$1.(12$ points$)$

Explain each of the following statements as true or false.

a$.$ Firm A has a higher degree of business risk than Firm B $.$ Firm A can offset this by using less financial leverage. Therefore, the variability of both firms' expected EBITs could actually be identical.

b$.$ The dividend irrelevance theory, proposed by Miller and Modigliani, says that as long as a firm pays a dividend, how much it pays does not affect either its cost of capital or its stock price.

c$.$ Going public establishes a true market value for the firm and ensures that a liquid market will always exist for the firm's shares.

d$.$ In the lease versus buy decision, leasing is often preferable since lease obligations do not affect the riskiness of the firm.

$2.(18$ points$)$

$$im$$ek Electronics has made the following forecast for the upcoming year based on the company's current capitalization:

The company has $\backslash (\backslash$$ $20\backslash )$ million worth of debt outstanding and all of its debt yields $10$ percent. The company's tax rate is $40$ percent. The company's price$-$earnings ratio $(\backslash (\backslash$mathrm$\{$P$\}/\backslash$mathrm$\{$E$\}\backslash ))$ has traditionally equaled $12,$ so the company forecasts that uhder the current capitalization its stock price will be $\backslash (\backslash$$ $43\mathrm{.}20\backslash )$ at year end. The company's investment bankers have suggested that the company do a recapitalization. Their suggestion is to issue enough new bonds at a yield of $10$ percent to repurchase $1$ million shares of common stock. Assume that the stock can be repurchased at today's $\backslash (\backslash$$ $40\backslash )$ stock price.

Assume that the repurchase will have no effect on the company's operating income; however, the repurchase will increase the company's dollar interest expense. Also, assume that as a result of the increased financial risk the company's price$-$earnings ratio will be $11\mathrm{.}5$ after the repurchase. Given these assumptions, what would be the expected year$-$end stock price if the company proceeded with the recapitalization?

$3.(12$ points$)$

Damla Inc. expects EBIT of $\backslash (\backslash$$ $2,000,000\backslash )$ for the coming year. The firm's capital structure consists of $40$ percent debt and $60$ percent equity, and its marginal tax rate $40$ percent. The cost of equity is $14$ percent and the company pays a $10$ percent rate on its $\backslash (\backslash$$ $5,000,000\backslash )$ of long$-$term debt. One million shares are outstanding.

In its next capital budgeting cycle, the firm expects to fund one large positive NPV project costing $\backslash (\backslash$$ $1,200,000\backslash ).$ It will fund this project in accordance with its target capital structure.

If the firm follows a residual dividend policy and has no other projects, what is its expected dividend payout ratio?

Would you recommend such a dividend policy for Damla Inc.? Explain.