Question 1

Companies HD and LD have identical amounts of assets, operating income (EBIT) , tax rates, and business risk. Company HD, however, has a much higher debt ratio than LD. Company HD's basic earning power ratio (BEP)  exceeds its cost of debt (rd) . Which of the following statements is CORRECT?

Accepted Answer

A)   Company HD has a higher return on assets (RO
A)   than Company LD.
B)   Company HD has a higher times interest earned (TI
E)   ratio thanCompany LD.
C)   Company HD has a higher return on equity (RO
E)   than Company LD, and its risk, as measured by the standard deviation of ROE, is alsoHigher than LD's.
D)   The two companies have the same ROE.
E)   Company HD's ROE would be higher if it had no debt.F) A) and B)
G) B) and D)

Question 2

Which of the following statements is CORRECT?

Accepted Answer

A)   As a rule, the optimal capital structure is found by determining the debt-equity mix that maximizes expected EPS.
B)   The optimal capital structure simultaneously maximizes EPS and Minimizes the WACC.
C)   The optimal capital structure minimizes the cost of equity, whichIs a necessary condition for maximizing the stock price.
D)   The optimal capital structure simultaneously minimizes the cost ofDebt, the cost of equity, and the WACC.
E)   The optimal capital structure simultaneously maximizes stock priceAnd minimizes the WACC.F) B) and C)
G) A) and C)

Question 3

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

Accepted Answer

A)   Firms whose assets are relatively liquid tend to have relatively lowBankruptcy 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 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) C) and E)
G) D) and E)

Question 4

Which of the following statements is CORRECT?

Accepted Answer

A)   In general, a firm with low operating leverage also has a small proportion of its total costs in the form of fixed costs.
B)   There is no reason to think that changes in the personal tax rateWould affect firms' capital structure decisions.
C)   A firm with high business risk is more likely to increase its use of financial leverage than a firm with low business risk, assumingAll else equal.
D)   If a firm's after-tax cost of equity exceeds its after-tax cost ofDebt, it can always reduce its WACC by increasing its use of debt.
E)   Suppose a firm has less than its optimal amount of debt. Increasing its use of debt to the point where it is at its optimal capitalStructure will decrease the costs of both debt and equity financing.F) B) and D)
G) A) and B)

Question 5

An increase in the debt ratio will generally have no effect on which of these items?

Accepted Answer

A)   Business risk.
B)   Total risk.
C)   Financial risk.
D)   Market risk.
E)   The firm's beta.F) A) and D)
G) C) and E)

Question 6

Elephant Books sells paperback books for $7 each. The variable cost per book is $5. At current annual sales of 200,000 books, the publisher is just breaking even. It is estimated that if the authors' royalties are reduced, the variable cost per book will drop by $1. Assume authors' royalties are reduced and sales remain constant; how much more money can the publisher put into advertising (a fixed cost)  and still break even?

Accepted Answer

A)   $600,000
B)   $466,667
C)   $333,333
D)   $200,000
E)   None of the aboveF) A) and B)
G) B) and E)

Question 7

Which of the following statements is CORRECT?

Accepted Answer

A)   Generally, debt-to-total-assets ratios do not vary much among different industries, although they do vary among firms within aGiven industry.
B)   Electric utilities generally have very high common equity ratios because their revenues are more volatile than those of firms inMost other industries.
C)   Drug companies (prescription, not illegal!)  generally have high debt-to-equity ratios because their earnings are very stable and, thus, they can cover the high interest costs associated with highDebt levels.
D)   Wide variations in capital structures exist both between industries and among individual firms within given industries. These differences are caused by differing business risks and alsoManagerial attitudes.
E)   Since most stocks sell at or very close to their book values, book value capital structures are almost always adequate for use inEstimating firms' costs of capital.F) C) and D)
G) None of the above

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) D) and E)
G) B) and E)

Question 9

The A. J. Croft Company (AJC)  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.
-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) None of the above
G) D) and E)

Question 10

Companies HD and LD have identical tax rates, total assets, and basic earning power ratios, and their basic earning power exceeds their before-tax cost of debt, rd. However, Company HD has a higher debt ratio and thus more interest expense than Company LD. Which of the following statements is CORRECT?

Accepted Answer

A)   Company HD has a higher net income than Company LD.
B)   Company HD has a lower ROA than Company LD.
C)   Company HD has a lower ROE than Company LD.
D)   The two companies have the same ROA.
E)   The two companies have the same ROE.F) B) and D)
G) B) and C)

Question 11

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 itsExpected 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) C) and D)

Question 12

Reynolds Resorts is currently 100% equity financed. The CFO is considering a recapitalization plan under which the firm would issue long-term debt with a yield of 9% and use the proceeds to repurchase common stock. The recapitalization would not change the company's total assets, nor would it affect the firm's basic earning power, which is currently 15%. The CFO believes that this recapitalization would reduce the WACC and increase stock price. Which of the following would also be
Likely to occur if the company goes ahead with the recapitalization plan?

Accepted Answer

A)   The company's net income would increase.
B)   The company's earnings per share would decline.
C)   The company's cost of equity would increase.
D)   The company's ROA would increase.
E)   The company's ROE would decline.F) A) and D)
G) B) and D)

Question 13

Which of the following events is likely to encourage a company to raise its target debt ratio, other things held constant?

Accepted Answer

A)   An increase in the corporate tax rate.
B)   An increase in the personal tax rate.
C)   An increase in the company's operating leverage.
D)   The Federal Reserve tightens interest rates in an effort to fightInflation.
E)   The company's stock price hits a new high.F) All of the above
G) A) and B)

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) A) and B)
G) A) and C)

Question 15

Which of the following statements is CORRECT?

Accepted Answer

A)   Increasing financial leverage is one way to increase a firm's basic earning power (BEP) .
B)   If a firm lowered its fixed costs while increasing its variable costs, holding total costs at the present level of sales constant,This would decrease its operating leverage.
C)   The debt ratio that maximizes EPS generally exceeds the debt ratioThat maximizes share price.
D)   If a company were to issue debt and use the money to repurchase common stock, this action would have no impact on its basic earning power ratio. (Assume that the repurchase has no impact on theCompany's operating income.) 
E)   If changes in the bankruptcy code made bankruptcy less costly to corporations, this would likely reduce the average corporation's debt ratio.F) A) and E)
G) A) and B)

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) A) and E)
G) A) and D) B

Question 17

Powell Plastics, Inc. (PP)  currently has zero debt. Its earnings before interest and taxes (EBIT)  are $80,000, and it is a zero growth company. PP's current cost of equity is 10%, and its tax rate is 40%. The firm has 10,000 shares of common stock outstanding selling at a price per share of $48.00.
-Now assume that PP is considering changing from its original capital structure to a new capital structure with 35% debt and 65% equity. This results in a weighted average cost of capital equal to 9.4% and a new value of operations of $510,638. Assume PP raises $178,723 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)   $45.90
B)   $48.12
C)   $51.06
D)   $53.33
E)   $58.75F) B) and E)
G) B) and D) C

Question 18

Simon Software Co. is trying to estimate its optimal capital structure. Right now, Simon has a capital structure that consists of 20% debt and 80% equity, based on market values. (Its D/S ratio is 0.25.)  The risk- free rate is 6% and the market risk premium, rM - rRF, is 5%. Currently the company's cost of equity, which is based on the CAPM, is 12% and its tax rate is 40%. What would be Simon's estimated cost of equity if it were to change its capital structure to 50% debt and 50% equity?

Accepted Answer

A)   13.00%
B)   13.64%
C)   14.35%
D)   14.72%
E)   15.60%F) All of the above
G) A) and D) C

Question 19

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) B) and C)
G) C) and D)

Question 20

Senbet Ventures is considering starting a new company to produce stereos. The sales price would be set at 1.5 times the variable cost per unit; the VC/unit is estimated to be $2.50; and fixed costs are estimated at $120,000. What sales volume would be required in order to break even, i.e., to have an EBIT of zero for the stereo business?

Accepted Answer

A)   86,640
B)   91,200
C)   96,000
D)   100,800
E)   105,840F) D) and E)
G) A) and D)

Exam 15: Capital Structure Decisions

Companies HD and LD have identical amounts of assets, operating income (EBIT) , tax rates, and business risk. Company HD, however, has a much higher debt ratio than LD. Company HD's basic earning power ratio (BEP) exceeds its cost of debt (rd) . Which of the following statements is CORRECT?

Correct Answer
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Which of the following statements is CORRECT?

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

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Which of the following statements is CORRECT?

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An increase in the debt ratio will generally have no effect on which of these items?

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Which of the following statements is CORRECT?

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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

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Which of the following events is likely to encourage a company to raise its target debt ratio, other things held constant?

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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?

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B

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C

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C

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Exam 15: Capital Structure Decisions

Companies HD and LD have identical amounts of assets, operating income (EBIT) , tax rates, and business risk. Company HD, however, has a much higher debt ratio than LD. Company HD's basic earning power ratio (BEP) exceeds its cost of debt (rd) . Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

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

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Which of the following statements is CORRECT?

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An increase in the debt ratio will generally have no effect on which of these items?

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Which of the following statements is CORRECT?

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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

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Which of the following events is likely to encourage a company to raise its target debt ratio, other things held constant?

Correct AnswerverifiedShow Answer

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?

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B

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C

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C

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