Name:____________________

MAN 321 Corporate Finance

Final Examination
Fall 2001
There are three sections on this examination. Section I contains 10 fill-in-the-blanks
questions. Answer these questions by entering your answer in the blanks. Section II
has 10 multiple choice questions. Enter your answers by circling the appropriate
letter on the exam. Section II contains 5 problems. Answer the problems in the spaces
provided on the exam. Good luck
SECTION I. Fill-in-the-blanks Questions (1 point each)
1. A(n) _____bond_________ is a long-term promissory note issued by a business
firm or governmental unit.
2. The stated face value of a bond is referred to as its _par_value.
3. The date at which the face value of a bond is repaid to each bondholder is known
as the __maturity_ __date__.
4. Market interest rates and bond prices move in _opposite____ directions from one
another.
5. Like other financial assets, the value of common stock is the __present__ value of
a future stream of income.
6. The income stream expected from a common stock consists of a(n) _dividend___
yield and a(n) _capital__ __gains_ yield.
7. Financial leverage refers to the use of __debt___ financing.
8. Expected EPS generally __increases___ as the debt/assets ratio increases.
9. A firm with __fluctuating__ earnings is most appropriate for using the policy of
extra dividends.
10. A stock split involves a reduction in the __par__ ___value__ of the common
stock, but no accounting transfers are made between accounts.

SECTION II. Multiple Choice Questions (1 point each)

1. Myron Gordon and John Lintner believe that the required return on equity increases
as the dividend payout ratio is decreased. Their argument is based on the
assumption that
a. Investors are indifferent between dividends and capital gains.
b. Investors require that the dividend yield and capital gains yield equal a
constant.
c. Capital gains are taxed at a higher rate than dividends.
d. Investors view dividends as being less risky than potential future capital gains.
e. Investors value a dollar of expected capital gains more highly than a dollar of
expected dividends because of the lower tax rate on capital gains.
2. In the real world, we find that dividends
a.
b.
c.
d.
e.

Usually exhibit greater stability than earnings.

Fluctuate more widely than earnings.
Tend to be a lower percentage of earnings for mature firms.
Are usually changed every year to reflect earnings changes.
Are usually set as a fixed percentage of earnings.

3. A decrease in a firms willingness to pay dividends is likely to result from an

increase in its
a.
b.
c.
d.
e.

Earnings stability.
Access to capital markets.
Profitable investment opportunities.
Collection of accounts receivable.
Stock price.

4. Which of the following would not have an influence on the optimal dividend
policy?
a.
b.
c.
d.
e.

The possibility of accelerating or delaying investment projects.

A strong shareholders preference for current income versus capital gains.
Bond indenture constraints.
The costs associated with selling new common stock.
All of the statements above can have an effect on dividend policy.

5. A stock split will cause a change in the total dollar amounts shown in which of the
following balance sheet accounts?
a.
b.
c.
d.
e.

Cash.
Common stock.
Paid-in capital.
Retained earnings.
None of the statements above is correct.

6. Petersen Co. has a capital budget of $1,200,000. The company wants to maintain a
target capital structure that consists of 60 percent debt and 40 percent equity. The
company forecasts that its net income this year will be $600,000. If the company
follows a residual dividend policy, what will be its payout ratio?
a.
b.
c.
d.
e.

0%
20%
40%
60%
80%

7. Which of the following affects a firms business risk?

a.
b.
c.
d.
e.

The level of uncertainty about future sales.

The degree of operating leverage.
The degree of financial leverage.
Statements a and b are correct.
All of the statements above are correct.

8. Which of the following statements best describes the optimal capital structure?
a. The optimal capital structure is the mix of debt, equity, and preferred stock
that maximizes the companys earnings per share (EPS).
b. The optimal capital structure is the mix of debt, equity, and preferred stock
that maximizes the companys stock price.
c. The optimal capital structure is the mix of debt, equity, and preferred stock
that minimizes the companys cost of capital (WACC).
d. Statements a and b are correct.
e. Statements b and c are correct.
9. From the information below, select the optimal capital structure for Minnow
Entertainment Company.
a.
b.
c.
d.
e.

Debt = 40%; Equity = 60%; EPS = $2.95; Stock price = $26.50.

Debt = 50%; Equity = 50%; EPS = $3.05; Stock price = $28.90.
Debt = 60%; Equity = 40%; EPS = $3.18; Stock price = $31.20.
Debt = 80%; Equity = 20%; EPS = $3.42; Stock price = $30.40.
Debt = 70%; Equity = 30%; EPS = $3.31; Stock price = $30.00.

10. Which of the following factors is likely to encourage a corporation to increase the
proportion of debt in its capital structure?
a.
b.
c.
d.
e.

An increase in the corporate tax rate.

An increase in the personal tax rate.
An increase in the companys degree of operating leverage.
The companys assets become less liquid.
An increase in expected bankruptcy costs.

SECTION III. Problems

Question 1: (15 points)
Holmgren Hotels stock has a required return of 12 percent. The stock currently does
not pay a dividend but it expects to begin paying a dividend of $1.00 per share starting
five years from today (i.e., D5 = $1.00). Once established, the dividend is expected to
grow by 25 percent per year for two years, after which time it is expected to grow at a
constant rate of 5 percent per year. What should be Holmgrens stock price today?
D1, D2, D3, D4 are 0
D5 = 1.00

D6 = 1.25

D7 = 1.5625

D8 = 1.6406

P7 = 1.64.06/(0.12 0.05) = 23.4371

PV of D5 = 0.5674
PV of D6 = 0.6333
PV of D7 = 0.7067
PV of P7 = 10.6006
P0= 12.5080

Question 2: (15 points)

Aaron Athletics is trying to determine its optimal capital structure. The companys
capital structure consists of debt and common stock. In order to estimate the cost of
debt, the company has produced the following table:
Debt to total
assets ratio
0.20
0.40
0.50

Equity-to-total
assets ratio
0.80
0.60
0.50

Bond Rating
AA
A
BB

Before tax
cost of debt
7.2%
8.8
9.6

The company uses the CAPM to estimate its cost of common equity, k s. The risk-free
rate is 5 percent and the market risk premium is 6 percent. Aaron estimates that if it
had no debt its beta would be 1.0. (Its unlevered beta, b U, equals 1.0.) Tax rate is
40%.
On the basis of this information, what is the companys optimal capital structure, and
what is the firms cost of capital at this optimal capital structure?
D/A = 0

b = 1.0

ks= 5 + 6 = 11%

D/A = 20% b= [1 + (0.4)2/8] = 1.15 ks=5+6(1.15) = 11.9

WACC = 0.6x7.2x0.2 + 0.8x11.9 = 10.384
D/A = 40%

b=1.40

ks=13.40

WACC=10.152*

D/A=50%

b=1.60

ks=14.6

WACC=10.18%

* optimum

Question 3: (20 points)

Copybold Corporation is a start-up firm considering two alternative capital structures,
one is conservative and the other aggressive. The conservative capital structure calls
for a D/A ratio = 0.25, while the aggressive strategy calls for D/A = 0.75. Once the
firm selects its target capital structure, it envisions two possible scenarios for its
operations: Feast or Famine. EBIT is expected to be $80,000 under the feast scenario
and $40,000 in a famine. Further, if the firm selects the conservative capital structure
its cost of debt will be 10 percent and it will issue 30,000 shares; while with the
aggressive capital structure its debt cost will be 12 percent and it will issue 10,000
shares. The firm will have $400,000 in total assets and it will face a 40 percent
marginal tax rate.
a. Find the EPS forecasts for Feast and Famine under the aggressive capital
structure?
b. Find the EPS forecasts for Feast and Famine under the conservative capital
structure?
EBIT
Interest
EBT
Tax
NI
# of shares
EPS
EBIT
Interest
EBT
Tax
NI
# of shares
EPS

80000

40000

(36000)
44000
(17600)
26400
10000
2.44

(36000)
4000
(1600)
2400
10000
0.24

80000

40000

(10000)
70000
(28000)
42000
30000
1.60

(10000)
30000
(12000)
18000
30000
0.60

Question 4: (15 points)

Clark Communications has a capital structure that consists of 70 percent common
stock and 30 percent long-term debt. In order to calculate Clarks weighted average
cost of capital (WACC), an analyst has accumulated the following information:

The company currently has 15-year bonds outstanding with annual coupon
payments of 8 percent. The bonds have a face value of $1,000 and sell for $1,091.
The risk-free rate is 5 percent.
The market risk premium is 4 percent.
The beta on Clarks common stock is 1.1.
The companys retained earnings are sufficient so that they do not have to issue
any new common stock to fund capital projects.
The companys tax rate is 38 percent.

Given this information, what is Clarks WACC?

kd: 1091 = 80 x PVIFAk,15 + 1000 x PVIF k,15
For k = 7% V = 1090 therefore YTM = 7% = kd
ks = 5 + 4(1.1) = 9.4%
WACC = 0.30 x 7 x (1 0.38) + 0.70 x 9.4 = 7.882%

Question 5: (15 points)

Zippy Pasta Corporation (ZPC) has a constant growth rate of 7 percent. The company
retains 30 percent of its earnings to fund future growth. ZPCs expected EPS (EPS 1)
and ks for various capital structures are given below. What is the optimal capital
structure for ZPC?
Debt/Total Assets
20%
30
40
50
70
Debt/Total Assets
20%
30
40
50
70

Expected EPS
$2.50
3.00
3.25
3.75
4.00
Expected DPS
$1.75
2.10
2.275
2.6250
2.80

ks
15.0%
15.5
16.0
17.0
18.0
P
21.875
24.7059
25.277
26.25*
25.45

* optimal capital structure