Financial Management

(D. Risk & Leverage)

D. RISK AND LEVERAGE tell which firm has the greater business risk given the above information.
D. To determine which firm has the greater business risk, we need to know the operating
THEORIES: income (NOI or EBIT) of each firm. Paranaque Corporation would have less business risk
Risk if its operating income is at least twice that of Alabang Company.
Business risk
Financial risk 9. Which of the following is incorrect regarding operating leverage?
12. Financial risk refers to the: A. Operating leverage is the degree to which costs are fixed.
A. risk of owning equity securities B. A project's break-even point will be affected by the extent to which costs can be reduced
B. risk faced by equity holders when debt is used as sales decline.
C. general business risk of the firm C. If the project has mostly variable costs, it is said to have high operating leverage.
D. possibility that interest rates will increase D. High operating leverage implies that profits are more sensitive to changes in sales.

Market risk 11. The extent to which fixed costs are used in a firm’s operations is called its:
Comprehensive A. financial leverage. C.financial leverage.
5. A decrease in the debt ratio will least likely affect: B. operating leverage. D.foreign risk exposure.
A. Financial risk C.Systematic or market risk
B. Business risk D.Total risk Financial Leverage
4. It refers to management strategy of financing assets with borrowed capital; such an extensive
14. Which of the following situations is likely to have the highest combined business and financial use raise the entity risk thereby impacting on the return on common stockholders’ equity to be
risk impact upon a business? above or below the rate of return on total assets.
A. A new labor-intensive operation is funded with operating cash flows A. Factoring C. Mortgage.
B. A fully automated plant is completed, funded with retained earnings B. Leverage. D. Restructuring
C. A fully automated plant is completed, funded with the issuance of 10-year bonds
D. An automated, but dated plant in the southern region is closed and operations are 1. The use of financial leverage by the firm has a potential impact on which of the following?
resumed in a labor-intensive plant in Central Luzon (1) The risk associated with the firm
(2) The return experienced by the shareholder
Operating Leverage (3) The variability of net income
2. Which of the following is a key determinant of operating leverage? (4) The degree of operating leverage
A. Level of debt C.Technology (5) The degree of financial leverage
B. Cost of debt D.Capital structure A. 1, 3, 5 C.1, 2, 3, 5
B. 2, 3, 4, 5 D.1, 2, 5
3. The degree of operating leverage for Alabang Company is 3.5, and the degree of operating
leverage for Paranaque Corporation is 7.0. According to this information, which firm is 16. The degree of financial leverage for April Company is 3.0, and the degree of financial leverage
considered to have greater business risk? for August Corporation is 6.2. According to this information, which firm is considered to have
A. Alabang Company. greater overall (total) risk?
B. Paranaque Corporation. A. April Company.
C. The degree of operating leverage is not a measure of business risk, so it is not possible to B. August Corporation.

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C. The degree of financial leverage is a measure of financial risk, so the only conclusion that 8. Although debt financing is usually the cheapest component of capital, it cannot be used to
can be made with the information given is that August Corporation has greater financial excess because
risk than April Company -- we cannot tell which firm has greater total risk. A. the interest rates may change.
D. To determine which firm has the greater total risk, we need to know the financial B. the firm's stock price will increase and raise the cost of equity financing.
breakeven point of each firm. C. the financial risk of the firm may increase and thus drive up the cost of all sources of
financing.
Weighted average Cost of capital D. none of the above.
6. Which of the following changes would tend to decrease the company cost of capital for a
traditional firm? PROBLEMS:
A. Decrease the proportion of equity financing. Capital structure
1
B. Increase the market value of the debt. . If the pro forma balance sheet shows that total assets must increase by P400,000 while
C. Decrease the proportion of debt financing. retaining a debt-equity ratio of .75 then:
D. Decrease the market value of the equity. A. debt must increase by P300,000.
B. equity must increase by the full P400,000.
15. The most commonly held view of capital structure is that the weighted average cost of capital: C. debt must increase by P171,428.
A. falls first with moderate levels of leverage and then increases. D. equity must increase by P100,000.
B. does not change with leverage.
C. increases proportionately with increases in leverage. Optimal capital budget
2
D. increases with moderate amounts of leverage and then falls. . Absolute Corporation has a capital structure that consists of 65% equity and 35% debt. The
company expects to report P100 million in net income this year, and 67.5% of the net income
Target capital structure will be paid out as dividends. How large can the firm's capital budget be this year without it
10. The mix of debt, preferred stock, and common equity with which the firm plans to raise capital having to include the cost of new common stock in its cost of capital analysis?
is called the:
A. financial risk C. business risk 1 .Answer: C
B. operating leverage D. target capital structure Debt ratio: 0.75 ÷ (1 + 0.75) 0.42857
Equity ratio: (1.00 – 0.42857) 0.57143
Optimal capital structure Increase in Equity: 0.57143 x 400,000 228,572
13. The mix of debt and equity that minimizes the cost of capital is the: Increase in debt: 0.42857 x 400,000 171,428
A. optimal operating leverage C. optimal degree of combined leverage
B. target financial structure D. optimal capital structure 2 .Answer: C
First, calculate the addition to retained earnings as the total net income minus dividends.
7. When establishing their optimal capital structure, firms should strive to: Second, calculate the retained earnings breakpoint by dividing the addition to retained
A. minimize the weighted average cost of capital earnings by the equity fraction of the capital structure.
B. minimize the amount of debt financing used Net income 100.0M
C. maximize the marginal cost of capital Deduct dividends (0.675 x 100M) 67.5M
D. none of the above Increase in retained earnings 32.5M
Capital budget supported by retained earnings 32.5M ÷ 0.65 50.0M

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A. P100.0 million C. P 50.0 million A. P1,392,000 C. P2,480,000

B. P 67.5 million D. P 32.5 million B. P1,488,000 D. P2,800,000

Dividend per share Weighted average cost of capital

3 5
. The Salvage Company projects the following for the upcoming year: . The Dumaguete Co. has an equity cost of capital of 17%. The debt to equity ratio is 1.5 and a
Earnings before interest and taxes P40 million cost of debt is 11%. What is the weighted average cost of capital of the firm? (Assume a tax
Interest expense P 5 million rate of 33%)
Preferred stock dividends P 4 million A. 3.06% C. 16.97%
Common stock dividend payout ratio 20% B. 13.40% D. 15.52%
Average number of common shares outstanding 2 million
Effective corporate income tax rate 40% Retained earnings breakpoint
6
The expected dividend per share of common stock is . During the past five years, Pena Company had consistently paid 50% of earnings available to
A. P1.70 C. P2.10 common as dividends. Next year, the Pena Company projects its net income, before the P1.2
B. P1.86 D. P1.00 million preferred dividends, at P6 million.
The capital structure for the company is maintained at:
Required cash flow before tax Debt 25.5%
4
. How much will a firm need in cash flow before tax and interest to satisfy debt holders and Preferred stock 15.0%
equity holders if the tax rate is 40%, there is P10 million in common stock requiring a 12% Common equity 60.0%
return, and P6 million in bonds requiring an 8% return? What is the retained earnings break-point next year?
A. P5,760,000 C. P4,000,000
3 .Answer: A B. P4,800,000 D. P6,000,000
EBIT P 40 M
Interest 5M
Before tax P 35 M 5 .Answer: B
Income tax 14 M Capital structure:
Net income 21 M Debt: 1.5 ÷ (1 + 1.5) 60.0%
Preferred dividend 4M Equity: 100% - 60% 40.0%
Available to common P 17 M WCCD (0.6 x 11%) 6.6%
Per common share: 17M x 0.20 ÷ 2M shares = P1.70 WCCE (0.4 x 17%) 6.8%
Weighted average cost of capital 13.4%
4 .Answer: C
Interest (6M x 0.08) P 480,000 6 .Answer: C
Before-tax dividends (10M x 0.12 ÷ 0.6) 2,000,000 Available earnings to Common 6M – 1.2M 4.8 M
Total cash flow requirements to cover dividends and interest P2,480,000 Retained income 4.8M x .5 2.4 M
The computation of cash flow required by the interest payments ignored because they are Retained earnings Breakpoint 2.4 M ÷ 0.6 P4,000,000
deductible in the computation of taxes. The dividends are calculated on a before-tax basis Retained earnings breakpoint refers to the maximum amount of funds or financing required
because it is a residual amount. whereby there is no need to issue common shares.

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7
. Balon Company expects P30 million in earnings next year. Its dividend payout ratio is 40 A. EPS increase to P15.63. C. EPS increase to P17.50.
percent, and its equity to asset ratio is 40 percent. Balon Company uses no preferred stock. B. EPS increase to P16.67. D. EPS increase to P20.00.
At what amount of financing will there be a break point in Balon’s cost of capital?
10
A. P45 million C. P30 million . The board of directors of Aggressive Company was unhappy with the current return on
B. P20 million D. P18 million common equity. Though the return on sales (profit margin) was impressively good at 12.5
percent, the asset turnover was only 0.75. The present debt ratio is 0.40.
Degree of Financial Leverage Ms. Sylvia Moreno, the vice-president of corporate planning, presented a proposal as follows:
8
. Calculate the DFL for a firm with EBIT of P6,000,000, fixed cost of P3,000,000, interest ● Profit margin should be raised to 15 percent.
expense of P1,000,000, preferred stock dividends of 800,000, and a 40 percent tax rate. ● The new capital structure will be revised by raising debt component.
A. 6.0 C. 1.43 ● The asset turnover will be maintained at 0.75.
B. 9.0 D. 1.64 The proposed adjustment is estimated to raise return on equity by 50 percent.
What debt ratio did Ms. Moreno propose in order to raise the return on equity (ROE) to 150
Sensitivity analysis percent of the present level?
9
. A firm is expected to generate P1.5 million in operating income and pay P250,000 in interest. A. 0.52 C. 0.61
Ignoring taxes, this will generate P12.50 earnings per share. What will happen to EPS if B. 0.68 D. 0.72
operating income increases to P2.0 million?
Residual dividend policy
11
7 .Answer: A . Alvin Company expects next year’s after-tax income to be P7,500,000. The firm’s debt ratio is
Expected earnings 30.0 million currently 40 percent. Alvin Company has P6,000,000 of profitable investment opportunities,
Deduct dividends (30M x 0.4) 12.0 million and it wishes to maintain its existing debt ratio. According to the residual dividend policy, what
Increase in retained earnings 18.0 million 10 .Answer: A
Breakpoint: 18.0M ÷ 0.4 45.0 million Return on Assets = Asset turnover x Return on Sales
= .125 x .75
8 .Answer: D = .09375 or 9.375
Earnings before interest P6,000,000 Current Return on equity = 9.375 ÷ .60 = .15625 or 15.625%
Interest 1,000,000 Target ROE = 15,625 x 1.50 = 23.4375%
Preferred Dividends (800,000/0.6) 1,333,333 2,333,333 Let X = Debt Ratio
Earnings after preferred dividends (before taxes) P3,666,667 .234375 = (.15 x.75)
DFL (6M ÷ 3,666,667) 1.64 1-X
For every 10 percent change in EBIT, EPS changes by 16.4 percent (10% x 1.64). Adding X = 52%
financial leverage to operating leverage increases the total risk of a company.
11 .Answer: A
9 .Answer: C Net income 7,500,000
Increase in Earnings after tax: (1,750,000 – 1,250,000) 500,000 Financing required from equity 6M x 0.6 3,600,000
Percentage increase: (500,000 ÷ 1,250,000) 40 percent Residual earnings for dividends 3,900,000
New EPS: 12.50 + (12.50 x 0.40) 17.50% Payout ratio: 3,900,000/7,500,000 52%

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is the expected dividend payout ratio next year? Balance Sheet

A. 52.0 percent C. 48.0 percent As of December 31, 2007
B. 75.0 percent D. 25.0 percent Assets
Cash P 150,000
12
. Ellis Company expects to generate P10 million internally which could be available for financing Marketable securities 100,000
part of its P12 million capital budget for this coming year. Ellis’ management believes that a Accounts receivable 2,000,000
debt-equity ratio of 40 percent is best for the firm. How much should be paid in dividends if the Inventory 3,800,000
target debt-equity ratio is to be maintained? Total current assets P 6,050,000
A. P2,800,000 C. P1,428,571 Net plant and equipment 6,750,000
B. P8,571,429 D. P4,000,000 Total assets P12,800,000

Comprehensive
Use the following information to answer Question Nos. 13 through 18: Liabilities and Stockholders' Equity
The Reliable Corporation, a manufacturer of radar control equipment, is planning to sell its shares Accounts payable P 1,000,000
to the general public for the first time. The firm's investment banker is working with the Reliable Notes payable 1,200,000
Corporation in determining a number of items. Information on the Reliable Corporation follows: Total current liabilities 2,200,000
Reliable Corporation Long-term liabilities 2,380,000
Income Statement Total liabilities P 4,580,000
For the Year 2007 Common stock (1,200,000 shares at P1 par) P 1,200,000
Sales (all on credit) P22,428,000 Capital in excess of par 2,800,000
Cost of goods sold 16,228,000 Retained earnings 4,220,000
Gross profit 6,200,000 Total stockholders' equity 8,220,000
Selling and administrative expenses 2,659,400 Total liabilities and stockholders' equity P12,800,000
Operating profit 3,540,600
Interest expense 370,600 The new public offering will be at 10 times the earnings per share.
Net income before taxes 3,170,000
Taxes 1,442,000 13
. Assume that 500,000 new corporate shares will be issued to the general public. What will
Net income P 1,728,000 earnings per share immediately after the public offering be?
A. P1.02 C. P1.19
B. P1.44 D. P1.59
12 .Answer: C
The Debt to Equity Ratio is 0.4 to 1 14
. Based on the price-earnings ratio of 10, what will the initial price of the stock be?
RE + 0.40RE = P12,000,000
RE = P12,000,000 ÷ 1.40 13 .Answer: A
RE = P 8,571,429 EPS = Net income ÷ No. of common shares outstanding:
Available Retained Earnings for Dividends: 1,728,000 ÷ (1,200,000 + 500,000) = P1.02
(P10,000,000 – P8,571,429) = P1,428,571
14 .Answer: C

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A. P14.40 C. P10.20 corporate shares currently outstanding. What will the initial market price of the stock be?
B. P11.90 D. P15.90 Assume a price-earnings ratio of 10 and use earnings per share after the distribution in the
calculation.
15
. Assuming an underwriting spread of 7 percent and out-of-pocket costs of P150,000, what will A. P10.90 C. P10.20
net proceeds to the corporation be? B. P11.90 D. P12.15
A. P4,743,000 C. P4,950,000
18
B. P4,593,000 D. P5,307,000 . Assuming an underwriter spread of 7 percent and out-of-pocket costs of P150,000, what return
must the corporation earn on the net proceeds to equal earnings per share before the
16
. What return must the corporation earn on the net proceeds to equal the earnings per share offering?
before the offering? A. 13.50% C. 15.68%
A. 16.18% C. 15.68% B. 13.76% D. 14.57%
B. 16.58% D. 15.98%
17
. Assume that, of the initial 500,000-share distribution, 250,000 shares belong to current
stockholders and 250,000 are new corporate shares, and these will be added to the 1,200,000

Initial market price = P/E ratio x EPS = (10 x 1.02) = P10.20

15 .Answer: B
Gross proceeds (500,000 x 10.20) 5,100,000
Less:
Spread (7%) 357,000
Out-of-pocket expenses 150,000 507,000
Net proceeds to the corporation 4,593,000

16 .Answer: C 18 .Answer: B
EPS before initial offering: (1,728,000 ÷ 1,200,000) 1.44 Required earnings: (1,450,000 x 1.44) 2,088,000
Required earnings: (1,700,000 x 1.44) 2,448,000 Less Prior earnings 1,728,000
Earnings prior to initial offering 1,728,000 Required earnings on new issues 360,000
Earnings required on additional funds 720,000 Gross proceeds (250,000 x 11.90) 2,975,000
Required percentage returns on net proceeds of Less:
new offering (720,000 ÷ 4,593,000) 15.68% Spread (7%) 208,250
Out-of-pocket costs 150,000 358,250
17 .Answer: B Net proceeds 2,616,75
EPS immediately after initial offering: (1,728,000 ÷ 1,450,000) P1.19 Required percentage returns on net proceeds from
Market price: (10 x 1.19) P11.90 new public offering (360,000 ÷ 2,616,750) 13.76%

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