Lebanese International University

School of Business
Masters of Business Administration
BFIN650 – Financial Strategy

Revision Sheet Chapters 14 & 15- Answer Key

Exercise 1:
Alpha Medical has 1 million shares outstanding trading at 90$ a share. The company is
contemplating a 3-for-2 stock split. Assume that the stock split will have no effect on the market
value of its equity.

Required:
a. What will be the company’s stock price following the split?
b. What will be the number of shares following the split?

Solution:
90
a. Ppost= Pprior / split = = $60/share
3/2

b. Npost= Nprior * split = 1 million * 3/2 = 1.5 million shares

Exercise 2:
Warren Supply Inc. is evaluating its capital budget. The company finances with debt and
common equity, but because of market conditions, wants to avoid issuing any new common
stock during the coming year. It is forecasting an EPS of $3.00 for the coming year on its
500,000 outstanding shares of stock. Its capital budget is forecasted at $800,000, and it is
committed to maintaining a $2.00 dividend per share.

Required:
Given these constraints, what percentage of the capital budget must be financed with debt?

Solution:
Determine NI:

 EPS= NI/Number of shares  NI= 3*500,000= $1.5 million

Determine Dividends:

 DPS= Dividends/ Number of shares  Dividends = 2*500,000= $1 million

Determine the % of Equity:

 Dividends = NI – (capital budget * % Equity)  %Equity = 62.5%

Determine the % of debt:

 100%=%Equity + %Debt  %Debt = 37.5%

Exercise 3:
The following data apply to Diesel Industries, Inc. (DII):

Free Cash Flow (FCF) $10,000

Extra cash $1,000
Number of shares 500
Intrinsic stock price $25

DII plans on distributing the extra cash to common stockholders via stock repurchase.

Required:
a. What is DII’s value of operations?
b. How many shares will remain after the repurchase?
Solution:
a. Vop = (N0*P) – Extra Cash = 500*25 – 100 = $11,500

b. N (repurchased) = Extra cash / P = 1,000 / 25 = 40 shares

N(post rep) = N(prior) – N(rep) = 500 – 40 = 460 shares

Exercise 4:
Dallas Company has 30 million shares of common stocks outstanding, and $40 million in short
term investments, which it plans to liquidate and distribute to common shareholders via stock
repurchase; the firm has no other non-operating assets.

Dallas current value of operations is $398 million. It has $258 million in debt and has no
preferred stocks outstanding.

Required:
a. Immediately before the repurchase, what is Dallas’ intrinsic value of equity?
b. Immediately after the repurchase, what is Dallas’s intrinsic value of equity?

Solution:
a. Vop 398 million
+ V. of non-operating assets 40 million
= Total intrinsic value of the firm 438 million
- Debt (258 million)

= Intrinsic value of equity (prior to rep) $180 million

b. Vop 398 million

+ V. of non-operating assets 0
= Total intrinsic value of the firm 398 million
- Debt (258 million)

= Intrinsic value of equity (post rep) $140 million

Exercise 5:
During next year, Lipstick Inc. is expecting to produce and sell 1,500,000 lipsticks at $20 each. It
estimates its fixed costs at $1,450,000 and expects to realize $2,750,000 profit before tax.

Required:
a. Calculate the variable cost per unit of Lipstick Inc.
b. Determine the Breakeven point QBE

Solution:
a. EBIT = P*Q – V*Q – F

2,750,000 = 20*1,500,000 – V*1,500,000 – 1,450,000

V=$17.2

b. QBE= F/(P-V) = 1,450,000 / (20 – 17.2)= 517,857 units.

Exercise 6:
Dyson Inc. is considering changing its capital structure from 20% debt to 60% by issuing
additional bonds and using the proceeds to repurchase and retire some common stock at book
value. The CFO has gathered the following data:

Risk free rate 6% Tax rate 35%

Market risk premium 6% Current debt ratio 20%
Current beta (Levered) 0.2 New debt ratio 60%

Required:
What would be the firm’s new cost of equity after recapitalization?

Solution:
 Determine the unlevered beta:
bU = bL current / [1 + (1 − T)(D/E)]
bU= 0.2/[1+(1-0.35)(0.2/0.8)] = 0.172

 Determine the new beta levered:

bL New = bU * [1 + (1 − T)(D/E)] = 0.172*[1+(1-0.35)(0.6/0.4)] = 0.3397

 Determine the new cost of equity:

New cost of equity = rsNew = rRF + bLNew(RPM)= 6% + (6%*0.3397) = 8.038%
Exercise 7:
Domino’s Inc. is considering a change in its capital structure and increase its debt ratio. The
below table shows both the current and the target capital structures.
Capital Structure Percentage of debt Percentage of equity
Current 55% 45%
Target 65% 35%
Assume that the return on risk free is R f=12%, the market risk premium RPm=14%, the current
cost of equity rs= 18% and the tax rate = 35%.
Required:
Calculate the estimated change in the cost of equity (r s new – rs old) if Domino’s Inc. has modified
its capital structure and comment the result.
Solution:
 Calculate β L old
r s old =Rf + β Lold ∗RPm
18%= 12% + β L old * 14%  β L old =0.428

 Calculate β u
β Lold
β u=
( 1−T )∗(% debt old ) 0.428
1+ = =0.238 ¿
(% equity ¿¿ old) ( 1−0.35 )∗0.55
1+
0.45

 Calculate β L new
(1−T )∗( % debt new )
β L new =β u∗1+
( 1−0.35 )∗0.65
(% equity ¿¿ new)=0.238∗1+ =0.5253 ¿
0.35

 Calculate r s new
r s new =Rf + β Lnew ∗RP m=12%+ (0.5253*14%)= 19.35%

 Calculate the change in the cost of equity

change ∈the cost of equity=r s new −r s old =19.35 %−18 %=1.35 %
 Comment
There is an increase in the cost of equity, so the company should be advised to keep its current
capital structure