAQ and assume it is currently trading on NASDAQ at $48.50. Does an arbitrage opportunity exists and if so how would you exploit it and how much would you make on a block trade of 100 shares? A) No, no arbitrage opportunity exists. B) Yes, buy on NASDAQ and sell on NYSE, make $25. C) Yes, buy on NYSE and sell on NASDAQ, make $25. D) Yes, buy on NASDAQ and sell on NYSE, make $250. Answer: B Explanation: B) Yes, buy 100 shares × 48.50 and sell 100 shares × 48.75 = $25.00 Diff: 2 Section: 3.4 Arbitrage and the Law of One Price Skill: Analytical 6) You are up late watching TV one night and see an ad from Ronco for the Dial-o-matic food slicer. You learn that the Dial-o-matic sells for $29.95. But wait, there is more. Ronco is also including in this deal a set of Ginsu steak knives worth $10.95 and another free gift worth $7.95. Assuming that there is a competitive market for Ronco items, at what price must Ronco be selling this three item Dial-o-matic deal to insure the absence of an arbitrage opportunity and uphold the law of one price? Answer: 29.95 + 10.95 + 7.95 = $48.85 Diff: 1 Section: 3.4 Arbitrage and the Law of One Price Skill: Analytical

20 Copyright © 2014 Pearson Education, Inc.

7) Advanced Micro Devices (NYSE: AMD) is currently trading at $20.75 on the NYSE. Advanced Micro Devices is also listed on NASDAQ and assume it is currently trading on NASDAQ at $20.50. Does an arbitrage opportunity exists and if so how would you exploit it and how much would you make on a block trade of 1000 shares? Answer: Yes, buy 1000 shares × 20.50 and sell 1000 shares × 20.75 = $250.00 Diff: 1 Section: 3.4 Arbitrage and the law of one">Law of One Price Skill: Analytical 3.5 No-Arbitrage and Security Prices 1) Which of the following statements regarding arbitrage and security prices is INCORRECT? A) We call the price of a security in a normal market the no-arbitrage price for the security. B) In financial markets it is possible to sell a security you do not own by doing a short sale. C) When a bond is underpriced, the arbitrage strategy involves selling the bond and investing some of the proceeds. D) The general formula for the no-arbitrage price of a security is Price(security) = PV(All cash flows paid by the security). Answer: C Diff: 2 Section: 3.5 No-Arbitrage and Security Prices Skill: Conceptual 2) Consider two securities, A & B. Suppose a third security, C, has the same cash flows as A and B combined. Given this information about securities A,B, & C, which of the following statements is INCORRECT? A) If the total price of A and B is cheaper than the price of C, then we could make a profit selling A and B and buying C. B) Price(C) = Price(A) + Price(B) C) Because security C is equivalent to the portfolio of A and B, by the law of one price they must have the same price. D) The relationship known as value additivity says that the value of a portfolio is equal to the sum of the values of its parts. Answer: A Diff: 2 Section: 3.5 No-Arbitrage and Security Prices Skill: Conceptual

21 Copyright © 2014 Pearson Education, Inc.

3) Which of the following statements regarding value additivity is FALSE? A) The value of a portfolio is equal to the sum of the values of its parts. B) The price or value of the entire firm is equal to the sum of the values of all projects and investments within the firm. C) To maximize the value of the entire firm, managers should make decisions that maximize NPV. D) Value additivity does not have important consequences for the value of the entire firm, only on portfolios of firms. Answer: D Diff: 2 Section: 3.5 No-Arbitrage and Security Prices Skill: Conceptual 4) Which of the following statements is FALSE? A) Financial transactions are not sources of value, but merely serve to adjust the timing and risk of the cash flows to best suit the needs of the firm or its investors. B) The NPV of trading a security in a normal market is zero. C) We cannot separate a firm's investment decision from the decision of how to finance the investment. D) In normal markets, trading securities neither creates nor destroys value. Answer: C Diff: 2 Section: 3.5 No-Arbitrage and Security Prices Skill: Conceptual 5) Suppose that Bondi Inc. is a holding company that owns both Pizza Hut and Kentucky Fried Chicken Franchised Restaurants. If the value of Bondi is $130 million, and the Pizza Hut Franchises are worth $70 million, then what is the value of the Kentucky Fried Chicken Franchises? A) $60 million B) $70 million C) $130 million D) Unable to determine with the information provided Answer: A Explanation: A) value KFC = value of Bondi - value of Pizza Hut = 130 - 70 = $60 million Diff: 1 Section: 3.5 No-Arbitrage and Security Prices Skill: Analytical

22 Copyright © 2014 Pearson Education, Inc.

Use the information for the question(s) below. An independent film maker is considering producing a new movie. The initial cost for making this movie will be $20 million today. Once the movie is completed, in one year, the movie will be sold to a major studio for $25 million. Rather than paying for the $20 million investment entirely using its own cash, the film maker is considering raising additional funds by issuing a security that will pay investors $11 million in one year. Suppose the risk-free rate of interest is 10%. 6) Without issuing the new security, the NPV for this project is closest to what amount? Should the film maker make the investment? A) $1.7 million; Yes B) $1.7 million; No C) $2.7 million; Yes D) $2.7 million; No Answer: C Explanation: C) NPV = -20 + 25/1.10 = $2.7 million, since NPV > 0 take the investment Diff: 2 Section: 3.5 No-Arbitrage and Security Prices Skill: Analytical 7) Assuming that the film maker issues the new security, the NPV for this project is closest to what amount? Should the film maker make the investment? A) $1.7 million; Yes B) $1.7 million; No C) $2.7 million; Yes D) $2.7 million; No Answer: C Explanation: C) NPV = -10 + (25 - 11)/1.10 = 2.7 million, since NPV > 0 then invest Diff: 2 Section: 3.5 No-Arbitrage and Security Prices Skill: Analytical 8) What is the NPV of this project if the film maker invests his own money and does not issue the new security? What is the NPV if the film maker issues the new security? A) $1.7 million; $1.7 million B) $1.7 million; $2.7 million C) $2.7 million; $1.7 million D) $2.7 million; $2.7 million Answer: D Explanation: D) NPV (no security) = -20 + 25/1.1 = $2.7 NPV(w/security) = -10 + (25 - 11)/1.10 = $2.7 million Diff: 2 Section: 3.5 No-Arbitrage and Security Prices Skill: Analytical

23 Copyright © 2014 Pearson Education, Inc.

Use the table for the question(s) below. Security A B C

Cash flow today 0 100 100

Cash flow in one year 100 0 100

9) If the risk-free rate of interest is 7.5%, then the value of security "A" is closest to: A) $91.00 B) $92.50 C) $93.00 D) $100.00 Answer: C Explanation: C) = 100/1.075 = 93.02 which is approximately $93.00 Diff: 2 Section: 3.5 No-Arbitrage and Security Prices Skill: Analytical 10) If the risk-free rate of interest is 7.5%, then the value of security "B" is closest to: A) $91.00 B) $92.50 C) $93.00 D) $100.00 Answer: D Explanation: D) Since the cash flow is already stated in today's dollars, no discounting is needed. The PV is $100. Diff: 2 Section: 3.5 No-Arbitrage and Security Prices Skill: Analytical 11) If the value of security "C" is $180, then what must be the value of security "A"? A) $80 B) $90 C) $100 D) Unable to determine without the risk-free rate. Answer: A Explanation: A) The cash flows from C are simply a combination of A & B, so price(C) = price(A) + price(B). Since B is already in todays dollars, price(B) must = 100, so price A = 180 100 = $80. Diff: 3 Section: 3.5 No-Arbitrage and Security Prices Skill: Analytical

24 Copyright © 2014 Pearson Education, Inc.

Use the information for the question(s) below. An exchange traded fund (ETF) is a security that represents a portfolio of individual stocks. Consider an ETF for which each share represents a portfolio of two shares of International Business Machines (IBM), three shares of Merck (MRK), and three shares of Citigroup Inc. (C). Suppose the current market price of each individual stock are shown below: Stock IBM MRK C

Current Price $121.57 $36.59 $3.15

12) The price per share of the ETF in a normal market is closest to: A) $161.31 B) $322.62 C) $362.36 D) $483.93 Answer: C Explanation: C) = 2 × 121.57 + 3 × 36.59 + 3 × 3.15 = $362.36 Diff: 2 Section: 3.5 No-Arbitrage and Security Prices Skill: Analytical 13) Suppose that the ETF is trading for $362.36; you should A) sell the EFT and buy 2 shares of IBM, 3 shares of MRK, and 3 shares of C. B) sell the EFT and buy 3 shares of IBM, 2 shares of MRK, and 3 shares of C. C) buy the EFT and sell 2 shares of IBM, 3 shares of MRK, and 3 shares of C. D) do nothing, no arbitrage opportunity exists. Answer: D Explanation: D) Value of ETF = 2 × 121.57 + 3 × 36.59 + 3 × 3.15 = $362.36, so no arbitrage opportunity exists Diff: 3 Section: 3.5 No-Arbitrage and Security Prices Skill: Analytical 14) Suppose a security with a risk-free cash flow of $1000 in one year trades for $909 today. If there are no arbitrage opportunities, then the current risk-free interest rate is closest to: A) 8% B) 10% C) 11% D) 12% Answer: B Explanation: B) PV = FV/(1 + i) → (1 + i) = FV/PV = $1000/$909 = 1.10 so i = 10% Diff: 3 Section: 3.5 No-Arbitrage and Security Prices Skill: Analytical 25 Copyright © 2014 Pearson Education, Inc.

15) An American Depository Receipt (ADR) is a security issued by a U.S. bank and traded on a U.S. stock exchange that represents a specific number of shares of a foreign stock. Siemens AG has an ADR that trades on the NYSE and is equivalent to one share of Seimens AG trading on the Frankfurt Stock Exchange in Germany. If Seimens trades for $95.19 on the NYSE and for €64.10 on the Frankfurt Stock Exchange, then under the law of one price, the current exchange rate is closest to: A) $0.6744/€ B) €0.6734/$ C) €1.4850/$ D) $1.5274/€ Answer: B Explanation: B) Exchange rate =

=

Diff: 3 Section: 3.5 No-Arbitrage and Security Prices Skill: Analytical Use the following information to answer the question(s) below. An exchange traded fund (ETF) is a security that represents a portfolio of individual stocks. Consider an ETF for which each share represents a portfolio of two shares of Apple Inc. (APPL), one share of Google (GOOG), and ten shares of Microsoft (MSFT). Suppose the current stock prices of each individual stock are as shown below: Stock APPL GOOG MSFT

Price $200.23 $570.51 $29.61

16) The price per share of this ETF in a normal market is closest to: A) $800 B) $1,001 C) $1,067 D) $1,267 Answer: D Explanation: D) Price = 2 × $200.23 + 1 × $570.51 + 10 × $29.61 = $1,267.07 Diff: 2 Section: 3.5 No-Arbitrage and Security Prices Skill: Analytical

26 Copyright © 2014 Pearson Education, Inc.

17) Suppose that a security with a risk-free cash flow of $1000 in one year trades for $930 today. If there are no arbitrage opportunities, then the current risk-free rate is closest to: A) 6.0% B) 6.5% C) 7.0% D) 7.5% Answer: D Explanation: D) i = $1000/$930 - 1 = 0.075269 or approx 7.5% Diff: 1 Section: 3.5 No-Arbitrage and Security Prices Skill: Analytical Use the information for the question(s) below. An exchange traded fund (ETF) is a security that represents a portfolio of individual stocks. Consider an ETF for which each share represents a portfolio of two shares of International Business Machines (IBM), three shares of Merck (MRK), and three shares of Citigroup Inc. (C). Suppose the current market price of each individual stock are shown below: Stock IBM MRK C

Current Price $121.57 $36.59 $3.15

18) Assume that the ETF is trading for $366.00, what (if any) arbitrage opportunity exists? What (if any) trades would you make? Answer: Value of ETF = 2 × 121.57 + 3 × 36.59 + 3 × 3.15 = $362.36, so an arbitrage opportunity exists. You should sell the EFT for $366.00 and buy 2 shares of IBM, 3 shares of MRK, and 3 shares of C. Diff: 3 Section: 3.5 No-Arbitrage and Security Prices Skill: Analytical 19) The price per share of the ETF in a normal market is: Answer: Value of ETF = 2 × 121.57 + 3 × 36.59 + 3 × 3.15 = $362.36 Diff: 2 Section: 3.5 No-Arbitrage and Security Prices Skill: Analytical

27 Copyright © 2014 Pearson Education, Inc.

Use the following information to answer the question(s) below. An exchange traded fund (ETF) is a security that represents a portfolio of individual stocks. Consider an ETF for which each share represents a portfolio of two shares of Apple Inc. (APPL), one share of Google (GOOG), and ten shares of Microsoft (MSFT). Suppose the current stock prices of each individual stock are as shown below: Stock APPL GOOG MSFT

Price $200.23 $570.51 $29.61

20) If the ETF is currently trading for $1,200, what arbitrage opportunity is available? What trades would you make? Answer: The ETF is underpriced. Therefore an arbitrage opportunity exists by shorting the individual stocks and longing the ETF. Sell or Short two shares of APPL, one share of GOOG, and ten shares of MSFT and buy one share of the ETF. Price = 2 × $200.23 + 1 × $570.51 + 10 × $29.61 = $1,267.07 Diff: 2 Section: 3.5 No-Arbitrage and Security Prices Skill: Analytical 21) If the ETF is currently trading for $1,300, what arbitrage opportunity is available? What trades would you make? Answer: The ETF is overpriced. Therefore an arbitrage opportunity exists by longing (buying) the individual stocks and shorting (selling) the ETF. Buy or Long two shares of APPL, one share of GOOG, and ten shares of MSFT and sell or Short one share of the ETF. Price = 2 × $200.23 + 1 × $570.51 + 10 × $29.61 = $1,267.07 Diff: 2 Section: 3.5 No-Arbitrage and Security Prices Skill: Analytical

28 Copyright © 2014 Pearson Education, Inc.

3.6 Appendix: The Price of Risk 1) Which one of the following statements is FALSE? A) When we compute the return of a security based on the average payoff we expect to receive, we call it the expected return. B) The notion that investors prefer to have a safe income rather than a risky one of the same average amount is call risk aversion. C) Because investors are risk averse, the risk-free interest rate is not the right rate to use when converting risky cash flows across time. D) The more risk averse investors are, the higher the current price of a risky asset will be compared to a risk-free bond. Answer: D Diff: 2 Section: 3.6 Appendix: The Price of Risk Skill: Conceptual 2) Pfizer Inc. (PFE) stock is currently trading on the NYSE with a quoted bid of $18.35 and an ask price of $18.40. At the same time NASDAQ dealers are posting for following bid and ask prices for PHE: Dealer 1 2 3

Bid $18.38 $18.30 $18.36

Ask $18.43 $18.34 $18.39

Which of these NASDAQ represents an arbitrage opportunity when compared to the NYSE quotes? A) Only NASDAQ dealer #1 B) Only NASDAQ dealer #2 C) Only NASDAQ dealer #3 D) Both NASDAQ dealer #1 and dealer #3 E) None of the above Answer: B Explanation: B) Only dealer #2, since the asking price is below the NYSE bid price. The quotes from dealers #1 and #3 fall within the NYSE spread. Diff: 2 Section: 3.6 Appendix: The Price of Risk Skill: Analytical

29 Copyright © 2014 Pearson Education, Inc.

Use the table for the question(s) below. Market Price Security A B C

Today 200 600 ???

Cash Flow in One Year Poor Economy Good Economy 840 0 0 840 840 4200

3) Based upon the information provided about securities A, B, and C, the risk-free rate of interest is closest to: A) 4% B) 5% C) 8% D) 10% Answer: B Explanation: B) We can construct the risk-free asset by forming a portfolio of A and B. This portfolio has a certain payoff of $840. The price for this portfolio is $800. We know that $800 = $840/(1 + i) → (1 + i) = 840/800 = 1.05 → i = .05 or 5%. Diff: 2 Section: 3.6 Appendix: The Price of Risk Skill: Analytical 4) What is the no-arbitrage price for security C? A) $800 B) $1600 C) $3200 D) $4000 Answer: C Explanation: C) Security C has the same payoffs as a portfolio consisting of 1 unit of security A and 5 units of security B. Therefore, under the law of one price, the value must be 1 × $200 + 5 × $600 = $3200. Diff: 2 Section: 3.6 Appendix: The Price of Risk Skill: Analytical

30 Copyright © 2014 Pearson Education, Inc.

5) Suppose a risky security pays an average cash flow of $100 in one year. The risk-free rate is 5%, and the expected return on the market index is 13%. If the returns on this security are high when the economy is strong and low when the economy is weak, but the returns vary by only half as much as the market index, what risk premium is appropriate for this security? A) 4% B) 6.5% C) 9% D) 11% Answer: A Explanation: A) Since the security is half as risky as the market, then the risk-premium for the security should be half of the market risk premium. The market risk premium is 13% - 5% = 8%, so the risk premium on this security should be half of this or 4%. Diff: 2 Section: 3.6 Appendix: The Price of Risk Skill: Analytical 6) Suppose a risky security pays an average cash flow of $100 in one year. The risk-free rate is 5%, and the expected return on the market index is 13%. If the returns on this security are high when the economy is strong and low when the economy is weak, but the returns vary by only half as much as the market index, then the price for this risky security is closest to: A) $88 B) $92 C) $93 D) $95 Answer: B Explanation: B) Since the security is half as risky as the market, then the risk-premium for the security should be half of the market risk premium. The market risk premium is 13% - 5% = 8%, so the risk premium on this security should be half of this or 4%. So the expected return should be equal to the risk-free rate + the risk premium = 5% + 4% = 9%. Therefore the price = $100/1.09 = $92. Diff: 3 Section: 3.6 Appendix: The Price of Risk Skill: Analytical

31 Copyright © 2014 Pearson Education, Inc.

Use the table for the question(s) below. Market Price Security A B C

Today 200 600 ???

Cash Flow in One Year Poor Economy Good Economy 840 0 0 840 840 4200

7) Suppose that security C had a risk premium of 30%, describe what arbitrage opportunity exists and how you would exploit it. Answer: Step #1 - Determine the risk-free rate We can construct the risk-free asset by forming a portfolio of A and B. This portfolio has a certain payoff of $840. The price for this portfolio is $800. We know that $800 = $840/(1 + i) → (1 + i) = 840/800 = 1.05 → i = .05 or 5%. Step #2 - Determine the price using the expected return. Since the risk premium is 30% and the risk-free rate is 5%, then the expected return is 35%. The average payoff of security C is (840 + 4200)/2 = 2520 so the price of C = 2520/(1.35) = $1,867. However, Security C has the same payoffs as a portfolio consisting of 1 unit of security A and 5 units of security B. Therefore, under the law of one price, the value must be 1 × $200 + 5 × $600 = $3200. Since these two prices are not the same, there must be an arbitrage opportunity. Here we can buy security C for $1,867 and sell the portfolio of A & B for $3,200 yielding an arbitrage profit of $1,333. Diff: 3 Section: 3.6 Appendix: The Price of Risk Skill: Analytical

32 Copyright © 2014 Pearson Education, Inc.

3.7 Appendix: Arbitrage with Transaction Costs 1) Which of the following statements is FALSE? A) No arbitrage opportunities will exist until the underlying prices diverge by more than the amount of the transaction costs. B) Because you will generally pay a slightly lower price when you buy a security (the ask price) than you receive when you sell (the bid price) you will pay the bid-ask spread. C) The price of a security should equal the present value of its cash flows, up to the transaction costs of trading the security and the cash flows. D) In most markets, you must pay transactions costs to trade securities. Answer: B Diff: 3 Section: 3.7 Arbitrage with Transactions Costs Skill: Conceptual 2) Consider a bond that pays $1000 in one year. Suppose that the market interest rate for savings is 8%, but the interest rate for borrowing is 10%. The price range that this bond must trade in a normal market if no arbitrage opportunities exist is closest to: A) $909 to $917 B) $909 to $926 C) $917 to $926 D) $909 to $1000 Answer: B Explanation: B) VB @ 8% = 1000/1.08 = $926 VB @ 10% = 1000/1.10 = $909 so range is 909 to 926 Diff: 2 Section: 3.7 Arbitrage with Transactions Costs Skill: Analytical Use the table for the question(s) below. Security IBM MRK C

Bid 123.20 36.50 3.15

Ask 123.25 36.55 3.20

3) Consider an ETF that is made up of one share each of IBM, MRK, and C. The minimum bid price for this ETF in a normal market is closest to: A) $162.85 B) $163.00 C) $168.00 D) $168.10 Answer: A Explanation: A) Here we use the Bid prices Value = 123.20 + 36.50 + 3.15 = 162.85 Diff: 2 Section: 3.7 Arbitrage with Transactions Costs Skill: Analytical 33 Copyright © 2014 Pearson Education, Inc.

4) Consider an ETF that is made up of one share each of IBM, MRK, and C. The minimum ask price for this ETF in a normal market is closest to: A) $162.85 B) $163.00 C) $168.00 D) $168.10 Answer: B Explanation: B) Here we use the ask prices Value = 123.25 + 36.55 + 3.20 = 163 Diff: 2 Section: 3.7 Arbitrage with Transactions Costs Skill: Analytical 5) In a normal market with transactions costs, is it possible for different investors to place different values on an investment opportunity? Are there any limits on the amount that their values can differ? Answer: Values can differ, but only up to the total amount of transactions costs. Diff: 2 Section: 3.7 Arbitrage with Transactions Costs Skill: Conceptual Use the table for the question(s) below. Security IBM MRK C

Bid 123.20 36.50 3.15

Ask 123.25 36.55 3.20

6) Consider an ETF that is made up of one share each of IBM, MRK, and C. The current quote for this ETF currently is $162.75 (bid) $162.80 (ask). What should you do? Answer: There is an arbitrage opportunity. Buy the ETF at the ask of $162.80 and sell the underlying securities at the bid prices. So we have 123.20 + 36.50 + 3.15 = 162.85 - 162.80 = . 05 arbitrage profit per share Diff: 2 Section: 3.7 Arbitrage with Transactions Costs Skill: Analytical 7) Consider an ETF that is made up of one share each of IBM, MRK, and C. The current quote for this ETF currently is $162.85 (bid) $163.00 (ask). What should you do? Answer: Nothing, there is no arbitrage opportunity here. The ask price must fall below $162.85 or the bid price must be above $163 for there to be an arbitrage. Diff: 2 Section: 3.7 Arbitrage with Transactions Costs Skill: Analytical

34 Copyright © 2014 Pearson Education, Inc.

8) Consider an ETF that is made up of one share each of IBM, MRK, and C. The current quote for this ETF currently is 163.15 (bid) $163.20 (ask). What should you do? Answer: There is an arbitrage opportunity. Sell the ETF at the bid of $163.15 and buy the underlying securities at the ask prices. So we have + $163.15 - 123.25 - 36.55 - 3.20 = .15 arbitrage profit per share Diff: 2 Section: 3.7 Arbitrage with Transactions Costs Skill: Analytical

35 Copyright © 2014 Pearson Education, Inc.