978-0133423822 Chapter 15 Part 3

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40) In the original version of the Modigliani and Miller capital structure theorem, as a irm

increases the amount of debt in its capital structure, the cost of equity will rise but the cost

of capital will remain the same.

Question Status: New question

Objective: 15.2 Explain why irms have diferent capital structures and how capital structure

inluences a irm’s weighted average cost of capital.

Keywords: capital structure

Principles: Principle 2: There Is a Risk-Return Tradeof

41) Adams Inc. expects EBIT of $50 million if there is a recession, $100 million if the

economy is normal, and $150 million if the economy expands. Bellingham Inc. also expects

EBIT of $50 million if there is a recession, $100 million if the economy is normal, and $150

million if the economy expands. Adams is inanced entirely with equity while Bellingham is

inanced 50% with debt at 10%. Adams has $200 million in equity; Bellingham is inanced

with $100 million of debt and $100 million of equity. The tax rate is 30%. Both irms pay out

all available earnings as dividends. If there is a recession, compare dividends and total

distributions to investors for each company.

Question Status: Previous edition

Objective: 15.2 Explain why irms have diferent capital structures and how capital structure

inluences a irm’s weighted average cost of capital.

Keywords: capital structure

Principles: Principle 2: There Is a Risk-Return Tradeof

42) Cheshire Corporation is now inanced 100% with equity. The cost of equity is 15%.

Cheshire is considering a proposal to borrow enough money at 7% to buy back half of its

common stock. It would then be inanced 50% with debt and 50% with equity. Assume that

this does not afect the cost of equity. Cheshire’s tax rate is 40%. What is Cheshire’s cost of

capital without and with the stock repurchase?

Question Status: Previous edition

Objective: 15.2 Explain why irms have diferent capital structures and how capital structure

inluences a irm’s weighted average cost of capital.

Keywords: capital structure

Principles: Principle 2: There Is a Risk-Return Tradeof

43) Under what conditions are shareholders likely to incur agency costs when managers

make capital budgeting decisions?

Question Status: Previous edition

Objective: 15.2 Explain why irms have diferent capital structures and how capital structure

inluences a irm’s weighted average cost of capital.

Keywords: capital structure

Principles: Principle 2: There Is a Risk-Return Tradeof

44) Briely explain what the empirical evidence suggests about inancial managers’ actions

as they relate to the capital structure theory.

Question Status: Previous edition

Objective: 15.2 Explain why irms have diferent capital structures and how capital structure

inluences a irm’s weighted average cost of capital.

Keywords: capital structure

Principles: Principle 2: There Is a Risk-Return Tradeof

15.3 Why Do Capital Structures Difer across Industries?

1) Which of the following factors favors the use of more debt in a company‘s inancial

structure?

A) High levels of taxable income

B) Low levels of taxable income

C) The business is basically risky with unpredictable cash lows.

D) Risk of bankruptcy would make customers reluctant to buy the company’s products.

Question Status: Previous edition

Objective: 15.3 Describe some fundamental diferences in industries that drive diferences in the

way they inance their investments.

Keywords: inancial structure

Principles: Principle 2: There Is a Risk-Return Tradeof

2) Which industry would you expect to have the highest Debt to Asset ratios?

A) Business oriented software

B) Electric utilities

C) Communications equipment

D) Retail clothing

Question Status: Previous edition

Objective: 15.3 Describe some fundamental diferences in industries that drive diferences in the

way they inance their investments.

Keywords: inancial structure

Principles: Principle 2: There Is a Risk-Return Tradeof

3) In which countries would you expect companies to have the lowest leverage ratios?

A) Countries with very high tax rates

B) Countries that tend to subsidize key industries and protect them from failure

C) Countries where creditors have very strong legal protection

D) Countries where the market value of companies is high compared to their book values

Question Status: Previous edition

Objective: 15.3 Describe some fundamental diferences in industries that drive diferences in the

way they inance their investments.

Keywords: inancial structure

Principles: Principle 2: There Is a Risk-Return Tradeof

4) Which of the following is a good reason for a company to have higher than average debt

ratios.

A) The company’s cash lows are diicult to predict.

B) The company generates little taxable income.

C) Customer support is an important aspect of the company’s business.

D) The company faces high marginal tax rates.

Question Status: Previous edition

Objective: 15.3 Describe some fundamental diferences in industries that drive diferences in the

way they inance their investments.

Keywords: inancial structure

Principles: Principle 2: There Is a Risk-Return Tradeof

5) At the beginning of the inancial crisis of 2008, excessive debt caused serious problems

in the ________ industry.

A) computer

B) pharmaceuticals

C) utilities

D) inancial

Question Status: New question

Objective: 15.3 Describe some fundamental diferences in industries that drive diferences in the

way they inance their investments.

Keywords: inancial structure

Principles: Principle 2: There Is a Risk-Return Tradeof

6) U. S. companies difer very little in their capital structures.

Question Status: Previous edition

Objective: 15.3 Describe some fundamental diferences in industries that drive diferences in the

way they inance their investments.

Keywords: inancial structure

Principles: Principle 2: There Is a Risk-Return Tradeof

7) Companies faced with higher tax burdens are likely to use more debt.

Question Status: Previous edition

Objective: 15.3 Describe some fundamental diferences in industries that drive diferences in the

way they inance their investments.

Keywords: inancial structure

Principles: Principle 2: There Is a Risk-Return Tradeof

8) Conservative balance sheets may be advantageous for companies that have long-term

relationships with their customers.

Question Status: New question

Objective: 15.3 Describe some fundamental diferences in industries that drive diferences in the

way they inance their investments.

Keywords: inancial structure

Principles: Principle 2: There Is a Risk-Return Tradeof

9) Top management’s desire to avoid the scrutiny that comes with higher levels of debt may

inluence the capital structures of some irms.

Question Status: New question

Objective: 15.3 Describe some fundamental diferences in industries that drive diferences in the

way they inance their investments.

Keywords: inancial structure

Principles: Principle 2: There Is a Risk-Return Tradeof

10) List and briely explain at least two important reasons why capital structures tend to

difer between industries and even companies within the same industry.

Question Status: Previous edition

Objective: 15.3 Describe some fundamental diferences in industries that drive diferences in the

way they inance their investments.

Keywords: inancial structure

Principles: Principle 2: There Is a Risk-Return Tradeof

15.4 Making Financing Decisions

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 irm in its industry.

D) Waltham’s EPS would be more sensitive than a typical irm’s to changes in EBIT.

Question Status: Previous edition

Objective: 15.4 Use the basic terms of inancial analysis to analyze a irm’s inancing decisions.

Keywords: EBIT-EPS

Principles: Principle 3: Cash Flows Are the Source of Value

2) Which two ratios would be most helpful in managing a irm’s capital structure?

A) Book Debt to Equity, Current Ratio

B) Debt to Value Ratio and Times Interest Earned

C) Debt to Assets, Proit Margin

D) Payables Turnover, Return on Assets

Question Status: Previous edition

Objective: 15.4 Use the basic terms of inancial analysis to analyze a irm’s inancing decisions.

Keywords: EBIT-EPS

Principles: Principle 3: Cash Flows Are the Source of Value

3) When benchmarking a irm’s capital structure, management should compare it to

A) irms in S&P 500.

B) irms in the same geographic region.

C) irms recognized for the quality of their management.

D) irms in similar lines of business.

Question Status: Previous edition

Objective: 15.4 Use the basic terms of inancial analysis to analyze a irm’s inancing decisions.

Keywords: EBIT-EPS

Principles: Principle 3: Cash Flows Are the Source of Value

4) If a irm 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 irm’s common stock would deinitely decline.

C) If economic forces cause a reduction of sales, the irm’s EPS might decline.

D) The irm’s WACC might decline.

Question Status: Previous edition

Objective: 15.4 Use the basic terms of inancial analysis to analyze a irm’s inancing 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 inancing and pure equity

inancing plan, the debt inancing plan line will have

A) a steeper slope than the equity inancing 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.

Question Status: Previous edition

Objective: 15.4 Use the basic terms of inancial analysis to analyze a irm’s inancing decisions.

Keywords: EBIT-EPS

Principles: Principle 3: Cash Flows Are the Source of Value

6) Basic tools of capital structure management include

A) EBIT-EPS analysis.

B) comparative proitability ratios.

C) capital budgeting techniques.

D) economic value added analysis.

Question Status: Revised

Objective: 15.4 Use the basic terms of inancial analysis to analyze a irm’s inancing 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

Question Status: Previous edition

Objective: 15.4 Use the basic terms of inancial analysis to analyze a irm’s inancing decisions.

Keywords: EBIT-EPS

Principles: Principle 3: Cash Flows Are the Source of Value

8) The EBIT-EPS indiference point

A) identiies the EBIT level at which the EPS will be the same regardless of the inancing

plan.

B) identiies the point at which the analysis can use EBIT and EPS interchangeably.

C) identiies the level of earnings at which the management is indiferent about the

payments of dividends.

D) none of the above.

Question Status: Previous edition

Objective: 15.4 Use the basic terms of inancial analysis to analyze a irm’s inancing 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.

Question Status: Previous edition

Objective: 15.4 Use the basic terms of inancial analysis to analyze a irm’s inancing decisions.

Keywords: EBIT-EPS

Principles: Principle 3: Cash Flows Are the Source of Value

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 irm.

C) minimize bankruptcy costs.

D) maximize the price per share of common stock.

Question Status: Previous edition

Objective: 15.4 Use the basic terms of inancial analysis to analyze a irm’s inancing decisions.

Keywords: EBIT-EPS

Principles: Principle 3: Cash Flows Are the Source of Value

Use the following information to answer the following question(s).

Your irm is trying to determine whether it should inance a project requiring $800,000

with new common stock or with debt. The irm is faced with the following inancing

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 irm 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.

Question Status: Previous edition

Objective: 15.4 Use the basic terms of inancial analysis to analyze a irm’s inancing 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.

Question Status: Previous edition

Objective: 15.4 Use the basic terms of inancial analysis to analyze a irm’s inancing decisions.

Keywords: EBIT-EPS

Principles: Principle 3: Cash Flows Are the Source of Value

13) Weaknesses of the EBIT-EPS analysis include

A) that it disregards the implicit costs of debt inancing.

B) that it ignores the efect of the speciic inancing decision on the irm’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.

Question Status: Previous edition

Objective: 15.4 Use the basic terms of inancial analysis to analyze a irm’s inancing decisions.

Keywords: EBIT-EPS

Principles: Principle 3: Cash Flows Are the Source of Value

14) Farar, Inc. projects operating income of $4 million next year. The irm’s income tax rate

is 40%. Farar presently has 750,000 shares of common stock, no preferred stock, and no

debt. The irm is considering the issuance of $6 million of 10% bonds to inance 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) $2.72

D) $4.53

Question Status: Revised

Objective: 15.4 Use the basic terms of inancial analysis to analyze a irm’s inancing decisions.

Keywords: EBIT-EPS

Principles: Principle 3: Cash Flows Are the Source of Value