8) List and briefly explain at least two important reasons why capital structures tend to differ
between industries and even companies within the same industry.
Topic: 15.3 Why Do Capital Structures Differ across Industries?
Keywords: capital structure
Principles: Principle 2: There Is a Risk-Return Tradeoff
1)
Waltham
Watch
Comparable
Firms
Debt ratio 33% 42%
Interest
-bearing debt
ratio 19% 23
Times interest
earned ratio 25 20
EBITDA
coverage ratio 6 4
From the table above we can conclude:
A) Waltham has a conservative capital structure policies.
B) Waltham has too much debt.
C) Waltham uses more leverage than the typical firm in its industry.
D) Waltham’s EPS would be more sensitive than a typical firm’s to changes in EBIT.
Topic: 15.4 Making Financing Decisions
Keywords: capital structure
Principles: Principle 3: Cash Flows Are the Source of Value
21
2) Which two ratios would be most helpful in managing a firm’s capital structure?
A) Book Debt to Equity, Current Ratio
B) Debt to Value Ratio and Times Interest Earned
C) Debt to Assets, Profit Margin
D) Payables Turnover, Return on Assets
Topic: 15.4 Making Financing Decisions
Keywords: capital structure
Principles: Principle 3: Cash Flows Are the Source of Value
3) When benchmarking a firm’s capital structure, management should compare it:
A) firms in S&P 500.
B) firms in the same geographic region.
C) firms recognized for the quality of their management.
D) firms in similar lines of business.
Topic: 15.4 Making Financing Decisions
Keywords: Benchmarking
Principles: Principle 3: Cash Flows Are the Source of Value
4) If a firm chose to increase its debt ratio from 20% to 40%, what is the potential risk?
A) The average cost of capital would most likely rise.
B) The price of the firm’s common stock would definitely decline.
C) If economic forces cause a reduction of sales, the firm’s EPS might decline.
D) The firm’s WACC might decline.
Topic: 15.4 Making Financing Decisions
Keywords: EBIT-EPS
Principles: Principle 3: Cash Flows Are the Source of Value
5) When using an EPS-EBIT chart to evaluate a pure debt financing and pure equity financing
plan, the debt financing plan line will have:
A) a steeper slope than the equity financing plan line.
B) a slower rate of change as EBIT increases.
C) a downward slope.
D) the same slope as the equity plan, but a higher intercept.
Topic: 15.4 Making Financing Decisions
Keywords: EBIT-EPS
Principles: Principle 3: Cash Flows Are the Source of Value
22
6) Basic tools of capital structure management include:
A) EBIT–EPS analysis.
B) comparative profitability ratios.
C) capital budgeting techniques.
D) none of the above.
Topic: 15.4 Making Financing Decisions
Keywords: EBIT-EPS
Principles: Principle 3: Cash Flows Are the Source of Value
7) An increase in the ________ is likely to encourage a corporation to increase its debt ratio.
A) corporate tax rate
B) personal tax rate
C) company’s degree of operating leverage
D) expected cost of bankruptcy
Topic: 15.4 Making Financing Decisions
Keywords: interest tax savings
Principles: Principle 3: Cash Flows Are the Source of Value
8) The EBIT-EPS indifference point:
A) identifies the EBIT level at which the EPS will be the same regardless of the financing plan.
B) identifies the point at which the analysis can use EBIT and EPS interchangeably.
C) identifies the level of earnings at which the management is indifferent about the payments of
dividends.
D) none of the above.
Topic: 15.4 Making Financing Decisions
Keywords: EBIT-EPS
Principles: Principle 3: Cash Flows Are the Source of Value
9) As a general rule, the optimal capital structure:
A) maximizes expected EPS and also maximizes the price per share of common stock.
B) minimizes the interest rate on debt and also maximizes the expected EPS.
C) minimizes the required rate on equity and also maximizes the stock price.
D) maximizes the price per share of common stock and also minimizes the weighted average
cost of capital.
Topic: 15.4 Making Financing Decisions
Keywords: optimal capital structure
Principles: Principle 3: Cash Flows Are the Source of Value
23
10) The capital structure that minimizes the weighted average cost of capital will also:
A) maximize EPS for any given level of EBIT.
B) minimize the value of the firm.
C) minimizes bankruptcy costs.
D) maximize the price per share of common stock.
Topic: 15.4 Making Financing Decisions
Keywords: optimal capital structure
Principles: Principle 3: Cash Flows Are the Source of Value
Use the following information to answer the following question(s).
Your firm is trying to determine whether it should finance a project requiring $800,000 with new
common stock or with debt. The firm is faced with the following financing alternatives:
I: Issue new common stock. Sale price of the common stock is expected to be $40 per
share.
II: Issue new bonds with a coupon rate of 12%.
The firm has a marginal tax rate of 34%, the company currently has 40,000 shares of common
stock outstanding, and $90,000 face value of 10% debt outstanding.
11) Total shares outstanding will be:
A) 20,000 under alternative I and zero under alternative II.
B) 40,000 under alternative I and 60,000 under alternative II.
C) 60,000 under alternative I and 40,000 under alternative II.
D) 60,000 under both alternative I and alternative II.
Topic: 15.4 Making Financing Decisions
Keywords: EBIT-EPS
Principles: Principle 3: Cash Flows Are the Source of Value
12) The total interest obligation will be:
A) $105,000 under alternative I and $9,000 under alternative II.
B) $9,000 under alternative I and $105,000 under alternative II.
C) zero under alternative I and $96,000 under alternative II.
D) $105,000 under both alternative I and alternative II.
Topic: 15.4 Making Financing Decisions
Keywords: EBIT-EPS
Principles: Principle 3: Cash Flows Are the Source of Value
24
13) Weaknesses of the EBIT-EPS analysis include:
A) that it disregards the implicit costs of debt financing.
B) that it ignores the effect of the specific financing decision on the firm’s cost of common equity
capital.
C) that it considers only the level of the earnings stream and ignores the variability inherent in it.
D) all of the above.
Topic: 15.4 Making Financing Decisions
Keywords: EBIT-EPS
Principles: Principle 3: Cash Flows Are the Source of Value
40%. Farar presently has 750,000 shares of common stock, no preferred stock, and no debt. The
firm is considering the issuance of $6 million of 10% bonds to finance a new product that is not
expected to generate an increase in income for two years. If Farar issues the bonds this year,
what will projected EPS be next year?
A) $1.53
B) $1.98
C) $2.33
D) $2.72
E) $3.12
Topic: 15.4 Making Financing Decisions
Keywords: EBIT-EPS
Principles: Principle 3: Cash Flows Are the Source of Value
40%. Zybeck presently has 750,000 shares of common stock which have a market value of $10
per share, no preferred stock, and no debt. The firm is considering two alternatives to finance a
new product: (a) the issuance of $6 million of 10% bonds, or (b) the issuance of 60,000 new
shares of common stock. There are no issuance costs for either the bonds or the stock. If Zybeck
issues common stock this year, what will projected EPS be next year?
A) $2.10
B) $2.96
C) $2.33
D) $1.67
Topic: 15.4 Making Financing Decisions
Keywords: EBIT-EPS
Principles: Principle 3: Cash Flows Are the Source of Value
25
40%. Zybeck presently has 750,000 shares of common stock which have a market value of $10
per share, no preferred stock, and no debt. The firm is considering two alternatives to finance a
new product: (a) the issuance of $6 million of 10% bonds, or (b) the issuance of 60,000 new
shares of common stock at $10 per share. If Zybeck issues common stock this year, what will the
firm’s return on equity be next year?
A) 16.7%
B) 18.2%
C) 22.1%
D) 26.4%
E) 29.6%
Topic: 15.4 Making Financing Decisions
Keywords: EBIT-EPS
Principles: Principle 3: Cash Flows Are the Source of Value
17) Lever Brothers has a debt ratio (debt to assets) of 20%. Management is wondering if its
current capital structure is too conservative. Lever Brothers’s present EBIT is $3 million, and
profits available to common shareholders are $1,680,000, with 457,143 shares of common stock
outstanding. If the firm were to instead have a debt ratio of 40%, additional interest expense
would cause profits available to stockholders to decline to $1,560,000, but only 342,857
common shares would be outstanding. What is the difference in EPS at a debt ratio of 40%
versus 20%?
A) $2.12
B) $1.95
C) $1.16
D) $0.88
Topic: 15.4 Making Financing Decisions
Keywords: EBIT-EPS
Principles: Principle 3: Cash Flows Are the Source of Value
26
18) Lever Brothers has a debt ratio (debt to assets) of 40%. Management is wondering if its
current capital structure is too conservative. Lever Brothers’s present EBIT is $3 million, and
profits available to common shareholders are $1,560,000, with 342,857 shares of common stock
outstanding. If the firm were to instead have a debt ratio of 60%, additional interest expense
would cause profits available to stockholders to decline to $1,440,000, but only 228,571
common shares would be outstanding. What is the difference in EPS at a debt ratio of 60%
versus 40%?
A) $1.75
B) $2.00
C) $3.25
D) $4.50
Topic: 15.4 Making Financing Decisions
Keywords: EBIT-EPS
Principles: Principle 3: Cash Flows Are the Source of Value
19) Lever Brothers has a debt ratio (debt to assets) of 60%. Management is wondering if its
current capital structure is too aggressive. Lever Brothers’s present EBIT is $3 million, and
profits available to common shareholders are $1,440,000, with 228,571 shares of common stock
outstanding. If the firm were to instead have a debt ratio of 20%, reduced interest expense would
cause profits available to stockholders to increase to $1,680,000, but 457,143 common shares
would be outstanding. What is the difference in EPS at a debt ratio of 20% versus 60%?
A) $-1.76
B) $-2.63
C) $-3.14
D) $-4.37
Topic: 15.4 Making Financing Decisions
Keywords: EBIT-EPS
Principles: Principle 3: Cash Flows Are the Source of Value
27