BAHRIA UNIVERSITY (KARACHI CAMPUS)

MIDTERM EXAMINATION – Fall SEMESTER – 2020

Class: MBA-Weekend Evening

Student’s Name: ____________________ Reg. No: _________

Note: You are required to show all calculations. Take assumptions where necessary.
Q1. Dillon Labs has asked its financial manager to measure the cost of each specific type of
capital as well as the weighted average cost of capital. The weighted average cost is to be
measured by using the following weights: 40% long-term debt, 10% preferred stock, and 50%
common stock equity. The firm’s tax rate is 40%.

Debt: The firm can sell for $980 a 10-year, $1,000-par-value bond paying annual interest at a
10% coupon rate.
Preferred Stock: Eight percent (annual dividend) preferred stock having a par value of $100
can be sold for $65.
Common Stock: The firm’s common stock is currently selling for $50 per share. The
dividend expected to be paid at the end of the coming year (2004) is $4. Dividend payments
are expected to continue at 6%.

a. Calculate the specific cost of each source of financing (Marks: 03)

b. Determine the weighted average cost of capital (Marks:02)

Q2. Qwert Typewriter Company and Yuiop Typewriters, Inc., are identical except for capital
structures. Qwert has 50 percent debt and 50 percent equity financing, whereas Yuiop has 20
percent debt and 80 percent equity financing. (All percentages are in market value terms.) The
borrowing rate for both companies is 13 percent in a no-tax world, and capital markets are
assumed to be perfect. The earnings of both companies are not expected to grow, and all
earnings are paid out to shareholders in the form of dividends.
 a. If you own 2 percent of the common stock of Qwert, what is your dollar return if the
company has net operating income of $360,000 and the overall capitalization rate of the
company, ko, is 18 percent? What is the implied equity capitalization rate, ke?
(Marks:2.5)
b. Yuiop has the same net operating income as Qwert. What is the implied equity
capitalization rate of Yuiop? Why does it differ from that of Qwert? (Marks:2.5)
Q3. Choose the correct answer (Marks:05)
i. Company X sells watches for $25 market values. The before-tax cost
per watch. The fixed cost of this for debt, preferred stock, and
operation is $80,000, while the common equity forms of capital are
variable costs are $15 per watch. 8%,9%, and 15%, respectively.
What is the break-even point in Assume a 40% tax rate.
number of watches? a. 6.4%
a. 6,000 watches b. 7.5%
b. 8,000 watches c. 9.3%
c. 2,000 watches d. 10.9%
d. 3,000 watches iv. If a firm's earnings before interest
ii. Virgo Airlines will pay a $4 and taxes is $12,000 and the
dividend next year on its common company's interest expense is
stock, which is currently selling at $9,000, the degree of financial
$100 per share. What is the market's leverage will be 4. What does this
required return on this investment if imply?
the dividend is expected to grow at a. For a 10% change in
5% forever? earnings before interest
a. 4% and taxes, earnings per
b. 5% share will change by
c. 7% 40%.
d. 9% b. For a 10% change in
iii. What is the overall (weighted sales, earnings before
average) cost of capital in the interest and taxes will
following situation? The firm has change by 40%.
$10 million in long-term debt, $2 c. For a 10% change in the
million in preferred stock, and $8 degree of operating
million in common equity -- all at leverage, the degree of
 financing leverage will return (divisional cost of capital) for
change by 40%. the Socks Division should be closest
d. None of the above to which of the following four
v. A(n) __________ occurs when there answers?
is an increase in the number of a. 6%
shares outstanding by reducing the b. 7%
par value of stock. c. 15%
a. Stock spilt d. 16%
b. Stock dividend viii. A firm with low fixed costs
c. Extra dividend a. generally, have high variable
d. Regular dividend costs.
vi. The Modigliani-Miller theory says b. Have high operating
that leverage.
a. if there are no taxes, firms c. have low financial leverage.
are indifferent concerning d. Will have a low degree of
the method of financing. combined leverage.
b. taking taxes into ix. If the intrinsic value of a stock is
consideration, firms should greater than its market value, which
maximize the use of debt. of the following is a reasonable
c. taking taxes into conclusion?
consideration, firms should a. The stock has a low level of
maximize the use of equity. risk.
d. both a and b b. The stock offers a high
e. both a and c dividend payout ratio.
vii. Socks-N-Shoes, Inc., used a proxy c. The market is undervaluing the
company to calculate an unlevered stock.
beta of 0.90 for its Socks Division. d. The market is overvaluing the
The firm's corporate cost of debt is stock.
5% on an after-tax basis. Sock-N- x. The purpose of a stock split is to ....
Shoes finances its projects with a a. Increase share price
b. Change in Shareholder
roughly 80%/20%mix of debt and
wealth
equity. The market has an expected c. decrease share price
d. none
rate of return of 16% and the risk-
free rate is 6%. The required rate of