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Final Exam Review

BUSI 2505

Ex 1: Merger and Acquisition

Consider 2 firms A and B, operating in the same industry and neither
has debt. The incremental value of the proposed acquisition is
estimated to be $25,000 perpetually. Cost of capital is 10%. Firm B
is willing to be acquired for $30 per share in cash.

Firm A: Number of Shares:50,000; Price per Share: $50.00
Firm B: Number of Shares:18,000; Price per Share: $22.50
A) What are the synergistic benefits that arise from the acquisition of
firm B?
B) What is the merger premium per share in this case?
C) What is the value of firm B to firm A?
D) What is the NPV for acquiring firm B?
E) What is the price per share of the merged firm after the
acquisition is completed?
Answer: A)$250,000 B)$7.50 C)$655,000 D)$115,000 E) $52.30

Ex 2: Lease financing
An oil company is trying to decide whether to
lease or buy a new drilling system. The
system costs $9.4 million and qualifies for a
25 percent CCA rate. The equipment will have
a $975,000 salvage value in 5 years. Tax rate
is 36 percent and the firm can borrow at 9
percent. A leasing Company has offered to
lease the drilling equipment for payments of
$2.15 million per year. Lease payments are
made at the beginning of the year.

Lease financing (contd)

a) What is the NAL for the oil company?
b) What is the maximum lease payment that will
be deemed acceptable by the oil company?
c) Suppose that the equipment will have no
salvage value at the end of the lease. What is
the maximum lease payment acceptable to
the lessee now?
) Answer: a) NAL=$32,985, b) max
payment=$2,161,493.70 c) Maximum lease

Ex 3: Ex-dividend
Shares of Markely, Inc. stock are currently
priced at $43.78. The stock goes ex-dividend
tomorrow in preparation for a $.60 quarterly
dividend. The average shareholder faces a
marginal tax rate of 30% and the company
has a cost of equity of 12% and a 35% tax
rate. At what price should the stock open
tomorrow, all else constant?
Answer: $43.36

Ex 4: Capital Restructure
Kate's Dry Goods currently has 15,000
shares of stock outstanding. Kate would
like to reduce the outstanding shares by
one-third by issuing debt and repurchasing
stock. The firm has an EBIT of $8,400 and a
cost of debt of 7%. How much debt does
Kate have to issue to accomplish her goal if
she wishes EBIT to remain constant?
Answer: $40,000

Ex 5: Goodwill
Suppose Perot Mfg. purchases Clinton
Enterprises for $120 million in cash. For
purposes of the acquisition, Clinton's fixed
assets were appraised at $95 million. Further,
assume Clinton Enterprises has working capital
of $15 million and no long-term debt. If Perot
Mfg. uses the purchase accounting method to
account for the acquisition, goodwill of
______________ is created.
Answer: $10 million

Ex 6: Merger payment
Firms A and B are competitors. Both have
similar assets and business risks and are allequity firms. Firm A has aftertax cash flow of
$20,000 per year forever and firm B has
aftertax cash flow of $150,000 per year forever.
If the two firms merge, the perpetual aftertax
cash flow will be $179,000. If the appropriate
discount rate is 15% what is the MOST B will
pay for A?
Answer: $193,333

Ex 7: Cash dividend
Alex, Inc. is financed 100% with equity. The firm
has 100,000 shares of stock outstanding with a
market price of $5 per share. Total earnings for
the most recent year are $50,000. The firm has
cash of $25,000 in excess of what is necessary to
fund its positive NPV projects. The firm is
considering using the cash to pay an extra
dividend of $25,000 or, alternatively, to
repurchase $25,000 of stock. The firm has other
assets worth $475,000 (market value). Assume
there are no transaction costs, taxes, or other
market imperfections.

Cash dividend (contd)

Assume the firm pays the $25,000 excess cash in the
form of a cash dividend.
A) What will be the firm's earnings per share once the
dividend is paid?
B) What will be the market price per share of Alex's
stock once the dividend is paid?
C)What will be the firm's price/earnings ratio once the
dividend is paid?
D) You own 1,000 shares and this comprises your
total wealth. Once the dividend is paid, what is your
total wealth?
Answer: A) $0.50 B)$4.75 C) 9.50 D) $5,000

Ex 8: Bid price
You will bid to supply three jets per year for
each of the next three years to the Navy. To get
set up, you will need $10 million in equipment,
which belongs in a 30% CCA class and will have
no salvage value. Total fixed costs per year are
$5 million, and variable costs are $7 million per
jet. Assuming a tax rate of 30% and a required
return of 10%, what is the minimum price at
which you should offer to supply the jets?
Answer: $11 million

Ex 9: Cash break-even
What is the cash break-even point?
Price = $100 per unit; variable cost
= $24 per unit, fixed cost = $40,000
per year; depreciation = $10,000 per
year. Assume a discount rate of
10%, project initial outlay of
$100,000, project life of 10 years,
and ignore taxes.
Answer: 527 units

Ex 10: DOL
Suppose that a project has a DOL =
0. 75. If the quantity being produced
increases from 96 to 100, what is the
expected percentage change in
operating cash flow?
Answer: 3.1%

Ex 11: Scenario analysis

A project has a seven-year life and an initial
investment of $228,700 in equipment. The
equipment will be depreciated straight-line to zero
over seven years. Fixed costs are $124,600. Variable
costs are $8.16 per unit. Sales are estimated at
54,500 units at an average price of $11.99. The
estimated ranges of each variable are: sales quantity
15%; sales price 2%; variable cost 10%; and
fixed costs 4%. The tax rate is 35%. Under the
worst-case scenario, what is the operating cash flow?
Answer: $10,740

Ex 12: EPS
A firm has 30,000 shares of stock
outstanding, $450,000 in debt at a
9% rate, an EBIT of $112,000, and a
tax rate of 0%. What is the EPS?

Answer: $2.38

Ex 13: Residual dividend

ABC, Inc. has 25,000 shares of stock outstanding
at a market price of $20. The firm has $500,000
in outstanding debt. Earnings for next year are
projected at $100,000. The firm plans on
spending $120,000 on capital projects next. The
firm also maintains a constant debt-equity ratio.
What is the projected dividend amount per share
if the firm follows a residual dividend policy?
Answer: $1.60

Ex 14: WACC
The Brassy Co. has expected EBIT =
$910, an unlevered cost of capital of
12%, and debt with a face and
market value of $2,000 paying an
8.5% annual coupon. If the tax rate
is 34%, what is the WACC of Brassy
Co. ?
Answer: 10.56%

Ex 15: Break-even EBIT

A firm is considering two separate
capital structures. The first is an all
equity plan consisting of 25,000
shares of stock. The second plan
would consist of 10,000 shares of
stock and $90,000 in debt at a cost
of 8%. Ignore taxes. What is the
break-even EBIT?
Answer: $12,000

Ex 16: Unlevered firm value

A firm has a tax rate of 35%, an
unlevered rate of return of 14%, total
debt of $1,000, and an EBIT of
$300.00. What is the unlevered value
of the firm?
Answer: $1,393

Ex 17: Residual dividend

A firm has 300,000 shares of
common stock outstanding and
maintains a debt-equity ratio of .5.
The earnings estimate for next year
is $90,000. What is the maximum
amount of capital spending that can
occur without the firm issuing any
additional equity?
Answer: $135,000

Ex 18: NAL
Your company is considering the purchase
of a fleet of cars for $195,000. It can
borrow at 8.5%. The cars can be leased for
$55,000 per year and will be worthless at
the end of four years. The corporate tax
rate is 34% and the cars belong in CCA
class 10 (a 30% class). If you do not
expect to pay taxes for the next four years,
what is the net advantage to leasing?
Answer: $-471

Ex 19: Ownership dilution

Stephen owns 5,000 shares of ABNC stock.
Currently, there are 1.2 million shares outstanding.
The company has just announced a rights offering
whereby 300,000 shares are being offered for sale
at a subscription price of $24 a share. The current
stock price is $27 a share. Assume that Stephen
sells his rights and that all rights are exercised.
What will his ownership percentage be in ABNC
after the rights are exercised?
Answer: 0.33%

Ex 20: Divisional cost of

Discount Retailers has an overall beta of .
96 and a cost of equity of 10.4% for the
firm overall. The firm is financed solely by
common stock. Division A within the firm
has an estimated beta of 1.13 and is the
riskiest of all of the firms divisions. What is
an appropriate cost of capital for division A
if the market risk premium is 5%?
Answer: 11.25%

Ex 21: Weighted average flotation

Green Yards has a capital structure of
50% common stock, 15% preferred
stock, and 35% debt. The flotation
costs are 3% for debt, 6% for
preferred stock, and 8% for common
stock. What is the weighted average
flotation cost?
Answer: 5.95%

Ex 22: Total Cost

The Lingo Co. has a debt-equity ratio of .
60. The firm is analyzing a new project
which requires an initial cash outlay of
$450,000 for new equipment. The
flotation cost for new equity is 10% and
for debt 5%. What is the initial cost of the
project including the flotation costs?
Answer: $489,796

Ex 23: Shares in a rights

TOYSrYOU plans to raise $8 million in
a rights offering. If management sets
the subscription price at $2 per share
and the current market price is $2.50
per share, how many shares need to
be sold in the rights offering?
answer: 4,000,000 shares

Ex 24: Number of rights

TOYSrYOU needs to raise $5 million
in a
rights offering. If the subscription
price is $10 per share, the stock
price is $12.50 per share, and there
are 4 million shares outstanding, how
many rights are required to purchase
one of the new shares?
answer: 8.0 rights

Ex 25: Value of a right

TOYSrYOU needs to raise $5 million
in a rights offering. If the subscription
price is $10 per share, the stock
price is $12.50 per share, and there
are 4 million shares outstanding,
what is the value of a right?
Answer: $0.28

Ex 26: Ex-rights price

Tell-Al, Inc. has 8 million shares of
common stock outstanding at a
market price of $22. The company
has just announced a rights offering
for $27 million at a subscription price
of $18. What is the ex-rights price?
Answer: $21.37

Ex 27: WACC/NPV/flotation
Hartley Inc. needs to purchase equipment
for its 2,000 drive-ins nationwide. The
total cost of the equipment is $2 million.
Aftertax cash inflows from the project will
be $210,000 annually in perpetuity.
Hartley has a market value debt-to-equity
ratio of 40%. The firms cost of equity is
13%, its pretax cost of debt is 8%, and the
flotation costs of debt and equity are 2%
and 8%, respectively. The tax rate is 34%.

WACC/NPV/flotation costs continued

1 What is Hartleys weighted average cost of capital?
2 Ignoring flotation costs, what is the NPV of the
proposed project?
3 What is the weighted average flotation cost for
4 What is the dollar flotation cost for the proposed
5 After considering flotation costs, what is the NPV of
the proposed project?
answer: 10.79%; -53,753; 6.29%; 134,244; -187,997

Ex 28: Reverse stock split

ZAC, Inc. has 450,000 shares of stock
outstanding at a market price of $8.20. Which of
the following statements are correct if the
company declares a 4-for-9 reverse stock split?
The number of shares outstanding will be
The number of shares outstanding will
be 200,000.
The market price per share will be $3.64.
The market price per share will be

Ex 29: Equity Beta

The equity beta of a firm depends on which of
the following?

I. The firm's business risk.

II. The firm's financial policy.

III. The firm's advertising policy.

A)I and II only
B)III only
C)I and III only
D)II and III only
E)I, II, and III

Ex 30: Forecast risk

Which one of the following most likely represents the
greatest forecasting risk?

A)The replacement of current machinery with similar
B)The reduction in production costs due to improved
quality controls.
C)The introduction of a new product that
expands the types of goods offered.
D)The introduction of an updated existing product.
E)The sale of a used piece of equipment that is no
longer needed.

Ex 31: WACC Risk

Ajax Corp. has been operating as three separate divisions over the
past ten years, although all capital budgeting decisions are
ultimately made at the home office using the firm's overall WACC.
Just recently, they discovered the divisions have significantly
different risks. Which of the following is also likely to be true?

A)The divisions are being rewarded for decreasing their risk.
B)Higher earning divisions will be less risky than the lower earning
C)Its low earning division tends to be ignored in capital
allocation even though it tends to maintain lower levels of
D)The differences in risk among the divisions has no impact on the
capital budgeting process.
E)The highest divisional cost of capital will approximately equal the
firm's overall cost of capital.

Ex 32: Optimal Capital


Which of the following will affect the optimal level

of debt for a firm?
Tax rate
Volatility of earnings
Nature of assets
Accumulated tax losses

A)I and II only
B)I and IV only
C)I, II, and III only
D)I, III, and IV only
E)I, II, III, and IV

Information content of
For the past four years Doodle Dee has paid quarterly
dividends of $.25 a share. The company just
announced that dividends are being increased by 8%.
As a result, the market price of Doodle Dee stock
increased. The increase in the share price is generally
attributed to the:

A)Increase in the current dividend amount.
B)Change in the dividend policy.
C)Information content of the dividend.
D)Residual effect of the dividend.
E)Reinvestment of the dividend amount.

Operating leases
Which of the following describe(s) an operating lease?

I. The lease is cancellable at the option of the


II. The term of the lease is relatively short.

III. The lessor is typically required to maintain the


A)I only
B)I and II only
C)I and III only
D)II and III only
E)I, II, and III

Acquisition by stock
Which one of the following is a characteristic of an
acquisition by stock?

A)Shareholders must vote and approve an acquisition.
B)The target firm's management can be bypassed by
the use of a tender offer.
C)Complete absorption of one firm occurs in an acquisition.
D)Minority shareholders are ignored in the acquisition
E)The acquisition cost is normally lower than that of a

Which of the following refer to
synergistic gains due to tax benefits
in an acquisition?

I. Complementary resources

II. Strategic benefits

III. Unused debt capacity

IV. Asset write-ups

Tax gains Mergers

Which of the following is a case in which tax gains are
used as a justification for purchasing another firm?
A) The target firm has resources to which the
purchaser wants access.
B) The target firm has no unused debt capacity.
C) The target firm has access to markets that the
bidder wishes to exploit.
D) The target firm has unused net operating
losses that can be used by the bidder.
E) The target firm has resources that are
complementary to the bidder.

Value of the target firm

The value of firm B to firm A is equal to the value
A) Firm B as a stand-alone firm plus the
synergy value.
B) The incremental benefit of the merger or
C) The incremental cash flows from the merger or
D) The incremental cash flows minus the value of
firm B as a stand-alone firm.
E) The firm AB plus the incremental gain.

Merger gain
The incremental gain from a merger is defined as the:
A) Stand-alone value of the target firm minus the
synergistic effects.
B) Value of the combined firm minus the sum of
the stand-alone values of each firm.
C) Stand-alone value of the acquired firm minus the
acquisition costs.
D) The sum of the stand-alone values of both firms
minus the acquisition costs.
E) The value of the purchasing firm plus the
synergistic effects minus the acquisition costs.

Merger and synergy

A successful merger requires that the:

A)P/E ratio maintains its pre-merger value.

B)Debt-equity ratio of the firm remains at its
pre-merger level.
C)Book value per share must remain
D)Book value per share must increase.
E)Value of the whole exceeds the value
of the sum of the parts.

Stock splits
A stock has a normal trading range of $22 to $30. The
stock is currently selling at $41 a share. It would be
common for a firm in this situation to:

A)Repurchase outstanding shares by issuing debt
B)Do a reverse stock split to lower the market price of the
C)Issue a one-time special dividend.
D)Increase the number of outstanding shares via a
stock split.
E)Issue a liquidating dividend to lower the value of the

Capital Lease
Which of the following characteristics would cause a lease
to be declared a capital lease for accounting purposes?
A) The present value of the lease payments equals 60% of
the fair market value at the start of the lease.
B) The lease does not transfer ownership of the property to
the lessee by the end of the lease term.
C) The lessee can purchase the asset at a price below
fair market value when the lease expires.
D) The lease term is at least 50% of the estimated
economic life of the asset.
E) The lessor maintains the insurance and maintenance on
the leased asset.

Operating Lease
An operating lease usually:
A) Normally has a payment structure
such that the payments are sufficient
to allow the lessor to recover the cost
of the asset.
B) Has a lease period of at least five
C) Cannot be canceled.
D) Requires the lessor to
maintain the asset.