1 Finance II ET Examination Time: 2 Hrs  Solve/answer ALL the questions in the answer sheet provided only. Write all the steps required to solve the questions in part B. Untidy work will be penalized. Use ball pen ONLY. Calculators are allowed. Maximum marks 60 Part A. State True or False -(50% negative marking) 20 1. The firm’s business risk is largely determined by the financial characteristics of its industry. F 2. Financial leverage affects both EPS and EBIT, while operating leverage only affects EBIT. F 3. Increasing a company’s debt ratio will typically reduce the marginal cost of both debt and equity financing; however, it still may raise the company’s WACC. F 4. Company A and Company B have the same total assets, operating income (EBIT), tax rate, and business risk. Company A, however, has a much higher debt ratio than Company B. Company A’s basic earning power (BEP) exceeds its cost of debt financing (rd). Indicate whether the following statements are true or false for A and B a. Company A has a higher return on assets (ROA) than Company B. F b. Company A has a higher times interest earned (TIE) ratio than Company B. F c. Company A has a higher return on equity (ROE) than Company B, and its risk, as measured by the standard deviation of ROE, is also higher than Company B’s. T 5. The announcement of an increase in the cash dividend always causes an increase in the price of the firm’s common stock. F 6. One problem with following a residual distribution policy (with all distributions in the form of dividends) is that it can lead to erratic dividend payouts that may prevent the firm from establishing a reliable clientele of investors who prefer a particular dividend policy. T 7. A decrease in a firm’s willingness to pay dividends is likely to result from (state true or false for each) a. an increase in its Earnings stability. F 2 b. an increase in its leverage. T c. an increase in its investment opportunities. T d. an increase in investor base in higher tax brackets. T 8. If it could be demonstrated that a clientele effect exists, this would suggest that firms could alter their dividend payment policies from year to year to take advantage of investment opportunities without having to worry about the effects of changing dividends on capital costs. F 9. The objective(s) of risk management may be to – (state true or false for each) a. Reduce the volatility of a company’s cash flows. T b. Eliminate the business risk. F c. Increase expected cash flows. F d. Avail firm’s comparative advantage in hedging. T e. Increase firm’s debt capacity. T f. Reduce financial distress. T g. Help make managers risk averse. F Part B: Solve for the following questions 1. A-star is a firm struggling to thwart a hostile takeover by another firm in the industry. To avoid such eventuality, A-star takes up maximum debt permissible by its worst case EBIT-interest coverage ratio of 6.0 for its existing credit rating. A-star, however, would retire this debt after one year and conform itself to the industry Debt to value ratio of 35%. Exhibit 1 shows the recent (Dec 2013) balance sheet and income statement of A-star along with some other relevant data. Further, following information is available about A-star:  Cash and equity in affiliates are non-operating in nature.  Operating costs will retain their respective proportion with sales in future.  Tax rate applicable is 33%. 3 You are required to estimate the following: a. Maximum debt that can be taken up by A-star in 2013. 2 b. EBIT and interest expenses to be incurred in 2014. Assume that interest is paid at the end of the year. 2 c. Free cash flow to firm in 2014. 1 d. Balance long term debt at Dec 2014, assuming no fresh equity will be issued, no dividends will be paid and no intermediate debt repayments will be made in 2014. 2 e. Growth rate for free cash flows beyond 2014. 3 f. Using Adjusted present value (APV) method, estimate the value of operating assets as of Dec 2013. 3 g. Value of non-operating assets and total value of the firm as of Dec 2013. 2 2. Financial information along with dividends and reinvestment requirements about three firms A,B, and C is given in Exhibit 2. Further, it is known that firm A and C follows a residual dividend distribution policy where after meeting their reinvestment needs in accordance with their target capital structure firms would payout the left-out earnings as dividends. Firm B, however follows a 25% payout policy and decides on its reinvestments according to this payout and their respective target capital structures. You are required to solve for all the empty cells in the exhibit. 15 3. A consultant has collected the following information regarding Sigma Publishing: Total assets ,000 million Tax rate 40% Operating income (EBIT) $800 million Debt ratio 0% Interest expense $0 million WACC 16% Net income $480 million M/B ratio 1.00× Share price $32.00 The company has no growth opportunities (g = 0), so the company pays out all of its earnings as dividends (EPS = DPS). The consultant believes that if the company moves to a capital structure financed with 20 percent debt and 80 percent equity (based on market values) by repurchasing some of the equity by debt, the cost of equity will increase to 11 percent and that the pre-tax cost of debt will be 10 percent. If the company makes this change, then a. Estimate the total market value of the firm. 2 b. Estimate the value of debt and equity. 2 c. Estimate the new share price and number of shares outstanding. 4 4 d. Estimate the new Market by Book value ratio of equity (M/B). 2 Exhibit 1 Cash 100 Account payables 310 Account receivables 300 Accruals 185 Inventory 250 Total Current Assets 550 Total Current Liabilities 495 Net Long term assets 8000 Long term debt 850 Investment in Equity Affiliates 1100 Common stock 750 Retained Earnings 7655 Total Equity 8405 Total Assets 9750 Total Equity and Liabilities 9750 Balance Sheet (Dec 2013, in Rs. million) Sales 4450 COGS 3115 Other expenses 120 Depreciation 150 EBIT 1065 Interest expense 69 Equity in Earnings of Affiliates 75 Taxable income 1071 Tax @ 33% 353.43 PAT 717.57 Income Statement (2013, in Rs. million) Incremental Investments required in working capital in 2014, Rs. million 65 Investments required in capital assets in 2014, Rs. million 510 Sales growth in 2014 15% Worst case EBIT Interest coverage ratio 6x Cost of Debt (pre-tax) 8.25% Riskfree rate 4.50% Market risk premium 7% Target D/V 35% Equity beta of comparable firms 1.1 P/E ratio for Equity Affiliates 13.4 Other Information 5 Exhibit 2 A B C Target and Dec 2012 capital structure Equity 2000 1500 Debt 1000 1000 Equity (%) 66.67% 60.00% Debt (%) 33.33% 40.00% Cost of debt (pre-tax) 8% 7% Cost of Equity 14% 12.50% 15% Income statement (Dec 2013) EBIT 1000 800 1825 Interest expenses EBT Tax @ 40% PAT Dividends 550 Dividend payout 25% Reinvestment needs 500 700 Dec 2013 capital structure Equity 3000 Debt 1200 Equity (%) 71.43% Debt (%) 28.57%