SECTION I: Multiple Choice Section (30 Marks, 30 Minutes, 2 Marks each)

CIRCLE THE MOST APPROPRIATE ANSWER TO EACH QUESTION.

1. Which of the following is NOT correct? 

A. The cost of equity is the return that equity investors require on their investment in
the firm.
B. The cost of equity can be found by either the dividend growth approach or the
SML approach.
C. The before tax cost of debt is the return that lenders require on the firm's debt.
D. If the firm has preferred stock in its capital structure, the cost of preferred stock
should be included in the cost of capital.
E. Book value capital structure weights should be used to calculate the WACC
rather than market value weights.

2. Which one of the following should be the primary consideration when determining the
appropriate cost of capital for a specific project? 

A. The initial capital requirement.

B. The risk level of the project.
C. The payback period.
D. The expected net present value.
E. The firm's current cost of capital.

3. The equity risk derived from the firm's operating activities is called ____________
risk. 

A. market
B. systematic
C. extrinsic
D. business
E. financial

4. All else the same, the financial leverage of a firm will _________________. 

A. decrease as the debt/equity ratio increases.

B. decrease as the firm's retained earnings account grows.
C. increase by the amount of equity it issues in a given year.
D. decrease if the firm has negative net income.
E. decrease as the firm uses debt to fund expansion projects.

5. A covenant limiting the issuer to an annual dividend payment of no more than 20

percent of net income before extraordinary items is an example of a:

A. positive covenant.
B. pledge covenant.
C. negative covenant.
D. payment covenant.

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6. Which of the following about sinking funds is FALSE?

A. A sinking fund improves the marketability of bonds.

B. A sinking fund increases the risk that the borrowing firm will be unable to
repay the principal at maturity.
C. In a sinking fund, the borrowing firm makes periodic payments to the trustee, who
uses the funds to retire some debt.
D. None of the above.

7. Which of the following about a call provision associated with debt is FALSE?

A. The call provision allows the issuing corporation to repurchase its debt before the
maturity date at a predetermined price.
B. The yield to maturity on a callable debt is typically higher than the yield to
maturity on an otherwise identical non-callable debt.
C. A call provision will likely be exercised if interest rates decline significantly.
D. None of the above.

8. Which of the following about convertible bonds is TRUE?

A. A convertible bond is equivalent to a regular bond plus a call option that allows
the issuing corporation to have the right to convert the bond into a specified
number of shares during the bond’s life.
B. The yield to maturity on a convertible bond is typically lower than the yield
to maturity on an otherwise identical non-convertible bond.
C. Holders of convertible bonds have the right to extend the maturity of the bond.
D. None of the above.

9. Which of the following about bonds is FALSE?

A. A zero-coupon (stripped) bond can sell for more than par value.
B. The higher the bond rating, the lower the risk of default, and the lower the
required return.
C. There is less price risk with floating rate bonds.
D. A zero-coupon (stripped) bond makes no periodic interest payments.

10. When a company issues new financial securities through a cash offering to new
investors, the firm may use:

I firm commitment
II public offering
III best efforts
IV rights offering

A. I, II and III only

B. I, II and IV only
C. I, III and IV only
D. II, III and IV only

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11. A Dutch auction is:

A. the selling of new financial securities in the Netherlands.

B. used by the syndicate in a public offering to establish the highest selling price
that will ensure that all the securities of the new issue will be sold.
C. a clause used by brokers in the event of an under-allocation of new securities
because not enough investors have bid to sell all of the securities.
D. used by the syndicate in a private placement that will establish the highest price
the broker will pay the issuing firm for the new securities.

12. The purpose of forming a syndicate is:

A. reducing risk for the brokers and the issuing firm.

B. provide more analytical skill for the syndicate.
C. pricing of the new securities.
D. price pegging in the market to establish a reasonable market price for the sale of
the new financial securities.

13. Issue costs for a new financial issue include:

I registration fees for a firm that is offering a seasoned equity issue.

II filing fees such as legal fees, filing fees with the SEC or distribution fees.
III printing costs for the prospectus and the new financial securities for the issue
IV the spread

A. I, II and III only

B. I, II and IV only
C. I, III and IV only
D. II, III and IV only

14. The contract provision whereby the underwriting syndicate may, at their option,
purchase additional securities from the issuing corporation at the initial offering price is
called (the):

A. regulation A
B. green shoe provision
C. best efforts option
D. direct rights option

15. The date on which existing shareholders are designated as the recipients of the stock
rights is referred to as:

A. announcement date
B. ex-rights date
C. holder-of-record date
D. declaration date

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SECTION II: Problems (70 Marks, 2 Hours)

ANSWER ALL THE PROBLEMS IN THE SPACE PROVIDED. IF YOU NEED

MORE SPACE, USE THE BACK OF THE PREVIOUS PAGE. YOU MUST
SHOW YOUR CALCULATIONS FOR EACH PROBLEM; FINAL ANSWER
WITHOUT SUPPORTING CALCULATIONS WILL GET ZERO POINT.

Problem #1 (20 Marks, 30 Minutes)

You are a new financial analyst at Belvedere Corp., a large manufacturing firm that is
currently looking at replacing some of its manufacturing equipment. You have found a
company in Ontario that can provide you with the new equipment at an installed cost of
$950,000. You have gathered the following information from Belvedere’s most recent
financial statements.

Assets
Cash
A/R

Assets
Cash
A/R
Belvedere’s bonds are currently selling at a quoted price of 108. New bonds would have
flotation costs of 4%. The preferred shares are selling for $40.98 per share and issuing
costs for new preferred would be 5%. Their common stock is selling $263. Belvedere
paid a dividend of $6.55 per share four years ago and dividends are expected to grow at
the same annual rate in the future as during the past four years. New common stock
would have flotation costs of 7% and the firm does not have enough in internally
generated funds to finance the equity portion of the project. The firm has an effective tax
rate of 35%.

a) Calculate the before-tax cost of debt. (3 Marks)

B0= $1,000 x 108 = $1,080

C = 6%(1,000)/2 = $30
t = 15x2=30

Before tax cost of debt = 2.628% x 2 = 5.2564%

(Financial calculator = 5.224%)

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 b) Calculate the cost of preferred shares. (2 Marks)

D ps
R p= . 05( $ 50)
Pp = =6 .1 %
$ 40 . 98

c) Calculate the cost of common equity. (3 Marks)

g=? Div (four years ago) = $6.55

Div (today) = $76,000/9500 = $8
$8 = $6.55(1+g)4
g = 5.126%

D 0 ( 1+ g ) $ 8(1 . 05126)
R E= + g= +.05126=8 . 3 %
P0 263

d) Calculate the WACC for the firm. (5 Marks)

Market Value of Debt = $400,000x 108% =$432,000

Market Value of Preferred = 500,000/50 =10,000 shares x 40.98 = $409,800
Market Value of Common = 9500 x 263 = $2,498,500
Total Market Value $3,340,300

%Debt = $432,000/$3,340,300= .12933

% Preferred = $409,800/$3,340,300= .12268
% Common = $2,498,500/$3,340,300= .74799

WACC=W D R D ( 1−T ) +W P R P +W E R E =.12933(5 . 2564 %)(1−. 35)+. 12268(6.1 %)+. 74799(8.3%)

¿. 4418+.748348+6.208317
¿7.398 %

e) If the project has an Internal Rate of Return (IRR) of 7%, should they accept or
reject the project? (2 Mark)

Reject the project since the IRR<WACC

f) Calculate the weighted average flotation costs. (2 Marks)

fa = Wefe + Wdfd+Wpfp
=.74799(7%)+.12268(5%)+.12933(4%)=6.36665%

g) Calculate the dollar amount of flotation costs. (3 Marks)

Amount needed =( 1−f a ) x( Amount raised )

$ 950 , 000=(1−. 0636665) x( Amount raised )
Amount raised = $950,000/.9363335 = $1,014,595.76

Flotation Costs = $1,014,595.76-950,000 = $64,595.76

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Problem #2 (15 Marks, 25 Minutes)
Skyworks Solutions, Inc. (Skyworks) is engaged in the production of analog
semiconductors. Skyworks is considering expanding into a new line of business by
developing a line of cloud-based computing services. Currently, Skyworks has a before
tax cost of debt of 5%, and an effective tax rate of 45%. Its stock has a beta of 2.5, and
the firm’s debt to equity ratio is 1. The firm has identified a pure play company
(Salesforce.com) whose only business is offering cloud-based computing services to
major U.S. companies. Salesforce.com also has a before tax cost of debt of 5%, its beta is
1.15, and it has a debt to equity ratio of 0.25. The effective tax rate of Salesforce.com is
40%. The expected return on the market is 7%, and the risk free rate of interest is 3%.

a) Determine the appropriate discount rate (WACC) Skyworks should use for evaluating
new projects within its business of analog semiconductors production. (5 marks)

WD = 50% WE = 50% (1 mark)

Cost of equity of Skyworks

R E =R F + β E ( R M −R F ) =3 %+ 2. 5∗(7 %−3 % )=13 %
(setup, 1 mark, answer, 1
mark)

WACC=W D R D ( 1−T ) +W E R E (setup, 1 mark)

WACC = .5*5%*(1-0.45)+ .5*13%
WACC = 7.875% (answer, 1 mark)

b) Determine the appropriate discount rate (WACC) Skyworks should use for evaluating
the new venture if the new venture will have a debt to equity ratio similar to that of
Skyworks. (8 marks)

Unlever the beta using information from the pure play firm
β levered firm 1. 15
β ASSET =β U = =1
1+ ( 1−T ) ( D/ E ) = 1+ ( 1−. 4 ) ( .25 ) (setup, 2 marks, answer, 1
mark)

Re-lever the beta using the venture’s debt to equity ratio and tax rate

β Levered Firm =1[ 1+(1−.45 )1]=1.55 (setup, 2 marks, answer, 1 mark)

Cost of equity for the new venture

R E=R F + β E ( R M −R F ) =3 %+1 . 55∗( 7 %−3 % )=9 . 2 %
(setup as before, 0 marks,
answer, 1 mark)

WD = 50% WE = 50% (as before, 0 marks)

WACC=W D R D ( 1−T ) +W E R E (setup as before, 0 marks)

WACC = .5*5%*(1-0.45)+ .5*9.2%
WACC =5.975% (answer, 1 mark)

c) What would happen if Skyworks uses the WACC of its business of analog
semiconductors production to evaluate this new venture? Briefly explain. (2 marks)

If Skyworks uses the WACC of its production of analog semiconductors business to

evaluate this new venture, the hurdle rate will be set too high for the new venture.

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Therefore, Skyworks will underestimates the profitability of the new venture and
could incorrectly reject the new venture.

Problem #3 (13 Marks, 25 Minutes)

The Connor Construction Company has grown rapidly during the past 5 years. They now
require a significant investment of $10,000,000 in new equipment to be able to complete
work on a large project. Discussions with an investment banker have assured the firm
that the following options are feasible:
o Option 1: Sell common stock at $10 per share
o Option 2: Issue $5,000,000, 8% coupon bonds with a 30-year maturity, in addition
to new equity.

The company currently has $12,000,000 of 6.5% coupon bonds and 4,000,000
common shares outstanding. The tax rate is 40%.

The company has prepared projections based on additional work they may be able to
secure with the new equipment. The projections are based on 2 scenarios – a strong
economy and a moderate economy:

State of Economy Probability EBIT

Strong 50% 7,000,000
Moderate 50% 4,000,000

a) Calculate the EBIT indifference point for the 2 options. At EBIT levels below this
point, which plan would you favour? (9 marks)

1st calculate the Indifference point = EPS1 = EPS2

1. Equity option: new shares = $10,000,000 / $10 = 1,000,000 new shares

2. Debt & Equity option:
Bonds - $5,000,000 x .08 = $400,000 new interest
New Shares = $5,000,000 / $10 = 500,000 new shares

( EBIT −I )( 1−T )−D ps ( EBIT −(780 , 000 ) ( 1−. 40 )

EPS1 = =
shares o/s 4 , 000 ,000+1 , 000 , 000
( EBIT −I ) ( 1−T )−D ps (( EBIT −( 400 , 000+780 ,000 ) ) ( 1−. 40 )
EPS2 = =
shares o /s 4 ,000 , 000+500 , 000

( EBIT −780 , 000 ) ( .60 ) ( EBIT−1, 180 , 000 ) (. 60 )

=
5 , 000 , 000 4 ,500 , 000
4.5(EBIT – 780,000) = 5(EBIT – 1,180,000)
.5EBIT = 2,390,000
EBIT = $4,780,000 (7 marks)

At EBIT amounts below $4,780,000, Alternative 1 (equity) becomes superior (2 marks)

b) What is the EPS at this level (indifference point)? (2 marks)

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 ( EBIT −I )( 1−T )−D ps ( 4 ,780 , 000−780 ,000 )( 1−. 40 )
EPS1 = = =. 48
shares o/s 5 , 000 , 000

( EBIT −I ) ( 1−T )−D ps

EPS2 =
shares o /s
(( 4 , 780 , 000−( 400 , 000+780 , 000)) ( 1−. 40 )
= =. 48
4 , 500 , 000

(2 marks for either)

c) Based on the company projections above, calculate the EPS at the expected level of
EBIT ONLY for the plan that provides the higher EPS at that level of EBIT. (2
marks)

Expected EBIT = .50($7,000,000) +.50($4,000,000) = $5,500,000 (1 mark)

( EBIT −I ) ( 1−T )−D ps ((5 , 500 , 000−(400 , 000+780 , 000)) ( 1−. 40 )

EPS2 = = =. 576
shares o /s 4 ,500 , 000
(1 mark)

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Problem #4 (12 Marks, 20 Minutes)
Smith Supplies manufactures hockey nets for large wholesale distributors. The
company’s income statement for the most recent year is provided below.

Smith Supplies
Sales (40,000 units @ $80) $3,200,000
Variable Costs (40,000 units @$41.50 each) 1,660,000
Fixed Costs 340,000
Depreciation 100,000
EBIT 1,100,000
Interest 600,000
EBT 500,000
Tax (at 40%) 200,000
Earnings After Tax (Net Income) 300,000

a) Calculate the degree of operating leverage. (2 marks)

Sales−Variable costs 3 ,200 ,000−1 , 660 ,000 1 ,540 , 000

DOL= = = =1 .4
EBIT 1, 100 , 000 1 ,100 , 000
or
EBIT +FC 1 ,100 , 000+340 , 000+100 , 000
DOL= = =1 . 4
EBIT 1 ,100 , 000

b) Calculate the degree of financial leverage. (2 marks)

EBIT 1, 100 , 000

DFL= = =2. 2
EBIT −I 1 ,100 , 000−600 , 000

c) Calculate the degree of combined leverage. (1 marks)

DCL = DOL X DFL = 1.4 x 2.2 = 3.08

d) Assuming the company has 125,000 shares issued and outstanding, what percentage
change in EPS would result from a 20% decrease in the sales volume? (1 mark)

% ch a n g Ee PS
DCL 
% ch a n g sa
e les

3.08 = % change EPS / -.20

% change EPS = 3.08 x -.20 = -.616 = -61.6%

e) What would the new EPS be as a result of the 20% decrease in sales? (4 mark)

New EPS = Old EPS x (1 + (% change in sales x DCL))

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Calculate old EPS:

( EBIT −I )( 1−T )−D ps ( 1 ,100 , 000−600 ,000 )( 1−. 40 )

EPS old = = =2. 40
shares o/s 125 , 000

New EPS = 2.40 x (1 + (-.20 x 3.08)

New EPS = 2.40 x (1 + (-.616)
New EPS = 2.40 x .384 = .9216 = .92

Or
New number of units = 40,000 units x .8 = 32,000 units

Sales (32,000 units @ $80) $2,560,000

Variable Costs (32,000 units @$41.50 each) 1,328,000
Fixed Costs 340,000
Depreciation 100,000
EBIT 792,000
Interest 600,000
EBT 192,000
Tax (at 40%) 76,800
Earnings After Tax (Net Income) 115,200

( EBIT −I ) (1−T )−D ps ( 792 ,000−600 , 000 ) (1−. 40 )

EPSnew = = =. 9216=. 92
shares o/ s 125 , 000

f) A competitor has the following leverage ratios:

DOL = 1.2
DFL = 2.4

Which company is riskier: Smith Supplies or the competitor? (2 marks)

Calculate DCL for competitor:

DCL = DOL x DFL = 1.2 x 2.4 = 2.88

The risk is related to the variability in the earnings and since Smith has a
higher DCL, changes will result in more variability in the earnings and
therefore more risk.

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Problem #5 (10 Marks, 20 Minutes)
Crushed Ice Airlines is a specialized airline that flies into remote locations in arctic and
Antarctic locations. The firm is an all equity firm with a book value of $1,200,000 and
the firm has 375,000 shares issued and outstanding. The firm has a tax rate of 40 percent
and has just paid its most recent dividend of $3.80 and the firm is expected to grow at 5
percent forever. The return on government T-bills is 3 percent, the return on the TSX is
15 percent and the firm has a beta 0.9979. Crushed Ice Airlines has decided to raise
$4,500,000 by issuing new equity shares through a rights offering. The brokers require a
brokerage fee of 4 percent of the total issue and the firm requires that the issue costs must
be covered by the new issue. The new shares will be sold to the existing shareholders at
a subscription price of $37.50 which is a discount of the current market price. Clearly
label your work and show your calculations for the following questions
a. Calculate the current market price for the equity shares. (2 marks)

CAPM r e =r f + β ( r m−r f )=3 % +0.9979 ( 15 %−3 % ) =14.9748 %

D 0 (1+ g) 3.80(1.05) 3.99

P 0= = = =40.00090303 ≅ $ 40.00 
r−g .149748−.05 0.099748

b. Calculate the amount of adjusted capital the firm needs to raise through the rights
offering and the number of new shares that will be issued. (2 marks)

capital required $ 4,500,000

A djusted capital= = =$ 4,687,500
1−f A 1−.04

adjusted capital 4,687,500

New shares= = =125,000 
subscription price 37.50

c. Calculate the number of rights a shareholder will need to provide when buying a
share of the new equity issue. (1 mark)

o
shares
s 375,000 
N= = =3.00
new shares 125,000

d. Calculate the value of each right. (1 mark)

M o−S $ 40.00−37.50 2.50

R= = = =0.625 
N +1 3+1 4

e. You own 37,500 of the shares of Crushed Ice Airlines on the announcement date.
Calculate your net wealth and ownership position in the company on the
announcement date. (1 mark)

Wealth 37,500 shares @ $40.00 = 1,500,000 ½

shares owned 37,500

Ownership position= = =.10 ≅ 10 % ½
shares outstanding 375,000

f. It is 1 day before the holder-of-record date. Calculate your net wealth and
ownership position in the company. (1 mark)

Shares trade ex-rights

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 37,500 shares @ $39.375 1,476,562.50

37,500 rights @ $ 0.625 23,437.50 ½

Total Wealth 1,500,000.00

shares owned 37,500

Ownership position= = =.10 ≅ 10 %½
shares outstanding 375,000

g. It is now the expiry date and you need to decide what to do with your rights by the
close of the markets today. You know from your class lectures that the last thing
you want to do is let the rights expire. Calculate your net wealth and ownership
position in the company for ONE of the remaining choices available for you.
Clearly state which option you chose and show your detailed work. (2 marks)

Wealth

37,500 old shares @ $39.375 1,476,562.50

12,500 new shares @ $ 39.375 492,187.50

Gross Wealth 1,968,750.00

Less cost of new shares 1

12,500 @ subscription price of $37.50 468,750.00

Total Wealth 1,500,000.00

shares owned
Ownership position=
shares outstanding
37,500+ 12,500 50,000
¿ = =.10 ≅ 10 % 1
375,000+ 125,000 500,000

OR

37,500 shares @ $39.375 1,476,562.50

37,500 rights @ $ 0.625 cash 23,437.50 1

Total Wealth 1,500,000.00

shares owned
Ownership position=
shares outstanding
37,500 37,500
¿ = =.075 ≅ 7.5 % 1
375,000+ 125,000 500,000

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