Name:____________________

MAN 321 Corporate Finance

Final Examination

Fall 2001

There are three sections on this examination. Section I contains 10 fill-in-the-blanks questions. Answer these questions by entering your answer in the blanks. Section II has 10 multiple choice questions. Enter your answers by circling the appropriate letter on the exam. Section II contains 5 problems. Answer the problems in the spaces provided on the exam. Good luck

SECTION I. Fill-in-the-blanks Questions (1 point each)

A(n) _____bond_________ is a long-term promissory note issued by a business firm or governmental unit.

The stated face value of a bond is referred to as its _par_value.

The date at which the face value of a bond is repaid to each bondholder is known as the __maturity_ __date__.

Market interest rates and bond prices move in _opposite____ directions from one another.

Like other financial assets, the value of common stock is the __present__ value of a future stream of income.

The income stream expected from a common stock consists of a(n) _dividend___ yield and a(n) _capital__ __gains_ yield.

Financial leverage refers to the use of __debt___ financing.

Expected EPS generally __increases___ as the debt/assets ratio increases.

A firm with __fluctuating__ earnings is most appropriate for using the policy of “extra” dividends.

A stock split involves a reduction in the __par__ ___value__ of the common stock, but no accounting transfers are made between accounts.

SECTION II. Multiple Choice Questions (1 point each)

1. Myron Gordon and John Lintner believe that the required return on equity increases as the dividend payout ratio is decreased. Their argument is based on the assumption that

a. Investors are indifferent between dividends and capital gains.

b. Investors require that the dividend yield and capital gains yield equal a constant.

c. Capital gains are taxed at a higher rate than dividends.

d. Investors view dividends as being less risky than potential future capital gains.

e. Investors value a dollar of expected capital gains more highly than a dollar of expected dividends because of the lower tax rate on capital gains.

2. In the real world, we find that dividends

a. Usually exhibit greater stability than earnings.

b. Fluctuate more widely than earnings.

c. Tend to be a lower percentage of earnings for mature firms.

d. Are usually changed every year to reflect earnings changes.

e. Are usually set as a fixed percentage of earnings.

3. A decrease in a firm’s willingness to pay dividends is likely to result from an increase in its

a. Earnings stability.

b. Access to capital markets.

c. Profitable investment opportunities.

d. Collection of accounts receivable.

e. Stock price.

4. Which of the following would not have an influence on the optimal dividend policy?

a. The possibility of accelerating or delaying investment projects.

b. A strong shareholders’ preference for current income versus capital gains.

c. Bond indenture constraints.

d. The costs associated with selling new common stock.

All of the statements above can have an effect on dividend policy.

5. A stock split will cause a change in the total dollar amounts shown in which of the following balance sheet accounts?

a. Cash.

b. Common stock.

c. Paid-in capital.

d. Retained earnings.

e. None of the statements above is correct.

6. Petersen Co. has a capital budget of $1,200,000. The company wants to maintain a target capital structure that consists of 60 percent debt and 40 percent equity. The company forecasts that its net income this year will be $600,000. If the company follows a residual dividend policy, what will be its payout ratio?

a. 0%

b. 20%

c. 40%

d. 60%

7. Which of the following affects a firm’s business risk?

a. The level of uncertainty about future sales.

b. The degree of operating leverage.

c. The degree of financial leverage.

d. Statements a and b are correct.

All of the statements above are correct.

8. Which of the following statements best describes the optimal capital structure?

a. The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company’s earnings per share (EPS).

b. The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company’s stock price.

c. The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company’s cost of capital (WACC).

d. Statements a and b are correct.

Statements b and c are correct.

9. From the information below, select the optimal capital structure for Minnow Entertainment Company.

a. Debt = 40%; Equity = 60%; EPS = $2.95; Stock price = $26.50.

b. Debt = 50%; Equity = 50%; EPS = $3.05; Stock price = $28.90.

c. Debt = 60%; Equity = 40%; EPS = $3.18; Stock price = $31.20.

d. Debt = 80%; Equity = 20%; EPS = $3.42; Stock price = $30.40.

e. Debt = 70%; Equity = 30%; EPS = $3.31; Stock price = $30.00.

10. Which of the following factors is likely to encourage a corporation to increase the proportion of debt in its capital structure?

a. An increase in the corporate tax rate.

b. An increase in the personal tax rate.

c. An increase in the company’s degree of operating leverage.

d. The company’s assets become less liquid.

e. An increase in expected bankruptcy costs.
SECTION III. Problems

Question 1: (15 points)

Holmgren Hotels’ stock has a required return of 12 percent. The stock currently does not pay a dividend but it expects to begin paying a dividend of $1.00 per share starting five years from today (i.e., D₅ = $1.00). Once established, the dividend is expected to grow by 25 percent per year for two years, after which time it is expected to grow at a constant rate of 5 percent per year. What should be Holmgren’s stock price today?

D₁, D₂, D₃, D₄ are 0

D₅ = 1.00 D₆ = 1.25 D₇ = 1.5625 D₈ = 1.6406

P₇ = 1.64.06/(0.12 – 0.05) = 23.4371

PV of D₅ = 0.5674

PV of D₆ = 0.6333

PV of D₇ = 0.7067

PV of P₇ = 10.6006

P₀= 12.5080
Question 2: (15 points)

Aaron Athletics is trying to determine its optimal capital structure. 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:

Debt to total assets ratio	Equity-to-total assets ratio	Bond Rating	Before tax cost of debt
0.20	0.80	AA	7.2%
0.40	0.60	A	8.8
0.50	0.50	BB	9.6

The company uses the CAPM to estimate its cost of common equity, k_s. The risk-free rate is 5 percent and the market risk premium is 6 percent. Aaron estimates that if it had no debt its beta would be 1.0. (Its “unlevered beta,” b_U, equals 1.0.) Tax rate is 40%.

On the basis of this information, what is the company’s optimal capital structure, and what is the firm’s cost of capital at this optimal capital structure?

D/A = 0 b = 1.0 k_s= 5 + 6 = 11%

D/A = 20% b= [1 + (0.4)2/8] = 1.15 k_s=5+6(1.15) = 11.9

WACC = 0.6x7.2x0.2 + 0.8x11.9 = 10.384

D/A = 40% b=1.40 k_s=13.40 WACC=10.152*

D/A=50% b=1.60 k_s=14.6 WACC=10.18%

* optimum

Question 3: (20 points)

Copybold Corporation is a start-up firm considering two alternative capital structures, one is conservative and the other aggressive. The conservative capital structure calls for a D/A ratio = 0.25, while the aggressive strategy calls for D/A = 0.75. Once the firm selects its target capital structure, it envisions two possible scenarios for its operations: Feast or Famine. EBIT is expected to be $80,000 under the feast scenario and $40,000 in a famine. Further, if the firm selects the conservative capital structure its cost of debt will be 10 percent and it will issue 30,000 shares; while with the aggressive capital structure its debt cost will be 12 percent and it will issue 10,000 shares. The firm will have $400,000 in total assets and it will face a 40 percent marginal tax rate.

Find the EPS forecasts for Feast and Famine under the aggressive capital structure?
Find the EPS forecasts for Feast and Famine under the conservative capital structure?

EBIT 80000 40000

Interest (36000) (36000)

EBT 44000 4000

Tax (17600) (1600)

NI 26400 2400

# of shares 10000 10000

EPS 2.44 0.24

EBIT 80000 40000

Interest (10000) (10000)

EBT 70000 30000

Tax (28000) (12000)

NI 42000 18000

# of shares 30000 30000

EPS 1.60 0.60

Question 4: (15 points)

Clark Communications has a capital structure that consists of 70 percent common stock and 30 percent long-term debt. In order to calculate Clark’s weighted average cost of capital (WACC), an analyst has accumulated the following information:

The company currently has 15-year bonds outstanding with annual coupon payments of 8 percent. The bonds have a face value of $1,000 and sell for $1,091.
The risk-free rate is 5 percent.
The market risk premium is 4 percent.
The beta on Clark’s common stock is 1.1.
The company’s retained earnings are sufficient so that they do not have to issue any new common stock to fund capital projects.
The company’s tax rate is 38 percent.

Given this information, what is Clark’s WACC?

k_d: 1091 = 80 x PVIFA_k,15 + 1000 x PVIF _k,15

For k = 7% V = 1090 therefore YTM = 7% = k_d

k_s = 5 + 4(1.1) = 9.4%

WACC = 0.30 x 7 x (1 – 0.38) + 0.70 x 9.4 = 7.882%
Question 5: (15 points)

Zippy Pasta Corporation (ZPC) has a constant growth rate of 7 percent. The company retains 30 percent of its earnings to fund future growth. ZPC’s expected EPS (EPS₁) and k_s for various capital structures are given below. What is the optimal capital structure for ZPC?

Debt/Total Assets Expected EPS k_s

20% $2.50 15.0%

30 3.00 15.5

40 3.25 16.0

50 3.75 17.0

70 4.00 18.0

Debt/Total Assets Expected DPS P

20% $1.75 21.875

30 2.10 24.7059

40 2.275 25.277

50 2.6250 26.25*

70 2.80 25.45

* optimal capital structure

Name:____________________

Final Examination

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