Fi

nanci
alManagement
(D.Risk&Lever
age)

D.RI
SKANDLEVERAGE B.ParanaqueCor porati
on.
C.Thedegr eeofoper ati
nglever
ageisnotameasur eofbusinessr i
sk,so
THEORI ES: i
tisnotpossibletot ellwhi
chfir
m hasthegreaterbusinessriskgiven
Risk theaboveinformation.
Businessr i
sk D.Todet erminewhichf i
rm hasthegreat
erbusinessrisk,weneedt o
Financialri
sk know theoper ati
ng income( NOIorEBI T)ofeachf ir
m.Par anaque
12.Financialri
skreferstothe: Corporati
onwoul dhavel essbusi
nessri
skifi
tsoperati
ngi ncomei sat
A.r i
skofowni ngequitysecurit
ies l
easttwicethatofAlabangCompany.
B.r i
skfacedbyequi tyholderswhendebtisused
C.gener albusinessri
skofthef ir
m 9.Whi
chofthef ol
lowingisincorr
ectregardi
ngoper ati
nglever
age?
D.possi bil
it
ythatinter
estrateswi l
li
ncr
ease A.Operati
ngleverageist hedegreetowhichcost sarefi
xed.
B.A proj
ect'
sbr eak-evenpoi ntwil
lbeaf fect
edbyt heextenttowhi ch
Marketr
isk cost
scanber educedassal esdecli
ne.
Comprehensive C.I
ftheprojecthasmost l
yvari
ablecosts
,itissaidtohavehighoper at
ing
5.Adecr easeint hedebtr
ati
owi
l
lleastli
kel
yaffect
: l
everage.
A.Fi nancial
risk C.Systematicormar
ketr
isk D.High operat
ing leverage i
mpl i
esthatpr ofi
tsar e more sensi
ti
ve to
B.Busi nessrisk D.Totalri
sk changesinsales.

1
4.Whichoft hef ol
l
owi ngsituati
onsislikelyt ohavet hehi ghestcombined 1
1.Theext
enttowhichf i
xedcost
sar
eusedi
naf i
rm’ :
businessandfi
nancialri
skimpactuponabusi ness? A.fi
nanci
alleverage. C.fi
nancial
lever
age.
A.Anewl abor-i
ntensi
veoper ati
onisf undedwi thoperati
ngcashf l
ows B.operat
ingleverage. D.forei
gnri
skexposure.
B.Af ul
l
yautomatedpl antiscompleted,f undedwithretainedear ni
ngs
C.Af ul
lyaut
omat edplantiscompl eted,f undedwiththei ssuanceof1 0- Fi
nancialLeverage
yearbonds 4.I tr
eferstomanagementst rat
egyoffi
nanci
ngasset swit
hborr
owedcapit
al;
D.Anaut omated,butdat edpl antint hesout her
nr egioni sclosedand suchanext ensiveuserai
setheenti
tyri
sktherebyimpacti
ngonther
eturn
operati
onsareresumedi nalabor-i
nt ensi
veplantinCent ral
Luzon oncommonst ockhol
ders
’
ontotalasset
s.
Oper
ati
ngLeverage A.Fact ori
ng C.Mor t
gage.
2.Whichofthefol
l
owi
ngi
sakeydet
ermi
nantofoperati
nglever
age? B.Lever age. D.Restructur
ing
A.Levelofdebt C.Technology
B.Costofdebt D.Capit
alstruct
ure 1
. Theuseoffinanciall
everagebyt hefir
m hasapotent
iali
mpactonwhi
ch
oft
hefoll
owing?
3.Thedegreeofoperati
nglever
ageforAl abangCompanyi s3.5,andthe (
1)Theri
skassociatedwi t
hthefi
rm
degr
eeofoperat
inglever
ageforParanaqueCor por
ati
onis7.
0.Accor
ding (
2)Thereturnexperi
encedbyt hesharehol
der
tot
hisi
nfor
mati
on,whichfi
rmisconsider
edt ohavegreat
erbusi
nessr
isk? (
3)Thevariabi
li
tyofnetincome
A.AlabangCompany. (
4)Thedegr eeofoperati
ngleverage

698
 Fi
nanci
alManagement
(D.Risk&Lever
age)

(5)Thedegr
eeoff
inanci
all
ever
age
A.1,3,5 C.1,2,3,5 Opti
mal capit
alstr
ucture
B.2,3,4,5 D.1,2,5 13.Themi xofdebtandequi tythatmi
nimizest
hecostofcapi
tali
sthe:
A.opt i
mal operat
ingleverage C.opti
mal degree of combined
1
6.Thedegr eeoff i
nanci alleveragef orApr ilCompanyi s3.0,andt hedegr ee l
everage
offinanciallever age f orAugustCor porat i
on is6. 2.Accor di
ng tot his B.targetfi
nancialst
ructure D.opti
malcapi
talst
ruct
ure
i
nformation,whi chf i
rmi sconsi deredt ohavegr eateroverall
(tot
al)ri
sk?
A.Apr i
lCompany. 7.Whenestablishi
ngtheiropt
imal capit
alstr
uct
ure,f
ir
msshoul
dst
ri
vet
o:
B.AugustCor porati
on. A.mini
mi zet heweightedaveragecostofcapital
C.Thedegr eeoff inanci all
everagei sameas ureoff i
nancialr
isk,sot he B.mini
mi zet heamountofdebtf inanci
ngused
onlyconcl usiont hatcanbemadewi ththei nformati
ongi veni sthat C.maximi zethemar gi
nalcostofcapi t
al
AugustCor porati
onhasgr erf
eat inanci alri
skthanApr ilCompany- -we D.noneoft heabove
cannottellwhi chf i
rm hasgr eat ertotal ri
sk.
D.Todet er
mi newhi chf ir
m hast hegr eat ertotalri
sk,weneedt oknowt he 8.Alt
houghdebtf i
nanci ngisusual
l
ythecheapestcomponentofcapit
al,it
fi
nancialbreakevenpoi ntofeachf i
rm. cannotbeusedt oexcessbecause
A.t heinterestratesmaychange.
Wei
ghtedaverageCostofcapital B.t he fir
m' s stock price wi
lli
ncr
ease and r
aise t
he costofequi t
y
6.Whichofthef ol
l
owi
ngchangeswoul dtendt odecr
easet
hecompanycost fi
nancing.
ofcapi
talforatr
adi
ti
onalfi
rm? C.t hefinancialriskofthefi
rm mayincr
easeandthusdri
veupthecostof
A.Decr easethepr
oporti
onofequi t
yf i
nancing. all
sour cesoff i
nanci
ng.
B.Increasethemarketvalueofthedebt . D.noneoft heabove.
C.Decr easethepr
oporti
onofdebtf inancing.
D.Decr easethemarketvalueoftheequity. PROBLEMS:
Capit
alst
ructur
e
1
5.Themostcommonl yheldvi ew ofcapitalst
ructureist hatthewei
ght
ed i
. Iftheprof ormabal ancesheetshowsthattot
alassetsmusti
ncr
easeby
aver
agecostofcapital
: P400,
000whi leretai
ningadebt-
equit
yrati
oof.75then:
A.fall
sfir
stwit
hmoder at
elevelsofleverageandt henincreases. A.debtmusti ncreasebyP300,000.
B.doesnotchangewi thleverage. B.equitymustincreasebytheful
lP400,000.
C.increasespropor
ti
onatel
ywi t
hincreasesinleverage. C.debtmusti ncreasebyP171,
428.
D.increaseswithmoderateamountsofl ever
ageandt henfall
s. D.equitymustincreasebyP100,000.

Targetcapit
alstructur
e Opti
mal capit
albudget
10.Themi xofdebt ,pr ef
err
edstock,andcommonequi t
ywi t
hwhicht
hef
ir
m i
i. Absolut
eCor porati
onhasacapi t
alst
ruct
urethatconsi
stsof65% equi t
y
planstoraisecapitali
scall
edthe: and35% debt .Thecompanyexpect storeportP100mill
i
oninneti ncome
A.f i
nancialri
sk C.businessr
isk thi
syear,and67. 5% oft
heneti ncomewillbepai
doutasdi vidends.How
B.oper ati
ngl ever
age D.tar
getcapitalst
ruct
ure l
argecant hefir
m' scapi
talbudgetbethi
syearwithouti
thavingtoinclude

699
 Fi
nanci
alManagement
(D.Risk&Lever
age)

t
hecostofnewcommonst
ocki
nit
scostofcapi
tal
analysi
s? Thecapit
alstr
uct ur
eforthecompanyismai nt
ainedat:
A.P100.0mil
l
ion C.P 50.0mil
li
on Debt 25.5%
B.P 67.5mil
l
ion D.P 32.5mil
li
on Pr
eferr
edst ock 15.
0%
Commonequi ty 60.0%
Di
videndpershar e Whatistheretainedearni
ngsbreak-
pointnextyear?
i
ii
.TheSal vageCompanypr oject
sthefoll
owingfortheupcomingyear: A.P5,760,000 C.P4, 000,000
Earningsbef oreinterestandtaxes P40mill
ion B.P4,800,000 D.P6, 000,000
Int
er estexpense P 5mill
ion
Preferredstockdi vi
dends P 4mill
ion vi
i
.Bal onCompanyexpectsP30mi ll
ioninearni
ngsnextyear.It
sdivi
dend
Commonst ockdi vi
dendpayoutr ati
o 20% payoutrat
iois40percent,anditsequit
yt oassetrat
iois40percent
.
Aver agenumberofcommonshar esoutst
andi
ng 2mill
ion BalonCompanyusesnopr ef
err
edstock.
Effectivecorporateincomet axrate 40% Atwhatamountoffi
nancingwil
ltherebeabr eakpoi
ntinBal
on’
Theexpect eddividendpershar eofcommonst ockis capit
al?
A.P1 .70 C.P2. 10 A.P45mi l
li
on C.P30mi ll
ion
B.P1 .86 D.P1 .00 B.P20mi ll
i
on D.P18mi ll
i
on

Requiredcashfl
owbef oretax DegreeofFi nancialLeverage
i
v.How muchwi llafi
rm needi ncashflow beforetaxandi
nter
estt
osatisf
y vi
i
i.Cal
culatet he DFL f ora firm wit
h EBI
T ofP6,000,000,fi
xed costof
debtholder
sandequi tyholder
sifthetaxr atei
s40%,thereisP1
0mi l
l
ion P3,000,000,interestexpenseofP1 ,
000,
000,pr
eferr
edstockdivi
dendsof
i
n common st ock r
equir
ing a 12% r eturn,and P6 mil
li
on i
n bonds 800,000,anda40per centtaxr
ate.
requi
ri
ngan8% r etur
n? A.6. 0 C.1
.43
A.P1 ,
392,000 C.P2, 480,000 B.9. 0 D.1
.64
B.P1 ,
488,000 D.P2, 800,000
Sensit
ivit
yanalysis
Weightedaver agecostofcapi
tal i
x.Af i
rmi sexpect edtogener at
eP1 .
5mi l
l
ioninoper ati
ngincomeandpay
v. TheDumaguet eCo.hasanequi tycostofcapitalof17%.Thedebtto P250, 000ininterest
.Ignori
ngtaxes
,thi
swil
l generat
eP1 2.50earni
ngsper
equit
yr at
iois1.5andacostofdebti
s11%.Whati stheweight
edaver
age share.Whatwi llhappent oEPS ifoperat
ingi ncomei ncreasest
oP2. 0
costofcapital
ofthefi
rm?(Assumeataxrateof33%) mil
lion?
A. 3. 06% C.16.97% A.EPSi ncreaset oP15.63. C.EPSi ncr
easetoP1 7.50.
B.1 3.40% D.15.52% B.EPSi ncreaset oP16.67. D.EPSi ncr
easetoP20. 00.

Retai
nedear ningsbreakpoint x. Theboardofdirector
sofAggr essi
veCompanywasunhappywi tht he
vi
.Dur ingthepastf i
veyear s,PenaCompanyhadconsist
ent
lypaid50% of cur
rentret
urnoncommonequi t
y. Thoughther et
urnonsales( profi
t
earnings avail
abl
et o common as dividends. Nextyear,the Pena margi
n)wasimpr essi
vel
ygoodat1 2.5percent
,theassett
urnoverwas
Company pr oj
ectsits netincome,bef
or ethe P1
.2 mi
ll
ion pr
efer
red onl
y0.75.Thepresentdebtr
atioi
s0.40.
di
vidends,atP6mi ll
ion. Ms.Syl
viaMoreno,thevi
ce-presi
dentofcor
porat
eplanni
ng,presenteda

700
 Fi
nanci
alManagement
(D.Risk&Lever
age)

proposalasfol
lows: FortheYear2007
 Pr ofi
tmarginshouldberaisedto1 5percent . Sales(alloncr
edit
) P22,
428,
000
 Thenewcapi talst
ruct
urewillberevi
sedbyr aisi
ngdebtcomponent. Costofgoodssol d 16,
228,
000
 Theassett urnoverwil
lbemai nt
ainedat0. 75. Grosspr ofi
t 6,
200,
000
Thepr oposedadj ust
mentisest i
mat edtor aiser et
urnonequit
yby50 Sell
ingandadmi ni
strat
iveexpenses 2,
659,
400
percent. Oper at
ingprof
it 3,
540,
600
Whatdebtr ati
odi dMs.Mor enopr oposeinor dertorai
setheretur
non I
nterestexpense 370,
600
equit
y( ROE)to1 50percentofthepresentlevel? Netincomebef oretaxes 3,
170,
000
A.0. 52 C.0. 61 Taxes 1,
442,
000
B.0. 68 D.0. 72 Netincome P1,
728,
000

Residualdi
videndpol i
cy BalanceSheet
xi
.Al vi
nCompanyexpect snextyear’ -taxincomet obeP7,500,000. AsofDecember31 ,2007
The fir
m’ . Al vi
n Company has Assets
P6,000,000 ofpr of
it
abl
ei nvest
mentoppor tuni
ties,and itwishes to
maintai
ni t
sexist
ingdebtrati
o.Accordingtother esi
dualdivi
dendpoli
cy, Cash P 1 50,
000
whatistheexpect eddivi
dendpayoutrati
onextyear ? Mar ketablesecuri
ties 100,
000
A.52. 0per cent C.48. 0percent Account sreceivable 2,
000,
000
B.75. 0per cent D.25. 0percent I
nvent ory 3,
800,
000
Tot alcurr
entasset s P 6,
050,
000
xi
i
.El l
i
sCompanyexpect st
ogenerat
eP1 0mi l
li
oninter
nall
ywhichcouldbe Netpl antandequi pment 6,
750,
000
avail
ableforf i
nancing par
tofit
s P12 mi l
l
ion capi
talbudgetforthi
s Totalassets P12,
800,
000
comingyear .Elli
s’ -equi
tyrat
ioof40
percentisbestforthefi
rm.How muchshoul dbepaidindivi
dendsift
he
tar
getdebt-equityrat
ioi
stobemaintai
ned? Li
abil
it
iesandSt ockhol ders'Equity
A.P2, 800,000 C.P1 ,
428,571 Accountspayabl e P1 ,
000,
000
B.P8, 571,
429 D.P4,000,000 Notespayabl e 1,
200,
000
Totalcurrentli
abili
ti
es 2,
200,
000
Compr ehensive Long-termliabil
i
ties 2,
380,
000
Usethef ol
lowinginf
ormat i
ontoanswerQuest
ionNos.1 3through18: Totalli
abil
it
ies P 4,
580,
000
The Reli
able Corporat
ion,a manufact
urerofr adarcont r
olequipment,i
s Commonst ock( 1,200,000shar esatP1par
) P1 ,
200,
000
pl
anningt oselli
tssharest othegener
alpubl
icf ort
hef i
rstti
me.Thefirm'
s Capit
al i
nexcessofpar 2,
800,
000
i
nvestmentbankeri swor kingwit
htheReli
abl
eCor porationindetermi
ninga Retai
nedear nings 4,
220,
000
numberofi tems.I
nformationontheRel
i
ableCorporat
ionf oll
ows: Totalstockholders'equity 8,
220,
000
Rel
iable Corpor at
ion Total
li
abili
ti
esandst ockholders'equi
ty P12,
800,
000
I
ncome Statement

701
 Fi
nanci
alManagement
(D.Risk&Lever
age)

Thenewpubl
i
cof
fer
ingwi
l
lbeat1
0ti
mest
heear
ningspershar
e. B.1
3.76% D.1
4.57%

xi
i
i.Assumet hat500,000new cor
porateshar
eswi l
lbeissuedtothegeneral
publi
c.Whatwi l
learni
ngspershareimmediatel
yaft
ert hepubl
icof
feri
ng i
. Answer:C
be? Debtrat
io: 0.75÷(1+0. 75) 0.
42857
A.P1 .02 C.P1.19 Equi
tyrati
o: (1
.00–0. 42857) 0.57143
B.P1 .44 D.P1.59 I
ncreaseinEqui
ty: 0.57143x400,000 228,572
I
ncreaseindebt
: 0.42857x400, 000 171,428
xi
v.Basedonthepr
ice-
ear
ningsr
ati
oof10,whatwi
l
lthei
nit
ialpr
iceoft
he
st
ockbe? i
i
. Answer:C
A.P14.40 C.P10.
20 Fi
rst,calculatet headdi ti
ont or etainedearningsasthetot
alnetincome
B.P11.
90 D.P15.
90 minusdi vidends.Second,cal culatet heret
ainedear
ningsbreakpointby
di
vidingt headdi t
iont or etainedear ni
ngsbyt heequit
yfracti
onoft he
xv.Assuminganunderwri
ti
ngspreadof7per
centandout -of
-pocketcost
s capit
alstructure.
ofP150,000,whatwi
l
lnetpr
oceedstot
hecor
por at
ionbe? Netincome 100.
0M
A.P4,743,000 C.P4,
950,000 Deductdi vi
dends( 0.675x1 00M) 67.
5M
B.P4,593,000 D.P5,
307,000 I
ncreasei nr etainedear nings 32.
5M
Capitalbudgetsuppor tedbyr etainedear
nings32.5M ÷0.6550.
0M
xvi
.Whatretur
nmustt hecorpor
ati
onearnonthenetpr
oceedst
oequalt
he
ear
ningspershar
ebeforetheoff
eri
ng? i
i
i.Answer:A
A.16.18% C.15.
68% EBIT P40M
B.16.58% D.15.
98% I
nterest 5M
Beforetax P35M
xvi
i
. Assumet hat,oft
heinit
ial500,000-sharedi st
ri
buti
on,250, 000shares I
ncomet ax 14M
bel
ongt ocur r
entstockholdersand250, 000ar enew cor porat
eshares, Netincome 21M
and these wi l
lbe added t othe 1,200,
000 cor porate sharescurrentl
y Prefer
reddivi
dend 4M
outst
andi ng.Whatwi l
ltheinit
ialmarketpriceoft hestockbe?Assumea Avail
abletocommon P1 7M
pri
ce-ear ni
ngs r at
io of 10 and use ear nings per shar e aft
er the Percommonshar e:1
7M x0.
20÷2M shar
es=P1 .
70
di
stri
butioninthecalculat
ion.
A.P1 0.90 C.P1 0.20 i
v.Answer :C
B.P1 1.90 D.P1 2.15 I
nterest(6M x0.08) P 480,000
Before-taxdivi
dends( 1
0M x0. 1
2÷0. 6) 2,
000,000
xvi
i
i. Assumi ng an under
writ
erspread of7 per centand out
-of
-pocket Totalcashflowrequir
ementst ocoverdi
vi
dendsandinterest
costsofP1 50,
000,whatr etur
nmustt hecor porati
onearnonthenet P2,480,000
proceedstoequalearni
ngspershar
ebef oret
heof fer
ing? Thecomput at
ionofcashf l
ow requir
edbytheint
erestpaymentsi gnored
A.1 3.50% C.1 5.68% becauset heyar ededucti
blei
nt hecomputati
onoftaxes.Thedi vidends

702
 Fi
nanci
alManagement
(D.Risk&Lever
age)

ar
ecal
cul
atedonabef
ore-
taxbasi
sbecausei
tisar
esi
dual
amount
. 500,000
Percent
agei
ncr
ease: (
500,0001,
250,
000) 40per
cent
v. Answer:B NewEPS: 1
2.50+(12.
50x0.40) 17.
50%
Capit
alstr
uctur
e:
Debt:1.5÷(1+1.5) 60.
0% x. Answer :A
Equi
ty:100% -60% 40.
0% ReturnonAsset
s=Assett ur
noverxReturnonSal
es
WCCD ( 0.6x1 1%) 6.
6% =.125x.75
WCCE ( 0.4x1 7%) 6.
8% =.09375or9. 375
Weightedaveragecostofcapi
tal 13.
4% CurrentRet
urnonequit
y=9. 375÷. 60=.15625or1
5.625%
TargetROE=1 5,625x1.50=23. 4375%
vi
.Answer :C LetX=DebtRat i
o
Avail
ableear ni
ngstoCommon6M –1 .
2M 4.8M .
234375=(.15x.
75)
Retai
nedi ncome 4.
8M x.5 2.4M 1
- X
Retai
nedear ni
ngsBreakpoint 2.
4M ÷0.6 P4,000,000 X = 52%
Retai
nedear ningsbreakpoi
ntrefer
stothemaxi
mum amountoffundsor
fi
nanci
ngr equiredwherebythereisnoneedtoi
ssuecommonshar es. xi
.Answer:A
Netincome 7,
500,
000
vi
i
.Answer:A Fi
nancingr equi
redfr
om equity 6M x0.
6 3,
600,
000
Expectedearnings 30.
0mi
l
li
on Resi
dual earni
ngsfordivi
dends 3,
900,
000
Deductdivi
dends( 30M x0.4) 12.
0mi
l
li
on Payoutrati
o: 3,900,000/7,
500,000 52%
I
ncreaseinretainedear
nings 18.
0mi
l
li
on
Breakpoi
nt:18.0M ÷0.4 45.
0mi
l
li
on xi
i
.Answer :C
TheDebtt oEquit
yRat iois0.4to1
vi
i
i.Answer :D RE+0. 40RE = P1 2,000,000
Earningsbeforeint
erest P6,000,000 RE= P1 2,000,000÷1 .40
I
nterest 1 ,
000,000 RE= P 8, 571,429
Preferr
edDividends( 800,000/
0.6) 1,
333,333 2, 333,
333 Avail
ableRetai
nedEar ningsforDividends:
Earningsaft
erpreferreddivi
dends(bef
oretaxes) P3,666,667 (P10,000,
000–P8, 571,429)= P1,428,571
DFL ( 6M ÷3,666,667) 1.64
Forever y10percentchangei nEBIT,EPSchangesby1 6.
4per cent(10% x xi
i
i.Answer:A
1.
64).Addi ngfi
nancialleveragetooperat
ingleveragei
ncreasesthet ot
al EPS =Neti
ncome÷No.ofcommonsharesout
standi
ng:
ri
skofacompany. 1,
728,
000÷(1,200,
000+500,
000)=P1
.02

i
x.Answer
:C xi
v.Answer:C
I
ncr
easei
nEar
ningsaf
tert
ax: (
1,750,
000–1
,250,
000) I
nit
ial
mar
ketpr
ice=P/
Erat
ioxEPS = (
10x1
.02)=P1
0.20

703
 Fi
nanci
alManagement
(D.Risk&Lever
age)

xv.Answer:B
Grossproceeds (500,000x1
0.20) 5,
100,
000
Less:
Spread(7%) 357,
000
Out-of
-pocketexpenses 150,
000 507,
000
Netproceedstothecorporati
on 4,
593,
000

xvi
.Answer:C
EPSbef oreinit
ialoff
eri
ng:( 1,
728,000÷1,200,000) 1.
44
Requir
edear nings:( 1,
700, 000x1 .
44) 2,
448,
000
Ear
ningspr i
ort oini
ti
alofferi
ng 1,
728,
000
Ear
ningsr equiredonaddi ti
onalfunds 720,
000
Requir
edper centagereturnsonnetproceedsof
newof feri
ng (720,000÷4,593,000) 15.
68%

xvi
i
. Answer:B
EPSimmedi at
elyaf
teri
nit
ial
off
eri
ng:(
1,728,000÷1,
450,
000)
P1.19
Marketpr
ice: (1
0x1 .
19) P11.
90

xvi
i
i. Answer :B
Requiredearni ngs: ( 1,
450, 000x1.44) 2,
088,
000
LessPr i
orear nings 1,
728,
000
Requiredearni ngsonnewi ssues 360,
000
Grosspr oceeds( 250,000x1 1.
90) 2,
975,
000
Less:
Spread( 7%) 208,250
Out-of-pocketcost s 150,
000 358,
250
Netproceeds 2,
616,
75
Requiredper cent ager
eturnsonnetpr oceedsfrom
newpubl icof fer
ing (360,000÷2, 616,750) 1
3.76%

704