FINANCIAL MANAGEMENT 2

REVISION QUESTIONS

1. Define intrinsic value, market value and going-concern value.

2. How do changes in interest rates affect bond prices and its Yield to Maturity after it
issued?
3. How does call provision benefit bond issuers?
4. Specify whether each of the subsequent actions will result in an increase or decrease
in a bond's yield to maturity: (a) The bond's price rises; (b) The bond undergoes a
downgrade by the rating agencies.
5. Define systematic risk and unsystematic risk.
6. What is Beta's meaning? How beta of a portfolio is measured.
7. Define the security market line.
8. What will be the reaction of investors if a security is undervalued in terms of Capital
– asset pricing model?
9. If the Beta of a company doubled, how the expected return of this company will
change?
10. What is the purpose of the statement of cash flows?
11. What is the benefits of cash budgeting to the firm? Show the differences between a
cash budget and the sources and uses of funds statement.
12. Why is it necessary to analyze a cash flow statement when the shareholders already
have the balance sheet and the income statement?
13. Define operating leverage, financial leverage, the degree of operating leverage
(DOL) and the degree of financial leverage (DFL).
14. Compare the financial leverage and the operating leverage.
15. How a change in selling price or wave of employees affect the Break-even point of
a company?
16. Explain your opinion on this argument: “ If a company maintains fixed operating
costs at a high level, the operating profit will fluctuate greatly when there is a change
in sales volume”
17. Present the definition of capital structure. Explain the Net operating income (NOI)
approach and the Traditional approach to the theory of capital structure.
18. Present the impacts of capital structure on the WACC of a Company?
19. Explain your opinion on this argument: “The company with the higher debt in its
capital structure will has higher EPS”
20. Present the definition of arbitrage. How does it affect the issue of capital structure?
21. What is the reason behind institutional lenders refraining from providing funds to a
corporation that accumulates excessive debt?
22. Define stock dividend, stock split and stock repurchase
23. Explain the M&M argument that dividends are irrelevant.
24. Explain the counterarguments to M&M - that dividends do matter.
25. Present the effect of dividend policy on the company's market value.
26. Why might some investors prefer stocks with low dividend yields while the others
prefer dividend-paying stocks?
27. Explain your opinion on this argument “Companies with elevated growth rates
typically maintain high dividend-payout ratios as a means to attract a larger investor
base”
28. How does a firm's liquidity and borrowing capacity impact its dividend-payout ratio
from a managerial perspective?
29. Explain your opinion on this argument : “The typical trend is for the stock price to
increase in response to an unforeseen dividend hike and decrease when an
unexpected dividend reduction occurs”.
30. Present the definition of mergers and acquisitions
EXERCISES
Question 1
A bond has a $1,000 face value. The appropriate discount rate is 12% (annual rate).
Calculate the value of the bond in the following cases:
1. The bond is a perpetual bond which provides an 7% annual coupon.
2. The bond provides an 9% annual coupon for 15 years.
3. The bond provides an 8% semi-annual coupon for 12 years.
4. The bond is a zero-coupon bond which has a 25-year life.
Question 2
The annual dividend that each share of stock X just received is $5. The appropriate discount
rate is 13%. Calculate the value of the common stock X in following cases:
1. Stock X has an expected growth rate of 0%.
2. Stock X has an expected dividend growth rate of 7%.
Question 3
BAY Company has outstanding a $1,000-face-value bond with a 14 % coupon rate and 3
years remaining until final maturity. Interest payments are made semiannually.
a. What value should you place on this bond if your nominal annual required rate of return
is (i) 12 %? (ii) 14 %? (iii) 16 %?
b. Assume that we are faced with a bond similar to the one described above, except that it
is a zero-coupon, pure discount bond. What value should you place on this bond if your
nominal annual required rate of return is (i) 12 %? (ii) 14 %? (iii) 16 %? (Assume
semiannual discounting.)
Question 4
BAY Company currently pays a dividend of $2.5 per share, and this dividend is expected
to grow at a 13 percent annual rate for four years, and then at a 8 percent rate forever.
What value would you place on the stock if an 18 percent rate of return was required?
Question 5
BAY Company currently pays a dividend of $1.60 per share on its common stock. The
company expects to increase the dividend at a 20% annual rate for the first 4 years and at
a 13% rate for the next 4 years, and then grow the dividend at a 7% rate thereafter. This
phased-growth pattern is in keeping with the expected life cycle of earnings. You require
a 16% return to invest in this stock. What value should you place on a share of this stock?
Question 6
On January 1, 2001, BAY Company has an issue of 12% semiannual coupon bonds with
20 years left to maturity (mature on December 31, 2020). The bond is sold at its par value
of $1,000.
a) Calculate the YTM on the day the bond issued.
b) What is the price of the bond five years later on January 1, 2006, assuming market
required rate of return fall to 10%?
c) On July 1, 2014, which is 6.5 years before maturity, the bond is sold for $920. Calculate
YTM at that time.
Question 7
BAY Company has a beta of 1.4. The risk-free rate is 8 percent and the expected return on
the market portfolio is 15 percent. The company currently pays a dividend of $2.5 a share,
and investors expect it to experience a growth in dividends of 9 percent per annum for
many years to come.
a. What is the stock’s required rate of return according to the CAPM?
b. What is the stock’s present market price per share, assuming this required return?
c. What would happen to the required return and to market price per share if the beta were
0.7? (Assume that all else stays the same.)
Question 8
BAY Paint Company has fixed operating costs of $3 million a year. Variable operating
costs are $1.75 per liter of paint produced, and the average selling price is $2 per liter.
a. What is the annual operating break-even point in liter? In dollars of sales?
b. If variable operating costs decline to $1.68 per liter, what would happen to the operating
break-even point ?
c. If fixed costs increase to $3.75 million per year, what would be the effect on the operating
break-even point?
d. Compute the degree of operating leverage (DOL) at the current sales level of 16 million
liter.
e. If sales are expected to increase by 15 percent from the current sales position of 16
million liter, what would be the resulting percentage change in operating profit (EBIT)
from its current position?
Question 9
BAY Company has a DOL of 2 at its current production and sales level of 20,000 units.
The resulting operating income figure is $1,000.
a. If sales are expected to increase by 15 percent from the current 20,000-unit sales position,
what would be the resulting operating profit figure?
b. At the company’s new sales position of 24,000 units, what is the firm’s “new” DOL
figure?
Question 10
BAY Company currently has $3 million in debt outstanding, bearing an interest rate of
12%. It wishes to finance a $4 million expansion program and is considering three
alternatives: additional debt at 14% interest (option 1), preferred stock with a 12% dividend
(option 2), and the sale of common stock at $16 per share (option 3). The company
currently has 800,000 shares of common stock outstanding and is in a 40% tax bracket.
a. If earnings before interest and taxes are currently $1.5 million, what would be earnings
per share for the three alternatives, assuming no immediate increase in operating profit?
b. Compute the degree of financial leverage (DFL) for each alternative at the expected
EBIT level of $1.5 million.
Question 11
X Company and Y Company are identical except for capital structures. X has 50 percent
debt and 50 percent equity financing, whereas Y has 20 percent debt and 80 percent equity
financing. (All percentages are in market value terms.) The borrowing rate for both
companies is 13 percent in a no-tax world, and capital markets are assumed to be perfect.
The earnings of both companies are not expected to grow, and all earnings are paid out to
shareholders in the form of dividends.
a. If you own 2 percent of the common stock of X, what is your dollar return if the company
has net operating income of $360,000 and the overall capitalization rate of the company,
ko, is 18 percent? What is the implied equity capitalization rate, ke?
b. Y has the same net operating income as X. What is the implied equity capitalization
rate of Y? Why does it differ from that of X?
Question 12
BAY Company has earnings before interest and taxes of $5 million and a 40 percent tax
rate. It is able to borrow at an interest rate of 14 percent, whereas its equity capitalization
rate in the absence of borrowing is 17 percent. The earnings of the company are not
expected to grow, and all earnings are paid out to shareholders in the form of dividends.
In the presence of corporate but no personal taxes, what is the value of the company in an
M&M world with no financial leverage? With $5 million in debt? With $8 million in debt?
Question 13
BAY Company expects with some degree of certainty to generate the following net income
and to have the following capital expenditures during the next five years (in thousands of
dollars):
Year 1 2 3 4 5
Net income $3,000 $2,500 $2,500 $2,700 $2,000
Capital $1,500 $1,500 $2,000 $1,500 $2,500
expenditures
The company currently has 1 million shares of common stock outstanding and pays
annual dividends of $1 per share.
a. Determine dividends per share and external financing required in each year if dividend
policy is treated as a residual decision.
b. Determine the amounts of external financing that will be necessary in each year if the
present annual dividend per share is maintained.
c. Determine dividends per share and the amounts of external financing that will be
necessary if a dividend-payout ratio of 40 percent is maintained.
Question 14
BAY company’s earnings per share ($) over the last 10 years were the following:
YEAR 1 2 3 4 5 6 7 8 9 10
EPS 1.70 1.82 1.44 1.88 2.18 2.32 1.84 2.23 2.5 2.73
a. Determine annual dividends per share under the following policies:
- A constant dividend-payout ratio of 50 percent (to the nearest cent).
- A regular dividend of 90 cents and an extra dividend to bring the payout ratio to
50 percent if it otherwise would fall below.