Question 1

Firms U and L each have the same amount of assets, and both have a basic earning power ratio of 20%. Firm 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?

Accepted Answer

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

Question 2

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

Accepted Answer

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

Question 3

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.

Accepted Answer

A) True 
 B)False

Question 4

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

Accepted Answer

A) True 
 B)False

Question 5

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.

Accepted Answer

A) True 
 B)False  True

Question 6

BB is considering moving to a capital structure that is comprised of 20% debt and 80% equity, based on market values. The debt would have an interest rate of 7%. The new funds would be used to repurchase stock. It is estimated that the increase in risk resulting from the additional
Leverage would cause the required rate of return on equity to rise to
14%)  If this plan were carried out, what would BB's new value of operations be?

Accepted Answer

A)  $498,339
B)   $512,188
C)   $525,237
D)   $540,239
E)   $590,718F) A) and B)
G) C) and D)

Question 7

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?

Accepted Answer

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

Question 8

The firm is considering moving to a capital structure that is comprised of 40% debt and 60% equity, based on market values. The new funds would be used to replace the old debt and to repurchase stock. It is estimated that the increase in risk resulting from the additional leverage would cause the required rate of return on debt to rise to 7%, while the required rate of return on equity would rise to 9.5%. If this plan were carried out, what would be AJC's new WACC and total value?

Accepted Answer

A)   7.38%; $800,008
B)   7.38%; $813,008
C)   7.50%; $813,008
D)   7.50%; $790,008
E)   7.80%; $790,008F) A) and B)
G) B) and D)

Question 9

Michaely Inc. is an all-equity firm with 200,000 shares outstanding. It 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?

Accepted Answer

A)   $65.77
B)   $69.23
C)   $72.69
D)   $76.33
E)   $80.14F) C) and D)
G) All of the above B

Question 10

Blemker Corporation has $500 million of total assets, its basic earning power is 15%, and it currently has no debt in its capital structure. 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?

Accepted Answer

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

Question 11

If 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.

Accepted Answer

A) True 
 B)False

Question 12

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

Accepted Answer

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

Question 13

Now assume that BB is considering changing from its original capital structure to a new capital structure with 45% debt and 55% equity. This results in a weighted average cost of capital equal to 10.4% and a new value of operations of $576,923. Assume BB raises $259,615 in new debt and purchases T-bills to hold until it makes the stock repurchase. BB then sells the T-bills and uses the proceeds to repurchase stock. How many shares remain after the repurchase, and what is the stock price per share immediately after the repurchase?

Accepted Answer

A)   11,001;$28) 85
B)   12,711;$35) 62
C)   13,901;$42) 57
D)   15,220;$54) 31
E)   17,105;$89) 67(The following data apply to Problems 69, 70, 71, and 72. The problems MUST be kept together, and they cannot be changed algorithmically.) The A. J. Croft Company (AJ
C)   currently has $200,000 market value (and book value)  of perpetual debt outstanding carrying a coupon rate of 6%. Its earnings before interest and taxes (EBIT)  are $100,000, and it is a zero growth company. AJC's current cost of equity is 8.8%, and its tax rate is 40%. The firm has 10,000 shares of common stock outstanding selling at a price per share of $60.00.F) A) and B)
G) A) and D)

Question 14

Which of the following would increase the likelihood that a company would increase its debt ratio, other things held constant?

Accepted Answer

A)   An increase in costs incurred when filing for bankruptcy.
B)   An increase in the corporate tax rate.
C)   An increase in the personal tax rate.
D)   The Federal Reserve tightens interest rates in an effort to fightInflation.
E)   The company's stock price hits a new low.F) All of the above
G) A) and C)

Question 15

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

Accepted Answer

A) True 
 B)False

Question 16

Aaron Athletics is trying to determine its optimal capital structure. The company's capital structure consists of debt and common stock. In order to estimate the cost of debt, the company has produced the following table:
 The company uses the CAPM to estimate its cost of common equity, rs.
The risk-free rate is 5% and the market risk premium is 6%. Aaron estimates that if it had no debt its beta would be 1.0. (Its "unlevered beta," bU, equals 1.0.)  The company's tax rate, T, is 40%.
On the basis of this information, what is the company's optimal capital structure, and what is the firm's cost of capital at this optimal capital structure?

Accepted Answer

A)   wc = 0.9; wd = 0.1; WACC = 14.96%
B)   wc = 0.8; wd = 0.2; WACC = 10.96%
C)   wc = 0.7; wd = 0.3; WACC = 7.83%
D)   wc = 0.6; wd = 0.4; WACC = 10.15%
E)   wc = 0.5; wd = 0.5; WACC = 10.18%F) A) and E)
G) A) and B)

Question 17

DeLong Inc. has fixed operating costs of $470,000, 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?

Accepted Answer

A)   391,667
B)   411,250
C)   431,813
D)   453,403
E)   476,073F) All of the above
G) C) and E)

Question 18

Which of the following statements is CORRECT?

Accepted Answer

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

Question 19

(The following data apply to Problems 63, 64, and 65. The problems MUST be kept together.) 
Volunteer Fabricators, Inc. (VF)  currently has zero debt. It is a zero growth company, and it has the data shown below. Now the company is considering using some debt, moving to the market value capital structure indicated below. The money raised would be used to repurchase stock. It is estimated that the increase in risk resulting from the additional leverage would cause the required rate of return on equity to rise somewhat, as indicated below.
 
-Now assume that VF is considering changing from its original zero debt capital structure to a new capital structure with even more debt. This results in changes in the cost of debt and equity, and thus to a new WACC and a new value of operations. Assume VF raises the amount of new debt indicated below and uses the funds to purchase and hold T-bills until it makes the stock repurchase. What is the stock price per share immediately after issuing the debt but prior to the repurchase?

Accepted Answer

A)   $50.67
B)   $53.33
C)   $56.00
D)   $58.80
E)   $61.74F) C) and D)
G) None of the above

Question 20

Firm 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.

Accepted Answer

A) True 
 B)False

Exam 15: Capital Structure Decisions

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

Correct Answer
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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.

Correct Answer
verified

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

Correct Answer
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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.

Correct Answer
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True

Correct Answer
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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?

Correct Answer
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B

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If 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.

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

Correct Answer
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E

Correct Answer
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Which of the following would increase the likelihood that a company would increase its debt ratio, other things held constant?

Correct Answer
verified

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

Correct Answer
verified

Correct Answer
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DeLong Inc. has fixed operating costs of $470,000, 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?

Correct Answer
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Which of the following statements is CORRECT?

Correct Answer
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Correct Answer
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Firm 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.

Correct Answer
verified

Exam 15: Capital Structure Decisions

Correct AnswerverifiedShow Answer

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

Correct AnswerverifiedShow Answer

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.

Correct AnswerverifiedShow Answer

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

Correct AnswerverifiedShow Answer

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.

Correct AnswerverifiedTrue

Correct AnswerverifiedShow Answer

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?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct AnswerverifiedB

Correct AnswerverifiedShow Answer

If 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.

Correct AnswerverifiedShow Answer

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

Correct AnswerverifiedE

Correct AnswerverifiedShow Answer

Which of the following would increase the likelihood that a company would increase its debt ratio, other things held constant?

Correct AnswerverifiedShow Answer

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

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

DeLong Inc. has fixed operating costs of $470,000, 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?

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Firm 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.

Correct AnswerverifiedShow Answer

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True

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B

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E

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