(Section A Total marks 10)

Q1. NorthFace Inc. is a firm that manufactures skis. The firm has no debt outstanding, 50 million
shares trading at $ 80 per share and a beta of 1.00. The firm is planning to increase its debt to
capital ratio to 25% of current firm value and believes that its cost of capital will drop to 8% at
this debt ratio. The current risk-free rate is 5% and the risk premium is 4%. Assuming that they
can borrow the money today and can buy the shares back at the current stock price, estimate the
value per share after the repurchase. (You can assume 3% growth in firm value forever) Hint:
Saving of cost of financing) (Marks 6)

Solution
Cost of capital before = 9.00% =0.05+0.04*1
Cost of capital after 8.00%
Change in firm value = 800 ((9%-8%)*4000)/(8%-3%)
Increase in dollar debt to get to 25% = 0.25*4000= 1000
Number of shares bought back = =1000/80 12.5
Number of shares left = 50-12.5 37.5
Increase in value per share = =80+800/37.5 101.33

1. if do not adjust growth rate=-2 marks

2. Did not adjust the number of shares for buyback : -2 marks
Each question 1 mark
2. The dividend-payout ratio is equal to
A. the dividend yield plus the capital gains yield.
B. dividends per share divided by earnings per share.
C. dividends per share divided by par value per share.
D. dividends per share divided by current price per share.
3. You are an activist investor looking to put pressure on companies that have accumulated too
much cash to return cash to stockholders. Which of the following companies would you put the
most pressure on to return cash? (You can assume that they all have a cost of capital of 10% and
an optimal debt ratio of 40%)
A. Company A: ROC = 25%, Actual debt ratio = 40%
B. Company B: ROC =25%, Actual debt ratio = 60%
C. Company C: ROC = 25%, Actual debt ratio = 10%
D. Company D: ROC = 5%, Actual debt ratio = 40%
E. Company E: ROC =5%, Actual debt ratio = 60%
F. Company F: ROC = 5%, Actual debt ratio = 10%
4. Sesame Sweet, Inc. has 220,000 shares outstanding with a par value of $1 per share and a market
price of $12.00 per share. Capital in excess of par amounts to $540,000, while retained earnings is
$275,000. There is no treasury stock and there are no transactions costs. Suppose Sesame Sweet
declares a 3-for-1 stock split. What is the market price of a share of the company's stock after the
split?
A. $4.00 per share
B. $5.75 per share
C. $6.00 per share
D. $8.00 per share
E. $36.00 per share
5. All else equal, which of the following are correct concerning stock splits and stock dividends?
All of the statements refer to book values, not market values.
I. The par value of the stock will change only with the stock split.
II. Total owners' equity will not change with either a stock split or a stock dividend.
III. The primary effect of either is to increase the number of shares outstanding.
IV. Earnings per share will likely decrease only with the stock dividend.
A. I and III only
B. II and IV only
C. I and II only
D. I, II and III only
E. I, II, III and IV