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16 x11 FinMan D Risk & Leverage
16 x11 FinMan 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
THEORIES: income (NOI or EBIT) of each firm. Paranaque Corporation would have less business risk
Risk if its operating income is at least twice that of Alabang Company.
Business risk
Financial risk 9. Which of the following is incorrect regarding operating leverage?
12. Financial risk refers to the: A. Operating leverage is the degree to which costs are fixed.
A. risk of owning equity securities B. A project's break-even point will be affected by the extent to which costs can be reduced
B. risk faced by equity holders when debt is used as sales decline.
C. general business risk of the firm C. If the project has mostly variable costs, it is said to have high operating leverage.
D. possibility that interest rates will increase D. High operating leverage implies that profits are more sensitive to changes in sales.
Market risk 11. The extent to which fixed costs are used in a firms operations is called its:
Comprehensive A. financial leverage. C. financial leverage.
5. A decrease in the debt ratio will least likely affect: B. operating leverage. D. foreign risk exposure.
A. Financial risk C. Systematic or market risk
B. Business risk D. Total risk Financial Leverage
4. It refers to management strategy of financing assets with borrowed capital; such an extensive
14. Which of the following situations is likely to have the highest combined business and financial use raise the entity risk thereby impacting on the return on common stockholders equity to be
risk impact upon a business? above or below the rate of return on total assets.
A. A new labor-intensive operation is funded with operating cash flows A. Factoring C. Mortgage.
B. A fully automated plant is completed, funded with retained earnings B. Leverage. D. Restructuring
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 1. The use of financial leverage by the firm has a potential impact on which of the following?
resumed in a labor-intensive plant in Central Luzon (1) The risk associated with the firm
(2) The return experienced by the shareholder
Operating Leverage (3) The variability of net income
2. Which of the following is a key determinant of operating leverage? (4) The degree of operating leverage
A. Level of debt C. Technology (5) The degree of financial leverage
B. Cost of debt D. Capital structure A. 1, 3, 5 C. 1, 2, 3, 5
B. 2, 3, 4, 5 D. 1, 2, 5
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 16. The degree of financial leverage for April Company is 3.0, and the degree of financial leverage
considered to have greater business risk? for August Corporation is 6.2. According to this information, which firm is considered to have
A. Alabang Company. greater overall (total) risk?
B. Paranaque Corporation. A. April Company.
C. The degree of operating leverage is not a measure of business risk, so it is not possible to B. August Corporation.
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Financial Management
(D. Risk & Leverage)
C. The degree of financial leverage is a measure of financial risk, so the only conclusion that 8. Although debt financing is usually the cheapest component of capital, it cannot be used to
can be made with the information given is that August Corporation has greater financial excess because
risk than April Company -- we cannot tell which firm has greater total risk. A. the interest rates may change.
D. To determine which firm has the greater total risk, we need to know the financial B. the firm's stock price will increase and raise the cost of equity financing.
breakeven point of each firm. C. the financial risk of the firm may increase and thus drive up the cost of all sources of
financing.
Weighted average Cost of capital D. none of the above.
6. Which of the following changes would tend to decrease the company cost of capital for a
traditional firm? PROBLEMS:
A. Decrease the proportion of equity financing. Capital structure
1
B. Increase the market value of the debt. . If the pro forma balance sheet shows that total assets must increase by P400,000 while
C. Decrease the proportion of debt financing. retaining a debt-equity ratio of .75 then:
D. Decrease the market value of the equity. A. debt must increase by P300,000.
B. equity must increase by the full P400,000.
15. The most commonly held view of capital structure is that the weighted average cost of capital: C. debt must increase by P171,428.
A. falls first with moderate levels of leverage and then increases. D. equity must increase by P100,000.
B. does not change with leverage.
C. increases proportionately with increases in leverage. Optimal capital budget
2
D. increases with moderate amounts of leverage and then falls. . 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
Target capital structure will be paid out as dividends. How large can the firm's capital budget be this year without it
10. The mix of debt, preferred stock, and common equity with which the firm plans to raise capital having to include the cost of new common stock in its cost of capital analysis?
is called the: A. P100.0 million C. P 50.0 million
A. financial risk C. business risk B. P 67.5 million D. P 32.5 million
B. operating leverage D. target capital structure
Dividend per share
3
Optimal capital structure . The Salvage Company projects the following for the upcoming year:
13. The mix of debt and equity that minimizes the cost of capital is the: Earnings before interest and taxes P40 million
A. optimal operating leverage C. optimal degree of combined leverage Interest expense P 5 million
B. target financial structure D. optimal capital structure Preferred stock dividends P 4 million
Common stock dividend payout ratio 20%
7. When establishing their optimal capital structure, firms should strive to: Average number of common shares outstanding 2 million
A. minimize the weighted average cost of capital Effective corporate income tax rate 40%
B. minimize the amount of debt financing used The expected dividend per share of common stock is
C. maximize the marginal cost of capital A. P1.70 C. P2.10
D. none of the above B. P1.86 D. P1.00
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Financial Management
(D. Risk & Leverage)
188
Financial Management
(D. Risk & Leverage)
189
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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1
. Answer: C
Debt ratio: 0.75 (1 + 0.75) 0.42857
Equity ratio: (1.00 0.42857) 0.57143
Increase in Equity: 0.57143 x 400,000 228,572
Increase in debt: 0.42857 x 400,000 171,428
2
. 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
3
. Answer: A
EBIT P 40 M
Interest 5M
Before tax P 35 M
Income tax 14 M
Net income 21 M
Preferred dividend 4M
Available to common P 17 M
Per common share: 17M x 0.20 2M shares = P1.70
4
. 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.
5
. Answer: B
Capital structure:
Debt: 1.5 (1 + 1.5) 60.0%
Equity: 100% - 60% 40.0%
WCCD (0.6 x 11%) 6.6%
WCCE (0.4 x 17%) 6.8%
Weighted average cost of capital 13.4%
6
. 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.
7
. Answer: A
Expected earnings 30.0 million
Deduct dividends (30M x 0.4) 12.0 million
Increase in retained earnings 18.0 million
Breakpoint: 18.0M 0.4 45.0 million
8
. 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.
9
. Answer: C
Increase in Earnings after tax: (1,750,000 1,250,000) 500,000
Percentage increase: (500,000 1,250,000) 40 percent
New EPS: 12.50 + (12.50 x 0.40) 17.50%
10
. Answer: A
Return on Assets = Asset turnover x Return on Sales
= .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%
11
. Answer: A
Net income 7,500,000
Financing required from equity 6M x 0.6 3,600,000
Residual earnings for dividends 3,900,000
Payout ratio: 3,900,000/7,500,000 52%
12
. 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
13
. Answer: A
EPS = Net income No. of common shares outstanding:
1,728,000 (1,200,000 + 500,000) = P1.02
14
. Answer: C
Initial market price = P/E ratio x EPS = (10 x 1.02) = P10.20
15
. Answer: B
Gross proceeds (500,000 x 10.20) 5,100,000
Less:
Spread (7%) 357,000
Out-of-pocket expenses 150,000 507,000
Net proceeds to the corporation 4,593,000
16
. Answer: C
EPS before initial offering: (1,728,000 1,200,000) 1.44
Required earnings: (1,700,000 x 1.44) 2,448,000
Earnings prior to initial offering 1,728,000
Earnings required on additional funds 720,000
Required percentage returns on net proceeds of
new offering (720,000 4,593,000) 15.68%
17
. Answer: B
EPS immediately after initial offering: (1,728,000 1,450,000) P1.19
Market price: (10 x 1.19) P11.90
18
. Answer: B
Required earnings: (1,450,000 x 1.44) 2,088,000
Less Prior earnings 1,728,000
Required earnings on new issues 360,000
Gross proceeds (250,000 x 11.90) 2,975,000
Less:
Spread (7%) 208,250
Out-of-pocket costs 150,000 358,250
Net proceeds 2,616,75
Required percentage returns on net proceeds from
new public offering (360,000 2,616,750) 13.76%