Exam 4 Review

Finance 335

Chapter 13

EBIT = PQ – VQ – F = 0 P = price per unit

Q = units of output
V = variable cost per unit
F = Fixed operating cost
QBE = F / P – V

1. The Weaver Watch Company manufacturers ladies’ watches that are sold through
discount houses. Each watch is sold for $25, the fixed costs are $140,000 for 30,000
watches or less; variable costs are $15 per watch.

a. What is the firm’s gain or loss at sales of 8,000 watches? 18,000 watches?

b. What is the breakeven point? Illustrate with a graph.

Financial risk is the additional risk placed on common stock holders as a result of the
decision to finance with debt.

Hamada Formula
Financial Risk is reflected in Beta and the required return to stockholders
Beta Levered = Beta Unlevered + BetaUnlevered (1-T) (D/E)
Business Risk + Financial Risk

T = Tax Rate D/E = Debt to Equity Ratio

BL = B u + Bu (1-T)(D/E)

BL = Bu (1 + [(1-T)D/E]) Bu = BL / (1 + [(1-T)D/E])
CAPM: SML: rs = rrf + (rm – rrf) BL

2. Cyclone Software Co. is trying to estimate its optimal capital structure. Cyclone’s
current capital structure consists of 25% debt and 75% equity, however, management
believes the firm should use more debt. The risk free rate is 5%, the market risk premium
is 6% and the firm’s tax rate is 40%. Currently, Cyclone cost of equity is 14%, which is
determined on the basis of the CAPM. What would be the estimated cost of equity if it
were to change its capital structure from its present capital structure to 50% debt and 50%
equity?

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 Chapter 14
 Three theories of dividend policy:
 Dividend irrelevance: Investors don’t care about payout.
 Bird-in-the-hand: Investors prefer a high payout.
 Tax preference: Investors prefer a low payout.

What’s the “information content,” or “signaling,” hypothesis

What’s the “clientele effect

Residual dividend model

 Capital budget – $800,000
 Target capital structure – 40% debt, 60% equity
 Forecasted net income – $600,000
 How much of the forecasted net income should be paid out as dividends?
 Calculate portion of capital budget to be funded by equity.
 Of the $800,000 capital budget, 0.6($800,000) = $480,000 will be funded with
equity.
 With net income of $600,000, there is more than enough equity to fund the
capital budget. There will be $600,000 - $480,000 = $120,000 left over to pay
as dividends. Calculate dividend payout ratio
 $120,000 / $600,000 = 0.20 = 20%

 Reasons for repurchases:

 As an alternative to distributing cash as dividends.
 To dispose of one-time cash from an asset sale.

Stock dividends vs. Stock splits

 Stock dividend: Firm issues new shares in lieu of paying a cash dividend. If
10%, get 10 shares for each 100 shares owned.
 Stock split: Firm increases the number of shares outstanding, say 2:1. Sends
shareholders more shares.
14-1 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?
3,000,000 * .3 = 900,000 2,000,000 – 900,000 = 1,100,000
Div payout ratio= 1100000/2000000
14-2 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?
Outstanding shares after split = shares * 3/2
Price after split = 90 * 2/3 = 60

Chapter 17

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# of units of foreign
Direct Quote Indirect Quote
Japanese yen 0.009 111.11
Australian dollar 0.650 1.5385

What is a cross rate?

 The exchange rate between any two currencies. Cross rates are actually
calculated on the basis of various currencies relative to the U.S. dollar.
 Cross rate between Australian dollar and the Japanese yen.
 Cross rate = (Yen / US Dollar) x (US Dollar / A. Dollar)

= 111.11 x 0.650

17-8 Suppose the exchange rate between the U.S. dollar and the Swedish krona was 10 krona
= $1.00, and the exchange rate between the dollar and the British pound was £1 = $1.50.
What was the exchange rate between Swedish kronas and pounds?
Cross Rate = 10 * $1.50 = Krona 15 per Pound

 In 2002, the full implementation of the “euro” was completed. The national
currencies of the 12 participating countries were phased out in favor of the “euro.” The
newly formed European Central Bank controls the monetary policy of the EMU.

17-4 A television set costs $500 in the United States. The same set costs 725 euros. If purchasing
power parity holds, what is the spot exchange rate between the euro and the dollar?
Direct 500/725 = $0.6897 Indirect 725/500 = Euros 1.45

FORWARD MARKET
US $ CURRENCY
EQUIV PER US $
S Franc (SPOT) .5728 1.7458
1 MONTH .5736 1.7434
2 MONTHS .5755 1.7378
6 MONTHS .5784 1.7288

Two Types of Transactions

1. Spot Market - Exchange currency on the spot - trade settled within 2 business days.
2. Forward Market - Forward trade is an agreement to exchange currency at some
time in the future.

RISK FREE RATES ACROSS COUNTRIES

REAL EXPECTED
RATE INFLATION
RISK FREE
RATE - USA = 2% + 3% = 5%
RISK FREE

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 RATE = 2% + 1% = 3%
S. Franc
* Difference in risk free rates between countries is approximately the difference in
inflation rates in the two countries
* Inflation is 2% lower in Switzerland than in USA and Risk Free Rate is 2% lower as
well.

FORWARD EXCHANGE RATES

Exchange rates in the forward market is different than the spot rate due to
- differences in the risk free rate
of the two countries
- differences in expected inflation
in the two countries
Predicting Forward Exchange Rates
S. Franc = SF 1.7458/$1 * 1.03/1.05
= One Year Forward
Exchange Rate
= SF 1.7125 / $1
Six-month T -bills have a nominal rate of 7 percent, while default-free Japanese bonds
that mature in 6 months have a nominal rate of 5.5 percent. In the spot exchange market,
one yen equals $0.009. If interest rate parity holds, what is the 6-month forward exchange
rate? Forward $.009 * 1.035/1.0275 = $.0091

Formula Sheet

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Io * ws = Equity Investment

Po = Do(1+g) / rs - g

EPS = Net Income / # of Shares Outstanding

PE = Price per share / EPS

BL = Bu (1 + [(1-T)D/E]) Bu = BL / (1 + [(1-T)D/E])

CAPM: SML: rs = rrf + (rm – rrf) BL

 Cross rate = (Yen / US Dollar) x (US Dollar / A. Dollar)

EBIT = PQ – VQ – F = 0 P = price per unit

Q = units of output
V = variable cost per unit
F = Fixed operating cost
QBE = F / P – V