Question 1

According to the traditional approach to capital structure, the value of a firm will be maximized when ________.
A) the financial leverage is maximized
B) the cost of debt is minimized
C) the weighted average cost of capital is minimized
D) the dividend payout is maximized

Accepted Answer

The traditional approach to capital structure suggests that a firm's value will be maximized when its weighted average cost of capital (WACC) is minimized. This can be achieved by balancing the use of debt and equity financing to optimize the cost of capital. While maximizing financial leverage may increase the return on equity, it also increases the cost of debt and increases the risk of financial distress. Minimizing the cost of debt is important, but it is only one factor in the overall cost of capital. Maximizing dividend payout may also benefit shareholders, but it does not necessarily lead to maximizing the overall value of the firm.

Question 2

Poor capital structure decisions can result in ________ the cost of capital, resulting in ________ acceptable investments.
A) increasing; fewer
B) decreasing; more
C) increasing; more
D) decreasing; fewer

Accepted Answer

Poor capital structure decisions can lead to higher cost of capital, which makes it more expensive for the company to borrow money or issue stocks. Higher cost of capital reduces the number of acceptable investments as the company may not be able to generate enough return to justify the cost of financing. Therefore, choice A - increasing the cost of capital and resulting in fewer acceptable investments is the best answer.

Question 3

Financial breakeven point represents the level of earnings after interest and taxes necessary for a firm to cover its fixed operating and financial changes-that is, the point at which dividends per share is equal to zero.

Accepted Answer

Financial breakeven point represents the level of earnings before interest and taxes necessary for a firm to cover its fixed operating and financial changes. It is the point at which the firm is able to cover all of its expenses but has not yet generated enough profit to pay dividends to shareholders.

Question 4

The basic shortcoming of EBIT-EPS analysis is that this model focuses on the maximization of earnings rather than on the maximization of owner wealth as reflected in a firm's stock price.

Accepted Answer

EBIT-EPS analysis only considers the impact of earnings on EPS, without taking into account other factors that affect a firm's stock price, such as market conditions, competition, and investor sentiment. Therefore, it may not always lead to the best decision for maximizing owner wealth.

Question 5

The EBIT-EPS analysis tends to concentrate on maximization of earnings rather than maximization of owners' wealth.

Accepted Answer

The EBIT-EPS analysis focuses on determining the level of earnings before interest and taxes (EBIT) needed to achieve a target earnings per share (EPS), which may not necessarily result in the maximization of owners' wealth. This is because the analysis only considers the impact of changes in EBIT on EPS, without taking into account factors such as the cost of capital or the level of risk involved in the investment decision. Therefore, while the EBIT-EPS analysis is a useful tool for evaluating alternative financing options, it should be used in conjunction with other analyses to make informed investment decisions that maximize owners' wealth.

Question 6

A firm has an operating profit of $300,000, interest of $35,000, and a tax rate of 40 percent. The firm has an after-tax cost of debt of 5 percent and a cost of equity of 15 percent. The firm's target capital structure is set at a mix of 40 percent debt and 60 percent equity. Assuming this as the optimum capital structure, the value of the firm is ________.
A) $1.4 million
B) $2.2 million
C) $1.8 million
D) $6.0 million

Accepted Answer

First, we need to calculate the weighted average cost of capital (WACC) using the target capital structure:

WACC = (0.4 x 0.05) + (0.6 x 0.15) = 0.09 or 9%

Next, we can use the constant growth model to value the firm:

V = (Operating profit - Interest) x (1 - Tax rate) / (WACC - g)

Where g is the expected growth rate. Since no growth rate is given, we can assume a reasonable long-term growth rate of 3%.

V = ($300,000 - $35,000) x (1 - 0.4) / (0.09 - 0.03) = $1,800,000

Therefore, the value of the firm is $1.8 million.

Question 7

The basic shortcoming of EBIT-EPS analysis is that this model focuses on the maximization of stock returns rather than on the maximization of share price.

Accepted Answer

EBIT-EPS analysis primarily focuses on the effects of financing decisions on earnings per share (EPS) and the overall cost of capital, which indirectly influences the maximization of share price, not just stock returns.

Question 8

A firm is analyzing two possible capital structures-30 and 50 percent debt ratios. The firm has total assets of $5,000,000 and common stock valued at $50 per share. The firm has a marginal tax rate of 40 percent on ordinary income. If the interest rate on debt is 7 percent and 9 percent for the 30 percent and the 50 percent debt ratios, respectively, the amount of interest on the debt under each of the capital structures being considered would be ________.
A) 30 percent debt ratio: $105,000 and 50 percent debt ratio: $225,000
B) 30 percent debt ratio: $245,000 and 50 percent debt ratio: $225,000
C) 30 percent debt ratio: $105,000 and 50 percent debt ratio: $250,000
D) 30 percent debt ratio: $135,000 and 50 percent debt ratio: $175,000

Accepted Answer

Under 30% debt ratio:
Total assets = $5,000,000
Equity = 70% x $5,000,000 = $3,500,000
Debt = 30% x $5,000,000 = $1,500,000
Interest on debt = 7% x $1,500,000 = $105,000

Under 50% debt ratio:
Total assets = $5,000,000
Equity = 50% x $5,000,000 = $2,500,000
Debt = 50% x $5,000,000 = $2,500,000
Interest on debt = 9% x $2,500,000 = $225,000

Therefore, the best choice is a 30% debt ratio as it has a lower interest expense.

Question 9

A firm is analyzing two possible capital structures-30 and 50 percent debt ratios. The firm has total assets of $5,000,000 and common stock valued at $50 per share. The firm has a marginal tax rate of 40 percent on ordinary income. The number of common shares outstanding for each of the capital structures would be ________.
A) 30 percent debt ratio: 30,000 shares and 50 percent debt ratio: 50,000 shares
B) 30 percent debt ratio: 50,000 shares and 50 percent debt ratio: 70,000 shares
C) 30 percent debt ratio: 70,000 shares and 50 percent debt ratio: 100,000 shares
D) 30 percent debt ratio: 70,000 shares and 50 percent debt ratio: 50,000 shares

Accepted Answer

The number of common shares outstanding is not affected by the debt ratio. Therefore, both capital structures would have the same number of common shares outstanding. Thus, the answer is 70,000 shares for both the 30% and 50% debt ratio options.

Question 10

The optimal capital structure is the one that balances ________.
A) return and risk factors in order to maximize profits
B) return and risk factors in order to maximize earnings per share
C) return and risk factors in order to maximize market value
D) return and risk factors in order to maximize dividends

Accepted Answer

The optimal capital structure should aim to balance the return and risk factors in order to maximize the market value of the firm. This means finding the right mix of debt and equity financing that maximizes shareholder wealth. Maximizing profits, earnings per share, or dividends may not necessarily lead to maximizing market value.

Question 11

The higher the degree of financial leverage (DFL), the greater the leverage a given financing plan has, and the steeper its slope when plotted on EBIT-EPS axes.

Accepted Answer

This statement is true. The degree of financial leverage (DFL) measures the sensitivity of earnings per share (EPS) to changes in earnings before interest and taxes (EBIT). A higher DFL means that a company has a greater degree of financial leverage, which can amplify both profits and losses. When plotted on EBIT-EPS axes, a higher DFL will result in a steeper slope for a given financing plan, indicating the greater impact of changes in EBIT on EPS.

Question 12

The EBIT-EPS approach to capital structure involves selecting the capital structure that maximizes earnings before interest and taxes (EBIT) over the expected range of earnings per share (EPS).

Accepted Answer

The EBIT-EPS approach to capital structure involves selecting the capital structure that maximizes earnings per share (EPS) for a given level of earnings before interest and taxes (EBIT), not the other way around. It focuses on the impact of debt on the EPS and the cost of debt on the company's overall value.

Question 13

The overriding objective of the capital structure decision should be to choose the level of debt that results in the largest possible share price.

Accepted Answer

The overriding objective of the capital structure decision is to choose the level of debt and equity that maximizes the value of the firm to its shareholders, which is reflected in the highest possible share price. This involves finding the optimal balance between debt and equity financing to minimize the cost of capital and maximize shareholder wealth.

Question 14

In the EBIT-EPS approach to capital structure, risk is represented by ________.
A) the slope of the capital market line
B) shifts in the cost of debt capital
C) the slope of the capital structure line
D) shifts in the times-interest-earned ratio

Accepted Answer

The EBIT-EPS approach involves determining the optimal capital structure that maximizes earnings per share (EPS) for a given level of earnings before interest and taxes (EBIT). In this approach, risk is represented by the slope of the capital structure line, which shows the change in EPS for a given change in EBIT. A steeper slope indicates higher financial risk since small changes in EBIT can lead to large changes in EPS. Therefore, the goal is to identify the capital structure that balances the benefits of borrowing (i.e., tax savings from interest payments) with the risks of financial distress.

Question 15

The higher the financial breakeven point and the steeper the slope of the capital structure line, the greater the financial risk.

Accepted Answer

Financial breakeven point is the level of sales at which the company neither earns a profit nor suffers a loss. A higher financial breakeven point implies that the company is more dependent on volume of sales to cover its fixed costs. The steeper the slope of the capital structure line, the larger the proportion of debt in the financing mix. This indicates that the company has a higher financial leverage. Higher financial leverage amplifies the impact of operating leverage on the earnings of the company. Therefore, the combination of higher financial breakeven point and steeper slope of capital structure line results in a higher level of financial risk.

Question 16

In the traditional approach to capital structure, as the amount of debt increases in a firm's capital structure, ________.
A) the cost of equity rises faster than the cost of debt
B) the cost of debt rises faster than the cost of equity
C) debt becomes less risky
D) equity cost is unaffected

Accepted Answer

The traditional approach to capital structure suggests that as a firm increases its leverage (amount of debt), the cost of equity increases because equity holders demand a higher return for the increased risk associated with higher debt levels. This is because with more debt, the firm has higher fixed obligations (interest payments), making the equity riskier as debt holders have priority over equity holders in case of liquidation.

Question 17

The value of a firm at optimum capital structure is computed as ________.
A) earnings before interest and taxes times one less tax rate divided by one plus weighted average cost of capital
B) earnings before interest and taxes times one less tax rate divided by weighted average cost of capital
C) operating cash flow divided by weighted average cost of capital
D) operating cash flow divided by one plus weighted average cost of capital

Accepted Answer

The value of a firm at optimum capital structure is computed as earnings before interest and taxes times one less tax rate divided by weighted average cost of capital. This is because at the optimum capital structure, the cost of debt and equity is balanced, and the weighted average cost of capital is minimized, leading to the value of the firm being maximized.

Question 18

Beginning with a zero-leverage company, as debt is substituted for equity in the capital structure ________.
A) the overall cost of capital first rises, reaches a maximum, and then declines
B) the overall cost of capital declines
C) the overall cost of capital first declines, reaches a minimum, and then rises
D) the overall cost of capital rises

Accepted Answer

When a zero-leverage company substitutes debt for equity in its capital structure, the overall cost of capital first declines due to the tax-deductibility of interest payments. However, as the company takes on more debt, the risk to equity holders increases, causing them to require a higher return, thereby increasing the overall cost of capital. At some point, the cost of debt and the increased cost of equity will outweigh the tax benefits of debt, and the overall cost of capital will begin to rise. Thus, the overall cost of capital first declines, reaches a minimum, and then rises.

Question 19

Because risk premiums increase with increases in financial leverage, maximizing EPS does not assure owners' wealth maximization.

Accepted Answer

Maximizing EPS does not take into consideration the increased risk associated with higher financial leverage. As risk premiums increase, shareholders may see a decrease in wealth even if EPS is maximized. Therefore, wealth maximization requires a balance between EPS and financial risk.

Question 20

The steeper the slope of the EBIT-EPS capital structure line, the lower is the financial risk.

Accepted Answer

The steeper the slope of the EBIT-EPS capital structure line, the higher the financial risk. This is because a steeper slope implies that a relatively small change in EBIT can lead to a large change in EPS, indicating that the firm is highly leveraged and therefore more vulnerable to fluctuations in earnings.

Quiz 13: Leverage and Capital Structure

According to the traditional approach to capital structure, the value of a firm will be maximized when ________.

Poor capital structure decisions can result in the cost of capital, resulting in acceptable investments.

Financial breakeven point represents the level of earnings after interest and taxes necessary for a firm to cover its fixed operating and financial changes-that is, the point at which dividends per share is equal to zero.

The basic shortcoming of EBIT-EPS analysis is that this model focuses on the maximization of earnings rather than on the maximization of owner wealth as reflected in a firm's stock price.

The EBIT-EPS analysis tends to concentrate on maximization of earnings rather than maximization of owners' wealth.

The basic shortcoming of EBIT-EPS analysis is that this model focuses on the maximization of stock returns rather than on the maximization of share price.

The optimal capital structure is the one that balances ________.

The higher the degree of financial leverage (DFL), the greater the leverage a given financing plan has, and the steeper its slope when plotted on EBIT-EPS axes.

The EBIT-EPS approach to capital structure involves selecting the capital structure that maximizes earnings before interest and taxes (EBIT) over the expected range of earnings per share (EPS).

The overriding objective of the capital structure decision should be to choose the level of debt that results in the largest possible share price.

In the EBIT-EPS approach to capital structure, risk is represented by ________.

The higher the financial breakeven point and the steeper the slope of the capital structure line, the greater the financial risk.

In the traditional approach to capital structure, as the amount of debt increases in a firm's capital structure, ________.

The value of a firm at optimum capital structure is computed as ________.

Beginning with a zero-leverage company, as debt is substituted for equity in the capital structure ________.

Because risk premiums increase with increases in financial leverage, maximizing EPS does not assure owners' wealth maximization.

The steeper the slope of the EBIT-EPS capital structure line, the lower is the financial risk.