Business Finance
Spring 2000
Final Examination
Name __________________
Select the best answer to each of the following questions. Show all work on the
problems. Transfer the answers to the answer sheet (back page) and detach from the
exam. The answer key will be posted one hour after the examination is completed.
3 points
1.
The Gordon/Lintner “Bird-in-the-Hand” Theory of Dividends suggests that:
A.
B.
C.
D.
E.
2.
____________ leverage is concerned with the relationship between sales revenue
and operating income (EBIT). ___________ leverage is concerned with the
relationship between sales revenue and earnings per share (EPS).
A.
B.
C.
D.
E.
3.
Operating; Financial
Financial; Total
Operating; Total
Total; Financial
Total; Operating
The problem with a constant percent dividend payout policy from the
shareholders perspective is that:
A.
B.
C.
D.
E.
4.
the firm should should never cut dividends.
the manner in which earnings are distributed have no effect on the firm's
value.
investors view potential capital gains as being less risky than current
dividends.
investors value a dollar of current dividends more highly than a dollar of
potential capital gains because of the uncertainty associated with future
capital gains.
the firm's investment policy should dictate the firm's distribution decision
policy.
there is no informational content.
if the firm's earnings drop, so does the dividend payment.
even when earnings are low, the company must pay a fixed dividend.
it decreases investor uncertainty.
it creates no investor excitement about the stock.
The “control issue” of dividend theory suggests that:
A.
B.
C.
D.
E.
closely held firms are less likely to pay higher dividends because of the
possible dilution of their ownership
large, well-known companies can afford to pay a higher portion of their
earnings as dividends than smaller, less well-known firms.
dividend policy is determined by investment policy.
the value of a firm depends on the earning power of the assets and not on
the manner in which earnings are distributed.
changes in dividend policy reflect management’s forecast of future
earnings.
5.
Modigliani and Millers' (M&M) contribution to Dividend Theory suggests that:
A.
B.
C.
D.
The primary motive for the use of debt in a firm’s capital structure is:
6.
A.
B.
C.
D.
E.
7.
To minimize the risk to shareholders.
To increase a firm's net income for a given level of sales.
To increase the expected returns to shareholders.
To increase of the variation of returns to shareholders.
To avoid the use of additional equity.
As a firm's financial position declines due to increased financial leverage, the
firm's managers may chose to act in a manner contrary to their traditional values.
This change in managerial behavior is referred to as:
A.
B.
C.
D.
E.
8.
Moral hazard.
Agency costs.
Costs of financial distress.
Business risk.
Bankruptcy costs.
The traditional approach to capital structure theory suggests that the moderate use
of debt can increase the total value of the firm. For what source does the
traditional theory suggests that these benefits arise?
A.
B.
C.
D.
E.
9.
changes in dividend policy reflect management's forecast of future
earnings.
the dividend payout policies set by firms attract investors and that changes
in payout policy cause those investors to sell their shares.
dividend policy is determined by investment policy.
the value of a firm depends on the earning power of the assets and not on
the manner in which earnings are distributed.
The reduction in uncertainty associated with the use of debt.
The higher operating leverage associated with the use of debt.
The higher earning power of the firm’s assets associated with the use of
debt.
The tax shield created through the use of debt.
The greater efficiency at which highly levered firms are forced to operate.
The operating risk (or business risk) of a firm can BEST be measured in variability of
____________, where the total risk of a firm is BEST measured in variability of
_____________.
A.
B.
C.
D.
E.
Sales; Net Income
ROA; ROE
EBIT; Sales
ROA; EBIT
Sales; EPS
10.
As the typical manufacturing firm DECREASES its operating leverage (all other
things held constant),:
A.
B.
C.
D.
its total fixed costs increase and variable cost per unit increases.
its total fixed costs increase and variable cost per unit decreases.
its total fixed costs decrease and variable cost per unit increases.
its total fixed costs decrease and variable cost per unit decreases.
6 points
11.
Assume that a firm has a DFL of 1.5. If sales increase by 20 percent, the firm
will experience a 80 percent increase in EPS, and it will have an EBIT of
$200,000. What will be the EBIT for this firm if sales do not increase?
A.
B.
C.
D.
E.
$ 211,111
$ 130,435
$ 195,652
$ 260,870
$ 326,087
F.
G.
H.
$ 236,000
$ 342,857
$ 450,000
12 points (3 points per section)
12.
The ACE Wine Company of El Paso produces a popular, low-cost wine. The firm
has fixed costs of $2,000,000 annually and variable costs per bottle of $4.00. The
division has $1,000,000 in debt outstanding at an annual interest rate of 12
percent.
A.
If the price per bottle is $20.00, what is the division's breakeven revenue?
A.
B.
C.
D.
E.
B.
$2,500,000
$3,300,000
$3,250,000
$18.00
$6.20
$8.80
$10.25
$13.00
F.
G.
H.
$20.00
$12.00
$9.00
If the firm sells 250,000 bottles at a price of $20.00, what is the firm's
degree of operating leverage?
A.
B.
C.
D.
E.
D.
F.
G.
H.
If the firm expects to sell 250,000 bottles, at what price must it sell each
bottle in order to break even?
A.
B.
C.
D.
E.
C.
$3,000,000
$5,000,000
$4,000,000
$2,000,000
$2,750,000
1.43
12.5
6.00
2.00
1.61
F.
G.
H.
7.50
5.00
2.22
If the firm sells 250,000 bottles at a price of $20.00, what is the firm's
degree of financial leverage?
A.
B.
C.
D.
E.
8.33
1.06
6.58
9.87
20.0
F.
G.
H.
6.58
1.43
5.55
24 points (4 points per section)
13.
Adams Corporation's present capital structure, which is also its target capital structure, is
25 percent debt and 75 percent common equity. Next year's net income is projected to be
$2,0000,000, Adams' dividend payout ratio is 40 percent. The company's earnings and
dividends are growing at a constant rate of 5 percent. The last dividend (Do) was $7.00
per share; and the current equilibrium stock price is $60.00. Adams can raise up to
$250,000 of debt at a 12 percent before-tax cost. Debt above $250,000 but below
$500,000 will have a before tax cost of 15 percent. Debt above $500,000 will cost 18
percent. If Adams issues new common stock, a 20 percent floatation cost will be
incurred. The firm's marginal tax rate is 40 percent.
A.
What is the firm's cost of retained earnings?
A.
B.
C.
D.
E.
B.
20.67 percent
17.83 percent
15.50 percent
19.58 percent
29.29 percent
22.50 percent
17.25 percent
26.00 percent
F.
G.
H.
24.83 percent
23.38 percent
20.31 percent
What is the firm's retained earnings breakpoint?
A.
B.
C.
D.
E.
D.
F.
G.
H.
What is the firm's cost of raising new common equity?
A.
B.
C.
D.
E.
C.
19.00 percent
16.67 percent
19.70 percent
18.00 percent
17.25 percent
$1,600,000
$3,000,000
$1,000,000
$2,800,000
$2,200,000
F.
G.
H.
What are the debt breakpoints?
A.
B.
C.
D.
E.
F.
G.
H.
$1,000,000
$1,800,000
$1,250,000
$1,250,000
$1,000,000
$1,800,000
$1,250,000
$1,000,000
and
and
and
and
and
and
and
and
$2,500,000
$3,200,000
$2,000,000
$3,000,000
$2,000,000
$3,000,000
$2,500,000
$3,000,000
$1,500,000
$1,800,000
$3,500,000
E.
What is the firm's marginal cost of capital (MCC) schedule?
A.
B.
C.
D.
E.
F.
G.
H.
F.
16.6%,
14.7%,
14.7%,
14.7%,
14.7%,
16.6%,
16.6%,
16.6%,
17.0%,
15.2%,
15.2%,
17.0%,
15.7%,
17.8%,
17.0%,
17.0%,
19.8%
17.5%
19.8%
22.6%
17.5%
20.5%
19.8%
19.0%
and
and
and
and
and
and
and
and
20.2%
17.9%
22.7%
23.0%
17.9%
21.2%
20.5%
20.2%
What will Adam’s optimal capital budget be if the firm can invest an indefinite
amount at an expected rate of return of 17.0 percent?
A.
B.
C.
D.
E.
$1,250,000
$1,600,000
$2,500,000
$1,500,000
$1,000,000
F.
G.
H.
$3,200,000
$2,800,000
$2,000,000
14.
16 points (4 per section)
Four recent liberal arts graduates have interested a group of venture capitalists in
backing a new enterprise. The proposed operation would consist of a series of
retail outlets to distribute and service a full line of vacuum cleaners and
accessories. These stores would be located in Houston, Dallas and San Antonio.
Two financing plans have been proposed by the graduates. Plan A is an allcommon equity structure. Five million dollars would be raised by selling
100,000 shares of common stock. Plan B would involve the use of long-term
debt financing. Three million dollars would be raised marketing bonds with an
effective interest rate of 10 percent. Under this alternative, another two million
dollars would be raised by selling 50,000 shares of common stock. With both
plans, then $5 million is needed to launch the new firm’s operations. The debt
funds raised under Plan B are thought to be part of the firm’s permanent capital
structure. Assume a 40 percent marginal tax rate for the analysis.
A.
Find the EBIT indifference level between the two proposals.
A.
B.
C.
D.
E.
$
$
$
$
$
B.
A.
B.
C.
D.
E.
What is the EPS at this indifference level of EBIT?
$6.00
F.
$1.50
$4.50
G.
$3.60
$5.40
H.
$2.40
$2.48
$3.00
C.
The average annual EBIT has been estimated at $750,000; what is the
expected EPS of each plan at this level of EBIT?
Plan A
Plan B
A.
$ 3.60
$ 4.50
B.
$ 4.50
$ 5.40
C.
$ 4.50
$ 5.50
D.
$ 4.50
$ 6.60
E.
$ 3.60
$ 8.40
F.
$ 3.60
$ 6.60
G.
$ 2.40
$ 4.50
H.
$ 2.40
$ 6.60
D.
Which plan should be selected if the expected annual EBIT is $750,000?
A.
B.
500,000
800,000
600,000
400,000
900,000
Plan A
Plan B
F.
G.
H.
$2,000,000
$1,000,000
$1,500,000
12 points (4 points for each section)
15.
Aberwald Heating, Inc. has a six-month backlog of orders for its patented solar
heating system. Management plans to expand production capacity by 50 percent,
with an $1,000,000 investment in plant machinery, to meet this demand. The firm
wants to maintain a 60 percent debt-to-asset ratio in its capital structure; it also
wants to maintain its past dividend policy of distributing 30 percent of last year's
after-tax earnings. In 1996, after-tax earnings were $500,000.
A.
If the firm has 1,000,000 shares outstanding, what will be the firm's
dividends per share (DPS) if it continues the current policy?
A.
B.
C.
D.
E.
B.
F.
G.
H.
$ 0.40
$ 1.60
$ 0.24
What would the dividend per share be if the firm employs the residual
theory of dividends? Assume 1 million shares outstanding.
A.
B.
C.
D.
E.
C.
$ 0.60
$ 0.32
$ 0.15
$ 0.48
$ 0.10
$ 0.30
$ 0.20
$ 0.40
$ 0.25
$ 0.15
F.
G.
H.
$ 0.00
$ 0.10
$ 0.60
If Aberwald is to meet both capital funding and dividend requirements,
how much external funding will be required?
A.
B.
C.
D.
E.
$ 80,000
$ 240,000
$ 480,000
$ 100,000
$ 40,000
F.
G.
H.
$ 50,000
$ 120,000
$ 0
FORMULAS
Kre = Rf + B(Rm - Rf) = (D0 (1 + g)/P0) + g
EPS = (EBIT-I)(1-TR)
shares
Kne = (D0 (1 + g)/(P0(1 - F)) + g
DOL =
Ka = wdkd(1-tr) + wpkp + weke
DTL = DOL x DFL
Q(P - VC)
Q(P – VC) - FC
DFL = EBIT
EBIT - I
DPS = EPS x payout ratio
BPre = Retained Earnings / % of capital structure which is equity
BPd = “Up to” / % of capital structure which is debt
1.
____ 3 pts
11. . ____ 6 pts
2.
____ 3 pts
12. A. ____ 3 pts
B. ____ 4 pts
3.
____ 3 pts
B. ____ 3 pts
C. ____ 4 pts
4.
____ 3 pts
C. ____ 3 pts
D. ____ 4 pts
5.
____ 3 pts
D. ____ 3 pts
15. A. ____ 4 pts
6.
____ 3 pts
13. A. ____ 4 pts
B. ____ 4 pts
7.
____ 3 pts
B. ____ 4 pts
C, ____ 4 pts
8.
____ 3 pts
C. ____ 4 pts
9.
____ 3 pts
D. ____ 4 pts
10.
____ 3 pts
E. ____ 4 pts
F. ____ 4 pts
14. A. ____ 4 pts