ALDERSGATE COLLEGE

FINANCIAL MANAGEMENT 2
SCHOOL OF BUSINESS AND ACCOUNTANCY
MODULE 1 LONG-TERM FINANCING DECISIONS

POSTTEST

I. Questions

1. What does risk taking have to do with the use of operating and finance leverage?

Both operating and financial leverage imply that the firm will employ a heavy component
of fixed cost resources. This is inherently risky because the obligation to make payments
remains regardless of the condition of the company or the economy.

2. Discuss the limitations of financial leverage.

Debt can only be used up to a point. Beyond that, financial leverage tends to increase
the overall costs of financing to the firm as well as encourage creditors to place
restrictions on the firm. The limitations of using financial leverage tend to be greatest in
industries that are highly cyclical in nature.

3. Explain how combined leverage brings together operating income and earnings per
share.

Operating leverage primarily affects the operating income of the firm. At this point,
financial leverage takes over and determines the overall impact on earnings per share.

4. Explain why operating leverage decreases as a company increases sales and shifts
away from the breakeven point.

At progressively higher levels of operations than the break-even point, the percentage
change in operating income as a result of a percentage change in unit volume
diminishes. The reason is primarily mathematical — as we move to increasingly higher
levels of operating income, the percentage change from the higher base is likely to be
less.

5. When you are considering two different financing plans, does being at the level where
earnings per share are equal between two plans always mean you are indifferent as to
which plan is selected?

The point of equality only measures indifference based on earnings per share. Since our
ultimate goal is market value maximization, we must also be concerned with how these
earnings are valued. Two plans that have the same earnings per share may call for

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different price-earnings ratios, particularly when there is a differential risk component
involved because of debt.

6. If a corporation has projects that will earn more than the cost of capital, should it ration
capital?

From a purely economic viewpoint, a firm should not ration capital. The firm should be able
to find additional funds and increase its overall profitability and wealth through accepting
investments to the point where marginal return equals marginal cost

II. Multiple Choice Questions

D 1. Which of the following is a characteristic of leveraged buyouts?

a. Buyouts are usually financed by debt.

b. Some corporate assets are often sold after the buy-out is completed.
c. Funds for the buy-out are raised through securities markets.
d. All the above are characteristics.

D 2. Firm E needs to net P7, 800,000 from the sale of ordinary shares. Its investment banker
has informed the firm that the retail price will be P22 per share, and that the firm will
receive P19 per share. Out-of- pocket costs are PI00, 000. How many shares must be
sold?

a. 410,526
b. 354,545
c. 359,091
d. 415,790

B 3. Boulder has net income of P2, 500,000 and 1,000,000 shares outstanding. Its ordinary
share is currently selling for P40 per share. It needs to raise P3, 610,000 in funds for a
new asset. Its investment banker plans to sell an issue of ordinary shares to the public
for P38 for a spread of 5%. How much must Boulder’s aftertax income increase to
prevent dilution of EPS?

a. P40.000
b. P23 7,500
c. P250,000
d. None of the above

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FINANCIAL MANAGEMENT 2
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A 4. Rainbow is about to go public. Its present stockholders own 500,000 shares. The new
public issue will represent 800,000 shares. The shares will be priced at P25 to the public
with a 4% spread. The out- ofpocket costs will be P450, 000. What are the net proceeds
to the firm?
a. P 18,750,000
b. P 19,200,000
c. P 18,250,000
d. P 19,550,000

A 5. Doors Corporation is considering a public offering of ordinary shares. The firm will offer
one million ordinary shares for sale. The estimated selling price is P30 per share with
Doors Corporation receiving P26.25 per share after the offering. Registration fees are
estimated at P275, 000.

If Doors Corporation needs to generate P28 million, how many shares will

have to be sold? a. 1,077,143 shares

b. 1,066,667 shares
c. 933,333 shares
d. 942,500 shares

C 6. The Davao Corp. needs to raise money for an addition to its plant. It will issue 300,000
new ordinary shares. The new shares will be priced at P60 per share with an 8.5%
spread on the offer price. Registration costs will be P 150,000. Presently Davao Corp.
has earnings of P3 million and 750,000 shares outstanding.

The net proceeds to Davao Corp. will be

a. P 16,470,000.
b. P 18,000,000.
c. P 16,320,000.
d. P 16,620,000.

B 7. Dory Company currently has net income of P3 million and 1.5 million ordinary shares
outstanding which sell for P20/share. Dory has decided to issue new stock to raise P4,
000,000 to expand its operations. Door’s investment banker will sell the stock for PI8
with a spread of 7%. There will be a P60, 000 registration cost.

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What will be the new EPS immediately after the sale if the PE ratio

remains constant? a. P 1.50

b. P 1.722
c. P 1.738
d. P 1.815

B 8. Happy Corp. is refunding P8 million worth of 13% debt. The new bonds will be issued for
8%. The corporation’s tax rate is 35%. The call premium is 9%. What is the net cost of
the call premium?

a. P260,000
b. P468,000
c. P400,000
d. P720,000

III. Problems

Problem 1

Union Business Forms’ capital structure is as follows:

Debt ……………………………………… 35%

Preference shares ………………………………………
Ordinary equity ………………………………………

The after-tax cost of debt is 7 percent; the cost of preference shares is 10 percent; and the cost
of ordinary equity (in the form of retained earnings) is 13 percent.

Calculate the Union Business Forms’ weighted average cost of

capital.

Cost (after-tax) Weights Weighted Cost

Debt 7% 35% 2.45%
Preference shares 10% 15% 1.50%
Common Equity 13% 50% 6.50%
Weighted Average cost of capital 10.45%

Problem 2

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Given the following information, calculate the weighted average cost of capital for the Holly
Corporation.

Percent of capital structure:

Preference …………………………………… 10%
shares …
Ordinary equity …………………………………… 60%
…
Debt …………………………………… 30%
…
Additional information:
Corporate tax ……………………………………
rate … 34%
Dividend, …………………………………… P9.0
preference … 0
Dividend …………………………………… P3.5
expected, … 0
ordinary

…………………………………… P102.
Price, preference … 00
Growth rate …………………………………… 6%
…
Bond yield …………………………………… 10%
…
…………………………………… P3.2
Flotation cost, preference … 0
Price, ordinary …………………………………… P70.
… 00

Cost (after-tax) Weights Weighted Cost

Debt 6.60% 30% 1.98%
Preference shares 9.11% 10% 0.91%
Common Equity 11.00% 60% 6.60%
Weighted Average cost of capital 9.49%

Problem 3: Optimal Budgeting Decisions

You are determining Union Brick’s optimal capital budget for next year. You have identified the
following possible indivisible, independent, average-risk capital projects:

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Project Cost IRR
A P 100,000 18%
B 80,000 16
C 50,000 15

The firm’s MCC schedule is as follows:

New Capital Marginal Cost

P0 - P200,000 14.2%
Above P200,000 15.4

REQUIRED:

What is the optimal capital budget?

Problem 4

Pizza Express Enterprises has a target capital structure of 50% debt and 50% ordinary equity.
The firm is considering a new independent project which has an IRR of 13% and which is not
related to pizza or pasta. However, a proxy firm has been identified that is exclusively engaged
in the new line of business. The proxy firm has a beta of 1.38. Both firms have a marginal tax
rate of 40%, and Pizza Express’s before-tax cost of debt is 12.0%. The risk-free rate is 10% and
the market risk premium is 5%.

REQUIRED:

Should the firm accept or reject the proposed project? Why?

Accept the proposed project since IRR of 13% is greater than WCC of 12.05%.

Problem 5

Happy Gilmore Co. is trying to calculate its cost of capital for use in a capital budgeting decision.
Mr. Shooter, the vice president of finance, has given you the following information and has
asked you to compute the weighted average cost of capital.

The company currently has outstanding a bond with an 11.2 percent coupon rate and another
bond with a 7.5 percent rate. The firm has been informed by its investment banker that bonds of
equal risk and credit ratings are now selling to yield 12.4 percent.

The ordinary share has a price of P54 and an expected dividend (DO of P2.70 per share. The
firm’s historical growth rate of earnings and dividends per share has been 14.5 percent, but
security analysts expect this growth to slow to 12 percent in future years.

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FINANCIAL MANAGEMENT 2
SCHOOL OF BUSINESS AND ACCOUNTANCY
The preference share is selling at P50 per share and carries a dividend of P4.75 per share. The
corporate tax rate is
35 percent. The flotation cost is 2.8 percent of the selling price for preference share. The
optimum capital structure for the firm seems to be 35 percent debt, 10 percent preference
share, and 55 percent ordinary equity in the form of retained earnings.

REQUIRED:

Compute the cost of capital for the individual components in the capital structure, and then
calculate the weighted average cost of capital.

Problem 6

The Snowbell Company manufactures skates. The company’s income statement for 2009 is as
follows:

SNOWBELL COMPANY
Income Statement
For the Year Ended December 31, 2009

Sales (10,000 skates @ P50 each) ………………………………… P

….. 500,000
Less: Variable costs (10,000 ………………………………… 200,000
skates at P20) …..
Fixed costs ………………………………… 150.000
…..
Earnings before interest and taxes (EBIT)
…………………………………….. P 150,000
Interest expense …………………………………….. 60.000
Earnings before taxes (EBT) …………………………………….. P 90,000
Income tax expense (40%) …………………………………….. 36.000
Earnings after taxes (EAT) …………………………………….. P 54.000

Given this income statement, compute the following:

a. Degree of operating leverage.

DOL = (500,000-200,000) / (500,000-200,000-150,000)
= 300,000 / 150,000
=2
b. Degree of financial leverage.
DFL = 150,000 / (150,000-60,000)
= 150,000 / 90,000

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= 5/3 or 1.67
c. Degree of combined leverage.
DCL = 2 * 5/3 = 10/3 = 3.333

d. Break-even point in units (number of skates).

Variable costs per unit = 20

Contribution margin per unit =30

Break-even point in Units = 150,000 / 30

= 5,000

The break-even point in units is 5,000 skates.

Problem 7

Pilak Company has P12 million in assets. Currently half of these assets are financed with long-
term debt at 10 percent and half with ordinary shares having a par value of P8. Ms. Santos,
vice-president of finance, wishes to analyze two refinancing plans, one with more debt (D) and
one with more equity (E). The company earns a return on assets before interest and taxes of 10
percent. The tax rate is 45 percent.

Under Plan D, a P3 million long-term bond would be sold at an interest rate of 12 percent and
375,000 shares would be purchased in the market at P8 per share and retired.

Under Plan E, 375,000 shares would be sold at P8 per share and the P3, 000,000 in proceeds
would be used to reduce long-term debt.

REQUIRED:

a. How would each of these plans affect earnings per share? Consider the current plan and
the two new plans.

Earnings per share current plan: P0.40

Plan D: P0.32
Plan E: P0.40

b. Which plan would be most favorable if return on assets fell to 5 percent'. Increased to 15
percent? Consider the current plan and the two new plans.

c. If the market price for ordinary shares rose to PI2 before the restructuring which plan
would then be most attractive? Continue to assume that P3 million in debt will be used to

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retire stock in Plan D and P3 million of new equity will be sold to retire debt in Plan E.
Also assume for calculations in part c that return on assets is 10 percent.

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