Practice Questions - Part B.

1
1. Ruchi and her group visited a company as a part of their industry visit program at IIM Indore.
The CFO of the company shared the latest balance sheet of the company, as of December 31,
2015, with Ruchi:
Balance Sheet (All figures in INR million) 2015
Net Working Capital 200
Fixed Assets (net) 300
Total Assets 500

Long Term Debt 150

Common Stock 150
Retained Earnings 200
Total Liabilities and Equity 500

The CFO also informed Ruchi that the Long Term Debt of the company is rated as per the
following rating standards:
Rating on Long Term Debt AAA AA A
Maximum Debt-to-Equity Ratio (book) 25.0% 35.0% 50.0%
Default Spread (%) 1.0% 3.0% 5.0%

(i) What is the current rating on the Long Term Debt of the company? What is the unused
debt capacity of the company at the current rating? (A rating; INR 25 million)

(ii) Assume that the risk-free rate is 10%, unlevered beta of the company is 1.10, equity
risk premium is 6%, marginal tax rate is 30%, and market-to-book ratio of equity is
1.01. What is the current Weighted Average Cost of Capital (WACC) of the company?
(16.2%)

The CFO has also shared its pro-forma income statement for 2016, which is as follows:
Income Statement (All figures in INR million) 2016
Sales 750
Net Income 150
Dividends 0

(iii) During 2016, the company will neither issue new debt, nor repay any principal amount
from its existing long term debt. What will be the new rating on the Long Term Debt
of the company at the end of 2016? What will be the unused debt capacity of the
company under the new rating, at the end of 2016? (AA rating; INR 25 million)

(iv) Assuming that all the assumptions mentioned in (ii) earlier still holds, what will be the
post-tax cost of debt of the company, at the end of 2016? (9.1%)

1
The market-to-book ratio of equity is 1.0, when book value of equity is equal to the market value of equity.
2. A manufacturing firm is currently unlevered (fully equity financed), and is considering an INR
1 billion recapitalization program, under which it intends to raise a long-term debt (of perpetual
maturity) of INR 1 billion, and use the cash to buy back its own securities from the market. The
company currently has 100 million shares outstanding, which are trading at INR 60 per share
(prior to the announcement of the recapitalization program).
(i) What will be Interest Tax Shield on the newly raised debt? Assume that marginal tax
rate is 30%, and the INR 1 billion debt is a perpetuity. (INR 300 million)
(ii) What will be the new share price of the company, immediately after the announcement
of the recapitalization and buyback program? Assume that market is efficient, the
bankruptcy costs of taking the additional debt is negligible, and the firm will be able to
implement the recapitalization program. (INR 63)
(iii) If the promoter of the company currently owns 50% stake in its firm, and will not be
participating in the buyback offer, what will the promoter stake in the company after
the completion of the recapitalization and buyback program? (59.43%)
(iv) What will be the debt-to-equity ratio of the company, after the recapitalization and
buyback program? (18.87%)

3. Identify, whether the statements are TRUE, or FALSE:

(i) Under perfect capital market conditions, share buybacks would increase the share price
and reduce the number of shares outstanding of the company. (F)
(ii) Paying dividends from unused cash balance increases the agency conflicts between the
managers and the equity shareholders of a company. (F)
(iii) Tax-free institutions such as pension funds prefer high dividing paying stocks. (T)
(iv) Stock repurchases are an alternate way of distributing earnings to shareholders. (T)
(v) On the ex-dividend date, the stock price reduces by the amount of the dividend, and the
dividend is received by the seller. (T)
(vi) There is no benefit of a share split for the shareholders of the company, as it does not
affect the share price of the company. (F)
*****
 Practice Questions Part B.2

1. Identify, whether the statements are TRUE, or FALSE:

(i) Growth rate = (Net Capex + Change in Working Capital) X (EBIT*(1-t)). (F)
(ii) Companies have an advantage in hedging relative to hedging ability of investors
because of transaction costs related to barriers to entry in some derivatives markets.
(T)
(iii) The net capital expenditure needs of a firm, for a given growth rate, should be inversely
proportional to the quality of its investments. (T)
(iv) A firm has a FCFF of Rs 400 m and is expected to grow at the rate of 12% for the next
two years. Thereafter it will stabilise at 6%. Its terminal value at the end of two years
is Rs 14,412m if firms cost of capital is 10%. (F)
(v) Any increases (decreases) in working capital will reduce (increase) cash flows in that
period. (T)
(vi) Debt includes all interest bearing liabilities, short term as well as long term. (T)
(vii) Start-up firms tend to have high debt. (F)
(viii) Tax benefit each year = (1-Tax Rate)* Interest Payment. (F)
(ix) Adjusted Present Value Method takes care of variability in discount rate. (F)
(x) Convertibles help reduce agency conflicts associated with asset substitution problem
(bait-and-switch) between shareholders and bond holders. (T)
(xi) The owner of a convertible bond owns, in effect, both a bond and a call option. (T)
(xii) Firms generally do not call their convertibles unless their conversion value is greater
than their call price. (T)
(xiii) Because preferred stock dividends are not tax deductible, the cost of preferred stock to
the issuing firm is the same on a before-tax and after-tax basis. (T)
(xiv) Reducing the volatility of cash flows will always increase the value of a company. (F)
(xv) Risk management can increase debt capacity. (T)
 2. Information about a firm is given below:

Forecast of Financing Need When The Company Pays 30% Dividend

Information Available 2014 2015 2016 2017

1 Annual Sales Growth 12.0%
2 Expected Sales in 2015 870.0
3 Net Income Margin 3.0% 4.0% 5.5%
4 Dividend Payout Ratio 30.0% 30.0% 30.0%
5 Total Borrowing 70.0
6 Total Equity Capital 233.3
7 Shares Outstanding 15.3
8 Maximum Permissible Debt/Equity Ratio 40.0%
9 Borrowing Rate 8.0%
10 Tax Rate 40.0%

Fill in the blank cells below

2015 2016 2017
Sales 870.0

Sources:
Net Income
Depreciation 21.0 24.0 28.0
Total Sources

Uses:
Capital Expenditures 40.0 59.0 52.0
Working Capital 18.0 21.0 24.0
Total Uses 58.0 80.0 76.0

Excess Cash (Borrowings)

Dividends
Net
Debt or (Excess Equity Funds)
Total Equity (ie. Net Worth)
Debt to Equity Ratio
Unused Debt Capacity

Assume that the Annual Sales Growth in 2016 and 2017 is same as that in 2015 (equal to 12%).
Solution: Sales: 870.0; 974.4; 1,091.3. Net Income: 26.1; 39.0; 60.0. Total Sources: 47.1; 63.0; 88.0.
Excess Cash: (10.9); (17.0); 12.0. Dividends: 7.8; 11.7; 18.0. Net: (18.7); (28.7); (6.0).
Debt: 88.7; 117.4; 123.4. Total Equity: 251.6; 278.9; 320.9. D/E Ratio: 35.3%; 42.1%; 38.5%.
Unused Debt Capacity: 11.9; (5.9); 4.9.
3. ABC Ltd. has 1.2 million common shares outstanding and following sets of information is
applicable to it:
a. Dividend per share (DPS) is 0.30 when net income (NI) is INR 800,000. If the expected
investments to be made is INR 1,000,000, estimate the total amount of debt to be raised
to fund these investments? (INR 560,000)
b. If in the previous case, net income would be INR 300,000, estimate the total amount of
debt to be raised? (INR 1,060,000)
c. If the investments of INR 1,000,000 is to be met by 50% debt and equity each, what
will be the DPS if the net income realized would be INR 650,000? (INR 0.125)
d. If the firm has to maintain 50% debt and equity in the capital structure for its funding
requirements and has to pay a DPS of 0.30 when the net income realized is INR
650,000, what will be the maximum investment the firm can make? (INR 580,000)

4. DEF Ltd. is presently an unlevered firm whose cost of equity is 12%. It is contemplating to
recapitalize itself so that the resulting Debt: Equity ratio in market value terms would become
30:70 at the end of third year from now and remain as it is forever. It is estimated that the firm
will be taking debt for the three years, whose interest is payable at the end of the year at a rate
of 8% p.a., as follows:

Year 1 Year 2 Year 3

Average Outstanding 120 180 240
Debt (INR million)

It is also estimated that the free cash flow to the firm (FCFF) would be growing at a rate of 5%
p.a. after year 3. The distribution of FCFF for year end 1-3 is as follows:

Year 1 Year 2 Year 3

Free Cashflow to Firm, -80 20 65
FCFF (INR million)

If the risk-free rate is 4.70%, market risk premium is 6%, applicable tax-rate is 40% and the
value of all non-operating assets at t=0 is INR 120 million, estimate the following:

a. Total present value of Tax-shields for next three years. (INR 14.59 million)
b. Total present value of unlevered cash flows for next three years. (INR -9.22 million)
c. Weighted average cost of capital (WACC) at the end of third year. (11.15%)
d. Terminal value of cash flows at the end of third year. (INR 1,109.03 million)
e. Total present value of all operating assets. (INR 812.92 million)
f. Total present value of the firm. (INR 932.92 million)
g. The share price, if total outstanding number of shares are 100 million. (INR 9.33)
5. The table below shows the balance sheet of GHI Ltd. Also following information is known for
GHI:

a. Total value of operating assets is INR 1,020 million.

b. The affiliate investment is in the form of 7.50% stake in some other non-core firm. The
PE ratio of Affiliate Investment firm stood at 21 which has current total earnings
reported as INR 120 million.
c. Book values are closely approximate to the market values for short term investments
and borrowings and long term debt.
d. Cash & equivalents, Short term (ST) investments and ST borrowings are not considered
to be part of operating working capital.

Assets INR mm Liabilities and Equity INR mm

Cash & Equivalents 12 Accounts Payable 37
Short Term Investments 81 Short Term Borrowings 21
Accounts Receivables 67 Accruals 41
Inventory 45 Total Current Liabilities 99
Total Current Assets 205
Long Term Debt 275
Investments in Affiliates 104
Gross Fixed Assets 870 Common Stock (issued at INR 105
10 par)
Less: Acc. Depreciation 345 Paid-in Capital 210
Net Fixed Assets 525 Retained Earnings 145
Total Common Equity 460
Total Assets 834 Total Equity and Liabilities 834

Estimate the following:

a. Total market value of the affiliate investment. (INR 189.00 million)
b. Total value of the firm. (INR 1,302.00 million)
c. Total value of common equity. (INR 1,006.00 million)
d. Share price of GHI. (INR 95.81)
 Practice Questions Part B.3

1. Hindustan Ltd. is an India-based manufacturing company. The company estimates that it will
generate Free Cash Flow to the Firm (FCFF) of INR 100 million, 200 million and 300 million
during the next three years, respectively. The Free Cash Flows to the Firm (FCFF) can be
assumed to grow at a constant rate of 3% after the end of the third year. The average outstanding
debt amount during each of these three years can be assumed to be INR 150 million, 250 million
and 500 million, respectively. The same figures are also provided in the table below:
All figures are in INR million Year 1 Year 2 Year 3
Free Cash Flow to Firm (FCFF) 100 200 300
Average Outstanding Debt 150 250 500

Hindustan Ltd. is currently unlevered (at t=0), and its unlevered cost of equity is 15%. The firm
will be able to borrow at a constant rate of 10% (pre-tax) at any point of time. Assume that the
risk free rate is 7%, equity risk premium is 5%, and marginal tax rate is 35%. The company has
100 million shares outstanding, and it intends to maintain a constant debt-to-equity ratio of 50%
on a market value basis after the end of third year. Total present value of all non-operating
assets in the company is estimated at INR 750 million.
Based on the information provided above, please calculate the following:
(i) What is the total present value of Interest Tax Shields (ITS) generated during the next
three years? (INR 25.15 million)

(ii) What is the present value of all Free Cash Flows to the Firm (FCFF) generated during
the next three years? (INR 435.44 million)

(iii) What is the Weighted Average Cost of Capital of the Firm (WACC), beyond the third
year? (13.9%)

(iv) What is the present value of terminal value of Free Cash Flow to Firm (FCFF)
generated after the end of third year? (INR 1,918 million)

(v) What is the present value of Operating Assets in the company? (INR 2,379 million)

(vi) What is the Enterprise Value of the firm? (INR 3,129 million)

(vii) If it is known that the firm has INR 500 million worth of cash lying in its balance sheet
currently (at t=0), which is not included in the value of non-operating assets mentioned
above, can you calculate the intrinsic share price of the firm? (INR 36.29)
2. Answer the following questions.

(i) In a given year, if a firm has a Total Revenue of INR 250 million, Net Income margin
of 20%, Depreciation of INR 15 million, Capital Expenditure of INR 35 million,
Increase in Net Working Capital of INR 25 million, and a stable 40% Dividend Pay-
out Policy, calculate the funding requirement (surplus). (Funding Req. of INR 15
million)

(ii) In the next year, if the Total Revenue of the firm grows by 20%, the firm improves its
Net Income margin from 20% to 25%, and revises its Dividend Pay-out Policy
downward to 20%, what will be the new funding requirement (surplus) in that year?
You can assume that the Depreciation, Capital Expenditure and Increase in Net
Working Capital would remain unchanged, as mentioned in (i) above. (Funding
Surplus of INR 15 million)

(iii) State, whether TRUE or FALSE. (TRUE)

The Enterprise Valuation of a Firm will remain unchanged, even if the firm raises
additional debt only for increasing the outstanding cash in its balance sheet.

(iv) Choose the most suitable option. (Option C).

For comparing the valuation multiples of two firms with widely different capital
structures, one should look at _____________ ratio.
(a) Price-to-Earnings. (b) Return on Equity. (c) Enterprise Value to EBITDA.
(d) Dividend Pay-out.
 Practice Questions Part B.4

1. State, whether TRUE or FALSE:

(i) The firm's business risk is largely determined by the financial characteristics of its
industry. (F)
(ii) If a firm utilizes debt financing, a decrease in earnings before interest and taxes (EBIT)
will result in a more than proportionate decrease in earnings per share. (T)
(iii) Since debt financing raises the firm's financial risk, raising a companys debt ratio will
always increase the companys WACC. (F)
(iv) Since debt financing is cheaper than equity financing, raising a companys debt ratio
will always reduce the companys WACC. (F)
(v) An increase in the corporate tax rate is likely to encourage a company to raise its target
debt ratio. (T)
(vi) A firm can use retained earnings without paying a flotation cost. Therefore, while the
cost of retained earnings is not zero, the cost of retained earnings is generally lower
than the after-tax cost of debt financing. (F)
(vii) The growth rate of a firms cash flows is directly proportional to the capital employed
by the firm so far. (F)
(viii) A firm that follows a residual distribution policy must believe that the dividend
irrelevance theory is correct. (F)
(ix) If investors view dividends as being less risky than potential future capital gains then
the required return on equity may increase as the dividend payout ratio is decreased.
(T)
(x) Interest tax shields are available to the firm on debt and preferred stock but not on
common equity. (F)
(xi) As a firm changes to a higher debt ratio, debt-holders will likely demand higher rates
of return. (T)
(xii) In general, we can expect a high growth pharmaceutical company to pay higher
dividends than a large, mature utility company. (F)
(xiii) Adjusted present value method cannot address the issue of unknown debt level. (T)
(xiv) APV = NPV of all equity firm + NPV of all debt firm. (F)
(xv) Tax shield from debt in each year = (1 - Tax Rate) * Interest Payment. (F)
(xvi) The two basic types of hedges involving the futures market are long hedges and short
hedges, where the words "long" and "short" refer to the maturity of the hedging
instrument. (F)
 (xvii) A futures contract is an option to buy or sell a specified quantity of a particular asset
during a given period for a given price. (F)
(xviii) The forward contracts are settled by clearing house. (F)
(xix) Since risk management can reduce the volatility of a companys cash flows, it can
increase the debt capacity of the firm. (T)

2. PEN Ltd. is an unlevered firm with an after-tax EBIT of INR 1,000,000 which is supposed to
remain constant due to no growth (i.e. no reinvestment needs) in future. Presently, the total
number of outstanding shares are 10,000 and the cost of equity is 12%. Assuming a tax rate of
40%, answer the following:
a. What is the value of the unlevered firm and its share price. (INR 8,333,333; INR 833)
b. If the firm targets a debt-to-capital (book value ratio) of 33.33% by replacing its equity
with some debt (which is not perpetual in nature), the market-to-book value of equity
(M/B ratio) would become 2.0 and the cost of debt and equity would be 7% and 13%
respectively. In this case what would be the WACC, value of the firm, debt and equity,
number of shares outstanding and share price after repurchasing equity. (WACC =
11.24%; Firm Value = INR 8,896,797; Debt = INR 1,779,359; Equity = INR
7,117,438; NOSO After Repurchase = 8,000; Share Price After Repurchase = INR
889.68 )

3. SKY Corp Ltd., has a total book value of debt and equity, as on March 31, 2015, to be INR 90
and 250 million. The firm has 11.2 million shares outstanding and is trying to decide on its
dividends for the FY 2016 by balancing its leverage and investment needs. Assuming only debt
is used to adjust any deficit or surplus in cash, answer the following:
a. If the expected net income, depreciation expenses, capital expenditure and change in
working capital numbers are 75, 15, 100 and 12 million respectively for the FY 2016
and debt-to equity ratio in book value terms remain at 40%, how much dividend per
share can the firm distribute in FY 2016? (INR 1.15)
b. If the firm decide to take on no additional debt in FY 2016, how much capital
expenditure it can incur to pay a dividend per share of 1.60 when the expected net
income, depreciation expenses, and change in working capital numbers are 75, 15, and
12 million respectively for the FY 2016. (INR 60.08 million)

4. Xylo Industries Ltd. is currently an unlevered firm with an operating income (EBIT) of INR
1913 mn for FY 2015. The firm is contemplating to raise debt which will have suitable
investment grade credit rating. The firm expects to raise maximum possible debt such that that
it has an interest coverage ratio of 5.0 (after raising the debt) with the current operating income.
 The pre-tax cost of such debt would be 5.50%. The immediate benefit of taking such debt would
be an increase in firm value and a consequent increase in its P/E ratio to 15. The associated D/E
ratio (market value terms) for industrial firms for investment grade debt ratings is given as
follows in the table below.

Ratings AA A BBB
Approx. D/E 50% 65% 80%

For a tax rate of 40%, estimate the credit rating applicable for the firm after raising the proposed
debt. (AA; D/E Ratio (market) = 50.51%)

5. It is end of 2015 and Elvis Ltd is considering acquiring Priestley Inc. Mr Jim Morrison, the
chief consultant from Hendrix & Knoffler, the bank handling the deal is trying to work out the
value of Priestley Inc. The Projected financials for Priestley Inc. is given in the Table below.
Further, the following information is known about Priestley:
Priestley currently is an unlevered firm and will be issuing a debt of $100 million for
the proposed merger, which will be repaid fully at the end of 2019 as a bullet
repayment. The cost of debt is 7.5% and the interest is paid annually.
Current Net working Capital is 45 million USD
The firm is expected to maintain a D/E ratio (market value) of 35% as it reaches stable
growth period at the end of 2019.
The stable growth rate is expected to be 3%
The unlevered beta of the firm is 0.85 while the 10 yr G-sec rate is 6% and market risk
premium is 4%.
The firm has 10 % stake in affiliate business whose total earnings is 50 million USD.
The P/E for the affiliate business is 22.

Table: Financial Projections for Priestley Inc. (all figures in million USD)

$ million 2016 2017 2018 2019

Revenue 200 225 255 275
Operating Cost 125 135 150 160
(Excl. Depreciation)
Depreciation 50 70 75 80
Capex 50 55 65 70
NWC 25% of revenue earned in that particular year
Marginal Tax Rate 40%
 For a tax rate of 40%, solve the following:

1. What is the value of the interim cash flow up to 2019 using APV? (INR 70.33 million)
2. What is the value of the operating assets? (INR 409.84 million)
3. What is the total value of the firm, assuming there is negligible cash at the end of 2015?
(INR 519.84 million)
4. What is the expected stock price of Priestley, if the total number of shares outstanding
is 10 million? (INR 41.98)

6. The Cheesecake Factorys relevant financial data is presented below:

EBIT INR 4.7 million

Tax rate 40%
Value of Debt INR 2 million
Kd 10%
Ke 15%
Number of Shares outstanding 600,000 shares
Current Stock Price INR 30

The Cheesecake Factorys market is stable, and it expects no growth, so all earnings are paid
out as dividends.

i) What is the total market value of the firm, and what is the market value of its equity?
(Firm Value = INR 20 million; Equity Value = INR 18 million)
ii) What is the Cheesecake Factorys weighted average cost of capital? (WACC = 14.10%)
iii) Suppose the Cheesecake Factory can increase its debt so that its capital structure has 50%
debt, based on market values (it plans to issue debt and buyback shares). At this level of
debt, its cost of equity rises to 18.5% and its cost of debt (on all debt) will rise to 12%.
a. What is the WACC under this capital structure? (12.85%)
b. What is the total value? (INR 21.95 million)
c. How much debt will it issue? (INR 8.97 million)
d. What is the stock price after the repurchase? (INR 33.24)
e. How many shares will remain outstanding after the repurchase? (NOSO after
Repurchase = 330,082)
 Practice Questions Part B.5

1. Anamika and her group visited a company as a part of their industry visit program at IIM Indore.
The company has 10 million shares outstanding, and the latest traded price is INR 50 per share.
The CFO of the company shared the latest balance sheet of the company, as of December 31,
2016, with Anamika:
Balance Sheet (Book value figures, in INR million) 2016
Net Working Capital 250
Fixed Assets (net) 450
Total Assets 700

Short Term Debt 100

Long Term Debt 300
Common Stock 150
Retained Earnings 150
Total Liabilities and Equity 700

The CFO also informed Ruchi that the Debt of the company is rated as per the following rating
standards:

Credit Rating AAA AA A BBB

Maximum Total Debt-to-Value Ratio
15.0% 25.0% 40.0% 60%
(market value based)
Default Spread (%) 2.0% 4.0% 6.0% 8%

(v) What is the current credit rating of the company? (BBB; D/V Ratio = 44.44%)

(vi) What is the unused debt capacity of the company at the current credit rating? (INR 350
million)

(vii) Assume that the risk-free rate is 10%, levered beta of the company is 1.50, equity risk
premium is 8% and marginal tax rate is 30%. Calculate the following:

a. What is the current Weighted Average Cost of Capital (WACC) of the company?
(WACC = 17.82%)

b. What will be the Weighted Average Cost of Capital (WACC) of the company, if
the company lowers its total outstanding debt to INR 100 million by issuing
additional equity in the market at INR 50 per share to retire (repay) all its long term
outstanding debt immediately? (new WACC = 17.26%)
2. Identify, whether the statements are TRUE, or FALSE:

(i) As per the trade-off theory of capital structure, in a world with taxes and financial
distress, a firm is operating with the optimal capital structure when the present value of
financial distress costs is minimized. (F)
(ii) The Weighted Average Cost of Capital (WACC) of a firm which has AAA grade credit
rating will always be higher than the Weighted Average Cost of Capital (WACC) of a
firm which has BBB grade credit rating. (F)
(iii) As per the firm life cycle theory of capital structure, a start-up firm is likely to be
predominantly equity-financed. (T)
(iv) The pecking order theory of capital structure suggests that a firm should issue riskier
(unsecured) debt first, and then issue safer (secured) debt. (F)
(v) In a Miller-Modigliani world with corporate taxes, the value of a firm always keeps on
increasing, as the firm leverage is monotonically increased. (T)
(vi) The free cash flow hypothesis of capital structure suggests that firms should conserve
free cash in their balance sheet as much as possible, to maintain the optimal level of
financial flexibility. (F)
(vii) The pecking order theory of capital structure is based on agency conflicts between the
debt holders and the equity shareholders. (F)
(viii) Signalling theory suggests that investors will generally view an increase in debt as a
negative sign for the firm's value. (F)
(ix) In a Miller-Modigliani world without taxes, the corporate finance manager should
remain indifferent to the financing mix of debt and equity while making the capital
budgeting decisions for the firm. (T)
(x) When a firms issues additional debt, both the interest tax shield, the financial distress
costs as well as the agency conflicts between bondholders and equity holders increases.
(T)

3. During a given year, a firm has a Total Revenue of INR 500 million, Operating income (EBIT)
margin of 60%, Depreciation of INR 35 million, Capital Expenditure of INR 259 million, and
a decrease in Net Working Capital of INR 25 million. The book value of outstanding debt at
the beginning of the year was INR 250 million, and the book value of total shareholders equity
at the beginning of the year was INR 900 million. The pre-tax cost of debt at the current leverage
is 10%, and the effective corporate tax rate is 40%.

a. Calculate the net funding requirement at the end of the year, in order to maintain a 40%
dividend pay-out policy by the firm. (INR 100 million)

b. Assume that any funding requirement at the end of the year is met by additional
borrowing. Calculate the book-value based debt-to-equity ratio at the end of the year,
if the firm has to maintain the 40% dividend pay-out policy at the end of this year, as
mentioned in part (a) above. (D/E Ratio (book) = 35%)

c. Assume that the maximum leverage in terms of book-value based debt-to-equity ratio
that the firm can afford to take on its balance sheet at the end of any year is 40%, and
any funding requirement at the end of the year is met by additional borrowing. Then,
calculate the maximum amount of dividends that the firm can distribute at the end of
the year, without breaching the maximum permissible leverage ratio limit. (INR 101
million)
4. Assume that an unlevered firm currently has 100 million shares outstanding in the market. The
firm intends to borrow some money from the market for financing the buyback of its own
shares. How many of its own shares should it buyback from the market, if it intends to achieve
a market-value based debt-to-capital ratio of 40% after the buyback? (40 million)

5. Identify, whether the statements are TRUE, or FALSE:

(i) As per the firm life cycle theory of dividend policies, companies with high growth rates
tend to have low dividend pay-out ratios. (T)

(ii) In a Miller-Modigliani world without corporate taxes, investment decisions remaining

the same, the market value of shareholder equity in a firm will remain constant,
irrespective of the dividend policy of the firm. (F)

(iii) Dividend Pay-out Ratio can be calculated as Dividend per Share (DPS) divided by
Earnings per Share (EPS). (T)

(iv) Since dividends are paid out of profits, therefore, they do not affect the liquidity
position of the firm. (F)

(v) A firm that follows a strict residual dividend policy is likely to maintain a stable pattern
of dividends over time. (F)

(vi) Suppose, the effective Dividend Distribution Tax rate on dividends increases all of a
sudden. Then, everything else remaining the same, one would expect the cost of equity
for high-dividend paying firms to decrease. (F)

(vii) On ex-dividend date, the dividend is received by the seller. (T)

(viii) Dividend policies tend to be more sticky, and less flexible than share buyback
decisions. (T)

(ix) As per signalling theory, stock prices tend to react favourably to dividend reductions,
as such dividend cuts improve the liquidity and cash position of the company. (F)

(x) In a perfect capital market with no transaction costs and no taxes, the stock price of a
firm will decrease exactly by the amount of dividend per share on the dividend
declaration date. (F)

(xi) Firms should give up positive NPV projects to pay dividends to its investors. (F)

(xii) Bonus issue of shares and stock splits tend to increase the liquidity of the stocks, as the
share price is lowered to a more preferred, tradable range. (T)

(xiii) The dividend policy of a company has no impact on the capital structure of the
company. Therefore, capital structure decisions and dividend policy decisions are
mutually independent of one another. (F)

(xiv) As per signalling theory, buyback decisions by a company tend to signal stock
undervaluation to the equity investors, and hence, is likely to result in stock price
increase in the real world market. (T)