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.
20) The indifference level of EBIT is:
A) $99,000.
B) $66,600.
C) $333,000.
D) $297,000.
Topic: 15.4 Making Financing Decisions
Keywords: EBIT-EPS
Principles: Principle 3: Cash Flows Are the Source of Value
21) EPS at the indifference level of EBIT is:
A) $3.17.
B) $4.80.
C) $5.27.
D) $5.90.
Topic: 15.4 Making Financing Decisions
Keywords: EBIT-EPS
Principles: Principle 3: Cash Flows Are the Source of Value
28
22) A firm is analyzing two different capital structures for financing a new asset that will cost
$100,000. The effects of the two structures on the firm’s balance sheet are described below.
Plan A: finance with 50% debt
New asset $100,000 Debt $50,000
Common equity $50,000
Total $100,000
Plan B: finance with 70% debt
New asset $100,000 Debt $70,000
Common equity $30,000
Total $100,000
Based on the information provided, we can conclude that:
A) if the firm chooses Plan A, then any changes in the firm’s EBIT will lead to larger fluctuations
in the firm’s EPS than if the firm chooses Plan B.
B) if the firm chooses Plan B, then any changes in the firm’s EBIT will lead to larger fluctuations
in the firm’s EPS than if the firm chooses Plan A.
C) if the firm chooses Plan A, then any changes in the firm’s EBIT will lead to the same
fluctuations in the firm’s EPS as will occur if the firm chooses Plan B.
D) if the firm chooses Plan B, then any changes in the firm’s EBIT will lead to smaller
fluctuations in the firm’s EPS than if the firm chooses Plan A.
Topic: 15.4 Making Financing Decisions
Keywords: EBIT-EPS
Principles: Principle 3: Cash Flows Are the Source of Value
23) The level of EBIT that will equate EPS between two different financing plans is called the:
A) indifference point.
B) optimal capital plan.
C) break-even point.
D) both A and C.
Topic: 15.4 Making Financing Decisions
Keywords: EBIT-EPS
Principles: Principle 3: Cash Flows Are the Source of Value
24) Useful ratios for benchmarking a firm’s capital structure include:
A) the Debt ratio.
B) Times Interest Earned ratio.
C) EBITDA coverage ratio.
D) all of the above.
Topic: 15.4 Making Financing Decisions
Keywords: Benchmarking
Principles: Principle 3: Cash Flows Are the Source of Value
29
25) Which of the following factors was most often cited by CFOs as an important influence on
debt use?
A) Keeping the confidence of customers and suppliers
B) Minimizing bankruptcy costs
C) Maintaining financial flexibility
D) Benchmarking against similar firms
Topic: 15.4 Making Financing Decisions
Keywords: capital structure
Principles: Principle 3: Cash Flows Are the Source of Value
26) The EBIT-EPS indifference point, sometimes called the break-even point, identifies the
optimal range of financial leverage regardless of the financing plan chosen by the financial
manager.
Topic: 15.4 Making Financing Decisions
Keywords: EBIT-EPS
Principles: Principle 3: Cash Flows Are the Source of Value
27) Comparative leverage ratio analysis does not involve the use of industry norms.
Topic: 15.4 Making Financing Decisions
Keywords: EBIT-EPS
Principles: Principle 3: Cash Flows Are the Source of Value
28) High coverage ratios, compared with a standard, imply unused debt capacity.
Topic: 15.4 Making Financing Decisions
Keywords: Benchmarking
Principles: Principle 3: Cash Flows Are the Source of Value
29) Benchmarking the company’s capital structure is popular because it is impossible to know
exactly what the company’s optimal capital structure should be.
Topic: 15.4 Making Financing Decisions
Keywords: Benchmarking
Principles: Principle 3: Cash Flows Are the Source of Value
30
30) Roberts, Inc. is trying to decide how best to finance a proposed $10 million capital
investment. Under Plan I, the project will be financed entirely with long-term 9% bonds. The
firm currently has no debt or preferred stock. Under Plan II, common stock will be sold to net the
40%.
a. Calculate the indifference level of EBIT associated with the two financing plans.
b. Which financing plan would you expect to cause the greatest change in EPS relative to a
change in EBIT? Why?
c. If EBIT is expected to be $3.1 million, which plan will result in a higher EPS?
Topic: 15.4 Making Financing Decisions
Keywords: EBIT-EPS
Principles: Principle 3: Cash Flows Are the Source of Value
31) Young Enterprises is financed entirely with 3 million shares of common stock selling for $20
a share. Capital of $4 million is needed for this year’s capital budget. Additional funds can be
raised with new stock (ignore dilution) or with 13% 10-year bonds. Young’s tax rate is 40%.
a. Calculate the financing plan’s EBIT indifference point.
b. Does the “indifference point” calculated in question (a) above truly represent a point where
stockholders are indifferent between stock and debt financing? Explain your answer.
Topic: 15.4 Making Financing Decisions
Keywords: EBIT-EPS
Principles: Principle 3: Cash Flows Are the Source of Value
31
32) The MAX Corporation is planning a $4 million expansion this year. The expansion can be
financed by issuing either common stock or bonds. The new common stock can be sold for $60
per share. The bonds can be issued with a 12% coupon rate. The firm’s existing shares of
preferred stock pay dividends of $2.00 per share. The company’s combined state and federal
corporate income tax rate is 46%. The company’s balance sheet prior to expansion is as follows:
MAX Corporation
Current assets $ 2,000,000
Fixed assets 8,000,000
Total assets $10,000,000
Current liabilities $ 1,500,000
Bonds:
(8%, $1,000 par value) 1,000,000
(10%, $1,000 par value) 4,000,000
Preferred stock:
($100 par value) 500,000
Common stock:
($2 par value) 700,000
Retained earnings 2,300,000
Total liabilities and equity $10,000,000
a. Calculate the indifference level of EBIT between the two plans.
b. If EBIT is expected to be $3 million, which plan will result in higher EPS?
Topic: 15.4 Making Financing Decisions
Keywords: EBIT-EPS
Principles: Principle 3: Cash Flows Are the Source of Value
32
33) Sunshine Candy Company’s capital structure for the past year of operation is shown below.
20,000 new shares of common stock can be sold to the public to net the candy company $50 per
share. A recent study, performed by an outside consulting organization, projected Sunshine
Candy Company’s long-term EBIT level at approximately $6.8 million. Find the indifference
level of EBIT (with regard to EPS) between the suggested financing plans.
50 EBIT – 23,250,000 = 51 EBIT – 31,875,000
EBIT = $8,625,000 indifference level
Topic: 15.4 Making Financing Decisions
Keywords: EBIT-EPS
Topic: 15.4 Making Financing Decisions
Keywords: Benchmarking
Principles: Principle 3: Cash Flows Are the Source of Value
33