# Increasing the Debt/Equity ratio

Multiple choice questions/problems:

36. Increasing the Debt/Equity ratio as one moves towards the optimal capital structure results in:

a. An increase in the degree of operating leverage

b. An increase in the cost of equity and debt

c. A decrease in the weighted average cost of capital

d. Both a. and b.

e. Both b. and c.

37. The weighted average cost of capital (WACC) for a company is influenced by:

a. The effective tax rate of the company

b. The financial risk of the company

c. The proportions of capital raised from debt vs. equity

d. Both a. and b.

e. a., b., and c.

38. The cost of equity capital is determined by:

a. The expected dividend yield

b. The dividend growth rate

c. The premium for market risk

d. Both a. and b.

e. a., b., and c.

39. The properly determined weighted average cost of capital (WACC):

a. Reflects the market values of debt, preferred stock, and common stock

b. Reflects the balance sheet values of debt, preferred stock, and common stock

c. Reflects the manner in which the company raises external capital.

d. Both a. and c.

e. Both b. and c.

40. You invested $1000 in stocks 10 year ago. Your account is now worth $2,839.42. What rate of return did your stocks earn?

a. 15%

b. 14%

c. 13%

d. 12%

e. 11%

41. You invest your money ($1000) in a bank account which has a nominal annual rate of 7.23% percent, compounding annually. How many years will it take for you to double your money?

a. 8.76 years

b. 9.15 years

c. 9.50 years

d. 9.93 years

e. 10.25 years

42. For the following cash flows, determine the present value if the discount rate is 8 percent.

Year 1 - 1000, Year 2 - 2000, Year 3 - 3000 and Year 4 - 4000

a. $2,500

b. $4,804

c. $5,302

d. $7,963

e. $10,000

43. BG Corporation has forecast the following for next year:

Sales: $1,000,000

Cost of Goods Sold: $600,000

Interest Expense: $100,000

Net Income: $180,000

Tax rate is 40% and cost of goods sold will remain 60% percent of sales, e.g., if the company's sales were to increase to $1.5 million, cost of goods sold would increase to $900,000. The CEO is unhappy with the forecast. He wants a net income equal to $240,000. Assume that interest expense remains constant. To achieve this level of net income, what sales are needed?

a. $400,000

b. $500,000

c. $750,000

d. $1,000,000

e. $1,250,000

44. Sanguillen Corp year-end 2006 retained earnings was $400,000. For 2007 the company's earnings per share (EPS) were $3.00, dividends paid per share (DPS) $1.00, and it has 200,000 shares of stock outstanding. The year-end 2007 retained earnings on the company's balance is:

a. $400,000

b. $500,000

c. $600,000

d. $700,000

e. $800,000

45. Calculate the Modified Internal Rate of Return (MIRR) for the following yearly cash flows (in millions). The company's cost of capital (reinvestment rate) is 12% and its borrowing rate is 8%.

Time 0 1 2 3

Cash Flow -23 +9 +14 -20

46. Clever Co. has more good projects than this year's capital budget will allow. The following are economically independent projects ($ amounts are in millions):

Project Capital Outlay Required NPV* Discount rate used**

A $22 $12 10%

B $8 $5 10%

C $10 $9 14%

D $6 $3 12%

E $15 $8 16%

* This is after subtracting the capital outlay required

** Appropriate rate or cost of capital given the risk of the project

a. The company has $35 million for the budget. Determine which project it should take

Take these projects________________________

b. The analyst used the risk-adjusted cost of capital. Rank the project from highest risk to lowest risk

Rank the projects ________________________

c. The analysis used the profitability per dollar of invested capital. Rank the project from highest to lowest profitability.

Rank the projects ________________________

47. Cox Technology's ordinary or straight preferred stock, 8%, par value $100, could be issued at a market price of $105.0 with floatation costs totaling $2.0 per share ââ?¬" so the company will receive net, $103 per share. The cost of capital from this preferred stock is:

_______________%

48. You believe in the CAPM. You estimate that the expected return on the market is 14%, observe that the risk free rate of return is 6%, and estimate that the beta of your company is 0.8. Estimate the cost of equity from retained earnings.

_______________%

49. SINCO, Inc. expects to raise money in the future by obtaining 20% from debt, 50% from retained earnings, and 30% from new equity. The company estimated cost of retained earnings as 16%, and the cost of new equity at 18%. SINCO estimates its weighted pre-tax cost of debt is 12%. SINCO's expected tax rate is 40%. The weighted average cost of capital (WACC) for ISNCO is:

_______________%

50. Analysts expect AGO's earnings and dividends to grow at a constant compound rate of above 4% per year for a very long time - essentially, forever. The current dividend is $1.20; market price is $22.0 per share. If they sold the stock, after expenses and underpricing, AGO would only net, or receive, $20.0 per share.

a. Use the discounted cash flow (DDM) approach to estimate the cost of equity from retained earnings. The estimate for the cost of RE is:

_______________%

b. Calculate the cost of equity from issuing stock after allowing for flotation costs and underpricing. The estimated for the cost of CE is:

_______________%

51. A bond with face or par of $1000 has 20 years to maturity, coupon of 8%, and the required rate of return, or yield to maturity for a bond of this risk and characteristics, is 12%. Interest payments are semiannual.

a. The market price of this bond is $__________________

b. Suppose market interest rates in the world increase but the world's perceptions of the (default and other) risks of this bond do not change. Then the price of this bond will (circle one)

increase decrease not change

c. If market interest rates in the world do not change and the premium of bearing risk in the world does not change, a perception by investors of increased default risk for the company will cause the price of this bond to (circle one)

increase decrease not change

52. If the discount rate is 12%, determine the present value (PV) of:

a. 8000 BGN per year received at the end of each of the next 6 years.

_______________ BGN

b. 5000 BGN at the end of each of the years 4 through 9 if the discount rate is 10% for the first three years:

_______________ BGN

53. If the discount rate is 12%, determine the future value (FV):

a. At the end of year 20 if 10,000 BGN is invested at the end of each of the next 20 years.

_______________ BGN

b. At the end of year 20 if 10,000 BGN is invested at the beginning of each of the next 20 years, the first deposit made now.

_______________ BGN

54. You do pro-forma financial statements to estimate future capital needs. On the pro forma balance sheet before getting new outside financing, you get the following:

Total Assets $423,000

Total Liabilities $223,000

Total equity $170,000

The amount of external funding or money needed is:

a. You do not need external funding. You have excess cash of $30,000

b. You need $30,000 from external funding.

c. You need $200,000 from some external source

d. None of the above

55. Use 360 day year. For the year, DCA Co. had sales (all are on credit) of $1080, cost of goods sold of $702, materials purchases on trade credit of $210.6, and average levels of sales of (show all your work!):

Cash $21.0

Raw Materials Inventory $16.4

Work in Process $15.6 (based on COGS)

Finished Goods Inventory $46.8 (based on COGS)

Accounts Receivable $126.0

Note: A/P = $210.6 or 30% of COGS; DPO = Acc. Payable / (Purchases/360)

a. Calculate the 'cash-to-cash' cycle.

_______________Days

b. Assume DCA currently pays for purchases 44 days after purchase. Determine the accounts payable you would expect:

$_______________

c. If DCA decides that now and in the future it wants to pay for the purchases at day 30 (and not 44), determine the amount of additional capital it will need from some source to make this possible:

$_______________

56. All sales are on credit. EXCO, Inc. expects sales as shown below, with 40% of sales collected in the month of sales, 25% in the next month, and the balance in the second month following the sales. You are constructing a cash balance. For the month of April on that budget, determine the total collections (receivables) from sales from various months. Show all your work!

Jan Feb Mar Apr May

Sales $65 $88 $94 $70 $60

$_______________

57. Use 360 day year. BDA, Inc. has credit sales of $1,512,000 per year, an accounts receivable balance of $197,400, and variable costs to sales ratio of 0.64, and its opportunity cost on working capital is 12%. A credit management program claims it will reduce the Days Receivable Outstanding (DRO) to 32 days without changing sales. If successful,

a. Determine the amount of capital disinvested from accounts receivable.

$_______________

b. Calculate the yearly pre-tax benefit of this freed up capital, ignoring any cost of the credit management program.

$_______________

58. Given: ROA = 6%; Equity Multiplier = 1.5; Profit margin = 2%; Asset Turnover = 3. Find the company's ROE:

_______________%

59. AirCar makes cargo containers for aircraft. The costs for each container are as follows:

Material $1,208

Direct Labor $6,300

Consumable Supplies $312

Other Variable Costs $430

Allocated Overhead $920

Sales Commission $540

Each container sells for $14,900. Fixed operating costs for the period are $386,000. Note: Use total variable costs, including allocated overheads.

a. How many units does AirCar have to make and sell to reach operating break-even?

_______________Units

b. How many units does it have to make and sell to have a pre-tax operating income of $80,000?

_______________Units

60. Use the graph below and draw in and label as requested. Assume out-of- tax world and a company with relatively low business risk such as Food Center, a large chain of grocery stores. How this will change in a world of taxes?

a. Label the X and Y axis.

b. Mark a risk free rate, Rf.

c. Mark a spot on the X axis to represent the optimal Debt/Equity ratio for this company.

d. Draw a curve for borrowing costs, starting at the no debt point and then moving towards and past the optimal D/E ratio.

e. Draw a curve to represent the cost of equity, starting at the no debt point and then moving towards and past the optimal D/E ratio.

f. Draw a curve to represent the Weighted Average Cost of Capital (WACC), starting from the no debt position and going past the optimal D/E ratio.

g. Draw a similar graph or lines if the company pays taxes.

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Multiple choice questions/problems:

36. Increasing the Debt/Equity ratio as one moves towards the optimal capital structure results in:

a. An increase in the degree of operating leverage

b. An increase in the cost of equity and debt

c. A decrease in the weighted average cost of capital

d. Both a. and b.

e. Both b. and c.

c. A decrease in the weighted average cost of capital

(This will lead to decrease in WACC as there is increase in debt which is less costly)

37. The weighted average cost of capital (WACC) for a company is influenced by:

a. The effective tax rate of the company

b. The financial risk of the company

c. The proportions of capital raised from debt vs. equity

d. Both a. and b.

e. a., b., and c.

e. a., b., and c.

( All the factors)

38. The cost of equity capital is determined by:

a. The expected dividend yield

b. The dividend growth rate

c. The premium for market risk

d. Both a. and b.

e. a., b., and c.

e. a., b., and c.

39. The properly determined weighted average cost of capital (WACC):

a. Reflects the market values of debt, preferred stock, and common stock

b. Reflects the balance sheet values of debt, preferred stock, and common stock

c. Reflects the manner in which the company raises external capital.

d. Both a. and c.

e. Both b. and c.

a. Reflects the market values of debt, preferred stock, and common stock

( This is slightly confusing)

40. You invested $1000 in stocks 10 year ago. Your account is now worth $2,839.42. What rate of return did your stocks earn?

a. 15%

b. 14%

c. 13%

d. 12%

e. 11%

Amount= Present value * ( 1+rate of return)^duration

2839.42= 1000*(1+r)^10

Hence r= 11%

Hence e

41. You invest your money ($1000) in a bank account which has a nominal annual rate of 7.23% percent, compounding annually. How many years will it take for you to double your money?

a. 8.76 years

b. 9.15 years

c. 9.50 years

d. 9.93 years

e. 10.25 years

Amount= Present value * ( 1+rate of return)^duration

2000= 1000*(1+7.23%)^n

Hence n= 9.93 years

Hence d

42. For the following cash flows, determine the present value if the discount rate is 8 percent.

Year 1 - 1000, Year 2 - 2000, Year 3 - 3000 and Year 4 - 4000

a. $2,500

b. $4,804

c. $5,302

d. $7,963

e. $10,000

Present value = Amount/( 1+r)^n

=1000/(1+8%)^1+2000/(1+8%)^2+3000/(1+8%)^3+4000/(1+8%)^4

=$7963

=d

43. BG Corporation has forecast the following for next year:

Sales: $1,000,000

Cost of Goods Sold: $600,000

Interest Expense: $100,000

Net Income: $180,000

Tax rate is 40% and cost of goods sold will remain 60% percent of sales, e.g., if the company's sales were to increase to $1.5 million, cost of goods sold would increase to $900,000. The CEO is unhappy with the forecast. He wants a net income equal to $240,000. Assume that interest expense remains constant. To achieve this level of net income, what sales are needed?

a. $400,000

b. $500,000

c. $750,000

d. $1,000,000

e. $1,250,000

Sales 1250000

Less Cost of Goods sold 750000

Interest 100000

400000

Less taxes 160000

Net Income 240000

Hence option e.

44. Sanguillen Corp year-end 2006 retained earnings was $400,000. For 2007 the company's earnings per share (EPS) were $3.00, dividends paid per share (DPS) $1.00, and it has 200,000 shares of stock outstanding. The year-end 2007 retained earnings on the company's balance is:

a. $400,000 ...

#### Solution Summary

Solution explains increasing the Debt/Equity ratio

Kellogg Company: Compute and analyze debt ratio, debt to equity ratio.

Balance Sheet and Market Value of Your Company's Liabilities and Equity

Refer to your company's most recent balance sheet (Kellogg Company). Review the 'liabilities and equity side' of the balance sheet.

(a) Find the total of the short term liabilities and long term liabilities.

(b) Find your company's market capitalization.

Once you have this information, prepare a two to three page paper with the following:

1. Compute the debt ratio of your company (total liabilities divided by the total liabilities plus equity) and the debt to equity ratio, (total liabilities divided by total equity). Also, show these two ratios for short-term liabilities only and for long-term liabilities only.

2. Should your SLP company increase its debt or take steps to pay off its debt?

3. Compute the debt to equity ratios to Kraft and General Mills. Which of these three companies has the highest debt to equity ratio, and why? Which of these three companies has the lowest debt to equity ratio, and why?

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