FINA3361Winter2011A3Key

FINA3361Winter2011A3Key - Assignments submitted without the...

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Assignments submitted without the cover sheet re ceive a mark of 0 Winter 2011 SAINT MARY’S UNIVERSITY FINANCE 3361 ASSIGNMENT #3  DUE FRIDAY, Feb. 18 th  by 12:00 noon Total 65 Problem #1 (5 marks) Do you agree or disagree with the following statement? Support your answer. “If things go poorly for a firm, increased leverage provides greater returns to shareholders (as measured by ROE and EPS)”. Solution: Disagree. The opposite is true. Increased leverage (fixed operating and/or financial costs) will magnify losses to shareholders when sales are poor. The company must cover fixed costs before any amounts flow to the shareholders. Therefore, both ROE and EPS will be lower. Problem #2 (5 marks) BK Inc. has a cost of debt of 10% and a WACC of 15%. The debt-equity ratio is .6. The tax rate is 35%. What is the cost of equity? Solution: D/E = .6 1 mark so D = .6/1.6 = 37.5% 1 mark E = 1/1.6 = 62.5% 1 mark ( 29 E E P P D D R W R W T R W WACC + + - = 1 ) R ( 625 . ) 35 . 1 %)( 10 ( 375 . % 15 E + - = 1 mark 15% = 2.4375% + .625R e 12.5625% = .625R e

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R e = = 625 . % 5625 . 12 20.10% 1 mark Problem #3 (5 marks) A firm has earnings per share of \$2.12 on 40,000 shares outstanding. The firm also has \$360,000 in debt at a cost of 9%. Tax rate is 40%. What is EBIT? Solution: ( 29 ( 29 S O P shares D T I EBIT EPS - - - = 1 ( 29 ( 29 000 , 40 40 . 1 400 , 32 12 . 2 - - = EBIT 2 marks 84,800 = .6EBIT – 19,440 104,240 = .6EBIT 2 marks EBIT = 173,733 1 mark Problem #4 (25 marks) Ink Inc. has 1,000,000 shares outstanding and EPS of \$1.74. The firm also currently has \$4,000,000 in debt outstanding with a coupon rate of 10%. At the current level of operations, the firms variable operating costs are \$320,000 and the fixed operating costs are \$250,000. Ink Inc. shares are currently selling in the market for \$10. The firm is evaluating a new project that would require an initial investment of \$2,400,000. To raise the additional \$2,400,000, the firm is considering three alternatives: i) Debt: sell \$2,400,000 worth of bonds that would carry a 14% coupon rate. ii) Equity: sell \$2,400,000 worth of new shares that would net the firm \$16 per share. iii) Debt & Equity: Raise 40% from selling new bonds with a coupon rate of 12% and 60% from new common shares to net the firm \$16 per share.
The new project is expected to increase annual sales from \$3,800,000 per year to \$4,500,000. As a result of the project, fixed costs are expected to remain the same; however, variable costs are expected to increase to \$400,000. The firm as a marginal

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FINA3361Winter2011A3Key - Assignments submitted without the...

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