03 Arbitrage and Financial Decision Making

Corporate Finance, 2e, Global Edition (Berk/DeMarzo)
Chapter 3 Arbitrage and Financial Decision Making
3.1 Valuing Decisions
1) Due to a pre-existing contract, Recycle America Inc. has the opportunity to acquire 10,000
pounds of scrap aluminum and 2,500 pounds of scrap lead for $10,750. If the current market
price for scrap aluminum is $0.83 per pound and the current market price for lead is $1.06 per
pound, then the added benefit (cost) to you if you acquire this metal is?
A) ($200)
B) $200
C) ($1,925)
D) $1,925
Answer: B
Explanation: B) Added Benefit = 10,000 x $0.83 + 2,500 x $1.06 - $10,750 = $200
Diff: 1
Section: 3.1 Valuing Decisions
Skill: Analytical
2) Which of the following statements regarding the valuing of costs and benefits is not correct?
A) The first step in evaluating a project is to identify its costs and benefits.
B) In the absence of competitive markets, we can use one-sided prices to determine exact cash
values.
C) Competitive market prices allow us to calculate the value of a decision without worrying
about the tastes or opinions of the decision maker.
D) Because competitive markets exist for most commodities and financial assets, we can use
them to determine cash values and evaluate decisions in most situations.
Answer: B
Diff: 2
Skill: Conceptual
3) Recycle America Inc. has the opportunity to trade 8,000 pounds of plastic pellets made from
recycled soda bottles for 5,000 pounds of aluminum cans. If the current market price of scrap
aluminum is $0.83 per pound and the current market price for plastic pellets is $0.57 per pound,
then the added benefit (cost) of making this trade is:
A) ($410)
B) $410
C) ($780)
D) $780
Answer: A
Explanation: A) Added Benefit = 5,000 x $0.83 - 8,000 x $0.57 = -$410
Diff: 1
Skill: Analytical
1
Copyright © 2011 Pearson Education
Use the information for the question(s) below.
Alaska North Slope Crude Oil (ANS) $71.75/Bbl

West Texas Intermediate Crude Oil
(WTI) $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

Added Benefits = Total Benefits - Base Case

= $771,400 - $770,000 = $1,400
Diff: 2
Skill: Analytical
2
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

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

= $773,908 - $770,000 = $3,908
Diff: 2
Skill: Analytical
6) Assuming you just purchased 10,000 Bbls of WTI crude at the current market price, the total
benefit (cost) to you if you were to refine this crude oil and sell the unleaded gasoline is closest
to:
A) $730,600
B) $770,000
C) $771,400
D) $773,908
Answer: B
Explanation: B) Total Benefits

Diff: 1
Skill: Analytical
3
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 total benefit (cost) to you if you take
the trade is closest to:
A) $730,600
B) $770,000
C) $771,400
D) $773,908
Answer: C
Explanation: C) Total Benefits

Diff: 2
Skill: Analytical
8) Assuming you currently have 10,000 Bbls of WTI crude, the total 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) $771,400
D) $773,908
Answer: D
Explanation: D) Total Benefits

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
Diff: 2
Skill: Analytical
4
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 x $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
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
Skill: Definition
5
Low-Grade Copper Ore $571 per Ton

High-Grade Copper Ore $843 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

Diff: 2
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)

Trade high-grade for low-grade

5,925 tons × $640 of copper/ton = $3,792,000 (total benefits)

= $3,792,000 - $3,760,000 = $32,000 (added benefit)
Diff: 2
Skill: Analytical
6
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 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 today.
Answer: D
Explanation: D) $1000 x 1.035 = $1035.00
Diff: 1
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
Skill: Analytical
7
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
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
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
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
Skill: Analytical
8
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
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
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
Skill: Definition
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
Skill: Definition
9
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: B
Explanation: B) 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
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.
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.
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
Skill: Analytical
10
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
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
Skill: Analytical
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
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
Skill: Analytical
11
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
Skill: Conceptual
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 + = 341,304
NPV#3 = -40,000 + = 329,565

Correct answer is #1 with NPV of 350,000.
Diff: 3
12
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
Answer: C
Explanation: C) NPV#1 = $350,000 (No TVM here)
NPV#2 = -50,000 + = 341,304
NPV#3= -40,000 + = 329,565

Diff: 3
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 + = 341,304
NPV#3 = -40,000 + = 329,565

Diff: 3
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
Skill: Conceptual
13
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
Skill: Conceptual
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
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
Skill: Analytical
14
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
Skill: Analytical
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.
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
Skill: Analytical
15
Use the table for the question(s) below.
Cash flow Cash flow

Project today in one year
Eenie -10 15
Meenie 10 -8
Mighty -15 20
Moe 10 -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
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
Skill: Analytical
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
Skill: Analytical
16
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
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
Skill: Analytical
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/£.
Answer: NPV = -500,000 + (£320,000 / 1.06) × $1.70/£ = $13,208 so since NPV > 0, accept
Diff: 2
Skill: Analytical
17
Cash flow Cash flow

Project today in one year
"alpha" -18 23
"beta" 15 -12
"gamma" 15 -20
"delta" -16 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
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
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
Skill: Conceptual
Consider the following prices from a McDonald's Restaurant:
Big Mac Sandwich $2.99

Large Coke $1.39
Large Fry $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
Skill: Analytical
19
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 McDonalds
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
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
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, theres 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
Skill: Analytical
20
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
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
Skill: Conceptual
21
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
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
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
Skill: Analytical
22
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
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
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
Skill: Analytical
23
Cash flow Cash flow

Security today in one year
A 0 100
B 100 0
C 100 100
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
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
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
Skill: Analytical
24
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 Current Price

IBM $121.57
MRK $36.59
C $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
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
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
Skill: Analytical
25
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 Seimans 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) $0.6744/€
B) €0.6744/$
C) €1.4850/$
D) $1.5274/€
Answer: B
Explanation: B) Exchange rate = =
Diff: 3
Skill: Analytical
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 Price
APPL $200.23
GOOG $570.51
MSFT $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
E) $1,601
Answer: D
Explanation: D) Price = 2 x $200.23 + 1 x $570.51 + 10 x $29.61 = $1,267.07
Diff: 2
Skill: Analytical
26
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%
E) 8.0%
Answer: D
Explanation: D) i = $1000/$930 - 1 = 0.075269 or approx 7.5%
Diff: 1
Skill: Analytical
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 Current Price

IBM $121.57
MRK $36.59
C $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
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
Skill: Analytical
27
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 Price
APPL $200.23
GOOG $570.51
MSFT $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 x $200.23 + 1 x $570.51 + 10 x $29.61 = $1,267.07

Diff: 2
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 x $200.23 + 1 x $570.51 + 10 x $29.61 = $1,267.07

Diff: 2
Skill: Analytical
28
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 Bid Ask

1 $18.38 $18.43
2 $18.30 $18.34
3 $18.36 $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
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
Skill: Analytical
29
Market Price Cash Flow in One Year

Poor
Security Today Economy Good Economy
A 200 840 0
B 600 0 840
C ??? 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
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
Skill: Analytical
30
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
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
Skill: Analytical
31
Market Price Cash Flow in One Year

Poor
Security Today Economy Good Economy
A 200 840 0
B 600 0 840
C ??? 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
Skill: Analytical
32
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
Skill: Analytical
Security Bid Ask

IBM 123.20 123.25
MRK 36.50 36.55
C 3.15 3.20
3) 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: A
Explanation: A) Here we use the Bid prices Value = 123.20 + 36.50 + 3.15 = 162.85
Diff: 2
Skill: Analytical
33
4) 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: B
Explanation: B) Here we use the ask prices Value = 123.25 + 36.55 + 3.20 = 163
Diff: 2
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
Skill: Conceptual
Security Bid Ask

IBM 123.20 123.25
MRK 36.50 36.55
C 3.15 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 -
162.850= .05 arbitrage profit per share
Diff: 2
Skill: Analytical
Answer: Nothing, there is no arbitrage opportunity here. The ask price must fall below $167.90
or the bid price must be above $168.10 for there to be an arbitrage.
Diff: 2
Skill: Analytical
34
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
Skill: Analytical
35

03 Arbitrage and Financial Decision Making

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03 Arbitrage and Financial Decision Making

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Corporate Finance, 2e, Global Edition (Berk/DeMarzo)

Chapter 3 Arbitrage and Financial Decision Making

3.1 Valuing Decisions

Alaska North Slope Crude Oil (ANS) $71.75/Bbl

Explanation: B) Total Benefits

No trade and refine WTI crude (base case)

Trade WTI for ANS crude

10,183 Bbls × $76 of gasoline/Bbl = $773,908

Added Benefits = Total Benefits - Base Case

Trade WTI for ANS crude

No trade and refine WTI crude (base case)

Sell WTI and use proceeds to buy ANS

Added Benefits = Total Benefits - Base Case

Sell WTI and use proceeds to buy ANS

No trade and refine WTI crude (base case)

Trade WTI for ANS crude

Sell WTI and use proceeds to buy ANS

Low-Grade Copper Ore $571 per Ton

No trade and refine high-grade ore (base case)

Trade high-grade for low-grade

No trade and refine high-grade ore (base case)

Trade high-grade for low-grade

Added Benefits = Total Benefits - Base Case

Use the information below to answer the following question(s):

1. Sell the restaurant now and retire.

2) If the interest rate is 7%, the NPV of alternative #1 is closest to:

4) If the interest rate is 7%, the NPV of alternative # 3 is closest to:

Use the following information to answer the question(s) below.

1. Sell the restaurant now and retire.

NPV#3 = -40,000 + = 329,565

NPV#3= -40,000 + = 329,565

NPV#3 = -40,000 + = 329,565

Cash flow Cash flow

Cash flow Cash flow

Would never invest in gamma. NPV gamma = 15 - 20 / 1.1 = -3.18

3.4 Arbitrage and the Law of One Price

1) Which of the following statements regarding arbitrage is the most correct?

Use the table for the question(s) below.

Consider the following prices from a McDonald's Restaurant:

Big Mac Sandwich $2.99

3.5 No-Arbitrage and Security Prices

4) Which of the following statements is false?

Cash flow Cash flow

Stock Current Price

Use the following information to answer the question(s) below.

Use the information for the question(s) below.

Stock Current Price

Price = 2 x $200.23 + 1 x $570.51 + 10 x $29.61 = $1,267.07

Price = 2 x $200.23 + 1 x $570.51 + 10 x $29.61 = $1,267.07

1) Which one of the following statements is false?

Dealer Bid Ask

Market Price Cash Flow in One Year

4) What is the no-arbitrage price for security C?

Market Price Cash Flow in One Year

Step #2 - Determine the price using the expected return.

1) Which of the following statements is false?

Use the table for the question(s) below.

Security Bid Ask

Use the table for the question(s) below.

Security Bid Ask

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