Assignment 2 & 3:

Course Title: Financial Management Topic Leverage

Course Program BBA
Semester: 4th Batch FA 18 Section: A
th
Assigned Date 27 April, 2021 Submission Date 1st May, 2021
Student’s Reg. No.

Assignment 2:

Residual dividend model: Axel Telecommunications has a target capital structure that consists
of 70 percent debt and 30 percent equity. The company anticipates that its capital budget for the
upcoming year will be $3,000,000. If Axel reports net income of $2,000,000 and it follows a
residual dividend payout policy, what will be its dividend payout ratio?

Stock split: Gamma Medical’s stock trades at $90 a share. The company is contemplating a 3-
for-2 stock split. Assuming that the stock split will have no effect on the market value of its
equity, what will be the company’s stock price following the stock split?

Stock repurchases: Beta Industries has net income of $2,000,000 and it has 1,000,000 shares of
common stock outstanding. The company’s stock currently trades at $32 a share. Beta is
considering a plan in which it will use available cash to repurchase 20 percent of its shares in the
open market. The repurchase is expected to have no effect on either net income or the company’s
P/E ratio. What will be its stock price following the stock repurchase?

Stock split: After a 5-for-1 stock split, the Strasburg Company paid a dividend of $0.75 per new
share, which represents a 9 percent increase over last year’s pre-split dividend. What was last
year’s dividend per share?

External equity financing: Northern Pacific Heating and Cooling Inc. has a 6-month backlog of
orders for its patented solar heating system. To meet this demand, management plans to expand
production capacity by 40 percent with a $10 million investment in plant and machinery. The
firm wants to maintain a 40 percent debt-to-total-assets ratio in its capital structure; it also wants
to maintain its past dividend policy of distributing 45 percent of last year’s net income. In 2005,
net income was $5 million. How much external equity must Northern Pacific seek at the
beginning of 2006 to expand capacity as desired? Assume the firm uses only debt and common
equity in its capital structure.
Assignment 3:

EBIT sensitivity Stewart Industries sells its finished product for $9 per unit. Its fixed operating
costs are $20,000, and the variable operating cost per unit is $5.
a. Calculate the firm’s earnings before interest and taxes (EBIT) for sales of 10,000 units.
b. Calculate the firm’s EBIT for sales of 8,000 and 12,000 units, respectively.
c. Calculate the percentage changes in sales (from the 10,000-unit base level) and associated
percentage changes in EBIT for the shifts in sales indicated in part b.
d. On the basis of your findings in part c, comment on the sensitivity of changes in EBIT in
response to changes in sales.

Degree of operating leverage Grey Products has fixed operating costs of $380,000, variable
operating costs of $16 per unit, and a selling price of $63.50 per unit.
a. Calculate the operating breakeven point in units.
b. Calculate the firm’s EBIT at 9,000, 10,000, and 11,000 units, respectively.
c. With 10,000 units as a base, what are the percentage changes in units sold and EBIT as sales
move from the base to the other sales levels used in part b?
d. Use the percentages computed in part c to determine the degree of operating leverage (DOL).
e. Use the formula for degree of operating leverage to determine the DOL at 10,000 units.

Degree of financial leverage Northwestern Savings and Loan has a current capital structure
consisting of $250,000 of 16% (annual interest) debt and 2,000 shares of common stock. The
firm pays taxes at the rate of 40%.
a. Using EBIT values of $80,000 and $120,000, determine the associated earnings per share
(EPS).
b. Using $80,000 of EBIT as a base, calculate the degree of financial leverage (DFL).
c. Rework parts a and b assuming that the firm has $100,000 of 16% (annual interest) debt and
3,000 shares of common stock.

Integrative—Multiple leverage measures Play-More Toys produces inflatable beach balls,

selling 400,000 balls per year. Each ball produced has a variable operating cost of $0.84 and sells
for $1.00. Fixed operating costs are $28,000. The firm has annual interest charges of $6,000,
preferred dividends of $2,000, and a 40% tax rate.
a. Calculate the operating breakeven point in units.
b. Use the degree of operating leverage (DOL) formula to calculate DOL.
c. Use the degree of financial leverage (DFL) formula to calculate DFL.
d. Use the degree of total leverage (DTL) formula to calculate DTL. Compare this to the product
of DOL and DFL calculated in parts b and c.

Capital Structure:
Unlevered beta Harley Motors has $10 million in assets, which were financed with $2 million of
debt and $8 million in equity. Harley’s beta is currently 1.2 and its tax rate is 40 percent. Use the
Hamada equation to find Harley’s unlevered beta, bU.
Hamada equation Cyclone Software Co. is trying to establish its optimal capital structure. Its
current capital structure consists of 25 percent debt and 75 percent equity; however, the CEO
believes the firm should use more debt. The risk-free rate, rRF, is 5 percent, the market risk
premium, RPM, is 6 percent, and the firm’s tax rate is 40 percent. Currently, Cyclone’s cost of
equity is 14 percent, which is determined by the CAPM. What would be Cyclone’s estimated
cost of equity if it changed its capital structure to 50 percent debt and 50 percent equity?

WACC and optimal capital structure Elliott Athletics is trying to determine its optimal capital
structure, which now consists of only debt and common equity. The firm does not currently use
preferred stock in its capital structure, and it does not plan to do so in the future. Its treasury staff
has consulted with investment bankers and, on the basis of those discussions, has created the
following table showing its debt cost at different levels:

Elliott uses the CAPM to estimate its cost of common equity, rs, and estimates that the risk-free
rate is 5 percent, the market risk premium is 6 percent, and its tax rate is 40 percent. Elliott
estimates that if it had no debt, its “unlevered” beta, bU, would be 1.2.
a. What is the firm’s optimal capital structure, and what would be its WACC at the optimal
capital structure?
b. If Elliott’s managers anticipate that the company’s business risk will increase in the future,
what effect would this increase likely have on its target capital structure?
c. If Congress were to dramatically increase the corporate tax rate, what effect would this
increase likely have on Elliott’s target capital structure?
d. Plot a graph of the after-tax cost of debt, the cost of equity, and the WACC versus
(1) the debt/assets ratio and (2) the debt/equity ratio.