Test Review 3

8/11/2019 Test Review 3

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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 debtfinancing and the benefits of debt financing.

a. Trueb. False

2. If Miller and Modigliani had considered the cost of bankruptcy, it is unlikely that they would haveconcluded that 1 percent debt financing is opti!al for the fir!.

a. Trueb. 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 alwaysincrease the co!pany's #()).

b. %ince debt financing is cheaper than e*uity financing, raising a co!pany's debt ratio will alwaysreduce the co!pany's #()).

c. Increasing a co!pany's debt ratio will typically reduce the !arginal cost of both debt and e*uityfinancing+ 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 itscapital 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.

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0. olga ublishing is considering a proposed increase in its debt ratio, which will also increase theco!pany's interest epense. The plan would involve the co!pany issuing new bonds and using theproceeds to buy back shares of its co!!on stock. The co!pany's )F3 epects that the plan will notchange the co!pany's total assets or operating inco!e. 4owever, the co!pany's )F3 does esti!ate thatit will increase the co!pany's earnings per share 56%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 olga's financial risk, the co!pany's stock price still !ight falleven though its 6% is epected 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 epected to increase 6%, this i!plies that net inco!e is also epected 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 netinco!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!edepends 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 ofretained earnings is not :ero, the cost of retained earnings is generally lower than the after-ta costof debt financing.

b. The capital structure that !ini!i:es the fir!'s cost of capital is also the capital structure that!ai!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!ai!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, anincrease 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 taes, a fir!'s opti!al capital structure would be al!ost 1 percentdebt.

a. Trueb. 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. Trueb. False

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11. #hich of the following would nothave an influence on the opti!al dividend policy$

a. The possibility of accelerating or delaying invest!ent prototal assets ratio7,the fir! should pay

a. o dividends ecept 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 dividendreinvest!ent plan, then it should i!ple!ent a new-stock dividend reinvest!ent plan, rather than anopen-!arket purchase plan.

b. If a co!pany undertakes a "-for-1 stock split, then the nu!ber of shares outstanding should fall, andthe 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 thecash 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.

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". ( consultant has collected the following infor!ation regarding Boung ublishingC

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 asdividends 56% A ?%7. The consultant believes that if the co!pany !oves to a capital structurefinanced with 2/ percent debt and 8/ percent e*uity 5based on !arket values7 that the cost of e*uity willincrease to 11 percent and that the pre-ta cost of debt will be 1 percent. If the co!pany !akes thischange, 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 0percent. Its earnings before interest and taes 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 ofco!!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$

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/. The fir! is considering !oving to a capital structure that is co!prised of percent debt and 0 percente*uity, based on !arket values. The new funds would be used to replace the old debt and to repurchasestock. It is esti!ated that the increase in riskiness resulting fro! the leverage increase would cause there*uired rate of return on debt to rise to 8 percent, while the re*uired rate of return on e*uity wouldincrease 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 structurewith / 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 structurethat 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 inthe recapitali:ation$

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9. etersen )o. has a capital budget of @1,2,. The co!pany wants to !aintain a target capitalstructure which is / percent debt and / percent e*uity. The co!pany forecasts that its net inco!e thisyear 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-1split led to a / percent increase in Tarheel's !arket capitali:ation. 5Market capitali:ation e*uals the stockprice 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 residualdividend policy, and anticipates a dividend payout ratio of percent. #hat is the si:e of the co!pany'scapital budget$

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11. lato Inc. epects to have net inco!e of @/,, during the net year. lato&s target capital structureis "/ percent debt and 0/ percent e*uity. The co!pany&s director of capital budgeting has deter!inedthat the opti!al capital budget for the co!ing year is @/,,. If lato follows a residual dividendpolicy to deter!ine the co!ing year's dividend, then what is lato&s payout ratio$

12. hillips 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 freeGtrade credit does hillips 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 thefir!'s inventory conversion period$

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1. Holan Inc. has annual sales of @"0,/, 5@1, a day on a "0/-day basis7. 3n average, theco!pany has @12,, in inventory and @9,, in accounts receivable. The co!pany is lookingfor ways to shorten its cash conversion cycle, which is calculated on a "0/-day basis. Its )F3 hasproposed new policies that would result in a 2 percent reduction in both average inventories andaccounts 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$ ound to the nearest whole day.

onus (* points each):

1. Tauscher Tetiles corporation has an inventory conversion period of / days and sales are @,";,29.4ow !uch inventory is on the fir!'s balance sheet$

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2. %i!on co!pany is trying to esti!ate its opti!al capital structure. ight now, %i!on has a capitalstructure that consists of 2J debt and 9J e*uity, based on !arket values. Its ?>6 ratio is .2/. Therisk-free rate is 0J and the !arket risk pre!iu! is /J. )urrently the co!pany's cost of e*uity, whichis based on )(M, is 12J and its ta rate is J. #hat would be %i!on's esti!ated cost of e*uity if itwere 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 whoprefer a particular dividend policy.

d. %tate!ents a and c are correct.e. (ll of the state!ents above are correct.

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Test Review 3