Question 1

(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.
EBIT = $80,000 New Debt/Value = 20%
Growth = 0% New Equity/Value = 80%
Orig cost of equity, rs = 10.0% No. of shares = 10,000
New cost of equity = rs = 11.0% Price per share = $48.00
Tax rate = 40% Interest rate = rd = 7.0%
-Based on the data in the previous two problems, what would the stock price be if VF issued the new debt and immediately used the proceeds to repurchase stock?

Accepted Answer

A)   $49.43
B)   $50.70
C)   $52.00
D)   $53.33
E)   $56.00F) A) and D)
G) A) and E)

Question 2

It is possible that two firms could have identical financial and operating leverage, yet have different degrees of risk as measured by the variability of EPS.

Accepted Answer

A) True 
 B)False

Question 3

Companies HD and LD have the same total assets, operating income Which of the following statements is CORRECT?

Accepted Answer

A)   HD should have a higher return on assets (RO
A)   than LD.
B)   HD should have a higher times interest earned (TI
E)   ratio than LD.
C)   HD should have a higher return on equity (RO
E)   than LD, but its risk, as measured by the standard deviation of ROE, should also be higher than LD's.
D)   Given that BEP > rd, HD's stock price must exceed that of LD.
E)   Given that BEP > rd, LD's stock price must exceed that of HD.F) C) and E)
G) A) and B)

Question 4

Stephens Electronics is considering a change in its target capital structure, which currently consists of 25% debt and 75% equity. The CFO believes the firm should use more debt, but the CEO is reluctant to increase the debt ratio. The risk-free rate, rRF, is 5.0%, the market risk premium, RPM, is 6.0%, and the firm's tax rate is 40%. Currently, the cost of equity, rs, is 11.5% as determined by the CAPM. What would be the estimated cost of equity if the firm used 60% debt? (Hint: You must first find the current beta and then the unlevered beta to solve the problem.)

Accepted Answer

A)   10.95%
B)   11.91%
C)   12.94%
D)   14.07%
E)   15.29%F) A) and D)
G) None of the above

Question 5

Provided a firm does not use an extreme amount of debt, financial leverage typically affects both EPS and EBIT, while operating leverage only affects EBIT.

Accepted Answer

A) True 
 B)False

Question 6

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 7

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 fight inflation.
E)   The company's stock price hits a new low.F) B) and D)
G) A) and B)

Question 8

A group of venture investors is considering putting money into Lemma Books, which wants to produce a new reader for electronic books. The variable cost per unit is estimated at $250, the sales price would be set at twice the VC/unit, fixed costs are estimated at $750,000, and the investors will put up the funds if the project is likely to have an operating income of $500,000 or more. What sales volume would be required in order to meet this profit goal?

Accepted Answer

A)   4,513
B)   4,750
C)   5,000
D)   5,250
E)   5,513F) C) and E)
G) A) and C)

Question 9

Which of the following statements is CORRECT? As a firm increases the operating leverage used to produce a given quantity of output, this will

Accepted Answer

A)   normally lead to an increase in its fixed assets turnover ratio.
B)   normally lead to a decrease in its business risk.
C)   normally lead to a decrease in the standard deviation of its expected EBIT.
D)   normally lead to a decrease in the variability of its expected EPS.
E)   normally lead to a reduction in its fixed assets turnover ratio.F) B) and C)
G) A) and E)

Question 10

Based on the information below, what is Ezzel Enterprises' optimal capital structure?

Accepted Answer

A)   Debt = 40%; Equity = 60%; EPS = $2.95; Stock price = $26.50.
B)   Debt = 50%; Equity = 50%; EPS = $3.05; Stock price = $28.90.
C)   Debt = 60%; Equity = 40%; EPS = $3.18; Stock price = $31.20.
D)   Debt = 80%; Equity = 20%; EPS = $3.42; Stock price = $30.40.
E)   Debt = 70%; Equity = 30%; EPS = $3.31; Stock price = $30.00.F) C) and E)
G) A) and B)

Question 11

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 debt ratio 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 the average corporation.
D)   An increase in the company's degree of operating leverage is likely to 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 E)
G) A) and B)

Question 12

Firms HD and LD are identical except for their level of debt and the interest rates they pay on debt--HD has more debt and pays a higher interest rate on that debt. Based on the data given below, what is the difference between the two firms' ROEs? Applicable to Both Firms Firm HD's Data Firm LD's Data
Assets $200 Debt ratio 50% Debt ratio 30%
EBIT $40 Interest rate 12% Interest rate 10%
Tax rate 35%

Accepted Answer

A)   2.18%
B)   2.29%
C)   2.41%
D)   2.54%
E)   2.66%F) All of the above
G) C) and E)

Question 13

(The following data apply to Problems 66, 67, and 68. The problems MUST be kept together, and they cannot be changed algorithmically.) 
Barnes Baskets, Inc. (BB)  currently has zero debt. Its earnings before interest and taxes (EBIT)  are $100,000, and it is a zero growth company. BB's current cost of equity is 13%, and its tax rate is 40%. The firm has 20,000 shares of common stock outstanding selling at a price per share of $23.08.
-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) B) and E)
G) C) and D)

Question 14

(The following data apply to Problems 66, 67, and 68. The problems MUST be kept together, and they cannot be changed algorithmically.) 
Barnes Baskets, Inc. (BB)  currently has zero debt. Its earnings before interest and taxes (EBIT)  are $100,000, and it is a zero growth company. BB's current cost of equity is 13%, and its tax rate is 40%. The firm has 20,000 shares of common stock outstanding selling at a price per share of $23.08.
-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. What is the stock price per share immediately after issuing the debt but prior to the repurchase?

Accepted Answer

A)   $14.42
B)   $19.36
C)   $23.91
D)   $28.85
E)   $35.62F) B) and D)
G) A) and B)

Question 15

(The following data apply to Problems 66, 67, and 68. The problems MUST be kept together, and they cannot be changed algorithmically.) 
Barnes Baskets, Inc. (BB)  currently has zero debt. Its earnings before interest and taxes (EBIT)  are $100,000, and it is a zero growth company. BB's current cost of equity is 13%, and its tax rate is 40%. The firm has 20,000 shares of common stock outstanding selling at a price per share of $23.08.
-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; $89.67F) A) and B)
G) A) and C)

Question 16

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) All of the above
G) B) and E)

Question 17

Which of the following statements is CORRECT?

Accepted Answer

A)   The capital structure that maximizes the stock price is also the capital structure that minimizes the weighted average cost of capital (WAC
C)  .
B)   The capital structure that maximizes the stock price is also the capital structure that maximizes earnings per share.
C)   The capital structure that maximizes the stock price is also the capital structure that maximizes the firm's times interest earned (TI
E)   ratio.
D)   Increasing a company's debt ratio will typically reduce the marginal costs of both debt and equity financing; however, this still may raise the company's WACC.
E)   If Congress were to pass legislation that increases the personal tax rate but decreases the corporate tax rate, this would encourage companies to increase their debt ratios.F) B) and C)
G) All of the above

Question 18

Volga Publishing is considering a proposed increase in its debt ratio, which would also increase the company's interest expense. The plan would involve issuing new bonds and using the proceeds to buy back shares of its common stock. The company's CFO thinks the plan will not change total assets or operating income, but that it will increase earnings per share (EPS) . Assuming the CFO's estimates are correct, which of the following statements is CORRECT?

Accepted Answer

A)   Since the proposed plan increases Volga's financial risk, the company's stock price still might fall even if EPS increases.
B)   If the plan reduces the WACC, the stock price is also likely to decline.
C)   Since the plan is expected to increase EPS, this implies that net income is also expected to increase.
D)   If the plan does increase the EPS, the stock price will automatically increase at the same rate.
E)   Under the plan there will be more bonds outstanding, and that will increase their liquidity and thus lower the interest rate on the currently outstanding bonds.F) C) and E)
G) All of the above

Question 19

As the text indicates, a firm's financial risk has identifiable market risk and diversifiable risk components.

Accepted Answer

A) True 
 B)False

Question 20

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 generally the capital structure that also maximizes earnings per share.
C)   All else equal, an increase in the corporate tax rate would tend to encourage a company to increase its debt ratio.
D)   Since debt financing raises the firm's financial risk, increasing a company'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) D) and E)
G) B) and E)

Exam 15: Capital Structure Decisions

It is possible that two firms could have identical financial and operating leverage, yet have different degrees of risk as measured by the variability of EPS.

Correct Answer
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Which of the following statements is CORRECT? As a firm increases the operating leverage used to produce a given quantity of output, this will

Correct Answer
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As the text indicates, a firm's financial risk has identifiable market risk and diversifiable risk components.

Correct Answer
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Which of the following statements is CORRECT?

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

Correct Answer
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Correct Answer
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Provided a firm does not use an extreme amount of debt, financial leverage typically affects both EPS and EBIT, while operating leverage only affects EBIT.

Correct Answer
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Which of the following statements is CORRECT?

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Companies HD and LD have the same total assets, operating income Which of the following statements is CORRECT?

Correct Answer
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Based on the information below, what is Ezzel Enterprises' optimal capital structure?

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

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

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Exam 15: Capital Structure Decisions

It is possible that two firms could have identical financial and operating leverage, yet have different degrees of risk as measured by the variability of EPS.

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT? As a firm increases the operating leverage used to produce a given quantity of output, this will

Correct AnswerverifiedShow Answer

As the text indicates, a firm's financial risk has identifiable market risk and diversifiable risk components.

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

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

Provided a firm does not use an extreme amount of debt, financial leverage typically affects both EPS and EBIT, while operating leverage only affects EBIT.

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

Companies HD and LD have the same total assets, operating income Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

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Based on the information below, what is Ezzel Enterprises' optimal capital structure?

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

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

Correct AnswerverifiedShow Answer

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