Financial Management (D. Risk & Leverage)
D. RISK AND LEVERAGE
tell which firm has the greater business risk given the above information. D. To determine which firm has the greater business risk, we need to know the operating income (NOI or EBIT) of each firm. Paranaque Corporation would have less business risk if its operating income is at least twice that of Alabang Company.
THEORIES: Risk Business risk Financial risk 12. Financial risk refers to the: A. risk of owning equity securities B. risk faced by equity holders when debt is used C. general business risk of the firm D. possibility that interest rates will increase
9. Which of the following is incorrect regarding operating leverage? A. Operating leverage is the degree to which costs are fixed. B. A project's break-even point will be affected by the extent to which costs can be reduced as sales decline. C. If the project has mostly variable costs, it is said to have high operating leverage. D. High operating leverage implies that profits are more sensitive to changes in sales.
Market risk Comprehensive 5. A decrease in the debt ratio will least likely affect: A. Financial risk C. Systematic or market risk B. Business risk D. Total risk
11. The extent to which fixed costs are used in a firm’s operations is called its: A. financial leverage. C. financial leverage. B. operating leverage. D. foreign risk exposure. Financial Leverage 4. It refers to management strategy of financing assets with borrowed capital; such an extensive use raise the entity risk thereby impacting on the return on common stockholders’ equity to be above or below the rate of return on total assets. A. Factoring C. Mortgage. B. Leverage. D. Restructuring
14. Which of the following situations is likely to have the highest combined business and financial risk impact upon a business? A. A new labor-intensive operation is funded with operating cash flows B. A fully automated plant is completed, funded with retained earnings C. A fully automated plant is completed, funded with the issuance of 10-year bonds D. An automated, but dated plant in the southern region is closed and operations are resumed in a labor-intensive plant in Central Luzon
1. The use of financial leverage by the firm has a potential impact on which of the following? (1) The risk associated with the firm (2) The return experienced by the shareholder (3) The variability of net income (4) The degree of operating leverage (5) The degree of financial leverage A. 1, 3, 5 C. 1, 2, 3, 5 B. 2, 3, 4, 5 D. 1, 2, 5
Operating Leverage 2. Which of the following is a key determinant of operating leverage? A. Level of debt C. Technology B. Cost of debt D. Capital structure 3. The degree of operating leverage for Alabang Company is 3.5, and the degree of operating leverage for Paranaque Corporation is 7.0. According to this information, which firm is considered to have greater business risk? A. Alabang Company. B. Paranaque Corporation. C. The degree of operating leverage is not a measure of business risk, so it is not possible to
16. The degree of financial leverage for April Company is 3.0, and the degree of financial leverage for August Corporation is 6.2. According to this information, which firm is considered to have greater overall (total) risk? A. April Company. B. August Corporation. 186
Financial Management (D. Risk & Leverage)
C. The degree of financial leverage is a measure of financial risk, so the only conclusion that can be made with the information given is that August Corporation has greater financial risk than April Company -- we cannot tell which firm has greater total risk. D. To determine which firm has the greater total risk, we need to know the financial breakeven point of each firm.
8. Although debt financing is usually the cheapest component of capital, it cannot be used to excess because A. the interest rates may change. B. the firm's stock price will increase and raise the cost of equity financing. C. the financial risk of the firm may increase and thus drive up the cost of all sources of financing. D. none of the above.
Weighted average Cost of capital 6. Which of the following changes would tend to decrease the company cost of capital for a traditional firm? A. Decrease the proportion of equity financing. B. Increase the market value of the debt. C. Decrease the proportion of debt financing. D. Decrease the market value of the equity.
PROBLEMS: Capital structure i . If the pro forma balance sheet shows that total assets must increase by P400,000 while retaining a debt-equity ratio of .75 then: A. debt must increase by P300,000. B. equity must increase by the full P400,000. C. debt must increase by P171,428. D. equity must increase by P100,000.
15. The most commonly held view of capital structure is that the weighted average cost of capital: A. falls first with moderate levels of leverage and then increases. B. does not change with leverage. C. increases proportionately with increases in leverage. D. increases with moderate amounts of leverage and then falls.
Optimal capital budget ii . Absolute Corporation has a capital structure that consists of 65% equity and 35% debt. The company expects to report P100 million in net income this year, and 67.5% of the net income will be paid out as dividends. How large can the firm's capital budget be this year without it having to include the cost of new common stock in its cost of capital analysis? A. P100.0 million C. P 50.0 million B. P 67.5 million D. P 32.5 million
Target capital structure 10. The mix of debt, preferred stock, and common equity with which the firm plans to raise capital is called the: A. financial risk C. business risk B. operating leverage D. target capital structure
Dividend per share iii . The Salvage Company projects the following for the upcoming year: Earnings before interest and taxes Interest expense Preferred stock dividends Common stock dividend payout ratio Average number of common shares outstanding Effective corporate income tax rate The expected dividend per share of common stock is A. P1.70 C. P2.10 B. P1.86 D. P1.00
Optimal capital structure 13. The mix of debt and equity that minimizes the cost of capital is the: A. optimal operating leverage C. optimal degree of combined leverage B. target financial structure D. optimal capital structure 7. When establishing their optimal capital structure, firms should strive to: A. minimize the weighted average cost of capital B. minimize the amount of debt financing used C. maximize the marginal cost of capital D. none of the above
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P40 million P 5 million P 4 million 20% 2 million 40%
Financial Management (D. Risk & Leverage)
Required cash flow before tax iv . How much will a firm need in cash flow before tax and interest to satisfy debt holders and equity holders if the tax rate is 40%, there is P10 million in common stock requiring a 12% return, and P6 million in bonds requiring an 8% return? A. P1,392,000 C. P2,480,000 B. P1,488,000 D. P2,800,000
Sensitivity analysis ix . A firm is expected to generate P1.5 million in operating income and pay P250,000 in interest. Ignoring taxes, this will generate P12.50 earnings per share. What will happen to EPS if operating income increases to P2.0 million? A. EPS increase to P15.63. C. EPS increase to P17.50. B. EPS increase to P16.67. D. EPS increase to P20.00.
Weighted average cost of capital v . The Dumaguete Co. has an equity cost of capital of 17%. The debt to equity ratio is 1.5 and a cost of debt is 11%. What is the weighted average cost of capital of the firm? (Assume a tax rate of 33%) A. 3.06% C. 16.97% B. 13.40% D. 15.52%
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Retained earnings breakpoint vi . During the past five years, Pena Company had consistently paid 50% of earnings available to common as dividends. Next year, the Pena Company projects its net income, before the P1.2 million preferred dividends, at P6 million. The capital structure for the company is maintained at: Debt 25.5% Preferred stock 15.0% Common equity 60.0% What is the retained earnings break-point next year? A. P5,760,000 C. P4,000,000 B. P4,800,000 D. P6,000,000 vii
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The board of directors of Aggressive Company was unhappy with the current return on common equity. Though the return on sales (profit margin) was impressively good at 12.5 percent, the asset turnover was only 0.75. The present debt ratio is 0.40. Ms. Sylvia Moreno, the vice-president of corporate planning, presented a proposal as follows: Profit margin should be raised to 15 percent. The new capital structure will be revised by raising debt component. The asset turnover will be maintained at 0.75. The proposed adjustment is estimated to raise return on equity by 50 percent. What debt ratio did Ms. Moreno propose in order to raise the return on equity (ROE) to 150 percent of the present level? A. 0.52 C. 0.61 B. 0.68 D. 0.72
Residual dividend policy xi . Alvin Company expects next year’s after-tax income to be P7,500,000. The firm’s debt ratio is currently 40 percent. Alvin Company has P6,000,000 of profitable investment opportunities, and it wishes to maintain its existing debt ratio. According to the residual dividend policy, what is the expected dividend payout ratio next year? A. 52.0 percent C. 48.0 percent B. 75.0 percent D. 25.0 percent
. Balon Company expects P30 million in earnings next year. Its dividend payout ratio is 40 percent, and its equity to asset ratio is 40 percent. Balon Company uses no preferred stock. At what amount of financing will there be a break point in Balon’s cost of capital? A. P45 million C. P30 million B. P20 million D. P18 million
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Degree of Financial Leverage viii . Calculate the DFL for a firm with EBIT of P6,000,000, fixed cost of P3,000,000, interest expense of P1,000,000, preferred stock dividends of 800,000, and a 40 percent tax rate. A. 6.0 C. 1.43 B. 9.0 D. 1.64 188
. Ellis Company expects to generate P10 million internally which could be available for financing part of its P12 million capital budget for this coming year. Ellis’ management believes that a debt-equity ratio of 40 percent is best for the firm. How much should be paid in dividends if the target debt-equity ratio is to be maintained? A. P2,800,000 C. P1,428,571 B. P8,571,429 D. P4,000,000
Financial Management (D. Risk & Leverage)
Total liabilities Common stock (1,200,000 shares at P1 par) Capital in excess of par Retained earnings Total stockholders' equity Total liabilities and stockholders' equity
Comprehensive Use the following information to answer Question Nos. 13 through 18: The Reliable Corporation, a manufacturer of radar control equipment, is planning to sell its shares to the general public for the first time. The firm's investment banker is working with the Reliable Corporation in determining a number of items. Information on the Reliable Corporation follows: Reliable Corporation Income Statement For the Year 2007 Sales (all on credit) P22,428,000 Cost of goods sold 16,228,000 Gross profit 6,200,000 Selling and administrative expenses 2,659,400 Operating profit 3,540,600 Interest expense 370,600 Net income before taxes 3,170,000 Taxes 1,442,000 Net income P 1,728,000
The new public offering will be at 10 times the earnings per share. xiii
Liabilities and Stockholders' Equity Accounts payable Notes payable Total current liabilities Long-term liabilities
. Assume that 500,000 new corporate shares will be issued to the general public. What will earnings per share immediately after the public offering be? A. P1.02 C. P1.19 B. P1.44 D. P1.59
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Balance Sheet As of December 31, 2007 Assets Cash Marketable securities Accounts receivable Inventory Total current assets Net plant and equipment Total assets
P 4,580,000 P 1,200,000 2,800,000 4,220,000 8,220,000 P12,800,000
P
150,000 100,000 2,000,000 3,800,000 P 6,050,000 6,750,000 P12,800,000
. Based on the price-earnings ratio of 10, what will the initial price of the stock be? A. P14.40 C. P10.20 B. P11.90 D. P15.90
. Assuming an underwriting spread of 7 percent and out-of-pocket costs of P150,000, what will net proceeds to the corporation be? A. P4,743,000 C. P4,950,000 B. P4,593,000 D. P5,307,000
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. What return must the corporation earn on the net proceeds to equal the earnings per share before the offering? A. 16.18% C. 15.68% B. 16.58% D. 15.98%
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P 1,000,000 1,200,000 2,200,000 2,380,000
. Assume that, of the initial 500,000-share distribution, 250,000 shares belong to current stockholders and 250,000 are new corporate shares, and these will be added to the 1,200,000 corporate shares currently outstanding. What will the initial market price of the stock be? Assume a price-earnings ratio of 10 and use earnings per share after the distribution in the calculation. A. P10.90 C. P10.20 B. P11.90 D. P12.15
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. Assuming an underwriter spread of 7 percent and out-of-pocket costs of P150,000, what
Financial Management (D. Risk & Leverage)
return must the corporation earn on the net proceeds to equal earnings per share before the offering? A. 13.50% C. 15.68% B. 13.76% D. 14.57%
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Answer: C Debt ratio: Equity ratio: Increase in Equity: Increase in debt:
0.75 ÷ (1 + 0.75) (1.00 – 0.42857) 0.57143 x 400,000 0.42857 x 400,000
0.42857 0.57143 228,572 171,428
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. Answer: C First, calculate the addition to retained earnings as the total net income minus dividends. Second, calculate the retained earnings breakpoint by dividing the addition to retained earnings by the equity fraction of the capital structure. Net income 100.0M Deduct dividends (0.675 x 100M) 67.5M Increase in retained earnings 32.5M Capital budget supported by retained earnings 32.5M ÷ 0.65 50.0M
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P 40 M 5M P 35 M 14 M 21 M 4M P 17 M P1.70
Answer: C Interest (6M x 0.08) P 480,000 Before-tax dividends (10M x 0.12 ÷ 0.6) 2,000,000 Total cash flow requirements to cover dividends and interest P2,480,000 The computation of cash flow required by the interest payments ignored because they are deductible in the computation of taxes. The dividends are calculated on a before-tax basis because it is a residual amount.
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Answer: B Capital structure: Debt: 1.5 ÷ (1 + 1.5) Equity: 100% - 60% WCCD (0.6 x 11%) WCCE (0.4 x 17%) Weighted average cost of capital
60.0% 40.0% 6.6% 6.8% 13.4%
Answer: C Available earnings to Common 6M – 1.2M 4.8 M Retained income 4.8M x .5 2.4 M Retained earnings Breakpoint 2.4 M ÷ 0.6 P4,000,000 Retained earnings breakpoint refers to the maximum amount of funds or financing required whereby there is no need to issue common shares.
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Answer: A EBIT Interest Before tax Income tax Net income Preferred dividend Available to common Per common share: 17M x 0.20 ÷ 2M shares =
Answer: A Expected earnings Deduct dividends (30M x 0.4) Increase in retained earnings Breakpoint: 18.0M ÷ 0.4
30.0 million 12.0 million 18.0 million 45.0 million
Answer: D Earnings before interest P6,000,000 Interest 1,000,000 Preferred Dividends (800,000/0.6) 1,333,333 2,333,333 Earnings after preferred dividends (before taxes) P3,666,667 DFL (6M ÷ 3,666,667) 1.64 For every 10 percent change in EBIT, EPS changes by 16.4 percent (10% x 1.64). Adding financial leverage to operating leverage increases the total risk of a company.
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Answer: C Increase in Earnings after tax: Percentage increase: New EPS:
(1,750,000 – 1,250,000) (500,000 1,250,000) 12.50 + (12.50 x 0.40)
Answer: A Return on Assets = Asset turnover x Return on Sales
500,000 40 percent 17.50%
= .125 x .75 = .09375 or 9.375 Current Return on equity = 9.375 ÷ .60 = .15625 or 15.625% Target ROE = 15,625 x 1.50 = 23.4375% Let X = Debt Ratio .234375 = (.15 x.75) 1-X X = 52% xi
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Answer: A Net income Financing required from equity 6M x 0.6 Residual earnings for dividends Payout ratio: 3,900,000/7,500,000
7,500,000 3,600,000 3,900,000 52%
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Answer: C The Debt to Equity Ratio is 0.4 to 1 RE + 0.40RE = P12,000,000 RE = P12,000,000 ÷ 1.40 RE = P 8,571,429 Available Retained Earnings for Dividends: (P10,000,000 – P8,571,429) = P1,428,571
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Answer: A EPS = Net income ÷ No. of common shares outstanding: 1,728,000 ÷ (1,200,000 + 500,000) = P1.02
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Answer: C Initial market price = P/E ratio x EPS = (10 x 1.02) = P10.20
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Answer: B Gross proceeds (500,000 x 10.20) Less: Spread (7%) Out-of-pocket expenses Net proceeds to the corporation
5,100,000 357,000 150,000
Answer: C EPS before initial offering: (1,728,000 ÷ 1,200,000) Required earnings: (1,700,000 x 1.44) Earnings prior to initial offering Earnings required on additional funds Required percentage returns on net proceeds of new offering (720,000 ÷ 4,593,000) Answer: B EPS immediately after initial offering: Market price:
(1,728,000 ÷ 1,450,000) (10 x 1.19)
Answer: B Required earnings: (1,450,000 x 1.44) Less Prior earnings Required earnings on new issues Gross proceeds (250,000 x 11.90) Less: Spread (7%) Out-of-pocket costs Net proceeds Required percentage returns on net proceeds from new public offering (360,000 ÷ 2,616,750)
507,000 4,593,000 1.44 2,448,000 1,728,000 720,000 15.68% P1.19 P11.90 2,088,000 1,728,000 360,000 2,975,000
208,250 150,000
358,250 2,616,75 13.76%
