Question 1 - Total 15 marks

a) In the real world, why will a firm not seek to take unlimited advantage of the interest tax shield? Explain your reasoning. ( 5 marks)

b) A firm shares the following information with you: EBIT = $25 million; Tax rate = 35%; Debt = $75 million; Cost of debt = 9%; Unlevered cost of capital = 12% The firm's creditors indicate that if the firm's debt reaches 50% of its total capital value, they would increase interest rate on future financing to 10%. Realizing an increase in the firm's borrowing cost; shareholders will also revise their required return to 13%.

i) What is the current % of debt used by the firm? ( 1 mark)

ii) Compute the current WACC. How will it change once the percentage debt reaches 50%? Should the firm borrow to increase its debt proportion in its capital structure? (4 marks)

c) Critically discuss the tenets and limitations of Purchasing Power Parity theory. (5 marks)

Question 2 - Total 15 marks

a) Assume Genron has $20 million in excess cash and no debt. The firm expects to generate additional free cash flows of $48 million per year in subsequent years. Its stock sells for $42 per share at present. Genron's board is meeting to decide how to pay out its $20 million in excess cash to shareholders. The board is considering two options: Use the $20 million to pay a $2 per share cash dividend for each of Genron's 10 million outstanding shares or repurchase shares instead of paying a dividend. They vote in favour of paying a $2 per share cash dividend now and $4.8 per share in subsequent years. Since a cash dividend is declared, the stock price will fall after the ex-dividend date. You have 2000 shares in Genron, but do not like the $2 per share dividend. You would rather have a constant earning of $4.50 per share. Show how you can accomplish this in a perfect world. Will your answer differ very significantly if you acted before or after the ex-dividend date? (10 marks)

b) What is a protective put? How can it be used to arrive at the Put-Call Parity condition? (5 marks)

Question 3 - Total 15 marks

a) "In a world where bankruptcy is a real possibility, it is costly to go bankrupt". In light of this statement, define bankruptcy and discuss the costs associated with going bankrupt? In such a case, will there be an optimal capital structure that a firm can strive for? (5 marks)

b) Built Rite Corp. is evaluating an extra dividend versus a share repurchase. In either case, $5,500 would be spent. Current earnings are $0.80 per share, and the stock currently sells for $33 per share. There are 250 shares outstanding. Ignore taxes and other imperfections. You own one share of stock in this company. If the company issues the dividend, what will your total investment be worth as compared to if the company opts for a share repurchase? (5 marks)

c) Verbal Communications, Inc., has 14,000 shares of stock outstanding with a par value of $1 per share and a market value of $32 per share. The firm just announced a 100 percent stock dividend. What is the market value per share after the dividend? (5 marks)

Question 4 - Total 15 marks

a) Billingsley United declared a $0.20 a share dividend on Thursday, October 16. The dividend will be paid on Monday, November 10 to shareholders of record on Friday, October 31. What is the exdividend date? ( 1 mark)

b) "Leverage is a fair-weather friend". In light of this, indicate when a company should or should not use financial leverage. (1 mark)

c) Briefly answer the following questions:

i) What is capital restructuring? (1 mark)

ii) The signalling theory assumes the existence of asymmetric information. Discuss this statement. (2 marks)

iii) How is a merger different from consolidation? (2 marks)

d) Obama Inc and Osama Inc are competitors with very similar assets and business risks. Both are all equity firms with aftertax cash flows of $12 per year forever. Both have an overall cost of capital of 8%. Obama Inc is thinking of buying Osama Inc . The aftertax cash flow from the merged firm would be $25 per year. Does the merger create synergy? What is value of the Obama Inc. after the merger ? What is V? What is the total value of Osama Inc. to Obama Inc? (5 marks)

e) John Jet has a market value equal to its book value. Currently, the firm has excess cash of $1,200, other assets of $5,800, and equity valued at $3,750. The firm has 250 shares of stock outstanding and net income of $420. What will the new earnings per share be if the firm uses 25 percent of its excess cash to complete a stock repurchase? (3 marks)

Question 5 - Total 15 marks

a) ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC is all equity financed with $480,000 in stock. XYZ also uses the same dollar amount of capital with $240,000 in equity and the interest rate on its debt is 9 percent. Both firms expect EBIT to be $58,400. Ignore taxes. Compute the cost of equity for both firms. (5 marks)

b) What is a stock repurchase? How can it be accomplished and what are its consequences? (5 marks)

c) Salsa Inc. estimates that the coming year's earnings will be $75 million. There are 12 million shares outstanding and the target capital structure is 1.5:1. If the planned capital outlay is for $72 million, will Salsa Inc. be in a position to pay dividends as per the Residual Dividend Policy? If so, what will be the dividend per share? (5 marks)

Question 6 - Total 15 marks

a) Trump Ltd. decided to increase its bill payment time from 20 days to 40 days. It was said that they wanted to exercise some cost control and optimize cash flow.

i) What impact will this have on Trump's operating and cash cycles?

ii) How will Trump's suppliers be affected?

iii) Is what Trump did ethical to do, especially with short suppliers?

iv) Is there any cash benefit to Trump from the decision? (1+1+2+1) = 5 marks

b) In recent times, we have observed a hike in world oil prices, followed by a decline. As an oil producer, you will be worried when you now see a slump in oil prices because your revenues may be hit badly. What would you, as a firm in such a situation? Explain why you may not be able to create perfect hedge against this situation? (5 marks)

c) A call option matures in 3 months. The underlying stock price is $60 and the standard deviation of stock's return is 10% per year. The risk-free rate is 4% per annum. The exercise price is zero. What is the price of the call option? (5 marks)