Finance 634 Fall 1999

Exam 3

 

True/False: Record your answer on your Scan-Tron answer sheet. Two points per question.

 

  1. The appropriate discount rate for all projects in a capital budgeting decision environment is the firm’s weighted average cost of capital.
  1. The method that is used to finance a project is usually irrelevant in the selection of the discount rate to use to evaluate the project.
  1. The risk of a project affects the selection of the appropriate discount rate to use to evaluate that project.
  1. Practically speaking, the weighted average cost of capital in the internal rate of return are the same thing.
  1. In a perfect capital market, the way that a firm finances its assets is irrelevant with respect to the value of the firm.
  1. Operating leverage increases as the amount of debt in the capital structure increases, other things equal.
  1. Operating leverage increases as EBIT falls toward the break-even point.
  1. The higher the dollar amount of fixed financing costs, the higher the variability of EBIT, other things equal.
  1. Financial leverage is generally more controllable than operating leverage.
  1. A firm that has no fixed operating costs and no fixed financing costs will have no variability of earnings per share.
  1. In a perfect capital market, there are never any arbitrage opportunities.
  1. In a perfect capital market, the cost of common stock is constant regardless of the capital structure.
  1. Debt is always a cheaper source of funds than equity.
  1. The value of the company is always highest at the capital structure that results in the lowest weighted average cost of capital.
  1. Since adding debt to the capital structure always increases financial leverage and financial risk, reducing debt should increase the value of the common stock, other things equal.
  1. Under the assumptions of perfect capital markets except for having corporate taxes, the weighted average cost of capital will fall as the amount of debt in the capital structure rises, other things equal.
  1. Under realistic assumptions concerning the riskiness of debt and the presence of taxes, changing the capital structure is the most important way in which managers can impact the price of the firm’s shares in the market.
  1. A firm’s choices concerning its working capital policy involve significant risk-return tradeoffs.
  1. A firm using the maturity matching approach to working capital management will have zero short-term borrowing at seasonal low spots.
  1. The risk assumed under the maturity matching approach is that a firm might have difficulty getting the money it needs at a reasonable cost.
  1. A conservative approach to working capital management is to use more short-term and less long term financing as compared to the maturity matching approach. 
  1. Firms with an aggressive working capital approach will have more marketable securities on average than a firm following a conservative working capital approach.
  1. Due to the normal shape of the yield curve, an aggressive manager has an incentive to make more use of short-term financing.
  1. Other things equal, a firm without ready access to capital markets should be more conservative in its approach to working capital management.
  1. The longer the payables deferral period, the longer will be the cash conversion cycle – other things equal.
  1. Compensating balances raise the effective cost of borrowing from banks.
  1. The incentive to using a lockbox system is to increase the security of the check collection process. 
  1. Trade credit is always the least expensive way to finance inventory. 
  1.  If a firm holds its inventory for 25 days before its sale, purchases from suppliers that grant 30 days credit, and extends credit to its customers for 60 days after the sale, its cash conversion cycle is 85 days.
  1. A zero-balance account automatically regulates the amount of short term debt and marketable securities that a firm has to keep the amount of idle cash at the lowest possible level at all times. 

 

 

Multiple Choice: Select the single best answer to each question and record your answer on your Scan-Tron Answer sheet. Two points per question.

 

Use the following information for the next three questions:

 

Consider a company with expected annual EBIT of $50 million per year, a current cost of common equity of 13%, before tax cost of debt of 8%, a tax rate of 30%, and long-term debt of $50,000,000. The company has 500,000 shares of common stock outstanding with a Beta coefficient of 1.20. Suppose the company can borrow an additional $80 million of debt at the same 8% rate. The debt is perpetual maturity debt, and the other standard MM assumptions apply. If the company uses the proceeds of the new debt issue to repurchase common shares, supply the answers to the following questions.

 

  1. The firm’s value prior to the restructuring is closest to:
    1. $424.9 million
    2. $303.8 million
    3. $297.7 million
    4. $287.7 million
    5. $434.0 million

  2. The total annual cash flow to the common shareholders prior to the restructuring is closest to:
    1. $35.0 million
    2. $28.0 million
    3. $40.0 million
    4. $29.2 million
    5. $32.2 million 

  3. After the restructuring, the value of the firm will be closest to:
    1. $311.7 million
    2. $321.7 million 
    3. $327.9 million
    4. $315.7 million
    5. Impossible to determine with this information

  4. Suppose an unleveraged company has a WACC of 12.5 % and a tax rate of 30%. If the company issues debt with a before-tax cost of 8% and uses the debt to repurchase common shares such that the capital structure after the repurchase is 65% equity and 35% debt, then the new cost of equity for the company will be closest to:
    1. 12.5%
    2. 14.2% 
    3. 14.9%
    4. 13.6%
    5. 13.2%

  5. Consider a company that has makes one product which it sells for $8.50 per unit. The variable cost per unit for this product is $5.75. The company has $450,000 annual fixed operating costs. The company’s break even point in units is closest to:
    1. 52,942
    2. 163,636
    3. 78,261
    4. 95,662
    5. 295,445

  6. At 400,000 units of production, the company described in Question 35 has Degrees of Operating Leverage (DOL) closest to:
    1. 1.48
    2. 2.09
    3. 1.55
    4. 1.69 
    5. 1.00

  7. Suppose a company purchases inventory from a supplier that has credit terms of 5/10 net 60. If the company can borrow funds from a bank at a rate of 8.5%, what is the best payment policy for the company if it needs the full 60 days to generate enough sales to cover the cost of the purchase?
    1. Pay for the purchase immediately and borrow all of the needed funds from the bank for 60 days.
    2. Pay for the purchase on the 5th day and borrow all of the needed funds from the bank for 55 days.
    3. Pay for the purchase on the 10th day and borrow all of the needed funds from the bank for 50 days.
    4. Pay for the purchase on the 60th day and borrow nothing from the bank.
  1. Consider a discount bank loan that has a 13.5% stated annual rate and a 7.5% compensating balance requirement. The actual annual interest rate on this loan (APR) is closest to:
    1. 17.09% 
    2. 13.5%
    3. 15.61%
    4. 16.54%
    5. 21.00%

You will receive automatic credit for Questions 39 and 40 only if your test has been turned in on time.

 

Problem  (20 Points)

 

You need to determine the cost of capital for your company. Your company is financed with debt and common stock, with a Long-Term-Debt/Total Assets ratio of .35 based on market values. This capital structure has been determined to be optimal for this company.  The marginal tax rate is 34%.

 

Your company currently has an issue of long-term bonds outstanding with 12 years remaining to maturity, an 11.5% coupon rate (semi-annual pay­ments) and a $1,000 par value.  The next coupon payment is due in exactly six months. The total face value of the issue is $25 million. These bonds are currently selling for $1,150 in the market. Your investment banker feels that new 20-year annual-payment bonds could be sold at par at the same yield to maturity as the existing bonds. Your company also has $15 million of trade credit (accounts payable) and a short-term bank loan for $6 million (8.0% rate) that is used to carry the company through the peak selling season, after which it is paid off within a few months.

 

Your common stock is not publicly traded, so you don't know your company's Beta.  How­ever, you have located a company that is very similar in terms of opera­tions, and their publicly traded stock reflects a Beta of 1.30.  The other company's capital structure is 20% debt and 80% common equity. The yield on T-bills is currently 4.5%, the yield on 20-year Treasury Bonds is 6.8%, and the S&P 500 had an average annual increase of 18% over the last year.

 

Given this information, complete the following table.  Support your answers with the appropriate computations and written explanations to justify any assumptions you made.

 

  

  Weight (%) Cost (%)
Short Term Debt    
Long Term Debt    
Common Stock    
WACC

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Answers:

 

1=F, 2=T, 3=T, 4=F, 5=T, 6=F, 7=T, 8=F, 9=T, 10=F, 11=T, 12=F, 13=T, 14=T, 15=F, 16=T, 17=F, 18=T, 19=T, 20=T, 21=F, 22=F, 23=T, 24=T, 25=F, 26=T, 27=F, 28=F, 29=T, 30=F, 31=C, 32=E, 33=B, 34=B, 35=B, 36=D, 37=C, 38=A

 

Wt of LTD = .35

Wt of Equity = .65

Cost of Debt before tax = 9.39%

Cost of Equity = 14.06% (Beta = 1.512)

WACC = 11.31%