Debt Financing; Capital Structure/Budget/Cost, Cash Conversion Cycle; Payout Ratio, Trade-Off Theory etc..

Test Review for Test 3

Name (print):_________________________________

Answer 11 out of the following 14 multiple choice questions.Circle your
final answer with an ink 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 100 percent debt financing
is optimal for the firm.

a. True

b. False

3. Which of the following statements is most correct?

a. Since debt financing raises the firm's financial risk, raising a
company’s debt ratio will always increase the company’s WACC.

b. Since debt financing is cheaper than equity financing, raising a
company’s debt ratio will always reduce the company’s WACC.

c. Increasing a company’s debt ratio will typically reduce the
marginal cost of both debt and equity financing; however, it still may
raise the company’s WACC.

d. Statements a and c are correct.

e. None of the statements above is correct.

4. Which of the following events is likely to encourage a company to
raise its target debt ratio?

a. An increase in the corporate tax rate.

b. An increase in the personal tax rate.

c. An increase in the company’s operating leverage.

d. Statements a and c are correct.

e. All of the statements above are correct.

5. Which of the following would increase the likelihood that a company
would increase its debt ratio in its capital structure?

a. An increase in costs incurred when filing for bankruptcy.

b. An increase in the corporate tax rate.

c. An increase in the personal tax rate.

d. A decrease in the firm’s business risk.

Statements b and d are correct.

6. Volga Publishing is considering a proposed increase in its debt
ratio, which will also increase the company’s interest expense. The
plan would involve the company issuing new bonds and using the proceeds
to buy back shares of its common stock. The company’s CFO expects that
the plan will not change the company’s total assets or operating
income. However, the company’s CFO does estimate that it will increase
the company’s earnings per share (EPS). Assuming the CFO’s estimates
are correct, which of the following statements is most correct?

a. Since the proposed plan increases Volga’s financial risk, the
company’s stock price still might fall even though its EPS is expected
to increase.

b. If the plan reduces the company’s WACC, the company’s stock price
is also likely to decline.

c. Since the plan is expected to increase EPS, this implies that net
income is also expected to increase.

d. Statements a and b are correct.

e. Statements a and c are correct.

7. If debt financing is used, which of the following is true?

a. The percentage change in net operating income is greater than a
given percentage change in net income.

b. The percentage change in net operating income is equal to a given
percentage change in net income.

c. The percentage change in net income relative to the percentage
change in net operating income depends on the interest rate charged on
debt.

d. The percentage change in net operating income is less than the
percentage change in net income.

e. The degree of operating leverage is greater than 1.

8. Which of the following statements is most correct?

a. A firm can use retained earnings without paying a flotation cost.
Therefore, while the cost of retained earnings is not zero, the cost of
retained earnings is generally lower than the after-tax cost of debt
financing.

b. The capital structure that minimizes the firm’s cost of capital is
also the capital structure that maximizes the firm’s stock price.

c. The capital structure that minimizes the firm’s cost of capital is
also the capital structure that maximizes the firm’s earnings per
share.

d. If a firm finds that the cost of debt financing is currently less
than the cost of equity financing, an increase in its debt ratio will
always reduce its cost of capital.

e. Statements a and b are correct.

9. MM showed that in a world without taxes, a firm’s optimal capital
structure would be almost 100 percent debt.

a. True

b. False

10. If the information content, or signaling, hypothesis is correct,
then changes in dividend policy can be important with respect to firm
value and capital costs.

a. True

b. False

11. Which of the following would not have an influence on the optimal
dividend policy?

a. The possibility of accelerating or delaying investment projects.

b. A strong shareholders' preference for current income versus capital
gains.

c. Bond indenture constraints.

d. The costs associated with selling new common stock.

e. All of the statements above can have an effect on dividend policy.

12. If a firm adheres strictly to the residual dividend policy, then if
its optimal capital budget requires the use of all earnings for that
year (along with new debt according to the optimal debt/total assets
ratio), the firm should pay

a. No dividends except out of past retained earnings.

b. No dividends to common stockholders.

c. Dividends, in effect, out of a new issue of common stock.

d. Dividends by borrowing the money (debt).

e. Either c or d above could be used.

13. Which of the following statements is most correct?

a. If a company wants to issue new shares of common stock and also wants
to implement a dividend reinvestment plan, then it should implement a
new-stock dividend reinvestment plan, rather than an open-market
purchase plan.

b. If a company undertakes a 3-for-1 stock split, then the number of
shares outstanding should fall, and the stock price should rise.

c. If a company wants to reduce its debt ratio, then it should
repurchase some of its common stock.

d. Answers a and c are correct.

e. Answers b and c are correct.

14. Ignoring cost and other effects on the firm, which of the following
measures would tend to reduce the cash conversion cycle?

a. Maintain the level of receivables as sales decrease.

b. Buy more raw materials to take advantage of price breaks.

c. Take discounts when offered.

d. Forgo discounts that are currently being taken.

e. Offer a longer deferral period to customers.

12 to 14 problems similar to these will appear on the Test. You should
do these by hand and not in excel

1. Elephant Books sells paperback books for $7 each. The variable cost
per book is $5. At current annual sales of 200,000 books, the publisher
is just breaking even. It is estimated that if the authors' royalties
are reduced, the variable cost per book will drop by $1. Assume
authors' royalties are reduced and sales remain constant; how much more
money can the publisher put into advertising (a fixed cost) and still
break even?



2. The Congress Company has identified two methods for producing playing
cards. One method involves using a machine having a fixed cost of
$10,000 and variable costs of $1.00 per deck of cards. The other method
would use a less expensive machine (fixed cost = $5,000), but it would
require greater variable costs ($1.50 per deck of cards). If the
selling price per deck of cards will be the same under each method, at
what level of output will the two methods produce the same net operating
income?



3. A consultant has collected the following information regarding Young
Publishing:

Total assets $3,000 million Tax rate 40%

Operating income (EBIT) $800 million Debt ratio 0%

Interest expense $0 million WACC 10%

Net income $480 million M/B ratio 1.00Ч

Share price $32.00 EPS = DPS $3.20

The company has no growth opportunities (g = 0), so the company pays
out all of its earnings as dividends (EPS = DPS). The consultant
believes that if the company moves to a capital structure financed with
25 percent debt and 75 percent equity (based on market values) that the
cost of equity will increase to 11 percent and that the pre-tax cost of
debt will be 10 percent. If the company makes this change, what would
be the total market value of the firm? (The answers are in millions.)

Use the following information to answer the next 4 questions:

AJC currently has $200,000 market value of perpetual debt outstanding
carrying a coupon rate of 6 percent. Its earnings before interest and
taxes (EBIT) are $100,000, and it is a zero-growth company. AJC’s
current cost of equity is 8.8 percent, and its tax rate is 40 percent.
The firm has 10,000 shares of common stock outstanding selling at a
price per share of $60.

4. What is AJC’s current total market value and weighted average
cost of capital?

5. The firm is considering moving to a capital structure that is
comprised of 40 percent debt and 60 percent equity, based on market
values. The new funds would be used to replace the old debt and to
repurchase stock. It is estimated that the increase in riskiness
resulting from the leverage increase would cause the required rate of
return on debt to rise to 7 percent, while the required rate of return
on equity would increase to 9.5 percent. If this plan were carried out,
what would be AJC's new WACC and total value?



6. Now assume that AJC is considering changing from its original capital
structure to a new capital structure with 50 percent debt and 50 percent
equity. If it makes this change, its resulting market value would be
$820,000. What would be its new stock price per share?



7. Now assume that AJC is considering changing from its original capital
structure to a new capital structure that results in a stock price of
$64 per share. The resulting capital structure would have a $336,000
total market value of equity and $504,000 market value of debt. How
many shares would AJC repurchase in the recapitalization?



8. Petersen Co. has a capital budget of $1,200,000. The company wants
to maintain a target capital structure which is 50 percent debt and 50
percent equity. The company forecasts that its net income this year
will be $800,000. If the company follows a residual dividend policy,
what will be its payout ratio?

9. Tarheel Computing’s stock was trading at $150 per share before its
recent 3-for-1 stock split. The 3-for-1 split led to a 5 percent
increase in Tarheel’s market capitalization. (Market capitalization
equals the stock price times the number of shares.) What was Tarheel’s
price after the stock split?

10. Brock Brothers wants to maintain its capital structure which is 40
percent debt, and 60 percent equity. The company forecasts that its net
income this year will be $1,000,000. The company follows a residual
dividend policy, and anticipates a dividend payout ratio of 40 percent.
What is the size of the company’s capital budget?

11. Plato Inc. expects to have net income of $5,000,000 during the next
year. Plato's target capital structure is 35 percent debt and 65
percent equity. The company's director of capital budgeting has
determined that the optimal capital budget for the coming year is
$5,000,000. If Plato follows a residual dividend policy to determine
the coming year’s dividend, then what is Plato's payout ratio?

12. Phillips Glass Company buys on terms of 2/15, net 30 days. It does
not take discounts, and it typically pays 30 days after the invoice
date. Net purchases amount to $730,000 per year. On average, how much
“free” trade credit does Phillips receive during the year? (Assume
a 365-day year.)

13. On average, a firm sells $2,000,000 in merchandise a month. It
keeps inventory equal to one-half of its monthly sales on hand at all
times. If the firm analyzes its accounts using a 365-day year, what is
the firm’s inventory conversion period?

14. Kolan Inc. has annual sales of $36,500,000 ($100,000 a day on a
365-day basis). On average, the company has $12,000,000 in inventory
and $8,000,000 in accounts receivable. The company is looking for ways
to shorten its cash conversion cycle, which is calculated on a 365-day
basis. Its CFO has proposed new policies that would result in a 20
percent reduction in both average inventories and accounts receivables.
The company anticipates that these policies will also reduce sales by 10
percent. Accounts payable will remain unchanged. What effect would
these policies have on the company’s cash conversion cycle? Round to
the nearest whole day.

Bonus (5 points each):

Tauscher Textiles corporation has an inventory conversion period of 45
days and sales are $4,309,028. How much inventory is on the
firm’s balance sheet?



Simon company is trying to estimate its optimal capital structure.
Right now, Simon has a capital structure that consists of 20% debt and
80% equity, based on market values. Its D/E ratio is .25. The
risk-free rate is 6% and the market risk premium is 5%. Currently the
company’s cost of equity, which is based on CAPM, is 12% and its tax
rate is 40%. What would be Simon’s estimated cost of equity if it
were to change its capital structure to 50% debt and 50% equity?

(Hint: First, find the firm’s levered beta, then unlevered beta and
new levered beta)

Which of the following statements is most correct?

The bird-in-the-hand theory implies that a company can reduce its WACC
by reducing its dividend payout.

The bird-in-the-hand theory implies that a company can increase its
stock price by reducing its dividend payout.

One problem with following a residual dividend policy is that it can
lead to erratic dividend payouts which may prevent the firm from
establishing a reliable clientele of investors who prefer a particular
dividend policy.

Statements a and c are correct.

All of the statements above are correct.

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