Financial Management

(D. Risk & Leverage)

D. RISK AND LEVERAGE D. To determine which firm has the greater business risk, we need to know the operating
income (NOI or EBIT) of each firm. Paranaque Corporation would have less business risk
THEORIES: if its operating income is at least twice that of Alabang Company.
Risk
Business risk 9. Which of the following is incorrect regarding operating leverage?
Financial risk A. Operating leverage is the degree to which costs are fixed.
12. Financial risk refers to the: B. A project's break-even point will be affected by the extent to which costs can be reduced
A. risk of owning equity securities as sales decline.
B. risk faced by equity holders when debt is used C. If the project has mostly variable costs, it is said to have high operating leverage.
C. general business risk of the firm D. High operating leverage implies that profits are more sensitive to changes in sales.
D. possibility that interest rates will increase
11. The extent to which fixed costs are used in a firm’s operations is called its:
Market risk A. financial leverage. C. financial leverage.
Comprehensive B. operating leverage. D. foreign risk exposure.
5. A decrease in the debt ratio will least likely affect:
A. Financial risk C. Systematic or market risk Financial Leverage
B. Business risk D. Total risk 4. It refers to management strategy of financing assets with borrowed capital; such an extensive
use raise the entity risk thereby impacting on the return on common stockholders’ equity to be
14. Which of the following situations is likely to have the highest combined business and financial above or below the rate of return on total assets.
risk impact upon a business? A. Factoring C. Mortgage.
A. A new labor-intensive operation is funded with operating cash flows B. Leverage. D. Restructuring
B. A fully automated plant is completed, funded with retained earnings
C. A fully automated plant is completed, funded with the issuance of 10-year bonds 1. The use of financial leverage by the firm has a potential impact on which of the following?
D. An automated, but dated plant in the southern region is closed and operations are (1) The risk associated with the firm
resumed in a labor-intensive plant in Central Luzon (2) The return experienced by the shareholder
(3) The variability of net income
Operating Leverage (4) The degree of operating leverage
2. Which of the following is a key determinant of operating leverage? (5) The degree of financial leverage
A. Level of debt C. Technology A. 1, 3, 5 C. 1, 2, 3, 5
B. Cost of debt D. Capital structure 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 16. The degree of financial leverage for April Company is 3.0, and the degree of financial leverage
leverage for Paranaque Corporation is 7.0. According to this information, which firm is for August Corporation is 6.2. According to this information, which firm is considered to have
considered to have greater business risk? greater overall (total) risk?
A. Alabang Company. A. April Company.
B. Paranaque Corporation. B. August Corporation.
C. The degree of operating leverage is not a measure of business risk, so it is not possible to C. The degree of financial leverage is a measure of financial risk, so the only conclusion that
tell which firm has the greater business risk given the above information. can be made with the information given is that August Corporation has greater financial

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(D. Risk & Leverage)

risk than April Company -- we cannot tell which firm has greater total risk. B. the firm's stock price will increase and raise the cost of equity financing.
D. To determine which firm has the greater total risk, we need to know the financial C. the financial risk of the firm may increase and thus drive up the cost of all sources of
breakeven point of each firm. financing.
D. none of the above.
Weighted average Cost of capital
6. Which of the following changes would tend to decrease the company cost of capital for a PROBLEMS:
traditional firm? Capital structure
A. Decrease the proportion of equity financing. i
. If the pro forma balance sheet shows that total assets must increase by P400,000 while
B. Increase the market value of the debt. retaining a debt-equity ratio of .75 then:
C. Decrease the proportion of debt financing. A. debt must increase by P300,000.
D. Decrease the market value of the equity. B. equity must increase by the full P400,000.
C. debt must increase by P171,428.
15. The most commonly held view of capital structure is that the weighted average cost of capital: D. equity must increase by P100,000.
A. falls first with moderate levels of leverage and then increases.
B. does not change with leverage. Optimal capital budget
C. increases proportionately with increases in leverage. ii
. Absolute Corporation has a capital structure that consists of 65% equity and 35% debt. The
D. increases with moderate amounts of leverage and then falls. company expects to report P100 million in net income this year, and 67.5% of the net income
will be paid out as dividends. How large can the firm's capital budget be this year without it
Target capital structure having to include the cost of new common stock in its cost of capital analysis?
10. The mix of debt, preferred stock, and common equity with which the firm plans to raise capital A. P100.0 million C. P 50.0 million
is called the: B. P 67.5 million D. P 32.5 million
A. financial risk C. business risk
B. operating leverage D. target capital structure Dividend per share
iii
. The Salvage Company projects the following for the upcoming year:
Optimal capital structure Earnings before interest and taxes P40 million
13. The mix of debt and equity that minimizes the cost of capital is the: Interest expense P 5 million
A. optimal operating leverage C. optimal degree of combined leverage Preferred stock dividends P 4 million
B. target financial structure D. optimal capital structure Common stock dividend payout ratio 20%
Average number of common shares outstanding 2 million
7. When establishing their optimal capital structure, firms should strive to: Effective corporate income tax rate 40%
A. minimize the weighted average cost of capital The expected dividend per share of common stock is
B. minimize the amount of debt financing used A. P1.70 C. P2.10
C. maximize the marginal cost of capital B. P1.86 D. P1.00
D. none of the above
Required cash flow before tax
8. Although debt financing is usually the cheapest component of capital, it cannot be used to iv
. How much will a firm need in cash flow before tax and interest to satisfy debt holders and
excess because equity holders if the tax rate is 40%, there is P10 million in common stock requiring a 12%
A. the interest rates may change. return, and P6 million in bonds requiring an 8% return?

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(D. Risk & Leverage)

A. P1,392,000 C. P2,480,000 A. EPS increase to P15.63. C. EPS increase to P17.50.

B. P1,488,000 D. P2,800,000 B. EPS increase to P16.67. D. EPS increase to P20.00.

Weighted average cost of capital x

. The board of directors of Aggressive Company was unhappy with the current return on
v
. The Dumaguete Co. has an equity cost of capital of 17%. The debt to equity ratio is 1.5 and a common equity. Though the return on sales (profit margin) was impressively good at 12.5
cost of debt is 11%. What is the weighted average cost of capital of the firm? (Assume a tax percent, the asset turnover was only 0.75. The present debt ratio is 0.40.
rate of 33%) Ms. Sylvia Moreno, the vice-president of corporate planning, presented a proposal as
A. 3.06% C. 16.97% follows:
B. 13.40% D. 15.52%  Profit margin should be raised to 15 percent.
 The new capital structure will be revised by raising debt component.
Retained earnings breakpoint  The asset turnover will be maintained at 0.75.
vi
. During the past five years, Pena Company had consistently paid 50% of earnings available The proposed adjustment is estimated to raise return on equity by 50 percent.
to common as dividends. Next year, the Pena Company projects its net income, before the What debt ratio did Ms. Moreno propose in order to raise the return on equity (ROE) to 150
P1.2 million preferred dividends, at P6 million. percent of the present level?
The capital structure for the company is maintained at: A. 0.52 C. 0.61
Debt 25.5% B. 0.68 D. 0.72
Preferred stock 15.0%
Common equity 60.0% Residual dividend policy
What is the retained earnings break-point next year? xi
. Alvin Company expects next year’s after-tax income to be P7,500,000. The firm’s debt ratio
A. P5,760,000 C. P4,000,000 is currently 40 percent. Alvin Company has P6,000,000 of profitable investment
B. P4,800,000 D. P6,000,000 opportunities, and it wishes to maintain its existing debt ratio. According to the residual
dividend policy, what is the expected dividend payout ratio next year?
vii
. Balon Company expects P30 million in earnings next year. Its dividend payout ratio is 40 A. 52.0 percent C. 48.0 percent
percent, and its equity to asset ratio is 40 percent. Balon Company uses no preferred stock. B. 75.0 percent D. 25.0 percent
At what amount of financing will there be a break point in Balon’s cost of capital?
A. P45 million C. P30 million xii
. Ellis Company expects to generate P10 million internally which could be available for
B. P20 million D. P18 million financing part of its P12 million capital budget for this coming year. Ellis’ management
believes that a debt-equity ratio of 40 percent is best for the firm. How much should be paid
Degree of Financial Leverage in dividends if the target debt-equity ratio is to be maintained?
viii
. Calculate the DFL for a firm with EBIT of P6,000,000, fixed cost of P3,000,000, interest A. P2,800,000 C. P1,428,571
expense of P1,000,000, preferred stock dividends of 800,000, and a 40 percent tax rate. B. P8,571,429 D. P4,000,000
A. 6.0 C. 1.43
B. 9.0 D. 1.64 Comprehensive
Use the following information to answer Question Nos. 13 through 18:
Sensitivity analysis The Reliable Corporation, a manufacturer of radar control equipment, is planning to sell its shares
ix
. A firm is expected to generate P1.5 million in operating income and pay P250,000 in interest. to the general public for the first time. The firm's investment banker is working with the Reliable
Ignoring taxes, this will generate P12.50 earnings per share. What will happen to EPS if Corporation in determining a number of items. Information on the Reliable Corporation follows:
operating income increases to P2.0 million?

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(D. Risk & Leverage)

Reliable Corporation Sales (all on credit) P22,428,000

Income Statement Cost of goods sold 16,228,000
For the Year 2007 Gross profit 6,200,000
Selling and administrative expenses 2,659,400
Operating profit 3,540,600
Interest expense 370,600
Net income before taxes 3,170,000
Taxes 1,442,000
Net income P 1,728,000

Balance Sheet
As of December 31, 2007
Assets
Cash P 150,000
Marketable securities 100,000
Accounts receivable 2,000,000
Inventory 3,800,000
Total current assets P 6,050,000
Net plant and equipment 6,750,000
Total assets P12,800,000

Liabilities and Stockholders' Equity

Accounts payable P 1,000,000
Notes payable 1,200,000
Total current liabilities 2,200,000
Long-term liabilities 2,380,000
Total liabilities P 4,580,000
Common stock (1,200,000 shares at P1 par) P 1,200,000
Capital in excess of par 2,800,000
Retained earnings 4,220,000
Total stockholders' equity 8,220,000
Total liabilities and stockholders' equity P12,800,000

The new public offering will be at 10 times the earnings per share.
xiii
. Assume that 500,000 new corporate shares will be issued to the general public. What will

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(D. Risk & Leverage)

earnings per share immediately after the public offering be?

A. P1.02 C. P1.19
B. P1.44 D. P1.59
xiv
. Based on the price-earnings ratio of 10, what will the initial price of the stock be?
A. P14.40 C. P10.20
B. P11.90 D. P15.90
xv
. Assuming an underwriting spread of 7 percent and out-of-pocket costs of P150,000, what
will net proceeds to the corporation be?
A. P4,743,000 C. P4,950,000
B. P4,593,000 D. P5,307,000
xvi
. What return must the corporation earn on the net proceeds to equal the earnings per share
before the offering?
A. 16.18% C. 15.68%
B. 16.58% D. 15.98%
xvii
. 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 corporate shares currently outstanding. What will the initial market price of the
stock be? Assume a price-earnings ratio of 10 and use earnings per share after the
distribution in the calculation.
A. P10.90 C. P10.20
B. P11.90 D. P12.15
xviii
. 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
offering?
A. 13.50% C. 15.68%
B. 13.76% D. 14.57%

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i
.Answer: C
Debt ratio: 0.75 ÷ (1 + 0.75) 0.42857
Equity ratio: (1.00 – 0.42857) 0.57143
Increase in Equity: 0.57143 x 400,000 228,572
Increase in debt: 0.42857 x 400,000 171,428

ii
.Answer: C
First, calculate the addition to retained earnings as the total net income minus dividends. Second, calculate the
retained earnings breakpoint by dividing the addition to retained earnings by the equity fraction of the capital
structure.
Net income 100.0M
Deduct dividends (0.675 x 100M) 67.5M
Increase in retained earnings 32.5M
Capital budget supported by retained earnings 32.5M ÷ 0.65 50.0M

iii
.Answer: A
EBIT P 40 M
Interest 5M
Before tax P 35 M
Income tax 14 M
Net income 21 M
Preferred dividend 4M
Available to common P 17 M
Per common share: 17M x 0.20 ÷ 2M shares = P1.70

iv
.Answer: C
Interest (6M x 0.08) P 480,000
Before-tax dividends (10M x 0.12 ÷ 0.6) 2,000,000
Total cash flow requirements to cover dividends and interest P2,480,000
The computation of cash flow required by the interest payments ignored because they are deductible in the
computation of taxes. The dividends are calculated on a before-tax basis because it is a residual amount.

v
.Answer: B
Capital structure:
Debt: 1.5 ÷ (1 + 1.5) 60.0%
Equity: 100% - 60% 40.0%
WCCD (0.6 x 11%) 6.6%
WCCE (0.4 x 17%) 6.8%
Weighted average cost of capital 13.4%

vi
.Answer: C
Available earnings to Common 6M – 1.2M 4.8 M
Retained income 4.8M x .5 2.4 M
Retained earnings Breakpoint 2.4 M ÷ 0.6 P4,000,000
Retained earnings breakpoint refers to the maximum amount of funds or financing required whereby there is no need to
issue common shares.

vii
.Answer: A
Expected earnings 30.0 million
Deduct dividends (30M x 0.4) 12.0 million
Increase in retained earnings 18.0 million
Breakpoint: 18.0M ÷ 0.4 45.0 million

viii
.Answer: D
Earnings before interest P6,000,000
Interest 1,000,000
Preferred Dividends (800,000/0.6) 1,333,333 2,333,333
Earnings after preferred dividends (before taxes) P3,666,667
DFL (6M ÷ 3,666,667) 1.64
For every 10 percent change in EBIT, EPS changes by 16.4 percent (10% x 1.64). Adding financial leverage to
operating leverage increases the total risk of a company.

ix
.Answer: C
Increase in Earnings after tax: (1,750,000 – 1,250,000) 500,000
Percentage increase: (500,000  1,250,000) 40 percent
New EPS: 12.50 + (12.50 x 0.40) 17.50%

x
.Answer: A
Return on Assets = Asset turnover x Return on Sales
 = .125 x .75
= .09375 or 9.375
Current Return on equity = 9.375 ÷ .60 = .15625 or 15.625%
Target ROE = 15,625 x 1.50 = 23.4375%
Let X = Debt Ratio
.234375 = (.15 x.75)
1-X
X = 52%

xi
.Answer: A
Net income 7,500,000
Financing required from equity 6M x 0.6 3,600,000
Residual earnings for dividends 3,900,000
Payout ratio: 3,900,000/7,500,000 52%

xii
.Answer: C
The Debt to Equity Ratio is 0.4 to 1
RE + 0.40RE = P12,000,000
RE = P12,000,000 ÷ 1.40
RE = P 8,571,429
Available Retained Earnings for Dividends:
(P10,000,000 – P8,571,429) = P1,428,571

xiii
.Answer: A
EPS = Net income ÷ No. of common shares outstanding:
1,728,000 ÷ (1,200,000 + 500,000) = P1.02

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

xv
.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

xvi
.Answer: C
EPS before initial offering: (1,728,000 ÷ 1,200,000) 1.44
Required earnings: (1,700,000 x 1.44) 2,448,000
Earnings prior to initial offering 1,728,000
Earnings required on additional funds 720,000
Required percentage returns on net proceeds of
new offering (720,000 ÷ 4,593,000) 15.68%

xvii
.Answer: B
EPS immediately after initial offering: (1,728,000 ÷ 1,450,000) P1.19
Market price: (10 x 1.19) P11.90

xviii
.Answer: B
Required earnings: (1,450,000 x 1.44) 2,088,000
Less Prior earnings 1,728,000
Required earnings on new issues 360,000
Gross proceeds (250,000 x 11.90) 2,975,000
Less:
Spread (7%) 208,250
Out-of-pocket costs 150,000 358,250
Net proceeds 2,616,75
Required percentage returns on net proceeds from
new public offering (360,000 ÷ 2,616,750) 13.76%