978-0134083285 Chapter 12 Part 4

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27) The Modigliani and Miller hypothesis suggests that capital structure doesn’t matter. All of the

following conditions need to be met for this hypothesis to be true EXCEPT

A) corporate income is not subject to taxation.

B) capital structure consists only of stocks and bonds.

C) securities are traded in perfect or efficient markets.

D) all corporate net income is paid out as dividends.

Keywords: Capital Structure, Modigliani and Miller Hypothesis

Learning Obj.: L.O. 12.4

AACSB: Reflective Thinking

28) Assuming no corporate taxes, the independence hypothesis suggests that a firm‘s weighted average

cost of capital will

A) remain constant regardless of capital structure because the cost of debt and the cost of equity are the

same.

B) remain constant because the cost of equity will be increasing as the amount of debt increases due to the

increased risk.

C) increase proportionally with the increase in the amount of debt a firm uses.

D) decrease proportionally with the increase in the amount of debt a firm uses.

Keywords: Independence Hypothesis, Weighted Average Cost of Capital

Learning Obj.: L.O. 12.4

AACSB: Reflective Thinking

29) Which of the following statements is MOST correct concerning a corporation’s optimal capital

structure?

A) The optimal capital structure maximizes the present value of the interest tax shield.

B) The optimal capital structure occurs at the point where the market value of the levered firm is

maximized.

C) The optimal capital structure minimizes the present value of financial distress costs and agency costs.

D) The optimal capital structure occurs where the present value of the interest tax shield equals the

present value of the firm’s bankruptcy costs.

Keywords: Optimal Capital Structure, Interest Tax Shield, Financial Distress Costs, Agency Costs

Learning Obj.: L.O. 12.4

AACSB: Reflective Thinking

30) One component of a firm‘s financial structure which is NOT a component of its capital structure is

A) common stock.

B) accounts payable.

C) long-term debt.

D) preferred stock.

Keywords: Capital Structure, Financial Structure

Learning Obj.: L.O. 12.4

AACSB: Reflective Thinking

31) According to the moderate view of capital costs and financial leverage, as the use of debt financing

increases,

A) the cost of capital continuously decreases.

B) the cost of capital remains constant.

C) the cost of capital continuously increases.

D) there is an optimal level of debt financing.

Keywords: Capital Structure Theory, Optimal Capital Structure

Learning Obj.: L.O. 12.4

AACSB: Reflective Thinking

32) When deciding upon how much debt financing to employ, most practitioners would cite which of the

following as the most important influence on the level of the debt ratio?

A) providing a borrowing reserve

B) maintaining desired bond rating

C) ability to adequately meet financing charges

D) exploiting advantages of financial leverage

Keywords: Debt Ratio, Capital Structure

Learning Obj.: L.O. 12.4

AACSB: Reflective Thinking

33) Optimal capital structure is

A) the mix of permanent sources of funds used by the firm in a manner that will maximize the company‘s

common stock price.

B) the mix of all items that appear on the right-hand side of the company‘s balance sheet.

C) the mix of funds that will minimize the firm’s cost of equity capital.

D) the mix of funds that will maximize the firm’s interest tax shield.

Keywords: Optimal Capital Structure

Learning Obj.: L.O. 12.4

AACSB: Reflective Thinking

34) Which of the following would NOT be a part of a firm‘s capital structure?

A) short-term notes payable

B) long-term bonds

C) preferred stock

D) common stock

Keywords: Capital Structure

Learning Obj.: L.O. 12.4

AACSB: Reflective Thinking

35) A firm‘s optimal capital structure occurs where?

A) EPS are maximized, and WACC is minimized.

B) Stock price is maximized, and EPS are maximized.

C) Stock price is maximized, and WACC is maximized.

D) WACC is minimized, and stock price is maximized.

Keywords: Optimal Capital Structure

Learning Obj.: L.O. 12.4

AACSB: Reflective Thinking

36) Which of the following would be considered the firm’s optimal capital structure?

A) Stock Price = $25, Earnings Per Share = $10, Cost of Equity Capital = 15%

B) Stock Price = $23, Earnings Per Share = $11, Cost of Equity Capital = 18%

C) Stock Price = $24, Earnings Per Share = $12, Cost of Equity Capital = 17%

D) Stock Price = $20, Earnings Per Share = $12, Cost of Equity Capital = 20%

Keywords: Optimal Capital Structure, Maximize Shareholder Value

Learning Obj.: L.O. 12.4

AACSB: Analytical Thinking

37) The market value of a leveraged firm is equal to the market value of an unleveraged firm

A) plus the present value of tax shields minus the present value of financial distress costs plus the present

value of agency costs.

B) plus the present value of tax shields plus the present value of financial distress costs plus the present

value of agency costs.

C) minus the present value of tax shields minus the present value of financial distress costs minus the

present value of agency costs.

D) plus the present value of tax shields minus the present value of financial distress costs minus the

present value of agency costs.

Keywords: Leverage, Distress Costs, Tax Shields, Agency Costs

Learning Obj.: L.O. 12.4

AACSB: Analytical Thinking

38) The “threat hypothesis”

A) reduces management’s tendency to spend freely.

B) encourages management to use debt to further their own interests.

C) increases the agency problem.

D) increases agency monitoring costs.

Keywords: Threat Hypothesis, Agency Costs

Learning Obj.: L.O. 12.4

AACSB: Reflective Thinking

39) How do agency costs and free cash flow relate to capital structure management?

Keywords: Capital Structure Management

Learning Obj.: L.O. 12.4

AACSB: Reflective Thinking

Learning Objective 12.5

1) Given taxes and bankruptcy costs exist, as financial leverage increases, the weighted average cost of

capital first decreases and then increases.

Keywords: Weighted Average Cost of Capital, Taxes, Bankruptcy Costs, Moderate View

Learning Obj.: L.O. 12.5

AACSB: Analytical Thinking

2) The EBIT-EPS indifference point is the level of production at which the company‘s EBIT equals its EPS.

Keywords: EBIT-EPS Indifference Point

Learning Obj.: L.O. 12.5

AACSB: Reflective Thinking

3) An EBIT-EPS analysis allows the decision maker to visualize the impact of different financing plans on

EPS over a range of EBIT levels.

Keywords: EBIT-EPS Analysis

Learning Obj.: L.O. 12.5

AACSB: Reflective Thinking

4) Because there are no fixed financing costs, a common stock plan line in an EBIT-EPS analysis chart will

have a less-steep slope than will a bond plan line.

Keywords: EBIT-EPS Analysis

Learning Obj.: L.O. 12.5

AACSB: Reflective Thinking

5) One danger of EBIT-EPS analysis is that it ignores the implicit cost of debt financing.

Keywords: EBIT-EPS Analysis

Learning Obj.: L.O. 12.5

AACSB: Reflective Thinking

6) Above the EBIT-EPS indifference point, a more heavily levered financial plan will produce greater EPS.

Keywords: EBIT-EPS Indifference Point

Learning Obj.: L.O. 12.5

AACSB: Reflective Thinking

7) The Modigliani and Miller hypothesis does NOT work in the “real world” because

A) interest expense is tax deductible, providing an advantage to debt financing.

B) higher levels of debt increase the likelihood of bankruptcy, and bankruptcy has real costs for any

corporation.

C) dividend payments are fixed and tax deductible for the corporation.

D) both A and B

Keywords: Modigliani and Miller Hypothesis, Taxes, Bankruptcy Costs

Learning Obj.: L.O. 12.5

AACSB: Reflective Thinking

8) When using an EPS-EBIT chart to evaluate a pure debt financing and pure equity financing plan,

A) the debt financing plan line will graph with a steeper slope than the equity financing plan line.

B) the debt financing plan line will have a lower level of EBIT at EPS = 0.

C) the line of the two financing plans will intersect on the EBIT axis.

D) the slope of the equity financing plan line will be steeper than the debt financing plan line below the

intersection of the two lines.

Keywords: EPS–EBIT Chart

Learning Obj.: L.O. 12.5

AACSB: Analytical Thinking

9) The primary weakness of EBIT-EPS analysis is that

A) it ignores the implicit cost of debt financing.

B) it double counts the cost of debt financing.

C) it applies only to firms with large amounts of debt in their capital structure.

D) it may only be used by firms that are profitable this year.

Keywords: EBIT-EPS Analysis

Learning Obj.: L.O. 12.5

AACSB: Reflective Thinking

10) Basic tools of capital-structure management include

A) EBIT-EPS analysis.

B) comparative leverage ratios.

C) capital budgeting techniques.

D) both A and B.

Keywords: Capital-Structure Management, EBIT-EPS Analysis, Comparative Leverage Ratios

Learning Obj.: L.O. 12.5

AACSB: Reflective Thinking

11) 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) identifies the sales level at which EBIT equals EPS.

Keywords: EBIT-EPS Indifference Point

Learning Obj.: L.O. 12.5

AACSB: Reflective Thinking

12) Balon Plastics, Inc. is trying to decide how best to finance a proposed $10,000,000 capital investment.

Under Plan I, the project will be financed entirely with long-term 9 percent bonds. The firm currently has

no debt or preferred stock. Under Plan II, common stock will be sold to net the firm $20 a share;

presently, 1,000,000 shares are outstanding. The corporate tax rate for Balon is 40 percent.

a. Calculate the indifference level of EBIT associated with the two financing plans.

b. Prepare an EBIT-EPS analysis chart, showing the intersection of the two financing plan lines.

c. Which financing plan would you expect to cause the greatest change in EPS relative to a change in

EBIT? Why?

d. If EBIT is expected to be $3.1 million, which plan will result in a higher EPS?

Keywords: EBIT-EPS Analysis, Indifference Point

Learning Obj.: L.O. 12.5

AACSB: Analytical Thinking

13) Balon Plastics, Inc. 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 percent 10-year bonds. The firm‘s tax rate is 40 percent.

a. Calculate the financing plan’s EBIT indifference point.

b. The expected level of EBIT is $10,320,000 with a standard deviation of $2,000,000. What is the

probability that EBIT will be above the indifference point?

c. 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.

Keywords: EBIT-EPS Analysis, Indifference Point

Learning Obj.: L.O. 12.5

AACSB: Analytical Thinking

14) The MAX Corporation is planning a $4,000,000 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 percent coupon rate. The firm’s existing shares of preferred stock pay dividends

of $2.00 per share. The company‘s corporate income tax rate is 46 percent. 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?

Keywords: EBIT-EPS Analysis, Indifference Point, EPS

Learning Obj.: L.O. 12.5

AACSB: Analytical Thinking

15) Sunshine Candy Company‘s capital structure for the past year of operation is shown below.

First mortgage bonds at 12% $2,000,000

Debentures at 15% 1,500,000

Common stock (1,000,000 shares) 5,000,000

Retained earnings 500,000

TOTAL $9,000,000

The federal tax rate is 50 percent. Sunshine Candy Company, home-based in Orlando, wants to raise an

additional $1,000,000 to open new facilities in Tampa and Miami. The firm can accomplish this via two

alternatives: (1) It can sell a new issue of 20-year debentures with 16 percent interest; or (2) 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 $6,800,000. Find the indifference level of EBIT (with regard to earnings per share)

between the suggested financing plans.

Keywords: EBIT-EPS Analysis, Indifference Point

Learning Obj.: L.O. 12.5

AACSB: Analytical Thinking

16) Premium Lodging, Inc., is financed entirely with 3 million shares of common stock selling for $50 a

share. Capital of $10 million is needed for this year’s capital budget. Additional funds can be raised with

new stock (ignore dilution) or with 11 percent 12-year bonds. Premium Lodging’s tax rate is 35 percent.

Calculate the financing plan’s EBIT indifference point.

Keywords: EBIT-EPS Analysis, Indifference Point

Learning Obj.: L.O. 12.5

AACSB: Analytical Thinking

17) Identify several factors that influence the decision to issue debt.

Keywords: Capital Structure Management

Learning Obj.: L.O. 12.5

AACSB: Reflective Thinking