Question 1

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 2

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

Accepted Answer

A higher financial breakeven point indicates that a company must generate more revenue to cover its fixed costs and reach its breakeven point. A steeper slope of the capital structure line indicates that a company has higher levels of debt, which increases its interest expenses and financial risk. Therefore, the combination of a high financial breakeven point and a steep capital structure line increases a company's financial risk.

Question 3

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 4

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 the value of a firm is maximized when the weighted average cost of capital is minimized. This means that the firm should aim for the optimal mix of debt and equity that would result in the lowest possible cost of capital while maintaining an acceptable level of risk. Maximizing financial leverage (A) may increase the cost of capital and also increase the risk of bankruptcy. Minimizing the cost of debt (B) is important, but not the only consideration in determining the optimal capital structure. Maximizing dividend payout (D) may be beneficial for shareholders, but it doesn't necessarily result in maximizing the value of the firm.

Question 5

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 6

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

Substituting debt for equity in the capital structure introduces the risk of bankruptcy, and as a company becomes more leveraged, its overall cost of capital declines to a minimum and then rises as bankruptcy risk increases. This is due to the fact that debt is a cheaper form of capital than equity due to its tax-deductibility, but comes with the added risk of default. As a company becomes more leveraged, the cost of debt financing increases as lenders demand higher interest rates to compensate for the increased risk of default. Additionally, the cost of equity financing increases as investors demand a higher return to compensate for the increased risk of bankruptcy. As a result, the overall cost of capital first declines as the cheaper debt financing outweighs the increased cost of equity financing, reaches a minimum, and then rises as the increased cost of debt financing begins to outweigh the cheaper equity financing.

Question 7

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 charges, not after. Additionally, it is the point at which earnings per share (EPS) is equal to zero, not dividends per share.

Question 8

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 how to generate the highest level of earnings per share through different financing and operating decisions. It does not take into consideration other factors that could impact the overall wealth of the company's owners, such as the cost of capital or the risk of the investments. As a result, maximizing EPS through EBIT-EPS analysis does not necessarily translate to maximization of owners' wealth.

Question 9

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

The statement is true. EBIT-EPS analysis does not consider the impact of capital structure on the firm's stock price and only focuses on maximizing earnings per share, which may not necessarily lead to the maximization of shareholder wealth.

Question 10

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

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 is financing its operations with more debt and less equity. This increases the leverage of its financing plan and makes it riskier. When plotted on EBIT-EPS axes, a higher DFL results in a steeper slope, because small changes in EBIT can have a larger impact on EPS.

Question 11

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 12

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 is one that balances return and risk factors in order to maximize market value. Maximized market value implies the shareholders' wealth is maximized.

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 objective of the capital structure decision is to find the optimal balance between debt and equity to maximize the value of the firm and, ultimately, the shareholder's wealth. The optimal capital structure is the one that minimizes the cost of capital, which results in a higher stock price. Thus, the ultimate goal of the capital structure decision is to maximize shareholder value by choosing the best financing mix that maximizes stockholder returns.

Question 14

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 formula represents the weighted average cost of capital which is the cost of the capital used in the business.

Question 15

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

Accepted Answer

Maximizing EPS may entail taking on more debt, which increases risk premiums and can decrease overall shareholder value. Therefore, EPS is not always an accurate measure of wealth maximization.

Question 16

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 17

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 18

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 an increase in the cost of capital, making it more expensive for a company to access capital. This, in turn, can result in fewer acceptable investments as the company may not have the necessary funds or may not be able to justify the high cost of capital for certain projects.

Question 19

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 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 because a small change in EBIT will result in a large change in EPS, indicating a higher level of operating leverage.

Quiz 12: Leverage and Capital Structure

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

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

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

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.

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

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 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 earnings rather than on the maximization of owner wealth as reflected in a firm's stock price.

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 optimal capital structure is the one that balances ________.

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

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

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

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

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

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