Test Review for Test 3

Name (print):_________________________________
Answer 11 out of the following 14 multiple choice questions!ircle "our final answer with an in# pen
1. The trade-off theory tells us that the capital structure decision involves a tradeoff between the costs of debt
financing and the benefits of debt financing.
a. True
b. False
2. If Miller and Modigliani had considered the cost of bankruptcy, it is unlikely that they would have
concluded that 1 percent debt financing is opti!al for the fir!.
a. True
b. False
". #hich of the following state!ents is !ost correct$
a. %ince debt financing raises the fir!&s financial risk, raising a co!pany's debt ratio will always
increase the co!pany's #()).
b. %ince debt financing is cheaper than e*uity financing, raising a co!pany's debt ratio will always
reduce the co!pany's #()).
c. Increasing a co!pany's debt ratio will typically reduce the !arginal cost of both debt and e*uity
financing+ however, it still !ay raise the co!pany's #()).
d. %tate!ents a and c are correct.
e. ,one of the state!ents above is correct.
-. #hich of the following events is likely to encourage a co!pany to raise its target debt ratio$
a. (n increase in the corporate ta. rate.
b. (n increase in the personal ta. rate.
c. (n increase in the co!pany's operating leverage.
d. %tate!ents a and c are correct.
e. (ll of the state!ents above are correct.
/. #hich of the following would increase the likelihood that a co!pany would increase its debt ratio in its
capital structure$
a. (n increase in costs incurred when filing for bankruptcy.
b. (n increase in the corporate ta. rate.
c. (n increase in the personal ta. rate.
d. ( decrease in the fir!'s business risk.
e. %tate!ents b and d are correct.
1
0. 1olga 2ublishing is considering a proposed increase in its debt ratio, which will also increase the
co!pany's interest e.pense. The plan would involve the co!pany issuing new bonds and using the
proceeds to buy back shares of its co!!on stock. The co!pany's )F3 e.pects that the plan will not
change the co!pany's total assets or operating inco!e. 4owever, the co!pany's )F3 does esti!ate that
it will increase the co!pany's earnings per share 562%7. (ssu!ing the )F3's esti!ates are correct,
which of the following state!ents is !ost correct$
a. %ince the proposed plan increases 1olga's financial risk, the co!pany's stock price still !ight fall
even though its 62% is e.pected to increase.
b. If the plan reduces the co!pany's #()), the co!pany's stock price is also likely to decline.
c. %ince the plan is e.pected to increase 62%, this i!plies that net inco!e is also e.pected to increase.
d. %tate!ents a and b are correct.
e. %tate!ents a and c are correct.
8. If debt financing is used, which of the following is true$
a. The percentage change in net operating inco!e is greater than a given percentage change in net
inco!e.
b. The percentage change in net operating inco!e is e*ual to a given percentage change in net inco!e.
c. The percentage change in net inco!e relative to the percentage change in net operating inco!e
depends on the interest rate charged on debt.
d. The percentage change in net operating inco!e is less than the percentage change in net inco!e.
e. The degree of operating leverage is greater than 1.
9. #hich of the following state!ents is !ost correct$
a. ( fir! can use retained earnings without paying a flotation cost. Therefore, while the cost of
retained earnings is not :ero, the cost of retained earnings is generally lower than the after-ta. cost
of debt financing.
b. The capital structure that !ini!i:es the fir!'s cost of capital is also the capital structure that
!a.i!i:es the fir!'s stock price.
c. The capital structure that !ini!i:es the fir!'s cost of capital is also the capital structure that
!a.i!i:es the fir!'s earnings per share.
d. If a fir! finds that the cost of debt financing is currently less than the cost of e*uity financing, an
increase in its debt ratio will always reduce its cost of capital.
e. %tate!ents a and b are correct.
;. MM showed that in a world without ta.es, a fir!'s opti!al capital structure would be al!ost 1 percent
debt.
a. True
b. False
1. If the infor!ation content, or signaling, hypothesis is correct, then changes in dividend policy can be
i!portant with respect to fir! value and capital costs.
a. True
b. False
2
11. #hich of the following would not have an influence on the opti!al dividend policy$
a. The possibility of accelerating or delaying invest!ent pro<ects.
b. ( strong shareholders& preference for current inco!e versus capital gains.
c. =ond indenture constraints.
d. The costs associated with selling new co!!on stock.
e. (ll of the state!ents above can have an effect on dividend policy.
12. If a fir! adheres strictly to the residual dividend policy, then if its opti!al capital budget re*uires the
use of all earnings for that year 5along with new debt according to the opti!al debt>total assets ratio7,
the fir! should pay
a. ,o dividends e.cept out of past retained earnings.
b. ,o dividends to co!!on stockholders.
c. ?ividends, in effect, out of a new issue of co!!on stock.
d. ?ividends by borrowing the !oney 5debt7.
e. 6ither c or d above could be used.
1". #hich of the following state!ents is !ost correct$
a. If a co!pany wants to issue new shares of co!!on stock and also wants to i!ple!ent a dividend
reinvest!ent plan, then it should i!ple!ent a new-stock dividend reinvest!ent plan, rather than an
open-!arket purchase plan.
b. If a co!pany undertakes a "-for-1 stock split, then the nu!ber of shares outstanding should fall, and
the stock price should rise.
c. If a co!pany wants to reduce its debt ratio, then it should repurchase so!e of its co!!on stock.
d. (nswers a and c are correct.
e. (nswers b and c are correct.
1-. Ignoring cost and other effects on the fir!, which of the following !easures would tend to reduce the
cash conversion cycle$
a. Maintain the level of receivables as sales decrease.
b. =uy !ore raw !aterials to take advantage of price breaks.
c. Take discounts when offered.
d. Forgo discounts that are currently being taken.
e. 3ffer a longer deferral period to custo!ers.
"
1$ to 14 pro%lems similar to these will appear on the Test &ou shoul' 'o these %" han' an' not in e(cel
1. 6lephant =ooks sells paperback books for @8 each. The variable cost per book is @/. (t current annual
sales of 2, books, the publisher is <ust breaking even. It is esti!ated that if the authors& royalties are
reduced, the variable cost per book will drop by @1. (ssu!e authors& royalties are reduced and sales
re!ain constant+ how !uch !ore !oney can the publisher put into advertising 5a fi.ed cost7 and still
break even$
2. The )ongress )o!pany has identified two !ethods for producing playing cards. 3ne !ethod involves
using a !achine having a fi.ed cost of @1, and variable costs of @1. per deck of cards. The other
!ethod would use a less e.pensive !achine 5fi.ed cost A @/,7, but it would re*uire greater variable
costs 5@1./ per deck of cards7. If the selling price per deck of cards will be the sa!e under each !ethod,
at what level of output will the two !ethods produce the sa!e net operating inco!e$
-
". ( consultant has collected the following infor!ation regarding Boung 2ublishingC
Total assets $3,000 million Tax rate 40%
Operating income (EBIT) $800 million Debt ratio 0%
Interest expense $0 million !"" #0%
$et income $480 million %&B ratio #'00(
)*are price $3+'00 E,) - D,) $3'+0
The co!pany has no growth opportunities 5g A 7, so the co!pany pays out all of its earnings as
dividends 562% A ?2%7. The consultant believes that if the co!pany !oves to a capital structure
financed with 2/ percent debt and 8/ percent e*uity 5based on !arket values7 that the cost of e*uity will
increase to 11 percent and that the pre-ta. cost of debt will be 1 percent. If the co!pany !akes this
change, what would be the total !arket value of the fir!$ 5The answers are in !illions.7
Use the following information to answer the next 4 questions:
(D) currently has @2, !arket value of perpetual debt outstanding carrying a coupon rate of 0
percent. Its earnings before interest and ta.es 56=IT7 are @1,, and it is a :ero-growth co!pany.
(D)'s current cost of e*uity is 9.9 percent, and its ta. rate is - percent. The fir! has 1, shares of
co!!on stock outstanding selling at a price per share of @0.
-. #hat is (D)'s current total !arket value and weighted average cost of capital$
/
/. The fir! is considering !oving to a capital structure that is co!prised of - percent debt and 0 percent
e*uity, based on !arket values. The new funds would be used to replace the old debt and to repurchase
stock. It is esti!ated that the increase in riskiness resulting fro! the leverage increase would cause the
re*uired rate of return on debt to rise to 8 percent, while the re*uired rate of return on e*uity would
increase to ;./ percent. If this plan were carried out, what would be (D)&s new #()) and total value$
0. ,ow assu!e that (D) is considering changing fro! its original capital structure to a new capital structure
with / percent debt and / percent e*uity. If it !akes this change, its resulting !arket value would be
@92,. #hat would be its new stock price per share$
8. ,ow assu!e that (D) is considering changing fro! its original capital structure to a new capital structure
that results in a stock price of @0- per share. The resulting capital structure would have a @""0, total
!arket value of e*uity and @/-, !arket value of debt. 4ow !any shares would (D) repurchase in
the recapitali:ation$
0
9. 2etersen )o. has a capital budget of @1,2,. The co!pany wants to !aintain a target capital
structure which is / percent debt and / percent e*uity. The co!pany forecasts that its net inco!e this
year will be @9,. If the co!pany follows a residual dividend policy, what will be its payout ratio$
;. Tarheel )o!puting's stock was trading at @1/ per share before its recent "-for-1 stock split. The "-for-1
split led to a / percent increase in Tarheel's !arket capitali:ation. 5Market capitali:ation e*uals the stock
price ti!es the nu!ber of shares.7 #hat was Tarheel's price after the stock split$
1. =rock =rothers wants to !aintain its capital structure which is - percent debt, and 0 percent e*uity.
The co!pany forecasts that its net inco!e this year will be @1,,. The co!pany follows a residual
dividend policy, and anticipates a dividend payout ratio of - percent. #hat is the si:e of the co!pany's
capital budget$
8
11. 2lato Inc. e.pects to have net inco!e of @/,, during the ne.t year. 2lato&s target capital structure
is "/ percent debt and 0/ percent e*uity. The co!pany&s director of capital budgeting has deter!ined
that the opti!al capital budget for the co!ing year is @/,,. If 2lato follows a residual dividend
policy to deter!ine the co!ing year's dividend, then what is 2lato&s payout ratio$
12. 2hillips Elass )o!pany buys on ter!s of 2>1/, net " days. It does not take discounts, and it typically pays
" days after the invoice date. ,et purchases a!ount to @8", per year. 3n average, how !uch FfreeG
trade credit does 2hillips receive during the year$ 5(ssu!e a "0/-day year.7
1". 3n average, a fir! sells @2,, in !erchandise a !onth. It keeps inventory e*ual to one-half of its
!onthly sales on hand at all ti!es. If the fir! analy:es its accounts using a "0/-day year, what is the
fir!'s inventory conversion period$
9
1-. Holan Inc. has annual sales of @"0,/, 5@1, a day on a "0/-day basis7. 3n average, the
co!pany has @12,, in inventory and @9,, in accounts receivable. The co!pany is looking
for ways to shorten its cash conversion cycle, which is calculated on a "0/-day basis. Its )F3 has
proposed new policies that would result in a 2 percent reduction in both average inventories and
accounts receivables. The co!pany anticipates that these policies will also reduce sales by 1 percent.
(ccounts payable will re!ain unchanged. #hat effect would these policies have on the co!pany's cash
conversion cycle$ Iound to the nearest whole day.
)onus (* points each):
1. Tauscher Te.tiles corporation has an inventory conversion period of -/ days and sales are @-,";,29.
4ow !uch inventory is on the fir!'s balance sheet$

;
2. %i!on co!pany is trying to esti!ate its opti!al capital structure. Iight now, %i!on has a capital
structure that consists of 2J debt and 9J e*uity, based on !arket values. Its ?>6 ratio is .2/. The
risk-free rate is 0J and the !arket risk pre!iu! is /J. )urrently the co!pany's cost of e*uity, which
is based on )(2M, is 12J and its ta. rate is -J. #hat would be %i!on's esti!ated cost of e*uity if it
were to change its capital structure to /J debt and /J e*uity$
54intC First, find the fir!'s levered beta, then unlevered beta and new levered beta7
". #hich of the following state!ents is !ost correct$
a. The bird-in-the-hand theory i!plies that a co!pany can reduce its #()) by reducing its
dividend payout.
b. The bird-in-the-hand theory i!plies that a co!pany can increase its stock price by reducing its
dividend payout.
c. 3ne proble! with following a residual dividend policy is that it can lead to erratic dividend
payouts which !ay prevent the fir! fro! establishing a reliable clientele of investors who
prefer a particular dividend policy.
d. %tate!ents a and c are correct.
e. (ll of the state!ents above are correct.
1