Deck 6: The Financing Decision

Question 1

As the financial vice president for Squamish Equipment, you have the following information:

For next year,calculate Squamish's times burden covered ratio if Squamish sells 2 million new shares at $20 a share.

A) 1.03
B) 1.38
C) 1.60
D) 1.89
E) 2.10
F) None of the above.

Answer 1

2.10

Question 2

Which of the following factors favor the issuance of debt in the financing decision?
I.Market signaling
II.Distress costs
III.Tax benefits
IV.Financial flexibility

A) I and II only
B) I and III only
C) II and IV only
D) I, II, and III only
E) I, II, and IV only
F) None of the above.

Answer 2

I, II, and III only

Question 3

Calculate Squamish's times interest earned ratio for next year assuming the firm raises $40 million of new debt at an interest rate of 7 percent.

A) 2.00
B) 3.09
C) 3.66
D) 4.35
E) None of the above. EBIT = [40/(1 - 0.36)] + 15 = $77.5. Interest = $15 + 0.07(40) = $17.8. Times interest earned = 77.5/17.8 = 4.35 times.

Answer 3

4.35

Question 4

Which of the following factors favor the issuance of equity in the financing decision?
I.Market signaling
II.Distress costs
III.Management incentives
IV.Financial flexibility

A) I and II only
B) I and III only
C) II and IV only
D) II, III, and IV only
E) I, II, and IV only
F) None of the above.

Question 5

Financial leverage:
I.increases expected ROE but does not affect its variability.
II.increases breakeven,like operating leverage,but increases the rate of earnings per share growth once breakeven is achieved.
III.is a fundamental financial variable affecting sustainable growth.
IV.increases expected return and risk to owners.

A) I and II only
B) I and III only
C) II and IV only
D) II, III, and IV only
E) I, II, III, and IV
F) None of the above.

Question 6

Calculate Squamish's times burden covered ratio for the next year assuming annual sinking fund payments on the new debt will equal $8 million.

A) 1.01
B) 1.08
C) 1.38
D) 1.49
E) 1.95
F) None of the above.

Question 7

Calculate Squamish's earnings per share next year assuming Squamish raises $40 million of new debt at an interest rate of 7 percent.

A) 1.28
B) 2.00
C) 2.12
D) 2.22
E) 3.06
F) None of the above.

Question 8

The term "financial distress costs" includes which of the following?
I.Direct bankruptcy costs
II.Indirect bankruptcy costs
III.Direct costs related to being financially distressed,but not bankrupt
IV.Indirect costs related to being financially distressed,but not bankrupt

A) I only
B) III only
C) I and II only
D) III and IV only
E) I, II, III, and IV
F) None of the above.

Question 9

Which of the following factors favor the issuance of debt in the financing decision?
I.Market signaling
II.Distress costs
III.Management incentives
IV.Financial flexibility

A) I and II only
B) I and III only
C) II and IV only
D) I, II, and III only
E) I, II, and IV only
F) None of the above.

Question 10

Which of the following is/are helpful for evaluating the effect of leverage on a company's risk and potential returns?
I.Estimated pro forma coverage ratios
II.The recognition that financing decisions do not affect firm or shareholder value
III.A range of earnings chart and proximity of expected EBIT to the breakeven value
IV.A conservative debt policy that obviates the need to evaluate risk

A) I only
B) III only
C) I and III only
D) II and III only
E) IV only
F) None of the above.

Question 11

The best financing choice is the one that:

A) sets the debt-to-assets ratio equal to 1.
B) trades off the tax disadvantage of debt against the signaling effects of equity.
C) maximizes expected cash flows.
D) ignores the false comfort of financial flexibility.
E) results in the lowest possible financial distress costs.

Question 12

As the financial vice president for Squamish Equipment, you have the following information:

For next year,calculate Squamish's earnings per share if Squamish sells 2 million new shares at $20 a share.

A) 1.28
B) 1.39
C) 2.00
D) 2.22
E) 4.00
F) None of the above.

Question 13

Homemade leverage is:

A) the incurrence of debt by a corporation in order to pay dividends to shareholders.
B) the exclusive use of debt to fund a corporate expansion project.
C) the borrowing or lending of money by individual shareholders as a means of adjusting their level of financial leverage.
D) best defined as an increase in a firm's debt-equity ratio.
E) the term used to describe the capital structure of a levered firm.
F) None of the above.

Question 14

As CFO of Nile Holdings, a carpet wholesaler, you have the following information as of December 2011:

Assume Nile raises $100 million of new debt at the end of 2011,at an interest rate of 7%.
a.Assuming Nile must make a $20 million payment on the new debt next year,calculate the firm's times burden covered ratio and times common covered (including debt payments)ratio.
b.As Nile's banker,would you be comfortable loaning the company this new debt?
Briefly explain why,or for what reasons you'd be comfortable or uncomfortable.

Question 15

In general,the capital structures used by non-financial U.S.firms:

A) typically result in debt-to-asset ratios between 60 and 80 percent.
B) tend to converge to the same proportions of debt and equity.
C) tend to be those that maximize the use of the firm's available tax shelters.
D) vary significantly across industries.
E) None of the above.

Question 16

According to the pecking-order theory proposed by Stewart Myers of MIT,which of the following are correct?
I.For financing needs,firms prefer to first tap internal sources such as retained profits and excess cash.
II.There is an inverse relationship between a firm's profit level and its debt level.
III.Firms prefer to issue new equity rather than source external debt.
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
F) None of the above.

Question 17

Which of the following is NOT a likely financing policy for a rapidly growing business?

A) Adopt a modest dividend payout policy that enables the company to finance most of its growth externally.
B) Borrow funds rather than limit growth, thereby limiting growth only as a last resort.
C) Maintain a conservative leverage ratio to ensure continuous access to financial markets.
D) If external financing is necessary, use debt to the point it does not affect financial flexibility.
E) None of the above.

Question 18

The interest tax shield has no value when a firm has:
I.no taxable income.
II.debt-equity ratio of 1.
III.zero debt.
IV.no leverage.

A) I and III only
B) II and IV only
C) I, III, and IV only
D) II, III, and IV only
E) I, II, and IV only
F) None of the above.

Question 19

The basic lesson of the M&M theory is that the value of a firm is dependent upon:

A) the firm's capital structure.
B) the total cash flow of the firm.
C) minimizing the marketed claims.
D) the amount of marketed claims to that firm.
E) the size of the stockholders' claims.
F) None of the above.

Question 20

As CFO of Nile Holdings, a carpet wholesaler, you have the following information as of December 2011:

Assume Nile raises $100 million of new debt at the end of 2011,at an interest rate of 7%.
a.Calculate the firm's pro forma 2012 times interest earned (TIE)ratio.
b.Calculate the percentage EBIT can fall (below expected EBIT)before interest coverage dips below 1.0.

Question 21

Calculate next year's times burden covered ratio and earnings per share if Nile sells 2 million new shares at $50 a share instead of raising new debt.

Question 22

Suppose Nile expects $4.52 in EPS next year if it does not go through with the investment and associated financing.As a shareholder,to satisfy its funding needs for the investment opportunity,do you prefer the company issues $100 million in new debt at an interest rate of 7%,or issues 2 million shares of equity at a target price of $50?
Show supporting calculations,and provide arguments and potential counter-arguments for your recommendation.

Question 23

Can a company incur costs of financial distress without ever going bankrupt?
Explain.What is the nature of these costs?

Question 24

Calculate next year's earnings per share assuming Nile raises the $100 million of new debt.