Subject: Business    / Finance    

    Debt can be used to constrain managers because it:

    Provides additional cash flow for their use.

    Precommits a firm's excess cash flow to debt servicing.

    Allows the management to issue more shares.

    Eliminates a CEO's tendency to acquire other firms without a sound economic rationale.

    Makes a CEO more likely to accept positive NPV projects.

10 points


    The CFO of Cicero Industries plans to calculate a new project's NPV by estimating the relevant cash flows for each year of the project's life (i.e., the initial investment cost, the annual operating cash flows, and the terminal cash flow), then discounting those cash flows at the company's overall WACC. Which one of the following factors should the CFO be sure to INCLUDE in the cash flows when estimating the relevant cash flows?
            All sunk costs that have been incurred relating to the project.
            All interest expenses on debt used to help finance the project.
            The investment in working capital required to operate the project, even if that investment will be recovered at the end of the project's life.
            Sunk costs that have been incurred relating to the project, but only if those costs were incurred prior to the current year.
            Effects of the project on other divisions of the firm, but only if those effects lower the project's own direct cash flows.

10 points


    While developing a new product line, Cook Company spent $3 million two years ago to build a plant for a new product. It then decided not to go forward with the project, so the building is available for sale or for a new product. Cook owns the building free and clear¾there is no mortgage on it. Which of the following statements is CORRECT?
            If the building could be sold, then the after-tax proceeds that would be generated by any such sale should be charged as a cost to any new project that would use it.
            This is an example of an externality, because the very existence of the building affects the cash flows for any new project that Rowell might consider.
            Since the building was built in the past, its cost is a sunk cost and thus need not be considered when new projects are being evaluated, even if it would be used by those new projects.
            If there is a mortgage loan on the building, then the interest on that loan would have to be charged to any new project that used the building.
            Since the building has been paid for, it can be used by another project with no additional cost. Therefore, it should not be reflected in the cash flows for any new project.

10 points


    Century Roofing is thinking of opening a new warehouse, and the key data are shown below. The company owns the building that would be used, and it could sell it for $100,000 after taxes if it decides not to open the new warehouse. The equipment for the project would be depreciated by the straight-line method over the project's 3-year life, after which it would be worth nothing and thus it would have a zero salvage value. No new working capital would be required, and revenues and other operating costs would be constant over the project's 3-year life. What is the project's NPV? (Hint: Cash flows are constant in Years 1-3.)

    WACC    10.0%
    Opportunity cost    $100,000
    Net equipment cost (depreciable basis)    $60,000
    Straight-line deprec. rate for equipment    33.333%
    Sales revenues, each year    $121,000
    Operating costs (excl. deprec.), each year    $20,000
    Tax rate    40%






10 points


    The capital budget of Serious Products Company is $1,000,000. The company wants to maintain a target capital structure that is 40% debt and 60% equity. The company forecasts that its net income this year will be $800,000. If the company follows a residual dividend policy, what will be its total dividend payment?






10 points


    According to the Trade-off Theory of Capital Structure:

    A firm should have no debt because of the expected bankruptcy costs.

    There is a trade-off between interest payments and tax savings of debt.

    There is a trade-off between expected bankruptcy costs and business risk.

    There is a trade-off between tax savings of debt and expected bankruptcy costs.

    There is no optimal capital structure.

10 points


    Which of the following statements is correct about dividend policies?

    According to the current tax code, dividend payments are taxed at a lower rate than long-term capital gains on stock.

    Dividend reinvestment plans (DRIPs) allow shareholders to avoid paying taxes on the dividends that they choose to reinvest.

    Residual dividend policy enables a company to follow a stable dividend policy.

    The clientele effect suggests that companies should follow a stable dividend policy.

    Modigliani and Miller argue that investors prefer dividends to capital gains because dividends are more certain than capital gains.

10 points


    Black Keys Manufacturing is considering making a change to its capital structure in hopes of increasing its value. The company's capital structure consists of debt and common stock. In order to estimate the cost of debt, the company has produced the following table:

    Percent financed    Percent financed    Bond    Before-tax    Levered    Cost of equity    
    with debt (wd)    with equity (we)    Rating    cost of debt    Beta    re    WACC
    0.1    0.9    AAA    7.00%            
    0.2    0.8    AA    7.20%            
    0.3    0.7    A    8%            
    0.4    0.6    BBB    9.60%            
    0.5    0.5    BB    10.75%            

    The company uses the CAPM to estimate its cost of common equity, rs. The risk-free rate is 5% and the market risk premium is 6%. Black Keys estimates that if it had no debt its beta would be 1.1. (Its "unlevered beta," bU, equals 1.1.) The company's tax rate, T, is 40%.

    On the basis of this information, what is Black Keys' optimal capital structure, and what is the firm's cost of capital at this optimal capital structure?

    we = 0.9; wd = 0.1; WACC = 11.01%

    we = 0.8; wd = 0.2; WACC = 10.96%

    we = 0.7; wd = 0.3; WACC = 10.75%

    we = 0.6; wd = 0.4; WACC = 10.15%

    we = 0.5; wd = 0.5; WACC = 10.18%

10 points


    Imagine a firm that follows the residual dividend policy very strictly. If its optimal capital budget requires the use of all earnings for a given year (along with new debt according to the optimal debt/total assets ratio), then the firm should pay

    no dividends to common stockholders.

    dividends only out of funds raised by the sale of new common stock.

    dividends only out of funds raised by borrowing money (i.e., issue debt).

    dividends only out of funds raised by selling off fixed assets.

    no dividends except out of past retained earnings.

10 points


    Firms that operate in industries with high business risk also choose to finance more of their assets with debt thereby balancing business and financial risk.



10 points


    Your firm follows a strict residual dividend policy. All else equal, which of the following factors would be most likely to lead to an increase in your firm's dividend per share?

    The company reduces the percentage of equity in its target capital structure.

    The number of profitable potential projects increases.

    Congress lowers the tax rate on capital gains.

    Earnings are unchanged, but the firm issues new shares of common stock.

    The firm's net income decreases.

10 points


    You are analyzing your firm's dividend policy. Your firm has a capital budget of $650,000, and you want to maintain a target capital structure of 60% debt and 40% equity. The company forecasts a net income of $500,000. If you follow the residual dividend policy, what is your firm's forecasted dividend payout ratio?






10 points


    When evaluating a new project, firms should include in the projected cash flows all of the following EXCEPT:
            Previous expenditures associated with a market test to determine the feasibility of the project, provided those costs have been expensed for tax purposes.
            The value of a building owned by the firm that will be used for this project.
            A decline in the sales of an existing product, provided that decline is directly attributable to this project.
            The salvage value of assets used for the project that will be recovered at the end of the project's life.
            Changes in net working capital attributable to the project.

10 points


    Kasper Film Co. is selling off some old equipment it no longer needs because its associated project has come to an end. The equipment originally cost $22,500, of which 80% has been depreciated. The firm can sell the used equipment today for $7,500, and its tax rate is 35%. What is the equipment's after-tax salvage value for use in a capital budgeting analysis? Note that if the equipment's final market value is less than its book value, the firm will receive a tax credit as a result of the sale.






10 points


    Worst Plumbers Inc. wants to maintain a target capital structure with 33% debt and 67% equity. Its forecasted net income is $500,000. If the firm follows the residual dividend policy, what is the maximum capital budget that is consistent with maintaining the target capital structure? Note, that it is the maximum capital budget the company can fund through debt and internal equity without giving any dividends this year or issuing new equity.






10 points


    Slow Watch Company has a levered beta of 1.10, its capital structure consists of 44% debt and 56% equity, and its tax rate is 40%. What would Slow Watch's beta be if it used no debt, i.e., what is its unlevered beta?






10 points


    The main difference between MM II (Modigliani Miller Model with Corporate Taxes) and Miller Model with Corporate and Personal Taxes is:

    MM II concludes that a capital structure with 100% debt is optimal but the Miller Model states that a capital structure with 100% equity is optimal.

    MM II concludes that a capital structure with 100% equity is optimal but the Miller Model states that a capital structure with 100% debt is optimal.

    Both conclude that a levered firm's value will be higher than an unlevered's firm but the size of that advantage is bigger in MM II's model.

    Both conclude that a levered firm's value will be higher than an unlevered's firm but the size of that advantage is smaller in MM II's model.

    There is no difference between these two models, they both conclude that capital structure is irrelevant but they base their conclusion on different arguments.

10 points


    Which of the following factors should be included in the cash flows used to estimate a project's NPV?

    Tax payment on profits made from selling equipment at the end of the project.

    Cannibalization effects on competitors' products in development stage.

    Tax savings from interest payments.

    Expenditures that will be incurred for future follow-up product development.

    Costs incurred on beta version of the product launched last year.

10 points


    Loud Music Inc recently completed a 3-for-1 stock split. Prior to the split, its stock sold for $120 per share. What was the stock price following the split?






10 points


    In theory, stock dividends (when shares are given as dividends instead of cash) and stock splits should have the same effect on shareholders' wealth.



10 points


    If Miller and Modigliani had incorporated the costs of bankruptcy into their model (MM II), it is unlikely that they would have concluded that 100% debt financing is optimal.



10 points


    As a result of many phases of trial and error, two methods for producing playing cards have been identified by the Modest Mouse Company. One method involves using a machine having a fixed cost of $10,000 and variable costs of $1.00 per deck of cards. The other method would use a less expensive machine (fixed cost = $2,000), but it would require greater variable costs ($1.40 per deck of cards). If the selling price per deck of cards will be the same under each method, at what level of output will the two methods produce the same net operating income (EBIT)?

    5,000 decks

    10,000 decks

    15,000 decks

    20,000 decks

    25,000 decks

10 points


    Which of the following statements is correct?

    If a company has an established clientele of investors who prefer a high dividend payout, and if management wants to keep stockholders happy, it should follow the strict residual dividend policy.

    If a firm follows a strict residual dividend policy, then, holding all else constant, its dividend payout ratio will tend to rise whenever the firm's investment opportunities decline.

    If Congress eliminates taxes on capital gains but leaves the personal tax rate on dividends unchanged, this would motivate companies to increase their dividend payout ratios.

    Despite its drawbacks, following the residual dividend policy will tend to stabilize actual cash dividends, and this will make it easier for firms to attract a clientele that prefers high dividends, such as retirees.

    One advantage of dividend reinvestment plans is that they enable investors to avoid paying taxes on the dividends they receive.

10 points


    Which of the following is NOT associated with (or does not contribute to) business risk? Recall that business risk is affected by a firm's operations.

    Sales price variability.

    The extent to which operating costs are fixed.

    The effect of exchange rate changes on its foreign sales.

    Raw material cost variability.

    Increase in its interest cost.

10 points


    Which of the following items should a company report directly in its monthly cash budget?
            Cash proceeds from selling one of its divisions.
            Accrued interest on zero coupon bonds that it issued.
            New shares issued in a stock split.
            New shares issued in a stock dividend.
            Its monthly depreciation expense.