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Exam 13: Leverage and Capital Structure

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Question 41

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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. According to the traditional approach to capital structure, the value of the firm is

A) $1.4 million.
B) $2.0 million.
C) $2.7 million.
D) $6.0 million.

E) A) and C)
F) B) and C)

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Question 42

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________ results from the use of fixed-cost assets or funds to magnify returns to the firm's owners.

A) Long-term debt
B) Equity
C) Leverage
D) Capital structure

E) None of the above
F) B) and C)

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Question 43

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The more fixed cost financing a firm has in its capital structure, the greater its financial leverage and risk.

The pecking order explanation of capital structure states that a hierarchy of financing exists for firms in which retained earnings are employed first, followed by debt financing and finally by external equity financing.

The basic sources of capital for a firm include all of the following EXCEPT

While operating leverage results only in a magnification of returns, financial leverage results only in a magnification of risk.

Tangshan Mining Company must choose its optimal capital structure. Currently, the firm has a 40 percent debt ratio and the firm expects to generate a dividend next year of $4.89 per share and dividends are grow at a constant rate of 5 percent for the foreseeable future. Stockholders currently require a 10.89 percent return on their investment. Tangshan Mining is considering changing its capital structure if it would benefit shareholders. The firm estimates that if it increases the debt ratio to 50 percent, it will increase its expected dividend to $5.24 per share. Because of the additional leverage, dividend growth is expected to increase to 6 percent and this growth will be sustained indefinitely. However, because of the added risk, the required return demanded by stockholders will increase to 11.34 percent. (a) What is the value per share for Tangshan Mining under the current capital structure? (b) What is the value per share for Tangshan Mining under the proposed capital structure? (c) Should Tangshan Mining make the capital structure change? Explain.

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 firm's capital structure is the mix of short-term and long-term debt and equity maintained by the firm.

Operating leverage is concerned with the relationship between the firm's sales revenue and its operating expenses.

One of the limitations of breakeven analysis is its short-term time horizon. A large outlay in the current financial period could significantly raise the firm's breakeven point, while the benefits may occur over a period of years.

A firm has fixed operating costs of $650,000, a sales price per unit of $20, and a variable cost per unit of $13. At a base sales level of 500,000 units, the firm's degree of operating leverage is ________.

Higher financial leverage causes ________ to increase more for a given increase in ________.

Which of the following is NOT a reason why debt capital is considered to be the least risky source of capital?

Holding all other factors constant, a firm that is subject to a greater level of business risk should employ less total leverage than an otherwise equivalent firm that is subject to a lesser level of business risk.

Asymmetric information results when managers of a firm have more information about operations and future prospects than do investors.

________ leverage is concerned with the relationship between sales revenues and earnings before interest and taxes.

As debt is substituted for equity in the capital structure and the debt ratio increases, the behavior of the overall cost of capital is partially explained by

Table 13.1 -What is the EPS under Financing Plan 1, if the firm projects EBIT of $200,000 and has a tax rate of 40 percent? (See Table 13.1)

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