BMCF5103JAN07/SI

INSTRUCTIONS: ANSWER ALL QUESTIONS

Question 1

a.

If a firm wishes to increase its cash dividend without changing its investment policy, any shortfall must be financed externally. What are the TWO (2) implications that may arise from this increase in dividend?

b.

Discuss FOUR (4) reasons why firms pay high dividends to their shareholders even in the presence of personal taxes on these dividends. [TOTAL: 25 MARKS]

Question 2 a. In a world with corporate taxes and costs of financial distress, discuss the relationship between value of the firm and capital structure AND explain how firms establish their capital structure. [TOTAL: 25 MARKS]

Question 3 a. Discuss the Efficient Market Hypotheses with respect to the following points: i. ii. iii. iv. v. vi. A Description of Efficient Capital Markets. Reaction of Stock Price to New Information. Information Sets and Forms of Efficient Market Hypothesis. The Evidence. Tests of the Weak Form EMH. Tests of the Semi-strong Form Efficiency.

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vii.

Implications for corporate financial managers. Can financial managers fool investors?

b.

According to the efficient market hypothesis, abnormal returns are expected to be zero. Therefore, no arbitrageurs can consistently earn abnormal profits. Comment the above statement. [TOTAL: 25 MARKS]

Question 4 Financial Leverage, EPS, and Firm Value We use the following example to demonstrate the effects of financial leverage on EPS and ROE. Financial Leverage, EPS, and ROE Current Assets Debt Equity Debt-to-Equity Ratio Interest Rate Shares Outstanding Stock Price $20,000 0 20,000 0 n/a 400 $50 Proposed $20,000 8,000 12,000 0.67 8% 240 $50

EPS and ROE under Current Capital Structure Recession EBIT Interest Net Income EPS ROA (EBIT/Assets) ROE (NI/Equity) 1,000 0 1,000 2.50 5% 5% Expected 2,000 0 2,000 5.00 10% 10% Expansion 3,000 0 3,000 7.50 15% 15%

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EPS and ROE under Proposed Capital Structure Recession EBIT Interest Net Income EPS ROA (EBIT/Assets) ROE (NI/Equity) 1,000 640 360 1.50 5% 3% Expected 2,000 640 1,360 5.67 10% 11% Expansion 3,000 640 2,360 9.83 15% 20%

The EPS-EBIT graph illustrates the relationship between EBIT and EPS under the two capital structures. The line for the proposed structure has a steeper slope, implying that higher financial leverage increases the sensitivity (risk) of EPS to EBIT. EPS and ROE are higher when EBIT is high and lower when EBIT is low. At the break-even EBIT point, EPS and ROE are the same under both capital structures. Since EPS = (EBIT I)/Shares when there is no tax, we compute the break-even EBIT point as: (EBIT)/400 = (EBIT 640)/240 => Break-even EBIT = $1,600

If EBIT is below the break-even point, then the current proposal (lower financial leverage) will result in a higher EPS and vice versa.

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But we have not answered a very important question: Which capital structure is better for stockholders? The answer to this question is the focus of the seminal Modigliani and Miller articles: i. "The Cost of Capital, Corporation Finance and the Theory of Investment," American Economic Review, June 1958. ii. "Corporate Income Taxes and the Cost of Capital: A Correction," American Economic Review, June 1963. Discuss which capital structure is better for stockholders. (Consider among others, the following in your answers: The Modigliani-Miller Model without corporate taxes and its assumptions). [TOTAL: 25 MARKS]

QUESTION PAPER ENDS HERE