Question 1

A corporation has $5,000,000 of 8 percent preferred stock outstanding and a 21 percent tax rate.The after-tax cost of the preferred stock is ________.

Accepted Answer

The after-tax cost of preferred stock is the preferred dividend multiplied by (1 - the tax rate). In this case, the after-tax cost of preferred stock is $5,000,000 * 0.08 * (1 - 0.21) = $506,329.

Question 2

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 is the financial risk because a small change in EBIT will result in a larger change in EPS, indicating higher volatility in earnings. A shallower slope indicates lower financial risk as a larger change in EBIT is required to cause a significant change in EPS.

Question 3

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 a company's earnings per share (EPS) to changes in its earnings before interest and taxes (EBIT). As the DFL increases, the leverage of a given financing plan also increases, meaning that a change in EBIT will have a greater impact on EPS. This is reflected in the steeper slope of the financing plan on an EBIT-EPS graph.

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 changes in EBIT on EPS, without taking into account the effect on the stock price. Therefore, it does not necessarily lead to maximizing owner wealth.

Question 5

Operating and financial constraints placed on a corporation by loan provision are ________.

Accepted Answer

Loan provisions such as interest payments and debt covenants act as constraints on a corporation's financial resources and decision-making abilities. These restrictions are designed to protect the lender's investment and limit the firm's risk of defaulting on the loan, but they also can create agency costs to the firm by limiting its flexibility and potential profitability.

Question 6

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 means that the company needs to generate more revenue in order to cover its fixed costs, which increases the risk. A steeper slope of the capital structure line indicates that the company is relying more heavily on debt financing, which also increases risk. Therefore, both factors contribute to a higher level of financial risk.

Question 7

Which of the following is a difference between debt and equity capital?

Accepted Answer

Debt capital requires a fixed rate of return, meaning the lender expects to receive a set amount of interest payments over the life of the loan. On the other hand, equity capital requires returns in proportion to profits, meaning the investor expects to receive a percentage of the company's profits.

Question 8

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

Accepted Answer

In the EBIT-EPS approach, risk is measured by the slope of the capital structure line, which indicates the change in EPS (earnings per share) associated with changes in EBIT (earnings before interest and taxes) as the firm varies its mix of debt and equity financing. A steeper slope represents higher financial risk, as a small change in EBIT can lead to a larger change in EPS.

Question 9

A corporation has $10,000,000 of 10 percent preferred stock outstanding and a 21 percent tax rate.The amount of earnings before interest and taxes (EBIT)required to pay the preferred dividends is ________.

Accepted Answer

The amount of EBIT required to pay the preferred dividends is $1,265,823. This is calculated as follows:Preferred dividends = $10,000,000 * 10% = $1,000,000EBIT required to pay preferred dividends = $1,000,000 / (1 - 21%) = $1,265,823

Question 10

After satisfying obligations to creditors,the government,and preferred stockholders,any remaining earnings will most likely be allocated to ________.

Accepted Answer

After satisfaction of obligations to debt holders, government, and preferred stockholders, any remaining earnings are distributed to common stockholders. Generally, companies allocate earnings to common shareholders as cash dividends.

Question 11

Management has just discovered an excellent investment for which it needs additional funding.Relative to the discussion on asymmetric information,the firm will ________.

Accepted Answer

If management believes the firm is undervalued, they would prefer to finance with debt to avoid issuing undervalued equity, which would dilute existing shareholders' value.

Question 12

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 13

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 14

The conflict resulting from a manager's desire to increase a firm's risk without increasing current borrowing costs and lenders' desire to limit lending is one effect of the ________ problem.

Accepted Answer

The conflict described is an example of the agency problem, which arises when there's a conflict of interest between the management (agents) and the lenders or shareholders (principals). In this case, the managers want to increase the firm's risk to potentially increase returns without raising borrowing costs, which may not align with the lenders' interests to limit risk and ensure repayment.

Question 15

The 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

The 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 the point at which dividends per share is equal to zero.

Question 16

A firm has a current capital structure consisting of $400,000 of 6 percent annual interest debt and 50,000 shares of common stock.The firm's tax rate is 21 percent on ordinary income.If the EBIT is expected to be $200,000,the firm's earnings per share will be ________.

Accepted Answer

To calculate EPS, first find the interest expense: $400,000 * 6% = $24,000. Then, calculate taxable income: $200,000 (EBIT) - $24,000 (interest) = $176,000. Calculate taxes: $176,000 * 21% = $36,960. Net income is $176,000 - $36,960 = $139,040. EPS is $139,040 / 50,000 shares = $2.78.

Question 17

A corporation borrows $1,000,000 at 10 percent annual rate of interest.The firm has a 21 percent tax rate.The yearly,after-tax cost of this debt is ________.

Accepted Answer

The after-tax cost of debt is calculated as the interest expense multiplied by (1 - tax rate). Here, it is $1,000,000 * 10% * (1 - 0.21) = $79,000.

Question 18

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 finding the level of earnings before interest and taxes (EBIT) necessary to meet a company's capital structure requirements and produce a desired level of earnings per share (EPS). While this analysis can be useful for decision-making purposes, it is limited in that it only considers earnings and ignores factors such as risk, time value of money, and overall shareholder value or wealth.

Question 19

A corporation has $5,000,000 of 6 percent bonds and $9,600,000 of 5 percent preferred stock outstanding.The firm's financial breakeven (assuming a 21 percent tax rate)is ________.

Accepted Answer

Financial breakeven = (Interest expense + Preferred stock dividends) / (1 - Tax rate)

Interest expense = $5,000,000 x 0.06 = $300,000
Preferred stock dividends = $9,600,000 x 0.05 = $480,000
Tax rate = 21%

Financial breakeven = ($300,000 + $480,000) / (1 - 0.21) = $907,595

Question 20

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

Accepted Answer

Maximizing EPS may require increasing financial leverage, which in turn increases the risk premiums. This increased risk may not be desirable for owners seeking wealth maximization. Therefore, EPS maximization may not always align with wealth maximization.

Quiz 12: Leverage and Capital Structure