Activity 6B

FINMA – Capital Structure and Long-term financing

I. Choose the best Answer.

1. In general, firms that are subject to a high degree of _________, relatively short production cycles, or both tend to use shorter
planning horizons.
a. profitability b. financial certainty c. operating uncertainty d. financial planning
2. An increase in non-diversifiable risk
a. would cause an increase in the beta and would lower the required return.
b. would have no effect on the beta and would, therefore, cause no change in the required return.
c. would cause an increase in the beta and would increase the required return.
d. would cause a decrease in the beta and would, therefore, lower the required rate of return.
3. Generally, long-term loans have higher interest rates than short-term loans because of
a. the general expectation of higher future rates of inflation.
b. lender preferences for shorter-term, more liquid loans.
c. greater demand for long-term rather than short-term loans relative to the supply of such loans.
d. all of the above.
4. If the expected return is above the required return on an asset, rational investors will
a. buy the asset, which will drive the price up and cause expected return to reach the level of the required return.
b. sell the asset, which will drive the price down and cause the expected return to reach the level of the required return.
c. sell the asset, which will drive the price up and cause the expected return to reach the level of the required return.
d. sell the asset, since price is expected to decrease.
5. In international capital budgeting decisions, political risks can be minimized using all of the following strategies except
a. structuring the investment as a joint venture and selecting well-connected local partner.
b. structuring the financing of such investments as equity rather than as debt.
c. structuring the financing of such investments as debt rather than as equity.
d. None of the above.
6. Equity capital can be raised through
(a) the money market. (c) retained earnings and the stock market.
(b) the NYSE bond market. (d) a private placement with an insurance company as the creditor.
7. An 8 percent preferred stock with a market price of P110 per share and a P100 par value pays a cash dividend of _________.
(a) P4.00 (b) P8.00 (c) P8.80 (d) P80.00
8. The disadvantages of issuing common stock versus long-term debt include all of the following EXCEPT
(a) the potential dilution of earnings. (b) high cost. (c) no maturity date.
(d) the market perception that management thinks the firm is over-valued, causing a decline in stock price.
9. Billick Brothers is estimating its WACC. The company has collected the
following information:
a. Its capital structure consists of 40 percent debt and 60 percent common
equity.
b.. The company has 20-year bonds outstanding with a 9 percent annual
coupon that are trading at par.
c. The company’s tax rate is 40 percent.
d. The risk-free rate is 5.5 percent.
e. The market risk premium is 5 percent.
f. The stock’s beta is 1.4.
What is the company’s WACC?
a. 9.71%
b. 9.66%
c. 8.31%
d. 11.18%
 e. 11.10%

10. A firm has an issue of preferred stock outstanding that has a stated annual dividend of P4. The required return on the
preferred stock has been estimated to be 16 percent. The value of the preferred stock is _________.
(a) P64 (b) P16 (c) P25 (d) P50
11. A firm has an expected dividend next year of P1.20 per share, a zero growth rate of dividends, and a required return of 10
percent. The value of a share of the firm’s common stock is _________.
(a) P120 (b) P10 (c) P12 (d) P100

12. Emmy Lou, Inc. has an expected dividend next year of P5.60 per share, a growth rate of dividends of 10 percent, and a
required return of 20 percent. The value of a share of Emmy Lou, Inc.’s common stock is _________.
(a) P28.00 (b) P56.00 (c) P22.40 (d) P18.67
13. According to the efficient market theory,
(a) prices of actively traded stocks can be under- or over-valued in an efficient market, and bear searching out.
(b) prices of actively traded stocks can only be under-valued in an efficient market.
(c) prices of actively traded stocks do not differ from their true values in an efficient market.
(d) prices of actively traded stocks can only be over-valued in an efficient market.
 Market efficiency refers to how well current prices reflect all available, relevant information about the actual value of the
underlying assets.

14. If the expected return is above the required return on an asset, rational investors will
(a) buy the asset, which will drive the price up and cause expected return to reach the level of the required return.
(b) sell the asset, which will drive the price down and cause the expected return to reach the level of the required return.
(c) sell the asset, which will drive the price up and cause the expected return to reach the level of the required return.
(d) sell the asset, since price is expected to decrease.
15. _________ in the beta coefficient normally causes _________ in the required return and therefore _________ in the price of
the stock, all else remaining the same.
(a) An increase; an increase; an increase (c) An increase; an increase; a decrease
(b) An increase; a decrease; an increase (d) A decrease; a decrease; a decrease
16. The size of the loan and its cost of borrowing are
(a) not related. (b) inversely related. (c) independent. (d) correlated.
17. The major factors affecting the cost of long-term debt include all of the following EXCEPT
(a) restrictive covenants. (b) loan maturity. (c) loan size. (d) the basic cost of money.
18. A feature that gives the issuer the opportunity to repurchase bonds at a stated price prior to maturity is called
(a) stock purchase warrants. (b) call feature. (c) conversion feature. (d) None
of the above.
19 The process that links risk and return in order to determine the worth of an asset is termed
(a) evaluation. (b) valuation. (c) discounting. (d) variable growth.
Questions 20 to 21 are based on the following information:
La Bekha Corporation asked you to interpret the following ratios provided by its accountant:
Acid-test ratio 1.2
Times interest earned 8
Gross margin ratio 40%
Inventory turnover 6 times
Debt to equity ratio 0.9:1
Ratio of operating expenses to sales 15%
Total stockholders’ equity on December 31, 2020 was P900,000. Gross margin for 2020 amounted to P600,000. Beginning
balance of merchandise inventory was P200,000. The company’s long-term liabilities consisted of bonds payable with interest
at 15%. You decided to reconstruct the company’s financial statements based on the limited information given to serve as basis
for further analysis.

20. Operating income was computed at

a. P525,000 b. P300,000 c. P375,000 d. Answer cannot be determined

21. Bond payable totaled

a. P312,500 b. P350,000 c. P400,000 d. Answer cannot be determined
22. The three elements needed to estimate the cost of equity capital for use in determining a firm’s weighted average cost of
capital are
a. Current dividends per share, expected growth rate in dividends per share, and current book value per share of common
stock.
b. Expected earnings per share, expected growth rate in dividends per share, and current market price per share of common
stock.
c. Current earnings per share, expected growth rate in earnings per share, and current book value per share of common
stock.
 d. Expected dividends per share, expected growth rate in dividends per share, the current market price per share and
common stock.
23. The investment-banking firm of Syria & Associates will use a dividend valuation model to appraise the shares of the
Lebanon Corporation. Dividends at the end of the current year will be P1.20. The growth rate is 9% and the discount rate is
13%. What should be the price of the stock to the public?
a. P28.75 b. P29.00 c. P30.00 d. P31.50

Items 25 to 27 are based on the following information

Spain Inc. is interested in measuring it overall cost of capital and has gathered the following data. Under the terms described
below, the company can sell unlimited amounts of all instruments.
 Spain can raise cash by selling P1,000, 8%, 20-year bonds with annual interest payments. In selling the issue, an
average premium of P30 per bond would be received, and the firm must pay flotation costs of P30 per bond. The
after-tax cost of funds is estimated to be 4.8%.
 Spain can sell 8% preferred stock at P105 per share. The cost of issuing and selling the preferred stock is expected
to be P5 per share.
 Spain’s common stock is currently selling for P100 per share. The firm expects to pay next year cash dividends of
P7 per share, and the dividends are expected to remain constant. The stock will have to be under-priced by P3 per
share, and flotation costs are expected to amount to P5 per share.
 Spain expects to have available P100,000 retained earnings in the coming year, once these retained earnings are
exhausted, the firm will use new common stock as the form of common stock equity financing.
 Spain’s preferred capital structure is: long-term debt 30%, Preferred stock 20% and common stock 50%.
24. The cost of funds from sale of common stock for Spain, Inc is
a. 7.0% b. 7.4% c. 7.6% d. 8.1%

25. If Spain, Inc. needs a total of P200,000, the firm weighted average cost of capital would be
a. 4.8% b. 6.5% c. 6.8% d. 19.80%

26. If Spain, Inc. needs a total of P1,000,000, the firm weighted average cost of capital would be
a. 4.8% b. 6.5% c. 6.8% d. 19.80%

27. Malaysia Company’s 10% preferred stock that has a par value of P100 per share is sold for P101, gross of underwriting
fees of P5 per share. If the tax rate is 40%, what is the cost of funds for preferred stock?
a. 4.2% b. 6.2% c. 10.0% d. 10.4%
28. The inexpensive nature of long-term debt in a firm’s capital structure is due to the fact that
(a) the equity holders are the true owners of the firm.
(b) equity capital has a fixed return.
(c) creditors have a higher position in the priority of claims.
(d) dividend payments are tax-deductible.

29. The inexpensive nature of long-term debt in a firm’s capital structure is due to the fact that
(a) the equity holders are the true owners of the firm.
(b) equity capital has a fixed return.
(c) interest payments are tax-deductible.
(d) equity holders have a higher position in the priority of claims.

30. A firm has a current capital structure consisting of P400,000 of 12 percent annual interest debt and 50,000 shares of common
stock. The firm’s tax rate is 40 percent on ordinary income. If the EBIT is expected to be P200,000, the firm’s earnings per
share will be _________.
(a) P2.40
(b) P3.04
(c) P7.04
(d) P1.82

31. The basic shortcoming of the EBIT-EPS approach to capital structure is

(a) that the optimal capital structure is difficult to compute.
(b) its disregard for the presence of preferred stock in the capital structure.
(c) its disregard for the firm’s dividend policy.
(d) that it concentrates on the maximization of EPS rather than the maximization of owner’s wealth.
32. A firm is analyzing two possible capital structures—30 and 50 percent debt ratios. The firm has total assets of P5,000,000
and common stock valued at P50 per share. The firm has a marginal tax rate of 40 percent on ordinary income. The number
of common shares outstanding for each of the capital structures would be
(a) 30 percent debt ratio: 30,000 shares and 50 percent debt ratio: 50,000 shares.
(b) 30 percent debt ratio: 50,000 shares and 50 percent debt ratio: 70,000 shares.
(c) 30 percent debt ratio: 70,000 shares and 50 percent debt ratio: 100,000 shares.
(d) 30 percent debt ratio: 70,000 shares and 50 percent debt ratio: 50,000 shares.

33. A firm has determined its cost of each source of capital and optimal capital structure, which is composed of the following
sources and target market value proportions:
Target Market After-Tax
Source of Capital Proportions Cost
Long-term debt 45% 5%
Preferred stock 10 14
Common stock equity 45 22

If the firm were to shift toward a more leveraged capital structure (i.e., a greater percentage of debt in the capital structure),
the weighted average cost of capital would
(a) increase.
(b) remain unchanged.
(c) decrease.
(d) not be able to be determined.