Question 1

Vegan Foods Inc.has a current capital structure of 30% debt,70% equity,and are in a 40% tax bracket.However,after speaking with their investment bankers they have decided to increase their debt to 40% of total capital.Some of the firm's managers are concerned that there may an increase in risk for stockholders due to the increased financial obligations resulting from the increased debt load.Currently,the levered beta for the firm is 1.20.
Use your knowledge of levered and unlevered betas to estimate the new levered beta for existing shareholders.

Accepted Answer

The answer of Vegan Foods Inc.has a current capital structure...

Question 2

If a firm is in a zero tax bracket,then the levered and unlevered betas will be identical no matter what the debt-equity ratio.

Accepted Answer

The levered beta takes into account the debt-equity ratio and the financial risk associated with leverage, even if the tax rate is zero. Levered beta increases with higher debt levels due to the increased financial risk, making it different from the unlevered beta, which does not consider debt.

Question 3

Larger firms and those with better credit ratings tend to also have less strict capital structure targets.

Accepted Answer

Larger firms and those with better credit ratings often have more defined capital structure targets because they have greater access to capital markets and can more easily balance debt and equity to optimize their financial strategies.

Question 4

To maximize flexibility in capital structure,it is ideal to have high levels of debt.

Accepted Answer

While debt can provide benefits such as tax shields and a lower cost of capital, having high levels of debt also increases financial risk and can limit flexibility in making strategic decisions. A balance between debt and equity is necessary for capital structure flexibility.

Question 5

EBIT break-even analysis indicates the projected EBIT level such that EPS is identical under two different debt-equity mix scenarios.

Accepted Answer

EBIT break-even analysis is used to determine the level of EBIT at which a company's earnings per share (EPS) will remain the same under two different debt-equity mix scenarios. Therefore, the statement is true.

Question 6

Define moral hazard in a financial sense.What must be present for moral hazard to arise? Describe the moral hazard that occurred with the Great Recession of 2007 - 2009.How could this type of behavior be avoided in the future?

Accepted Answer

The answer of Define moral hazard in a financial sense.What...

Question 7

Published betas are typically levered betas not unlevered betas if the firm in question has debt in its capital structure.

Accepted Answer

Published betas are calculated using the asset beta, which includes the effects of leverage. This means that the beta reflects the risk of the entire firm, including its debt. If an analyst wants to calculate the unlevered beta, they would need to remove the effects of debt from the published beta.

Question 8

If a firm has a positive debt-equity ratio,then the unlevered beta is greater than the levered beta.

Accepted Answer

The statement is incorrect. If a firm has a positive debt-equity ratio, it means that it has some amount of debt in its capital structure. As a result, the firm's levered beta will be higher than its unlevered beta, as debt adds financial risk to the company. The formula for unlevered beta is calculated based on the asset beta, which assumes that the company has no debt. Therefore, the statement that the unlevered beta is greater than the levered beta is incorrect.

Question 9

Optimal capital structure,or debt capacity,is the debt-equity mix that minimizes the cost of the firm's debt.

Accepted Answer

Optimal capital structure is the debt-equity mix that minimizes the firm's overall cost of capital, not just the cost of debt. It balances the trade-off between the benefits and costs of debt and equity financing to achieve the lowest possible cost of capital for the firm.

Question 10

The Global Financial Crisis or Great Recession is generally recognized as the greatest financial crisis since the Great Depression of the 1930s.

Accepted Answer

The Global Financial Crisis is indeed recognized as the greatest financial crisis since the Great Depression.

Quiz 12: Designing an Optimal Capital Structure