Deck 15: Cap Structure

Question 1

firms, although they operate in different industries, have the same expected earnings per share and the same standard deviation of expected EPS Thus, the two firms must have the same business risk.

Answer 1

False

Question 2

Whenever a firm borrows money, it is using financial leverage.

Answer 2

True

Question 3

a firm utilizes debt financing, an X% decline in earnings before interest and taxes (EBIT) will result in a decline in earnings per share that is larger than X.

Answer 3

True

Question 4

graphical probability distribution of ROE for a firm that uses financial leverage would tend to be more peaked than the distribution if the firm used no leverage, other things held constant.

Question 5

Which of the following is NOT associated with (or does not contribute to) business risk? Recall that business risk is affected by a firm's operations.

A) Sales price variability.
B) The extent to which operating costs are fixed.
C) The extent to which interest rates on the firm's debt fluctuate.
D) Input price variability.
E) Demand variability.

Question 6

Miller and Modigliani had incorporated the costs of bankruptcy into their model, it is unlikely that they would have concluded that 100% debt financing is optimal.

Question 7

Financial risk refers to the extra risk stockholders bear as a result of using debt as compared with the risk they would bear if no debt were used.

Question 8

Different borrowers have different risks of bankruptcy, and bankruptcy is costly to lenders Therefore, lenders charge higher rates to borrowers judged to be more at risk of going bankrupt.

Question 9

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.

Question 10

Which of the following events is likely to encourage a company to raise its target debt ratio, other things held constant?

A) An increase in the personal tax rate.
B) An increase in the company's operating leverage.
C) The Federal Reserve tightens interest rates in an effort to fight inflation.
D) The company's stock price hits a new high.
E) An increase in the corporate tax rate.

Question 11

Provided a firm does not use an extreme amount of debt, financial leverage typically affects both EPS and EBIT, while operating leverage only affects EBIT.

Question 12

trade-off theory states that the capital structure decision involves a tradeoff between the costs and benefits of debt financing.

Question 13

Which of the following would increase the likelihood that a company would increase its debt ratio, other things held constant?
A) An increase in costs incurred when filing for bankruptcy.

A) An increase in the corporate tax rate.
B) An increase in the personal tax rate.
C) The Federal Reserve tightens interest rates in an effort to fight inflation.
D) The company's stock price hits a new low.

Question 14

the text indicates, a firm's financial risk has identifiable market risk and diversifiable risk components.

Question 15

Which of the following statements is CORRECT?

A) The capital structure that minimizes the interest rate on debt also maximizes the expected EPS.
B) The capital structure that minimizes the required return on equity also maximizes the stock price.
C) The capital structure that minimizes the WACC also maximizes the price per share of common stock.
D) The capital structure that gives the firm the best credit rating also maximizes the stock price.
E) The capital structure that maximizes expected EPS also maximizes the price per share of common stock.

Question 16

firm's business risk is largely determined by the financial characteristics of its industry, especially by the amount of debt the average firm in the industry uses.

Question 17

is possible that two firms could have identical financial and operating leverage, yet have different degrees of risk as measured by the variability of EPS.

Question 18

Which of these items will not generally be affected by an increase in the debt ratio?

A) Total risk.
B) Financial risk.
C) Market risk.
D) The firm's beta.
E) Business risk.

Question 19

Which of the following statements is CORRECT?

A) Since debt financing is cheaper than equity financing, raising a company's debt ratio will always reduce its WACC.
B) Increasing a company's debt ratio will typically reduce the marginal cost of both debt and equity financing. However, this action still may raise the company's WACC.
C) Increasing a company's debt ratio will typically increase the marginal cost of both debt and equity financing. However, this action still may lower the company's WACC.
D) Since a firm's beta coefficient it not affected by its use of financial leverage, leverage does not affect the cost of equity.
E) Since debt financing raises the firm's financial risk, increasing a company's debt ratio will always increase its WACC.

Question 20

firm's capital structure does not affect its calculated free cash flows, because FCF reflects only operating cash flows.

Question 21

Which of the following statements is CORRECT?

A) The optimal capital structure simultaneously maximizes EPS and minimizes the WACC.
B) The optimal capital structure minimizes the cost of equity, which is a necessary condition for maximizing the stock price.
C) The optimal capital structure simultaneously minimizes the cost of debt, the cost of equity, and the WACC.
D) The optimal capital structure simultaneously maximizes stock price and minimizes the WACC.
E) As a rule, the optimal capital structure is found by determining the debt-equity mix that maximizes expected EPS.

Question 22

world-famous discounter, Fernwood Booksellers, specializes in selling paperbacks for $7 each The variable cost per book is $5 At current annual sales of 200,000 books, the publisher is just breaking even It is estimated that if the authors' royalties are reduced, the variable cost per book will drop by $1 Assume authors' royalties are reduced and sales remain constant; how much more money can the publisher put into advertising (a fixed cost) and still break even?

A) $600,000
B) $466,667
C) $333,333
D) $200,000
E) None of the above

Question 23

Larsen Films's is analyzing its cost structureIts fixed operating costs are $470,000, its variable costs of $2.80 per unit produced, and its products sell for $4.00 per unit What is the company's breakeven point, i.e., at what unit sales volume would income equal costs?

A) 391,667
B) 411,250
C) 431,813
D) 453,403
E) 476,073

Question 24

Which of the following statements is CORRECT?

A) The capital structure that maximizes the stock price is generally the capital structure that also maximizes earnings per share.
B) All else equal, an increase in the corporate tax rate would tend to encourage a company to increase its debt ratio.
C) Since debt financing raises the firm's financial risk, increasing a company's debt ratio will always increase its WACC.
D) Since debt is cheaper than equity, increasing a company's debt ratio will always reduce its WACC.
E) When a company increases its debt ratio, the costs of equity and debt both increase. Therefore, the WACC must also increase.

Question 25

Firms U and L both have a basic earning power ratio of 20% and each has the same amount of assetsFirm U is unleveraged, i.e., it is 100% equity financed, while Firm L is financed with 50% debt and 50% equity Firm L's debt has a before-tax cost of 8% Both firms have positive net income Which of the following statements is CORRECT?

A) Firm L has a lower ROA than Firm U.
B) Firm L has a lower ROE than Firm U.
C) Firm L has the higher times interest earned (TIE) ratio.
D) Firm L has a higher EBIT than Firm U.
E) The two companies have the same times interest earned (TIE) ratio.

Question 26

Barette Consulting currently has no debt in its capital structure, has $500 million of total assets, and its basic earning power is 15% The CFO is contemplating a recapitalization where it will issue debt at a cost of 10% and use the proceeds to buy back shares of the company's common stock, paying book value If the company proceeds with the recapitalization, its operating income, total assets, and tax rate will remain unchanged Which of the following is most likely to occur as a result of the recapitalization?

A) The ROA would remain unchanged.
B) The basic earning power ratio would decline.
C) The basic earning power ratio would increase.
D) The ROE would increase.
E) The ROA would increase.

Question 27

debt financing is used, which of the following is CORRECT?

A) The percentage change in net operating income will be equal to a given percentage change in net income.
B) The percentage change in net income relative to the percentage change in net operating income will depend on the interest rate charged on debt.
C) The percentage change in net income will be greater than the percentage change in net operating income.
D) The percentage change in sales will be greater than the percentage change in EBIT, which in turn will be greater than the percentage change in net income.
E) The percentage change in net operating income will be greater than a given percentage change in net income.

Question 28

Which of the following statements is CORRECT?

A) Electric utilities generally have very high common equity ratios because their revenues are more volatile than those of firms in most other industries.
B) Drug companies (prescription, not illegal!) generally have high debt-to-equity ratios because their earnings are very stable and, thus, they can cover the high interest costs associated with high debt levels.
C) Wide variations in capital structures exist both between industries and among individual firms within given industries. These differences are caused by differing business risks and also managerial attitudes.
D) Since most stocks sell at or very close to their book values, book value capital structures are almost always adequate for use in estimating firms' costs of capital.
E) Generally, debt-to-total-assets ratios do not vary much among different industries, although they do vary among firms within a given industry.

Question 29

Which of the following statements is CORRECT?

A) If a firm lowered its fixed costs while increasing its variable costs, holding total costs at the present level of sales constant, this would decrease its operating leverage.
B) The debt ratio that maximizes EPS generally exceeds the debt ratio that maximizes share price.
C) If a company were to issue debt and use the money to repurchase common stock, this action would have no impact on its basic earning power ratio. (Assume that the repurchase has no impact on the company's operating income.)
D) If changes in the bankruptcy code made bankruptcy less costly to corporations, this would likely reduce the average corporation's debt ratio.
E) Increasing financial leverage is one way to increase a firm's basic earning power (BEP).

Question 30

Based on the information below for Benson Corporation, what is the optimal capital structure?

A) Debt = 50%; Equity = 50%; EPS = $3.05; Stock price = $28.90.
B) Debt = 60%; Equity = 40%; EPS = $3.18; Stock price = $31.20.
C) Debt = 80%; Equity = 20%; EPS = $3.42; Stock price = $30.40.
D) Debt = 70%; Equity = 30%; EPS = $3.31; Stock price = $30.00.
E) Debt = 40%; Equity = 60%; EPS = $2.95; Stock price = $26.50.

Question 31

Companies HD and LD have identical tax rates, total assets, and basic earning power ratios, and their basic earning power exceeds their before-tax cost of debt, rd However, Company HD has a higher debt ratio and thus more interest expense than Company LD Which of the following statements is CORRECT?

A) Company HD has a lower ROA than Company LD.
B) Company HD has a lower ROE than Company LD.
C) The two companies have the same ROA.
D) The two companies have the same ROE.
E) Company HD has a higher net income than Company LD.

Question 32

Other things held constant, which of the following events is most likely to encourage a firm to increase the amount of debt in its capital structure?

A) The costs that would be incurred in the event of bankruptcy increase.
B) Management believes that the firm's stock has become overvalued.
C) Its degree of operating leverage increases.
D) The corporate tax rate increases.
E) Its sales become less stable over time.

Question 33

Which of the following statements best describes the optimal capital structure? The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company's ______________.

A) stock price.
B) cost of equity.
C) cost of debt.
D) cost of preferred stock.
E) earnings per share (EPS).

Question 34

Which of the following statements is CORRECT, holding other things constant?

A) An increase in the personal tax rate is likely to increase the debt ratio of the average corporation.
B) If changes in the bankruptcy code make bankruptcy less costly to corporations, then this would likely reduce the debt ratio of the average corporation.
C) An increase in the company's degree of operating leverage is likely to encourage a company to use more debt in its capital structure.
D) An increase in the corporate tax rate is likely to encourage a company to use more debt in its capital structure.
E) Firms whose assets are relatively liquid tend to have relatively low bankruptcy costs, hence they tend to use relatively little debt.

Question 35

Which of the following statements is CORRECT?

A) There is no reason to think that changes in the personal tax rate would affect firms' capital structure decisions.
B) A firm with high business risk is more likely to increase its use of financial leverage than a firm with low business risk, assuming all else equal.
C) If a firm's after-tax cost of equity exceeds its after-tax cost of debt, it can always reduce its WACC by increasing its use of debt.
D) Suppose a firm has less than its optimal amount of debt. Increasing its use of debt to the point where it is at its optimal capital structure will decrease the costs of both debt and equity financing.
E) In general, a firm with low operating leverage also has a small proportion of its total costs in the form of fixed costs.

Question 36

Blueline Publishers is considering a recapitalization planIt is currently 100% equity financed but under the plan it would issue long-term debt with a yield of 9% and use the proceeds to repurchase common stock The recapitalization would not change the company's total assets, nor would it affect the firm's basic earning power, which is currently 15%The CFO believes that this recapitalization would reduce the WACC and increase stock priceWhich of the following would also be likely to occur if the company goes ahead with the recapitalization plan?

A) The company's earnings per share would decline.
B) The company's cost of equity would increase.
C) The company's ROA would increase.
D) The company's ROE would decline.
E) The company's net income would increase.

Question 37

operationally similar companies, HD and LD, have identical amounts of assets, operating income (EBIT), tax rates, and business risk Company HD, however, has a much higher debt ratio than LD Company HD's basic earning power ratio (BEP) exceeds its cost of debt (rd) Which of the following statements is CORRECT?

A) Company HD has a higher times interest earned (TIE) ratio than Company LD.
B) Company HD has a higher return on equity (ROE) than Company LD, and its risk, as measured by the standard deviation of ROE, is also higher than LD's.
C) The two companies have the same ROE.
D) Company HD's ROE would be higher if it had no debt.
E) Company HD has a higher return on assets (ROA) than Company LD.

Question 38

Which of the following statements is CORRECT?

A) A change in the personal tax rate should not affect firms' capital structure decisions.
B) "Business risk" is differentiated from "financial risk" by the fact that financial risk reflects only the use of debt, while business risk reflects both the use of debt and such factors as sales variability, cost variability, and operating leverage.
C) The optimal capital structure is the one that simultaneously (1) maximizes the price of the firm's stock, (2) minimizes its WACC, and (3) maximizes its EPS.
D) If changes in the bankruptcy code make bankruptcy less costly to corporations, then this would likely reduce the debt ratio of the average corporation.
E) If corporate tax rates were decreased while other things were held constant, and if the Modigliani-Miller tax-adjusted tradeoff theory of capital structure were correct, this would tend to cause corporations to decrease their use of debt.

Question 39

Bailey and Sons has a levered beta of 1.10, its capital structure consists of 40% debt and 60% equity, and its tax rate is 40% What would Bailey's beta be if it used no debt, i.e., what is its unlevered beta?

A) 0.64
B) 0.67
C) 0.71
D) 0.75
E) 0.79

Question 40

Which of the following statements is CORRECT? As a firm increases the operating leverage used to produce a given quantity of output, this will

A) normally lead to a decrease in its business risk.
B) normally lead to a decrease in the standard deviation of its expected EBIT.
C) normally lead to a decrease in the variability of its expected EPS.
D) normally lead to a reduction in its fixed assets turnover ratio.
E) normally lead to an increase in its fixed assets turnover ratio.

Question 41

assume that AJC is considering changing from its original capital structure to a new capital structure that results in a stock price of $64 per share The resulting capital structure would have a $336,000 total market value of equity and a $504,000 market value of debt How many shares would AJC repurchase in the recapitalization?

A) 4,250
B) 4,500
C) 4,750
D) 5,000
E) 5,250

Question 42

Laramie Trucking's CEO is considering a change to the company's capital structure, which currently consists of 25% debt and 75% equity The CFO believes the firm should use more debt, but the CEO is reluctant to increase the debt ratio The risk-free rate, rRF, is 5.0%, the market risk premium, RPM, is 6.0%, and the firm's tax rate is 40% Currently, the cost of equity, rs, is 11.5% as determined by the CAPM What would be the estimated cost of equity if the firm used 60% debt? (Hint: You must first find the current beta and then the unlevered beta to solve the problem.)

A) 10.95%
B) 11.91%
C) 12.94%
D) 14.07%
E) 15.29%

Question 43

Morales Publishing's tax rate is 40%, its beta is 1.10, and it uses no debt However, the CFO is considering moving to a capital structure with 30% debt and 70% equity If the risk-free rate is 5.0% and the market risk premium is 6.0%, by how much would the capital structure shift change the firm's cost of equity?

A) 1.53%
B) 1.70%
C) 1.87%
D) 2.05%
E) 2.26%

Question 44

all-equity firm with 200,000 shares outstanding, Antwerther Inc., has $2,000,000 of EBIT, which is expected to remain constant in the future The company pays out all of its earnings, so earnings per share (EPS) equal dividends per shares (DPS) Its tax rate is 40%. The company is considering issuing $5,000,000 of 10.0% bonds and using the proceeds to repurchase stock The risk-free rate is 6.5%, the market risk premium is 5.0%, and the beta is currently 0.90, but the CFO believes beta would rise to 1.10 if the recapitalization occurs.
Assuming that the shares can be repurchased at the price that existed prior to the recapitalization, what would the price be following the recapitalization?

A) $65.77
B) $69.23
C) $72.69
D) $76.33
E) $80.14

Question 45

Merriwether Building has operating income of $20 million, a tax rate of 40%, and no debt It pays out all of its net income as dividends and has a zero growth rate The current stock price is $40 per share, and it has 2.5 million shares of stock outstanding If it moves to a capital structure that has 40% debt and 60% equity (based on market values), its investment bankers believe its weighted average cost of capital would be 10% What would its stock price be if it changes to the new capital structure?

A) $40
B) $48
C) $52
D) $54
E) $60

Question 46

following information has been presented to you about the Gibson Corporation. The company has no growth opportunities (g = 0), so the company pays out all of its earnings as dividends (EPS = DPS) The consultant believes that if the company moves to a capital structure financed with 20% debt and 80% equity (based on market values) that the cost of equity will increase to 11% and that the pre-tax cost of debt will be 10% If the company makes this change, what would be the total market value (in millions) of the firm?

A) $3,200
B) $3,600
C) $4,000
D) $4,200
E) $4,800

Question 47

Serendipity Incis re-evaluating its debt levelIts current capital structure consists of 80% debt and 20% common equity, its beta is 1.60, and its tax rate is 35% However, the CFO thinks the company has too much debt, and he is considering moving to a capital structure with 40% debt and 60% equity The risk-free rate is 5.0% and the market risk premium is 6.0% By how much would the capital structure shift change the firm's cost of equity?

A) -5.20%
B) -5.78%
C) -6.36%
D) -6.99%
E) -7.69%