Question 1. (3 marks)
Explain what is meant by operating and financial risk.Suppose that firm A has a greater operating risk than firm B.Is it true that firm A also has a higher cost of equity?
Question 2. (3 marks)
Why is the use of debt referred to as financial leverage?
Problem 1 (10 marks)
You are the lead broker for the syndicate that will be issuing $45,000,000 in a new equity issue for the Rocket Science Corporation.The issue will be a firm commitment offering and the entire issue was purchased for a discounted price. The new equity issue will be sold using a Dutch auction.Calculate the selling price and the number of shares each successful bidder will receive. Show your work!
Problem 2 (18 marks)
You have been provided the following income statements for Tiger Industries and SMU DAWG Incorporated.
Calculate the degree of operating leverage for each firm. Show your work (4 marks)
Calculate the degree of financial leverage for each firm. (4 marks)
Calculate the degree of combined leverage for each firm. (4 marks)
If both firms were to experience a 15% increase in sales, what is the percentage change impact in the EPS and what is the new EPS for each firm. (4 marks)
Which firm is more risky? (2 marks)
Problem 3 (9 marks)
Husky Dudz Inc. is a high end producer of dog clothes for the pets of celebrities.The firm is considering the opening of a new subsidiary in Los Angeles so the firm will be closer to its market.The subsidiary will operate as a separate company in the United States and the firm has a tax rate of 40 percent.The company’s financial experts have estimated that EBIT will average $6,000,000 per year.The firm is considering the following financial plans:
Plan A: Issue 2 million shares at $10.00 (net) each.
Plan B: Issue $10 million in 8 percent coupon bonds and finance the balance with equity.
a.Calculate the EBIT/EPS indifference point. (3 marks)
b.How do you know your calculations are correct? (2 marks)
c.What is the significance of this EBIT/EPS indifference point? (2 marks)
d.Which financing plan should the company use? (2 marks)