CHAPTER 9 RISKS AND RETURNS qstFORIES: of financial lever i Te wing? ee by the firm has a potential impact on which of the (1) The risk associated with the firm (Q) The return experienced by the sharcholder @) The variability of net income (4) The degree of operating leverage (6) The degree of financial leverage A 13,5 B 23,45 c 4235 Dp. 125 Which of the following is not a key determinan 2 uN a ey of financial leverage? B Cost of debt CC. Technology D. Capital structure 3, The degree of operating leverage for Alabang Company is 35, 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 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. 4 It refers to management strategy of financing assets with borrowed capital; such an extensive use raises 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 B, Leverage. ail10. Cc. Mortgage. D. Restructunng A decrease in the debt ratio will least likely’ atfect A, financial nsk B. business risk systematic or market risk D, total nsk Which of the following changes would tend (o increase the COMPANY cos, of capital tor 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. When establishing their optimel 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 given choices Although debt financing is usually the cheapest component of capital, it cannot be used ercessively because A. the interest rates may change. B, the firm's stock price will increase and raise the cost of equity financ ing. C._ the financial risk of the firm may increase and thus drive up the cost of all sources of financing. D__ none of the given choices. The inix of debt, preferred stock, and common equity with which the firm plans to raise capital is called the A financial risk B. operating leverage C. business risk D. target capital structure Financial nsk refers to the: A. tisk of owning equity securities risk faced by equity holders when debt is used B C. general business risk of the firm D. possibility that interest rates will increase 212C._aconstant rate of 2 or more percent per year p. P5or more per year. pROBLEMS: Af the pro forma balance sheet show: is 1 anilevetaining a prised a total assets must increase by P400,000 A. debt must increase by P300,000, B. equity must increase by the full P400,000, CC. debt must increase by P171,428, D. equity must increase by 710,000. ‘Leverage Corporation has a capital structure that consists of debt. The company expects to report P100 million in net i x 0 income this year, and 67.5% of the net income will be paid out as dividends. low large can the fim’s capital budget be this year without it having to include the stock in its cost of capital analysis? costof nes: common A. P100.0 million B. P 675 million Cc. P 50.0 million D. P 325 million 65% equity and 35% 3, The Equity Company projects the following for the upcoming year: Earnings before interest and taxes ‘P40 million Interest expense P 5 million Preferred stock dividends P 4 million Common stock dividend payout ratio 20% Average number of common shares outstanding 2million Effective corporate income tax rate 40% The expected dividend per share of common stock is A. PL70 Cc. P210 B. P1.86 D. P1.00 4. 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% retum, and P6 million in bonds requiring an 8% return? A. P1,392,000 C. P2,480,000 B. P 1,488,000 D. P2,800,000 221~ Company had consistently paiq 50 dends. Next year, the Pledge Coin % of the past five years, Pledge 1.2 million preferred divi ends, sed lable to common as divi 1 income, before the PI During the p eamings avail projects its nel million, intained at: The capital structure for the company is maintained ow Debt a Preferred stock pee Common equity s break-point next year? Sa ined avn CC. P4,000,000 B. 4,800,000 D. P6,000,000 30 niiion in earnings next year. Its qd Cartel Company expects P30 mi ext - payout ven is 40 percent, ‘and its equity to asset ratio is 40 percent, rend Company uses no preferred stock. Carte] ‘At what amount of financing, will there be a break point in Cartel’s cost of capital? ; A. P45 million C. P30 million B. P20 million D. P18 million Deep Sea Company expects next year’s after-tax income to be P7,500,000, Th Peer rebt ao i currently 40 percent. Deep Sea Company has P6,000,600 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% C. 48.0% B. 75.0% D. 25.0% ‘The Florida Co. has an equity cost of capital of 17%. The debt to equity ratio is 15 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 306% C. 16.97% B. 13.40% D. 18.52% Calculate the DFI. for a firm with EBIT of P6,000,000, fi ‘ 3,000,000, fixed cost of P3,000,009, interest expense of P1,000,000, pref vi and a 40 ieeteae preferred stock dividends of 800,000, and a 40 A. 60 cu B. 9.0 D. to 22210. 2 Mu. A firm is expected to generate P15 mj in interest. Ignoring taxes, thi -3 Million in opera happen to EPS if Speke Bencrate P1250 eae a By 150,000 ‘A. EPSincrease to P15.63, exeases 10 P20 million Ne hat wil B. EPSincrease to P16 67, ” Cc, EPS increase to P17.50. D. EPS increase to P20,00. The board of directors of Mod The ard of datos Maer Con impressively good at 12.5 percent, the. present debt ratio is 0.40. vine a i ale unhappy with the current rem Nn sales (profit margin) was set tumover was only 0.75. The Ms. Norma Flor, the vice-presid oc lent of corporate planning, presented a proposal + Profit margin should be raised to 15 percent. The new capi ‘ i f ‘apital structure will be revised by raising debt 3 Theasset turnover will be mainuined at075. The proposed adjustment is estimated to raise return on equity by 50 y 50 percent. What debt ratio did Ms. Flor propose it (ROB) to 150 percent of the peau level? Biles to:enite the return on.egity A 052 : C. 061 B. 0.68 D. 072 Eclipse Company expects to generate P10 million ex internally which could be available for financing part of its P12 million capital tudes! Tor this coming year clipes ae believes that a debt-equity ratio of 40 percent is t for the firm. How much should be paid in dividends if equity ratio is to be maintained? palin ividends the wrest de A, P2,800,000 C. P1,428,571 B. P8571,429 D. 4,000,000 ‘A five-year P1,000 par value bord pays a 6.50% annual coupon. Given a YTM of 3.0%, what is the price of the bond today? A. P1040 cc. P 940 B. P 860 D. P1,000 ock is expected to generate a dividend and terminal value one year from now ‘of P57.00. The stock has a beta of 1.3, the risk-free interest rate is 6 percent. and the expected return market return is 11 percent. What should the equilibrium price of ‘investors’ stock in the market now? C. P5377 A. 50.67 Paramount Company's st 223