Financial Management

(Risk & Leverage)

RISK AND LEVERAGE

THEORIES:
Risk
Business risk
Financial risk
12. Financial risk refers to the:
A. risk of owning equity securities
B. risk faced by equity holders when debt is used
C. general business risk of the firm
D. possibility that interest rates will increase
Market risk
Comprehensive
5. A decrease in the debt ratio will least likely affect:
A. Financial risk
C. Systematic or market risk
B. Business risk
D. Total risk
14. Which of the following situations is likely to have the highest combined business and financial
risk impact upon a business?
A. A new labor-intensive operation is funded with operating cash flows
B. A fully automated plant is completed, funded with retained earnings
C. A fully automated plant is completed, funded with the issuance of 10-year bonds
D. An automated, but dated plant in the southern region is closed and operations are
resumed in a labor-intensive plant in Central Luzon

income (NOI or EBIT) of each firm. Paranaque Corporation would have less business risk
if its operating income is at least twice that of Alabang Company.
9. Which of the following is incorrect regarding operating leverage?
A. Operating leverage is the degree to which costs are fixed.
B. A project's break-even point will be affected by the extent to which costs can be reduced
as sales decline.
C. If the project has mostly variable costs, it is said to have high operating leverage.
D. High operating leverage implies that profits are more sensitive to changes in sales.
11. The extent to which fixed costs are used in a firms operations is called its:
A. financial leverage.
C. financial leverage.
B. operating leverage.
D. foreign risk exposure.
Financial Leverage
4. It refers to management strategy of financing assets with borrowed capital; such an extensive
use raise the entity risk thereby impacting on the return on common stockholders equity to be
above or below the rate of return on total assets.
A. Factoring
C. Mortgage.
B. Leverage.
D. Restructuring

Operating Leverage
2. Which of the following is a key determinant of operating leverage?
A. Level of debt
C. Technology
B. Cost of debt
D. Capital structure

1. The use of financial leverage by the firm has a potential impact on which of the following?
(1) The risk associated with the firm
(2) The return experienced by the shareholder
(3) The variability of net income
(4) The degree of operating leverage
(5) The degree of financial leverage
A. 1, 3, 5
C. 1, 2, 3, 5
B. 2, 3, 4, 5
D. 1, 2, 5

3. The degree of operating leverage for Alabang Company is 3.5, and the degree of operating
leverage for Paranaque Corporation is 7.0. According to this information, which firm is
considered to have greater business risk?
A. Alabang Company.
B. Paranaque Corporation.
C. The degree of operating leverage is not a measure of business risk, so it is not possible to
tell which firm has the greater business risk given the above information.
D. To determine which firm has the greater business risk, we need to know the operating

16. The degree of financial leverage for April Company is 3.0, and the degree of financial leverage
for August Corporation is 6.2. According to this information, which firm is considered to have
greater overall (total) risk?
A. April Company.
B. August Corporation.
C. The degree of financial leverage is a measure of financial risk, so the only conclusion that
can be made with the information given is that August Corporation has greater financial
risk than April Company -- we cannot tell which firm has greater total risk.

Financial Management
(Risk & Leverage)

D. To determine which firm has the greater total risk, we need to know the financial
breakeven point of each firm.
Weighted average Cost of capital
6. Which of the following changes would tend to decrease the company cost of capital for a
traditional firm?
A. Decrease the proportion of equity financing.
B. Increase the market value of the debt.
C. Decrease the proportion of debt financing.
D. Decrease the market value of the equity.
15. The most commonly held view of capital structure is that the weighted average cost of capital:
A. falls first with moderate levels of leverage and then increases.
B. does not change with leverage.
C. increases proportionately with increases in leverage.
D. increases with moderate amounts of leverage and then falls.
Target capital structure
10. The mix of debt, preferred stock, and common equity with which the firm plans to raise capital
is called the:
A. financial risk
C. business risk
B. operating leverage
D. target capital structure
Optimal capital structure
13. The mix of debt and equity that minimizes the cost of capital is the:
A. optimal operating leverage
C. optimal degree of combined leverage
B. target financial structure
D. optimal capital structure
7. When establishing their optimal capital structure, firms should strive to:
A. minimize the weighted average cost of capital
B. minimize the amount of debt financing used
C. maximize the marginal cost of capital
D. none of the above
8. Although debt financing is usually the cheapest component of capital, it cannot be used to
excess because
A. the interest rates may change.
B. the firm's stock price will increase and raise the cost of equity financing.

C. the financial risk of the firm may increase and thus drive up the cost of all sources of
financing.
D. none of the above.
PROBLEMS:
Capital structure
i
.If the pro forma balance sheet shows that total assets must increase by P400,000 while retaining
a debt-equity ratio of .75 then:
A. debt must increase by P300,000.
B. equity must increase by the full P400,000.
C. debt must increase by P171,428.
D. equity must increase by P100,000.
Optimal capital budget
ii
.Absolute Corporation has a capital structure that consists of 65% equity and 35% debt. The
company expects to report P100 million in net income this year, and 67.5% of the net income
will be paid out as dividends. How large can the firm's capital budget be this year without it
having to include the cost of new common stock in its cost of capital analysis?
A. P100.0 million
C. P 50.0 million
B. P 67.5 million
D. P 32.5 million
Dividend per share
iii
.The Salvage Company projects the following for the upcoming year:
Earnings before interest and taxes
Interest expense
Preferred stock dividends
Common stock dividend payout ratio
Average number of common shares outstanding
Effective corporate income tax rate
The expected dividend per share of common stock is
A. P1.70
C. P2.10
B. P1.86
D. P1.00

P40 million
P 5 million
P 4 million
20%
2 million
40%

Required cash flow before tax

iv
.How much will a firm need in cash flow before tax and interest to satisfy debt holders and
equity holders if the tax rate is 40%, there is P10 million in common stock requiring a 12%
return, and P6 million in bonds requiring an 8% return?
A. P1,392,000
C. P2,480,000

Financial Management
(Risk & Leverage)

B. P1,488,000

D. P2,800,000

Weighted average cost of capital

v
.The Dumaguete Co. has an equity cost of capital of 17%. The debt to equity ratio is 1.5 and a
cost of debt is 11%. What is the weighted average cost of capital of the firm? (Assume a tax
rate of 33%)
A. 3.06%
C. 16.97%
B. 13.40%
D. 15.52%
Retained earnings breakpoint
vi
.During the past five years, Pena Company had consistently paid 50% of earnings available to
common as dividends. Next year, the Pena Company projects its net income, before the
P1.2 million preferred dividends, at P6 million.
The capital structure for the company is maintained at:
Debt
25.5%
Preferred stock
15.0%
Common equity
60.0%
What is the retained earnings break-point next year?
A. P5,760,000
C. P4,000,000
B. P4,800,000
D. P6,000,000
vii

.Balon Company expects P30 million in earnings next year. Its dividend payout ratio is 40
percent, and its equity to asset ratio is 40 percent. Balon Company uses no preferred stock.
At what amount of financing will there be a break point in Balons cost of capital?
A. P45 million
C. P30 million
B. P20 million
D. P18 million

Degree of Financial Leverage

viii
.Calculate the DFL for a firm with EBIT of P6,000,000, fixed cost of P3,000,000, interest expense
of P1,000,000, preferred stock dividends of 800,000, and a 40 percent tax rate.
A. 6.0
C. 1.43
B. 9.0
D. 1.64
Sensitivity analysis
ix
.A firm is expected to generate P1.5 million in operating income and pay P250,000 in interest.
Ignoring taxes, this will generate P12.50 earnings per share. What will happen to EPS if
operating income increases to P2.0 million?
A. EPS increase to P15.63.
C. EPS increase to P17.50.

B. EPS increase to P16.67.

D. EPS increase to P20.00.

.The board of directors of Aggressive Company was unhappy with the current return on
common equity. Though the return on sales (profit margin) was impressively good at 12.5
percent, the asset turnover was only 0.75. The present debt ratio is 0.40.
Ms. Sylvia Moreno, the vice-president of corporate planning, presented a proposal as
follows:

Profit margin should be raised to 15 percent.

The new capital structure will be revised by raising debt component.

The asset turnover will be maintained at 0.75.

The proposed adjustment is estimated to raise return on equity by 50 percent.
What debt ratio did Ms. Moreno propose in order to raise the return on equity (ROE) to 150
percent of the present level?
A. 0.52
C. 0.61
B. 0.68
D. 0.72

Residual dividend policy

xi
.Alvin Company expects next years after-tax income to be P7,500,000. The firms debt ratio is
currently 40 percent. Alvin Company has P6,000,000 of profitable investment opportunities,
and it wishes to maintain its existing debt ratio. According to the residual dividend policy,
what is the expected dividend payout ratio next year?
A. 52.0 percent
C. 48.0 percent
B. 75.0 percent
D. 25.0 percent
.Ellis Company expects to generate P10 million internally which could be available for financing
part of its P12 million capital budget for this coming year. Ellis management believes that a
debt-equity ratio of 40 percent is best for the firm. How much should be paid in dividends if
the target debt-equity ratio is to be maintained?
A. P2,800,000
C. P1,428,571
B. P8,571,429
D. P4,000,000

xii

Comprehensive
Use the following information to answer Question Nos. 13 through 18:
The Reliable Corporation, a manufacturer of radar control equipment, is planning to sell its shares
to the general public for the first time. The firm's investment banker is working with the Reliable
Corporation in determining a number of items. Information on the Reliable Corporation follows:
Reliable
Corporation

Financial Management
(Risk & Leverage)

Income
For the Year 2007
Sales (all on credit)
Cost of goods sold
Gross profit
Selling and administrative expenses
Operating profit
Interest expense
Net income before taxes
Taxes
Net income
Balance Sheet
As of December 31, 2007
Assets
Cash
Marketable securities
Accounts receivable
Inventory
Total current assets
Net plant and equipment
Total assets

Liabilities and Stockholders' Equity

Accounts payable
Notes payable
Total current liabilities
Long-term liabilities
Total liabilities
Common stock (1,200,000 shares at P1 par)
Capital in excess of par
Retained earnings
Total stockholders' equity
Total liabilities and stockholders' equity

Statement
P22,428,000
16,228,000
6,200,000
2,659,400
3,540,600
370,600
3,170,000
1,442,000
P 1,728,000

The new public offering will be at 10 times the earnings per share.
xiii

.Assume that 500,000 new corporate shares will be issued to the general public. What will
earnings per share immediately after the public offering be?
A. P1.02
C. P1.19
B. P1.44
D. P1.59

xiv

.Based on the price-earnings ratio of 10, what will the initial price of the stock be?
A. P14.40
C. P10.20
B. P11.90
D. P15.90

xv

150,000
100,000
2,000,000
3,800,000
P 6,050,000
6,750,000
P12,800,000

P 1,000,000
1,200,000
2,200,000
2,380,000
P 4,580,000
P 1,200,000
2,800,000
4,220,000
8,220,000
P12,800,000

.Assuming an underwriting spread of 7 percent and out-of-pocket costs of P150,000, what will
net proceeds to the corporation be?
A. P4,743,000
C. P4,950,000
B. P4,593,000
D. P5,307,000

xvi

.What return must the corporation earn on the net proceeds to equal the earnings per share
before the offering?
A. 16.18%
C. 15.68%
B. 16.58%
D. 15.98%

xvii

.Assume that, of the initial 500,000-share distribution, 250,000 shares belong to current
stockholders and 250,000 are new corporate shares, and these will be added to the
1,200,000 corporate shares currently outstanding. What will the initial market price of the
stock be? Assume a price-earnings ratio of 10 and use earnings per share after the
distribution in the calculation.
A. P10.90
C. P10.20
B. P11.90
D. P12.15

xviii

.Assuming an underwriter spread of 7 percent and out-of-pocket costs of P150,000, what

return must the corporation earn on the net proceeds to equal earnings per share before the
offering?
A. 13.50%
C. 15.68%
B. 13.76%
D. 14.57%

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