Practice Questions - Part B.

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1. Ruchi and her group visited a company as a part of their industry visit program at IIM Indore.
The CFO of the company shared the latest balance sheet of the company, as of December 31,
2015, with Ruchi:
Balance Sheet (All figures in INR million) 2015
Net Working Capital 200
Fixed Assets (net) 300
Total Assets 500

Long Term Debt 150
Common Stock 150
Retained Earnings 200
Total Liabilities and Equity 500

The CFO also informed Ruchi that the Long Term Debt of the company is rated as per the
following rating standards:
Rating on Long Term Debt AAA AA A
Maximum Debt-to-Equity Ratio (book) 25.0% 35.0% 50.0%
Default Spread (%) 1.0% 3.0% 5.0%

(i) What is the current rating on the Long Term Debt of the company? What is the unused
debt capacity of the company at the current rating? (A rating; INR 25 million)

(ii) Assume that the risk-free rate is 10%, unlevered beta of the company is 1.10, equity
risk premium is 6%, marginal tax rate is 30%, and market-to-book ratio of equity is
1.01. What is the current Weighted Average Cost of Capital (WACC) of the company?
(16.2%)

The CFO has also shared its pro-forma income statement for 2016, which is as follows:
Income Statement (All figures in INR million) 2016
Sales 750
Net Income 150
Dividends 0

(iii) During 2016, the company will neither issue new debt, nor repay any principal amount
from its existing long term debt. What will be the new rating on the Long Term Debt
of the company at the end of 2016? What will be the unused debt capacity of the
company under the new rating, at the end of 2016? (AA rating; INR 25 million)

(iv) Assuming that all the assumptions mentioned in (ii) earlier still holds, what will be the
post-tax cost of debt of the company, at the end of 2016? (9.1%)

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The market-to-book ratio of equity is 1.0, when book value of equity is equal to the market value of equity.

The company currently has 100 million shares outstanding. immediately after the announcement of the recapitalization and buyback program? Assume that market is efficient. whether the statements are TRUE. share buybacks would increase the share price and reduce the number of shares outstanding of the company. and the firm will be able to implement the recapitalization program. and use the cash to buy back its own securities from the market. (T) (iv) Stock repurchases are an alternate way of distributing earnings to shareholders. and the dividend is received by the seller. (T) (v) On the ex-dividend date. (T) (vi) There is no benefit of a share split for the shareholders of the company. the stock price reduces by the amount of the dividend. and is considering an INR 1 billion recapitalization program. and the INR 1 billion debt is a perpetuity.2. (F) ***** .87%) 3. A manufacturing firm is currently unlevered (fully equity financed). (F) (ii) Paying dividends from unused cash balance increases the agency conflicts between the managers and the equity shareholders of a company. (i) What will be Interest Tax Shield on the newly raised debt? Assume that marginal tax rate is 30%. (INR 300 million) (ii) What will be the new share price of the company. (INR 63) (iii) If the promoter of the company currently owns 50% stake in its firm. (F) (iii) Tax-free institutions such as pension funds prefer high dividing paying stocks. which are trading at INR 60 per share (prior to the announcement of the recapitalization program). under which it intends to raise a long-term debt (of perpetual maturity) of INR 1 billion. as it does not affect the share price of the company. or FALSE: (i) Under perfect capital market conditions. Identify. the bankruptcy costs of taking the additional debt is negligible.43%) (iv) What will be the debt-to-equity ratio of the company. what will the promoter stake in the company after the completion of the recapitalization and buyback program? (59. and will not be participating in the buyback offer. after the recapitalization and buyback program? (18.

2 1. (F) (viii) Tax benefit each year = (1-Tax Rate)* Interest Payment. for a given growth rate. short term as well as long term. Its terminal value at the end of two years is Rs 14. (F) (ix) Adjusted Present Value Method takes care of variability in discount rate. (T) (iii) The net capital expenditure needs of a firm. both a bond and a call option.412m if firm’s cost of capital is 10%. the cost of preferred stock to the issuing firm is the same on a before-tax and after-tax basis. Identify. (T) . (T) (xiv) Reducing the volatility of cash flows will always increase the value of a company. (F) (ii) Companies have an advantage in hedging relative to hedging ability of investors because of transaction costs related to barriers to entry in some derivatives markets. (T) (vii) Start-up firms tend to have high debt. (F) (x) Convertibles help reduce agency conflicts associated with asset substitution problem (bait-and-switch) between shareholders and bond holders. should be inversely proportional to the quality of its investments. (T) (vi) Debt includes all interest bearing liabilities. (F) (v) Any increases (decreases) in working capital will reduce (increase) cash flows in that period. (T) (xii) Firms generally do not call their convertibles unless their conversion value is greater than their call price. whether the statements are TRUE. (T) (iv) A firm has a FCFF of Rs 400 m and is expected to grow at the rate of 12% for the next two years. Thereafter it will stabilise at 6%. (F) (xv) Risk management can increase debt capacity. or FALSE: (i) Growth rate = (Net Capex + Change in Working Capital) X (EBIT*(1-t)). in effect. (T) (xiii) Because preferred stock dividends are not tax deductible. Practice Questions – Part B. (T) (xi) The owner of a convertible bond owns.

0.0% 9 Borrowing Rate 8.0% 5 Total Borrowing 70.1.9.9.0). .0% 10 Tax Rate 40.1%.0% 30.1.7.0.7. Dividends: 7. 4. 123. Net: (18.0% 4. Information about a firm is given below: Forecast of Financing Need When The Company Pays 30% Dividend Information Available 2014 2015 2016 2017 1 Annual Sales Growth 12.0 59.0.0 Total Uses 58. 42.0 52.0 3 Net Income Margin 3.0 24.3 8 Maximum Permissible Debt/Equity Ratio 40.9.7).5% 4 Dividend Payout Ratio 30. 18. 974.0 80.6.0 24.7). Excess Cash: (10. 60.0). 38. 12. Total Equity: 251.0 Working Capital 18.9). 320.3.0 Total Sources Uses: Capital Expenditures 40.0. 11. Solution: Sales: 870. (17.9.0% 2 Expected Sales in 2015 870. 1.0. Net Worth) Debt to Equity Ratio Unused Debt Capacity Assume that the Annual Sales Growth in 2016 and 2017 is same as that in 2015 (equal to 12%).0 6 Total Equity Capital 233.0% 30.0 28.0% 5.4. Unused Debt Capacity: 11.3%. 2. Debt: 88.0 Sources: Net Income Depreciation 21. 88. 39.8.0. Net Income: 26.0% Fill in the blank cells below 2015 2016 2017 Sales 870. 117.0 21. Total Sources: 47. 63.5%. (28. 278. (5.0. (6.4.091. D/E Ratio: 35.4.9).0 Excess Cash (Borrowings) Dividends Net Debt or (Excess Equity Funds) Total Equity (ie.0 76.3 7 Shares Outstanding 15.

000. what will be the DPS if the net income realized would be INR 650. The distribution of FCFF for year end 1-3 is as follows: Year 1 Year 2 Year 3 Free Cashflow to Firm. estimate the total amount of debt to be raised to fund these investments? (INR 560. (INR -9. estimate the total amount of debt to be raised? (INR 1. (INR 1. Total present value of the firm. is presently an unlevered firm whose cost of equity is 12%. applicable tax-rate is 40% and the value of all non-operating assets at t=0 is INR 120 million.15%) d. It is contemplating to recapitalize itself so that the resulting Debt: Equity ratio in market value terms would become 30:70 at the end of third year from now and remain as it is forever. If the expected investments to be made is INR 1. -80 20 65 FCFF (INR million) If the risk-free rate is 4. whose interest is payable at the end of the year at a rate of 8% p.70%. Weighted average cost of capital (WACC) at the end of third year.30 when the net income realized is INR 650. Total present value of Tax-shields for next three years.125) d.a. (INR 9.060. If the investments of INR 1. ABC Ltd. (INR 14. (INR 812.000) c. market risk premium is 6%.109. Terminal value of cash flows at the end of third year.000. Dividend per share (DPS) is 0. DEF Ltd.000. after year 3. Total present value of all operating assets.92 million) f.000) b. If the firm has to maintain 50% debt and equity in the capital structure for its funding requirements and has to pay a DPS of 0.03 million) e. (11.000) 4.000. if total outstanding number of shares are 100 million. estimate the following: a. Total present value of unlevered cash flows for next three years. as follows: Year 1 Year 2 Year 3 Average Outstanding 120 180 240 Debt (INR million) It is also estimated that the free cash flow to the firm (FCFF) would be growing at a rate of 5% p.a. If in the previous case.. has 1.92 million) g. (INR 932. what will be the maximum investment the firm can make? (INR 580.59 million) b. It is estimated that the firm will be taking debt for the three years.000.000? (INR 0.33) . net income would be INR 300.3.22 million) c. The share price.30 when net income (NI) is INR 800.2 million common shares outstanding and following sets of information is applicable to it: a.000 is to be met by 50% debt and equity each.000.

Total value of the firm.302. Book values are closely approximate to the market values for short term investments and borrowings and long term debt. The PE ratio of Affiliate Investment firm stood at 21 which has current total earnings reported as INR 120 million. (INR 1. Assets INR mm Liabilities and Equity INR mm Cash & Equivalents 12 Accounts Payable 37 Short Term Investments 81 Short Term Borrowings 21 Accounts Receivables 67 Accruals 41 Inventory 45 Total Current Liabilities 99 Total Current Assets 205 Long Term Debt 275 Investments in Affiliates 104 Gross Fixed Assets 870 Common Stock (issued at INR 105 10 par) Less: Acc. Cash & equivalents.5.50% stake in some other non-core firm. b. The table below shows the balance sheet of GHI Ltd.020 million. (INR 189.00 million) c. Total value of common equity. Depreciation 345 Paid-in Capital 210 Net Fixed Assets 525 Retained Earnings 145 Total Common Equity 460 Total Assets 834 Total Equity and Liabilities 834 Estimate the following: a.006.81) . Total market value of the affiliate investment. Share price of GHI.00 million) d. Short term (ST) investments and ST borrowings are not considered to be part of operating working capital. Also following information is known for GHI: a. Total value of operating assets is INR 1. d. (INR 1. The affiliate investment is in the form of 7.00 million) b. c. (INR 95.

29) . is currently unlevered (at t=0). Assume that the risk free rate is 7%. 250 million and 500 million.379 million) (vi) What is the Enterprise Value of the firm? (INR 3.15 million) (ii) What is the present value of all Free Cash Flows to the Firm (FCFF) generated during the next three years? (INR 435.918 million) (v) What is the present value of Operating Assets in the company? (INR 2.129 million) (vii) If it is known that the firm has INR 500 million worth of cash lying in its balance sheet currently (at t=0). beyond the third year? (13. Hindustan Ltd. which is not included in the value of non-operating assets mentioned above. Based on the information provided above. and marginal tax rate is 35%. is an India-based manufacturing company. Practice Questions – Part B. The firm will be able to borrow at a constant rate of 10% (pre-tax) at any point of time.3 1. and it intends to maintain a constant debt-to-equity ratio of 50% on a market value basis after the end of third year. The same figures are also provided in the table below: All figures are in INR million Year 1 Year 2 Year 3 Free Cash Flow to Firm (FCFF) 100 200 300 Average Outstanding Debt 150 250 500 Hindustan Ltd. Total present value of all non-operating assets in the company is estimated at INR 750 million. can you calculate the intrinsic share price of the firm? (INR 36. respectively. equity risk premium is 5%. please calculate the following: (i) What is the total present value of Interest Tax Shields (ITS) generated during the next three years? (INR 25. The Free Cash Flows to the Firm (FCFF) can be assumed to grow at a constant rate of 3% after the end of the third year.9%) (iv) What is the present value of terminal value of Free Cash Flow to Firm (FCFF) generated after the end of third year? (INR 1. respectively. The average outstanding debt amount during each of these three years can be assumed to be INR 150 million. 200 million and 300 million during the next three years. The company estimates that it will generate Free Cash Flow to the Firm (FCFF) of INR 100 million.44 million) (iii) What is the Weighted Average Cost of Capital of the Firm (WACC). and its unlevered cost of equity is 15%. The company has 100 million shares outstanding.

(d) Dividend Pay-out. Depreciation of INR 15 million. if a firm has a Total Revenue of INR 250 million. Answer the following questions. of INR 15 million) (ii) In the next year. what will be the new funding requirement (surplus) in that year? You can assume that the Depreciation. (TRUE) The Enterprise Valuation of a Firm will remain unchanged. even if the firm raises additional debt only for increasing the outstanding cash in its balance sheet. Increase in Net Working Capital of INR 25 million. (Funding Surplus of INR 15 million) (iii) State. For comparing the valuation multiples of two firms with widely different capital structures. as mentioned in (i) above. (i) In a given year. (iv) Choose the most suitable option. one should look at _____________ ratio. the firm improves its Net Income margin from 20% to 25%. (Option C). calculate the funding requirement (surplus).2. Capital Expenditure and Increase in Net Working Capital would remain unchanged. (Funding Req. Net Income margin of 20%. (b) Return on Equity. (a) Price-to-Earnings. if the Total Revenue of the firm grows by 20%. (c) Enterprise Value to EBITDA. and revises its Dividend Pay-out Policy downward to 20%. . whether TRUE or FALSE. Capital Expenditure of INR 35 million. and a stable 40% Dividend Pay- out Policy.

a decrease in earnings before interest and taxes (EBIT) will result in a more than proportionate decrease in earnings per share. (F) (ix) If investors view dividends as being less risky than potential future capital gains then the required return on equity may increase as the dividend payout ratio is decreased. (T) (vi) A firm can use retained earnings without paying a flotation cost. (F) (xv) Tax shield from debt in each year = (1 . raising a company’s debt ratio will always reduce the company’s WACC. (T) (xiv) APV = NPV of all equity firm + NPV of all debt firm. State. whether TRUE or FALSE: (i) The firm's business risk is largely determined by the financial characteristics of its industry. Practice Questions – Part B. (F) (ii) If a firm utilizes debt financing. (F) (xi) As a firm changes to a higher debt ratio. (F) . (F) (xiii) Adjusted present value method cannot address the issue of unknown debt level. the cost of retained earnings is generally lower than the after-tax cost of debt financing. (T) (xii) In general. debt-holders will likely demand higher rates of return. (F) (iv) Since debt financing is cheaper than equity financing. raising a company’s debt ratio will always increase the company’s WACC. (F) (viii) A firm that follows a residual distribution policy must believe that the dividend irrelevance theory is correct. while the cost of retained earnings is not zero. (F) (vii) The growth rate of a firm’s cash flows is directly proportional to the capital employed by the firm so far. where the words "long" and "short" refer to the maturity of the hedging instrument. we can expect a high growth pharmaceutical company to pay higher dividends than a large. (T) (iii) Since debt financing raises the firm's financial risk. Therefore.4 1. (F) (v) An increase in the corporate tax rate is likely to encourage a company to raise its target debt ratio. (F) (xvi) The two basic types of hedges involving the futures market are long hedges and short hedges. mature utility company. (T) (x) Interest tax shields are available to the firm on debt and preferred stock but not on common equity.Tax Rate) * Interest Payment.

In this case what would be the WACC. value of the firm.000 and the cost of equity is 12%. PEN Ltd.. Share Price After Repurchase = INR 889.08 million) 4.438.68 ) 3. has a total book value of debt and equity. 100 and 12 million respectively for the FY 2016 and debt-to equity ratio in book value terms remain at 40%. is currently an unlevered firm with an operating income (EBIT) of INR 1913 mn for FY 2015.000 which is supposed to remain constant due to no growth (i. The firm is contemplating to raise debt which will have suitable investment grade credit rating. 15. the market-to-book value of equity (M/B ratio) would become 2. Presently. The firm has 11.779.896.15) b. NOSO After Repurchase = 8. answer the following: a. (INR 60. as on March 31.0 and the cost of debt and equity would be 7% and 13% respectively. no reinvestment needs) in future. Assuming only debt is used to adjust any deficit or surplus in cash. answer the following: a. Xylo Industries Ltd. If the expected net income.0 (after raising the debt) with the current operating income.333. 15. and change in working capital numbers are 75.333. depreciation expenses. If the firm decide to take on no additional debt in FY 2016. the total number of outstanding shares are 10. 2015. (F) (xix) Since risk management can reduce the volatility of a company’s cash flows. (xvii) A futures contract is an option to buy or sell a specified quantity of a particular asset during a given period for a given price.000. (INR 8. . how much capital expenditure it can incur to pay a dividend per share of 1. (WACC = 11. Assuming a tax rate of 40%.359. number of shares outstanding and share price after repurchasing equity. INR 833) b.117. The firm expects to raise maximum possible debt such that that it has an interest coverage ratio of 5.60 when the expected net income. debt and equity. how much dividend per share can the firm distribute in FY 2016? (INR 1. Debt = INR 1.24%.2 million shares outstanding and is trying to decide on its dividends for the FY 2016 by balancing its leverage and investment needs.797. capital expenditure and change in working capital numbers are 75.33% by replacing its equity with some debt (which is not perpetual in nature).000. and 12 million respectively for the FY 2016. is an unlevered firm with an after-tax EBIT of INR 1. depreciation expenses.e. it can increase the debt capacity of the firm. Equity = INR 7. to be INR 90 and 250 million. (F) (xviii) The forward contracts are settled by clearing house. (T) 2. What is the value of the unlevered firm and its share price. Firm Value = INR 8. SKY Corp Ltd. If the firm targets a debt-to-capital (book value ratio) of 33.

(all figures in million USD) $ million 2016 2017 2018 2019 Revenue 200 225 255 275 Operating Cost 125 135 150 160 (Excl.5% and the interest is paid annually. estimate the credit rating applicable for the firm after raising the proposed debt. It is end of 2015 and Elvis Ltd is considering acquiring Priestley Inc. Further. is given in the Table below. Depreciation) Depreciation 50 70 75 80 Capex 50 55 65 70 NWC 25% of revenue earned in that particular year Marginal Tax Rate 40% . The associated D/E ratio (market value terms) for industrial firms for investment grade debt ratings is given as follows in the table below. Table: Financial Projections for Priestley Inc.85 while the 10 yr G-sec rate is 6% and market risk premium is 4%. • Current Net working Capital is 45 million USD • The firm is expected to maintain a D/E ratio (market value) of 35% as it reaches stable growth period at the end of 2019. Mr Jim Morrison. D/E Ratio (market) = 50. D/E 50% 65% 80% For a tax rate of 40%.51%) 5. The pre-tax cost of such debt would be 5. Ratings AA A BBB Approx. The immediate benefit of taking such debt would be an increase in firm value and a consequent increase in its P/E ratio to 15. • The firm has 10 % stake in affiliate business whose total earnings is 50 million USD. (AA. the following information is known about Priestley: • Priestley currently is an unlevered firm and will be issuing a debt of $100 million for the proposed merger. The P/E for the affiliate business is 22. the bank handling the deal is trying to work out the value of Priestley Inc.50%. The cost of debt is 7. the chief consultant from Hendrix & Knoffler. The Projected financials for Priestley Inc. • The stable growth rate is expected to be 3% • The unlevered beta of the firm is 0. which will be repaid fully at the end of 2019 as a bullet repayment.

its cost of equity rises to 18. if the total number of shares outstanding is 10 million? (INR 41. and what is the market value of its equity? (Firm Value = INR 20 million. a. i) What is the total market value of the firm. What is the value of the operating assets? (INR 409. The Cheesecake Factory’s relevant financial data is presented below: EBIT INR 4.84 million) 4. What is the WACC under this capital structure? (12.10%) iii) Suppose the Cheesecake Factory can increase its debt so that its capital structure has 50% debt.24) e. Equity Value = INR 18 million) ii) What is the Cheesecake Factory’s weighted average cost of capital? (WACC = 14. What is the total value? (INR 21.5% and its cost of debt (on all debt) will rise to 12%.000 shares Current Stock Price INR 30 The Cheesecake Factory’s market is stable.33 million) 2. solve the following: 1. What is the total value of the firm.85%) b. At this level of debt. How many shares will remain outstanding after the repurchase? (NOSO after Repurchase = 330. and it expects no growth. assuming there is negligible cash at the end of 2015? (INR 519. so all earnings are paid out as dividends. How much debt will it issue? (INR 8.84 million) 3. For a tax rate of 40%. based on market values (it plans to issue debt and buyback shares).082) . What is the stock price after the repurchase? (INR 33.7 million Tax rate 40% Value of Debt INR 2 million Kd 10% Ke 15% Number of Shares outstanding 600.97 million) d.98) 6. What is the expected stock price of Priestley. What is the value of the interim cash flow up to 2019 using APV? (INR 70.95 million) c.

as of December 31. and the latest traded price is INR 50 per share.82%) b.50.0% 8% (v) What is the current credit rating of the company? (BBB. if the company lowers its total outstanding debt to INR 100 million by issuing additional equity in the market at INR 50 per share to retire (repay) all its long term outstanding debt immediately? (new WACC = 17. levered beta of the company is 1. equity risk premium is 8% and marginal tax rate is 30%. in INR million) 2016 Net Working Capital 250 Fixed Assets (net) 450 Total Assets 700 Short Term Debt 100 Long Term Debt 300 Common Stock 150 Retained Earnings 150 Total Liabilities and Equity 700 The CFO also informed Ruchi that the Debt of the company is rated as per the following rating standards: Credit Rating AAA AA A BBB Maximum Total Debt-to-Value Ratio 15.0% 4.26%) .0% 60% (market value based) Default Spread (%) 2.44%) (vi) What is the unused debt capacity of the company at the current credit rating? (INR 350 million) (vii) Assume that the risk-free rate is 10%.0% 25. Calculate the following: a. The company has 10 million shares outstanding. What will be the Weighted Average Cost of Capital (WACC) of the company.0% 40. Anamika and her group visited a company as a part of their industry visit program at IIM Indore. Practice Questions – Part B. 2016.0% 6.5 1. What is the current Weighted Average Cost of Capital (WACC) of the company? (WACC = 17. The CFO of the company shared the latest balance sheet of the company. with Anamika: Balance Sheet (Book value figures. D/V Ratio = 44.

as the firm leverage is monotonically increased. Calculate the book-value based debt-to-equity ratio at the end of the year. and the book value of total shareholders’ equity at the beginning of the year was INR 900 million. (D/E Ratio (book) = 35%) c. (T) 3. the corporate finance manager should remain indifferent to the financing mix of debt and equity while making the capital budgeting decisions for the firm. Identify. a start-up firm is likely to be predominantly equity-financed. in a world with taxes and financial distress. (INR 100 million) b. whether the statements are TRUE. if the firm has to maintain the 40% dividend pay-out policy at the end of this year. in order to maintain a 40% dividend pay-out policy by the firm. and then issue safer (secured) debt. Capital Expenditure of INR 259 million. and the effective corporate tax rate is 40%. (F) (ii) The Weighted Average Cost of Capital (WACC) of a firm which has AAA grade credit rating will always be higher than the Weighted Average Cost of Capital (WACC) of a firm which has BBB grade credit rating. (F) (viii) Signalling theory suggests that investors will generally view an increase in debt as a negative sign for the firm's value. Assume that the maximum leverage in terms of book-value based debt-to-equity ratio that the firm can afford to take on its balance sheet at the end of any year is 40%. to maintain the optimal level of financial flexibility. Assume that any funding requirement at the end of the year is met by additional borrowing. the value of a firm always keeps on increasing. calculate the maximum amount of dividends that the firm can distribute at the end of the year. a firm is operating with the optimal capital structure when the present value of financial distress costs is minimized. (F) (v) In a Miller-Modigliani world with corporate taxes. (T) (x) When a firms issues additional debt. (F) (iii) As per the firm life cycle theory of capital structure. (F) (vii) The pecking order theory of capital structure is based on agency conflicts between the debt holders and the equity shareholders. a firm has a Total Revenue of INR 500 million. During a given year. both the interest tax shield. the financial distress costs as well as the agency conflicts between bondholders and equity holders increases. Calculate the net funding requirement at the end of the year. or FALSE: (i) As per the trade-off theory of capital structure. and any funding requirement at the end of the year is met by additional borrowing. as mentioned in part (a) above. (T) (iv) The pecking order theory of capital structure suggests that a firm should issue riskier (unsecured) debt first.2. (T) (vi) The free cash flow hypothesis of capital structure suggests that firms should conserve free cash in their balance sheet as much as possible. Depreciation of INR 35 million. Then. The book value of outstanding debt at the beginning of the year was INR 250 million. and a decrease in Net Working Capital of INR 25 million. without breaching the maximum permissible leverage ratio limit. The pre-tax cost of debt at the current leverage is 10%. a. (F) (ix) In a Miller-Modigliani world without taxes. Operating income (EBIT) margin of 60%. (INR 101 million) .

(F) (vi) Suppose. Therefore. the stock price of a firm will decrease exactly by the amount of dividend per share on the dividend declaration date. they do not affect the liquidity position of the firm. (T) . (F) (v) A firm that follows a strict residual dividend policy is likely to maintain a stable pattern of dividends over time. the dividend is received by the seller. everything else remaining the same. and hence. Assume that an unlevered firm currently has 100 million shares outstanding in the market. (F) (iii) Dividend Pay-out Ratio can be calculated as Dividend per Share (DPS) divided by Earnings per Share (EPS). (F) (vii) On ex-dividend date. is likely to result in stock price increase in the real world market. The firm intends to borrow some money from the market for financing the buyback of its own shares. as the share price is lowered to a more preferred. (F) (xii) Bonus issue of shares and stock splits tend to increase the liquidity of the stocks. (T) (viii) Dividend policies tend to be more ‘sticky’. therefore. the effective Dividend Distribution Tax rate on dividends increases all of a sudden. whether the statements are TRUE. companies with high growth rates tend to have low dividend pay-out ratios. How many of its own shares should it buyback from the market. (T) (ii) In a Miller-Modigliani world without corporate taxes. if it intends to achieve a market-value based debt-to-capital ratio of 40% after the buyback? (40 million) 5. buyback decisions by a company tend to signal stock undervaluation to the equity investors. (T) (xiii) The dividend policy of a company has no impact on the capital structure of the company. irrespective of the dividend policy of the firm. capital structure decisions and dividend policy decisions are mutually independent of one another. as such dividend cuts improve the liquidity and cash position of the company. (F) (xi) Firms should give up positive NPV projects to pay dividends to its investors. Then. investment decisions remaining the same. (F) (x) In a perfect capital market with no transaction costs and no taxes. and less flexible than share buyback decisions.4. one would expect the cost of equity for high-dividend paying firms to decrease. or FALSE: (i) As per the firm life cycle theory of dividend policies. tradable range. Identify. stock prices tend to react favourably to dividend reductions. (T) (ix) As per signalling theory. the market value of shareholder equity in a firm will remain constant. (T) (iv) Since dividends are paid out of profits. (F) (xiv) As per signalling theory.