Addis Ababa University

College of Business and Economics

Financial Management II

Ch01-Ch03 - Worksheet
Group Hand in Assignment – Ch01 & Ch02
Submission Date: December 15, 2022

Ch01 & Ch02

1. The Willy Bunker School of Karate has annual fixed operating costs of $24,000. Each student
pays $200 in fees; $40 of this amount covers the per student cost of instructional hand-outs
and supplies. There are no other operating costs.
a) How many students must the school enroll in order to break even?
b) Determine the break-even point if the cost of instructional materials were to increase to
$50 per student.
c) Ignoring part b above, what would be the break-even point if fees were to increase by 20
percent?
d) Ignoring parts b and c above, what would be the break-even point if fixed costs were
reduced to $21,280?
e) Calculate the break-even point if all the above changes (b, c, and d) were to take place
simultaneously.

2. Milwaukee Melon Manufacturers sells exotic melons at one price, $10 each. The firm has
variable costs of $160,000 on sales of 32,000 melons. Fixed costs are $80,000. Operating
income (EBIT) this year is $80,000 and after-tax net income is $30,000. Interest expense is
$20,000.
a) What is its degree of financial leverage at the current level of EBIT?
b) Suppose that EBIT were to decline 10 percent next year. What would be the percentage
decline in earnings per share (EPS)?
3. Explain the relationship between DOL, DFL, and DTL and discuss whether firms attempt to
achieve a high DOL and a high DFL.
4. David Company and Goliath Company are virtually identical firms ($50,000 NOI) except for
the use of leverage. David has permanent debt of $200,000 with a 14% interest rate, while
Goliath has no debt. The equity capitalization rate of Goliath (in the absence of borrowing) is
20 percent. The corporate tax rate for both firms is 40 percent. Assume that there are no
personal taxes.
a) What is the present value of the debt tax-shield benefit for David?
 b) Calculate the income available to all suppliers of capital (both debtholders and
shareholders) for the firms.
c) Calculate the total value of each firm.
5. Describe the elements that should be considered (financing checklist) to determine the
appropriate capital structure.
6. Dickson Corp. is comparing two different capital structures. Plan I would result in 12,700
shares of stock and $100,050 in debt. Plan II would result in 9,800 shares of stock and
$226,200 in debt. The interest rate on the debt is 10 percent.
a) Ignoring taxes, compare both of these plans to an all-equity plan assuming that EBIT will
be $70,000. The all-equity plan would result in 15,000 shares of stock outstanding. Which
of the three plans has the highest EPS? The lowest?
b) In part (a), what are the break-even levels of EBIT for each plan as compared to that for
an all-equity plan? Is one higher than the other? Why?
c) Ignoring taxes, when will EPS be identical for Plans I and II?
d) Repeat parts (a), (b), and (c) assuming that the corporate tax rate is 21 percent. Are the
break-even levels of EBIT different from before? Why or why not?
7. The Continental Company reported the following income statement for 2010:
Sales 15,000,000
Less: Operating expenses
Wages, salaries, benefits 6,000,000
Raw materials 3,000,000
Depreciation 1,500,000
General, administrative, and selling expenses 1,500,000
Total operating expenses 12,000,000
Earnings before interest and taxes (EBIT) 3,000,000
Less: Interest expense 750,000
Earnings before taxes 2,250,000
Less: Income taxes 1,000,000
Earnings after taxes 1,250,000
Less: Preferred dividends 250,000
Earnings available to common stockholders 1,000,000
Earnings per share—250,000 shares outstanding 4
Assume that all depreciation and 75 percent of the firm’s general, administrative, and selling
expenses are fixed costs and that the remainder of the firm’s operating expenses are variable
costs.
a) Determine Continental’s fixed costs, variable costs, and variable cost ratio.
b) Based on its 2010 sales, calculate the following for the firm:
i) Degree of operating leverage
ii) Degree of financial leverage
iii) Degree of combined leverage and interpret this value
8. Two identical firms exist except that Firm A uses no debt and Firm B uses some debt. The
total value of Firm A is less than the total value of Firm B, but you own 2% of Firm B. Based
on the arguments by Modigliani and Miller regarding the total value principle, what should
you do (Multiple choice – Choose the correct one)?
a) Buy 2% of Firm A with funds from "shorting" your shares in Firm B. Submit a press
release that the two firms should be worth identical values. This will cause Firm A to rise
in value and leave you extra funds for investment.
b) You should borrow enough funds to equal the difference in firm value, purchase shares of
Firm A with these funds, and sell your shares in Firm B. This will leave extra funds for
an investment of your choice.
c) Sell your shares, personally borrow 2% of the quantity of firm debt, and purchase 2% of
Firm A. This will leave extra funds for an investment of your choice.
d) Sell enough of your shares (Firm B) to purchase 2% of Firm A. This will leave extra
funds for an investment of your choice.
9. (M&M) Sugar Skull Corp. uses no debt. The weighted average cost of capital is 7.9 percent.
If the current market value of the equity is $15.6 million and there are no taxes, what is
EBIT?
10. (M&M and Taxes) In Problem 9, suppose the corporate tax rate is 22 percent. What is EBIT
in this case? What is the WACC? Explain.
11. (Calculating WACC) Solar Industries has a debt-equity ratio of 1.25. Its WACC is 7.8
percent, and its cost of debt is 4.7 percent. The corporate tax rate is 21 percent.
a) What is the company’s cost of equity capital?
b) What is the company’s unlevered cost of equity capital?
c) What would the cost of equity be if the debt-equity ratio were 2? What if it were 1? What
if it were zero?
12. (Calculating WACC) Navarro Corp. has no debt but can borrow at 5.9 percent. The firm’s
WACC is currently 9.2 percent, and the tax rate is 21 percent.
a) What is the company’s cost of equity?
b) If the firm converts to 25 percent debt, what will its cost of equity be?
c) If the firm converts to 50 percent debt, what will its cost of equity be?
d) What is the company’s WACC in part (b)? In part (c)?
13. (M&M) Tool Manufacturing has an expected EBIT of $57,000 in perpetuity and a tax rate of
21 percent. The firm has $134,000 in outstanding debt at an interest rate of 5.35 percent, and
its unlevered cost of capital is 10.3 percent. What is the value of the firm according to M&M
Proposition I with taxes? Should the company change its debt-equity ratio if the goal is to
maximize the value of the firm? Explain.
14. (Firm Value) Tempest Corporation expects an EBIT of $37,700 every year forever. The
company currently has no debt, and its cost of equity is 11 percent. The tax rate is 22 percent.
a) What is the current value of the company?
 b) Suppose the company can borrow at 6 percent. What will the value of the firm be if the
company takes on debt equal to 50 percent of its unlevered value? What if it takes on
debt equal to 100 percent of its unlevered value?
c) What will the value of the firm be if the company takes on debt equal to 50 percent of its
levered value? What if the company takes on debt equal to 100 percent of its levered
value?
15. Smalltown Diners has a policy of treating dividends as a passive residual. It forecasts that net
earnings after taxes in the coming year will be $500,000. The firm has earned the same
$500,000 for each of the last five years and has paid between $200,000 and $350,000 out in
dividends in each of those years. The company is financed entirely with equity and its cost of
equity capital is 12 percent.
a) How much of the coming year's earnings should be paid out in dividends if the company
has $400,000 in projects whose expected returns exceed 12 percent?
b) How much should be paid out if the company has investment projects of $5,000,000
whose expected return is greater than 12 percent?
16. Modigliani and Miller argue that the dividend decision __________.
a) is irrelevant as the value of the firm is based on the earning power of its assets
b) is relevant as the value of the firm is not based just on the earning power of its assets
c) is irrelevant as dividends represent cash leaving the firm to shareholders, who own the
firm anyway
d) is relevant as cash outflow always influences other firm decisions
17. Financial signaling has been raised as an argument in the battle over the relevancy of
dividends. Which of the following statements concerning dividends is most likely to be
voiced by someone using the financial signaling argument?
a) A dividend decrease should be viewed by investors as "good news." The dividend
decrease acts to add conviction to the statement that the firm has better uses for the
earnings of the company than the stockholders.
b) Reported accounting earnings of a company, not dividends, are a proper reflection or
signal of the company's economic earnings.
c) The price of a firm's stock should react unfavorably to an increase in dividends.
d) Cash dividends speak louder than words when it comes to conveying information about
management's expectations of the future.

Ch03
18. Assume that Garden Corporation generated Br 2 million in sales during year 2 and its year-
end total assets were Br 2.5 million (Br. 1 million of fixed assets). Also, at end of year 2,
current liabilities were Br, 500,000 consisting of Br 200,000 of Notes Payable, Br 200,000 of
Accounts payable and Br 100,000 of accruals. Looking ahead to year 3, the company
estimates that its current assets must increase 75 cents for every Br 1 increase in sales. Net
 profit margin is 5% and its payout ratio is 60% of net income. Assets were operated at 90%
capacity in year 2. Only accounts payable and accruals are proportionally affected by sales.
Projected sales will be Br 2.6 million.
a) The amount by which sales can increase without having additional investment in fixed
assets.
b) Increase in current assets and current liabilities
c) Increase in working capital
d) Required increase in fixed assets
e) Projected profit (net income) for year 3
f) Projected Dividend payment in year 3
g) Internally generated funds
h) External funds required
19. Assume that Minas Co. has the following balance sheet as of 31 December 2016:
Assets Liabilities & Equity
Cash 20,000 Accounts payable 20,000
Accounts receivable 25,000 Accruals 10,000
Inventory 15,000 Notes payable 30,000
Fixed assets 180,000 Long term debts 60,000
Common stock 100,000
Retained earnings 20,000
Total 240,000 Total 240,000

Sales for the year just ended were br400,000 and fixed assets were used at 100% capacity. Its
current assets were also used at optimal levels. Sales are expected to grow by 30% next year.
Dividend payout ratio will be 20%. Projected net profit margin is 4%. Any additional funds
will be raised 20% using notes payable, 40% using common stock, and the remaining using
long term debts. Any excess fund will be used to reduce notes payable.
a) Planned increase in sales.____________________________________________
b) Increase in working capital.__________________________________________
c) Increase in fixed assets._____________________________________________
d) Spontaneously generated funds.________________________________________
e) Internally generated funds.____________________________________________
f) Additional funds needed._____________________________________________
g) The amount by which sales can increase without requiring external funding.____
h) Projected cash balance, notes payable balance, and retained earning balance._____