Finance 4610/Prof.

Eytan

Test 1 Version 2 (70 minutes)

You may use a financial or a simple calculator.

Please write your name, course and test number and the test version number on the Scantron

Student: ___________________________________________________________________________

1. Which of the following are correct according to pecking-order theory?

I. Firms stockpile internally-generated cash.

II. There is an inverse relationship between a firm's profit level and its debt level.
III. Firms avoid external debt at all costs.
IV. A firm's capital structure is dictated by its need for external financing.

A. I and III only

B. II and IV only
C. I, III, and IV only
D. I, II, and IV only
E. I, II, III, and IV

2. Which form of financing do firms prefer to use first according to the pecking-order theory?
A. Regular debt
B. convertible debt
C. common stock
D. preferred stock
E. internal funds

3. M & M Proposition II is the proposition that:

A. the capital structure of a firm has no effect on the firm's value.
B. the cost of equity depends on the return on debt, the debt-equity ratio, and the tax rate.
C. a firm's cost of equity is a linear function with a slope equal to (RU - RD).
D. the cost of equity is equivalent to the required rate of return on a firm's assets.
E. the size of the pie does not depend on how the pie is sliced.

1
4. XYZ Co. has an unlevered cost of capital of 20%, a tax rate of 20% percent, and expected earnings
before interest and taxes of $400,000 (in perpetuity). The company has outstanding bonds with a
market value of $1 million, and a yield of 6%. What is the cost of equity?

A. 15.64%
B. 16.42%
C. 25.12%
D. 38.67%
E. none of the above

5. XYZ has equity worth $10 million and debt worth $4 million. Assuming that the debt is riskless and the
beta of the equity is 2.0, what is the beta of the assets?
A. 2.00
B. 1.43
C. more information is needed
D. none of the above

6. Which of the following statements are correct in relation to M & M Proposition II with no taxes?
I. The required return on assets is equal to the weighted average cost of capital.
II. Financial risk is determined by the debt-equity ratio.
III. Financial risk determines the return on assets.
IV. The cost of equity declines when the amount of leverage used by a firm rises.

A. I and III only

B. II and IV only
C. I and II only
D. III and IV only
E. I and IV only

7. The Green Fiddle has declared a $5 per share dividend. Suppose capital gains are not taxed, but
dividends are taxed at 15 percent. New IRS regulations require that taxes be withheld at the time the
dividend is paid. Green Fiddle stock sells for $71.50 per share, and the stock is about to go ex-dividend.
What will the ex-dividend price be?
A. $67.25
B. $67.90
C. $78.30
D. $79.50
E. $82.23

2
8. Consider a firm with a debt to equity ratio of 0.2, that is contemplating switching its capital structure
to a debt equity ratio of 0.6. Joe owns 6,000 shares, each one is currently priced at $20.00. If the firm
decides not to implement the change, how can Joe achieve the effect of the contemplated capital
structure of using home-made leverage? Ignore taxes.

A. Joe should borrow $40,000 and buy 2,000 shares.

B. Joe should borrow $30,000 and buy 1,500 shares
C. Joe should borrow $72,000.
D. Joe should sell 1,500 shares and lend $30,000.

9. Which one of the following is a result of a 2-for-1 stock split?

A. A 100% increase in the number of shareholders.

B. A 100 percent increase in the common stock account balance.
C. A 100% decrease in the stock price.
D. A 50 percent decrease in the number of shares outstanding.
E. A 50% decrease in the par value per share.

10. The Bear Rug has sales of $800,000. The cost of goods sold is equal to 65 percent of sales. The
beginning accounts receivable balance is $40,000 and the ending accounts receivable balance is
$38,000. How long on average does it take the firm to collect its receivables?

A. 16 days
B. 21 days
C. 24 days
D. 18 days

11. XYZ Enterprises currently has an operating cycle of 64 days. The firm is analyzing some operational
changes, which are expected to increase the accounts receivable period by 3 days and decrease the
inventory period by 6 days. The accounts payable turnover rate is expected to increase from 9 to 11
times per year. If all of these changes are adopted, what will the firm's new operating cycle be?

A. 53 days
B. 64 days
C. 54 days
D. 68 days
E. 61 days

12. XYZ has accounts receivable with an average collection period of 25 days. A factor is willing to
finance the accounts receivable at 99% of face value. What is the effective annual rate on this
financing?

A. 14.0%
B. 15.8%
C. 21.2%
D. none of the above

3
13. If you ignore information effects, taxes and costs, a stock repurchase will:
I. reduce the total assets of a firm.
II. decrease the earnings per share.
III. reduce the PE ratio more so than an equivalent stock dividend.
IV. reduce the total equity of a firm.

A. I and III only

B. I and IV only
C. II and IV only
D. I, III, and IV only
E. II, III, and IV only

14. XYZ is paying a $1.10 per share dividend today. There are 350,000 shares outstanding with a market
price of $25 per share. Ignore taxes. Before the dividend, the company had earnings per share of $1.74.
As a result of this dividend, the:

A. retained earnings will decrease by $350,000.

B. retained earnings will increase by $385,000.
C. total firm value will not change.
D. earnings per share will increase to $2.84.
E. price-earnings ratio will be 13.74.

15. Consider a change to the tax law that allows a company to increase its depreciation charges.
According to the static theory of capital structure, the optimal level of debt should be lower than it was
before the change.

A. True
B. False

16. XYZ expects its EBIT to be $100,000 every year forever. The firm can borrow at 8 percent. XYZ
currently has no debt, and its cost of equity is 14 percent. The tax rate is 30 percent. Bruce will borrow
$60,000 and use the proceeds to repurchase shares. What will the firm’s Opportunity Cost of Capital be
after recapitalization?

A. 13.79 percent
B. 15.87 percent
C. 17.15 percent
D. 18.29 percent
E. 18.86 percent

17. New Schools expects an EBIT of $100,000 every year forever. The firm currently has no debt, and its
cost of equity is 10 percent. The firm can borrow at 6 percent and the corporate tax rate is 20 percent.

4
What will the value of the firm be if it converts to 50 percent debt? (50 percent of the levered firm
value.)

A. $888,888.89
B. $444,444.44
C. $460,146.57
D. $880,000.00
E. None of the above.

18. “Floor Planning” is a _________________

A. Trust Receipt loan used by car dealerships

B. a requirement by mortgage lenders to home buyers
C. a blanket lien inventory financing
D. none of the above