41) The inexpensive nature of long-term debt in a firm’s capital structure is partly because
________.
A) the equity holders are the true owners of the firm
B) equity capital has a fixed return
C) interest payments are tax-deductible
D) equity holders have a higher position in the priority of claims
42) Which of the following is a basic source of capital for a firm?
A) short-term debt
B) discounts from suppliers
C) current liabilities
D) common stock
43) A decrease in the use of financing that requires fixed payments will result in a(n)________.
A) increase in financial risk
B) decrease in financial risk
C) increase in operating leverage
D) decrease in operating leverage
44) 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 ________.
A) the tax-deductibility of interest payments
B) the increase in the number of common shares outstanding
C) the reduction in risk as perceived by the common shareholders
D) the decrease in the cost of equity
45) According to the pecking order theory, which of the following is the order in which
corporations use different financing sources to fund investment projects?
A) retained earnings, equity, debt
B) retained earnings, debt, equity
C) debt, retained earnings, equity
D) equity, retained earnings, debt
46) ________ is the risk reflected in fluctuations of a firm’s cash flows because it uses debt or
other fixed-cost financing.
A) Systematic risk
B) Business risk
C) Financial risk
D) Diversifiable risk
47) ________ is the risk that is reflected in fluctuations of the firm’s cash flows before
considering any debt financing.
A) Systematic risk
B) Business risk
C) Financial risk
D) Diversifiable risk
48) Which of the following affects business risk?
A) operating leverage
B) interest rate stability
C) preferred stock
D) financial lease
49) Revenue stability affects ________.
A) dividend risk
B) maturity risk
C) business risk
D) interest rate risk
50) Which of the following is a difference between debt and equity capital?
A) Debt capital does not require periodic payments, whereas equity capital requires period
payments.
B) Debt capital requires returns in proportion to profits, whereas equity capital requires a fixed
rate of return.
C) Debt capital provides a tax shield, whereas equity capital does not provide a tax shield.
D) Debt capital affects operating leverage, whereas equity capital affects financial leverage.
51) Which of the following is a difference between debt and equity capital?
A) Debt capital does not require periodic payments, whereas equity capital requires period
payments.
B) Debt capital requires a fixed rate of return, whereas equity capital requires returns in
proportion to profits.
C) Debt capital does not provides a tax shield, whereas equity capital provides a tax shield.
D) Debt capital affects operating leverage, whereas equity capital affects financial leverage.
52) After satisfying obligations to creditors, the government, and preferred stockholders, any
remaining earnings will most likely be allocated to ________.
A) common shareholders as cash dividends
B) common shareholders as stock dividends
C) other firms requiring capital
D) pay future preferred dividends
53) The conflict resulting from a manager’s desire to increase a firm’s risk without increasing
current borrowing costs and lenders’ desire to limit lending is one effect of the ________
problem.
A) agency
B) leverage
C) capital
D) variable cost
54) Operating and financial constraints placed on a corporation by loan provision are ________.
A) agency costs to lenders
B) agency costs to a firm
C) necessary to regulate ownership of a firm
D) necessary to control the risk of a firm
55) Management has just discovered an excellent investment for which it needs additional
funding. Relative to the discussion on asymmetric information, the firm will ________.
A) finance with new common stock if management believes the firm is undervalued
B) finance with debt if management believes the firm is undervalued
C) finance with debt if management believes the firm is overvalued
D) finance with preferred stock if the firm is at value
46
Copyright © 2019 Pearson Education, Inc.
12.3 EBIT-EPS approach to capital structure
1) A corporation borrows $1,000,000 at 10 percent annual rate of interest. The firm has a 21
percent tax rate. The yearly, after-tax cost of this debt is ________.
A) $21,000
B) $79,000
C) $100,000
D) $126,582
2) A corporation has $5,000,000 of 8 percent preferred stock outstanding and a 21 percent tax
rate. The after-tax cost of the preferred stock is ________.
A) $506,329
B) $1,904,762
C) $666,667
D) $400,000
3) A corporation has $10,000,000 of 10 percent preferred stock outstanding and a 21 percent tax
rate. The amount of earnings before interest and taxes (EBIT) required to pay the preferred
dividends is ________.
A) $1,000,000
B) $210,000
C) $790,000
D) $1,265,823
4) A corporation has $5,000,000 of 6 percent bonds and $9,600,000 of 5 percent preferred stock
outstanding. The firm’s financial breakeven (assuming a 21 percent tax rate) is ________.
A) $637,595
B) $1,387,595
C) $907,595
D) $780,000
5) The EBIT-EPS approach to capital structure involves selecting the capital structure that
maximizes earnings before interest and taxes (EBIT) over the expected range of earnings per
share (EPS).
6) The EBIT-EPS analysis tends to concentrate on maximization of earnings rather than
maximization of owners’ wealth.
7) The financial breakeven point represents the level of earnings after interest and taxes
necessary for a firm to cover its fixed operating and financial changes—that is, the point at
which dividends per share is equal to zero.
8) The higher the financial breakeven point and the steeper the slope of the capital structure line,
the greater the financial risk.
9) The higher the degree of financial leverage (DFL), the greater the leverage a given financing
plan has, and the steeper its slope when plotted on EBIT-EPS axes.
10) The steeper the slope of the EBIT-EPS capital structure line, the lower is the financial risk.
11) Because risk premiums increase with increases in financial leverage, maximizing EPS does
not assure owners’ wealth maximization.
12) The basic shortcoming of EBIT-EPS analysis is that this model focuses on the maximization
of earnings rather than on the maximization of owner wealth as reflected in a firm’s stock price.
13) The basic shortcoming of EBIT-EPS analysis is that this model focuses on the maximization
of stock returns rather than on the maximization of share price.
14) In the EBIT-EPS approach to capital structure, risk is represented by ________.
A) the slope of the capital market line
B) shifts in the cost of debt capital
C) the slope of the capital structure line
D) shifts in the times-interest-earned ratio
15) A firm has a current capital structure consisting of $400,000 of 6 percent annual interest debt
and 50,000 shares of common stock. The firm’s tax rate is 21 percent on ordinary income. If the
EBIT is expected to be $200,000, the firm’s earnings per share will be ________.
A) $3.12
B) $0.74
C) $3.52
D) $2.78
16) The EBIT-EPS approach to capital structure proposes that an optimal capital structure be
selected which ________.
A) maximizes the weighted average cost of capital
B) minimizes the cost of debt
C) maximizes the EPS
D) minimizes dividends
17) A firm has interest expense of $145,000, preferred dividends of $25,000, and a tax rate of 21
percent. The firm’s financial breakeven point is ________.
A) $25,000
B) $201,646
C) $176,646
D) $145,000
18) A firm has a current capital structure consisting of $400,000 of 6 percent annual interest debt
and 50,000 shares of common stock. The firm’s tax rate is 21 percent on ordinary income. If the
EBIT is expected to be $200,000, two EBIT-EPS coordinates for the firm’s existing capital
structure are ________.
A) ($24,000, $0) and ($200,000, $0.74)
B) ($24,000, $0) and ($200,000, $2.78)
C) ($0, $24,000) and ($200,000, $1.82)
D) ($24,000, $0) and ($200,000, $3.52)
19) The major shortcoming of the EBIT-EPS approach to capital structure is that ________.
A) the technique does not promote the maximization of shareholder wealth
B) the technique does not consider the cost of capital
C) the technique only considers leverage-related risk
D) the technique does not maximize earnings per share
20) The basic shortcoming of the EBIT-EPS approach to capital structure is ________.
A) that the optimal capital structure is difficult to compute
B) its disregard for the presence of preferred stock in the capital structure
C) its disregard for the firm’s dividend policy
D) that it concentrates on the maximization of EPS rather than the maximization of owner’s
wealth
21) Assuming a 21 percent tax rate, what is the financial breakeven point for each plan? (See
Table 13.1)
22) What is the degree of financial leverage at a base level EBIT of $120,000 for both financing
plans? The firm has a 21 percent tax rate. (See Table 13.1)
23) What is the EPS under Financing Plan 1, if the firm projects EBIT of $200,000 and has a tax
rate of 21 percent? (See Table 13.1)
24) At about what EBIT level should the financial manager be indifferent to either plan? (See
Table 13.1)
25) Which plan has a higher degree of financial leverage and financial risk? (See Table 13.1)
26) Frankline Coin, Inc. is considering two capital structures. The key information follows.
Assume a 40 percent tax rate and expected EBIT of $50,000.
(a) Calculate two EBIT-EPS coordinates for each of the structures.
(b) Indicate over what EBIT range, if any, each structure is preferred.
1) Minimizing the weighted average cost of capital allows management to undertake a larger
number of profitable projects, thereby further increasing the value of a firm.
2) Optimal capital structure is the capital structure at which the weighted average cost of capital
is minimized, thereby maximizing a firm’s value.
3) An increase in fixed operating and financial cost results in an increase in risk, since the firm
will have to achieve a higher level of sales just to break even.
4) The cost of equity is greater than the cost of debt and increases with increasing financial
leverage, but generally less rapidly than the cost of debt.
5) The cost of equity increases with increasing financial leverage in order to compensate the
stockholders for the higher degree of financial risk.
6) As financial leverage increases, the cost of debt initially remains constant and then rises, while
the cost of equity always rises.
7) If we assume that EBIT is constant, the value of a firm is maximized by minimizing the
weighted average cost of capital.
8) In theory, a firm’s optimal capital structure is that which minimized the firm’s overall cost of
capital resulting in a maximization of the market value of a firm.
9) The overriding objective of the capital structure decision should be to choose the level of debt
that results in the largest possible share price.
10) The optimal capital structure is the one that balances ________.
A) return and risk factors in order to maximize profits
B) return and risk factors in order to maximize earnings per share
C) return and risk factors in order to maximize market value
D) return and risk factors in order to maximize dividends
11) Beginning with a zero-leverage company, as debt is substituted for equity in the capital
structure ________.
A) the overall cost of capital first rises, reaches a maximum, and then declines
B) the overall cost of capital declines
C) the overall cost of capital first declines, reaches a minimum, and then rises
D) the overall cost of capital rises
12) Poor capital structure decisions can result in ________ the cost of capital, resulting in
________ acceptable investments.
A) increasing; fewer
B) decreasing; more
C) increasing; more
D) decreasing; fewer
13) According to the traditional approach to capital structure, the value of a firm will be
maximized when ________.
A) the financial leverage is maximized
B) the cost of debt is minimized
C) the weighted average cost of capital is minimized
D) the dividend payout is maximized
14) In the traditional approach to capital structure, as the amount of debt increases in a firm’s
capital structure, ________.
A) the cost of equity rises faster than the cost of debt
B) the cost of debt rises faster than the cost of equity
C) debt becomes less risky
D) equity cost is unaffected
15) The value of a firm at optimum capital structure is computed as ________.
A) earnings before interest and taxes times one less tax rate divided by one plus weighted
average cost of capital
B) earnings before interest and taxes times one less tax rate divided by weighted average cost of
capital
C) operating cash flow divided by weighted average cost of capital
D) operating cash flow divided by one plus weighted average cost of capital
16) 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. Assuming this as
the optimum capital structure, the value of the firm is ________.
A) $1.4 million
B) $2.2 million
C) $1.8 million
D) $6.0 million
17) A firm is analyzing two possible capital structures—30 and 50 percent debt ratios. The firm
has total assets of $5,000,000 and common stock valued at $50 per share. The firm has a
marginal tax rate of 40 percent on ordinary income. The number of common shares outstanding
for each of the capital structures would be ________.
A) 30 percent debt ratio: 30,000 shares and 50 percent debt ratio: 50,000 shares
B) 30 percent debt ratio: 50,000 shares and 50 percent debt ratio: 70,000 shares
C) 30 percent debt ratio: 70,000 shares and 50 percent debt ratio: 100,000 shares
D) 30 percent debt ratio: 70,000 shares and 50 percent debt ratio: 50,000 shares
18) A firm is analyzing two possible capital structures—30 and 50 percent debt ratios. The firm
has total assets of $5,000,000 and common stock valued at $50 per share. The firm has a
marginal tax rate of 40 percent on ordinary income. If the interest rate on debt is 7 percent and 9
percent for the 30 percent and the 50 percent debt ratios, respectively, the amount of interest on
the debt under each of the capital structures being considered would be ________.
A) 30 percent debt ratio: $105,000 and 50 percent debt ratio: $225,000
B) 30 percent debt ratio: $245,000 and 50 percent debt ratio: $225,000
C) 30 percent debt ratio: $105,000 and 50 percent debt ratio: $250,000
D) 30 percent debt ratio: $135,000 and 50 percent debt ratio: $175,000
19) Firms having stable and predictable revenues can more safely employ highly leveraged
capital structures than can firms with volatile patterns of sales revenue.
20) Harry Trading Company must choose its optimal capital structure. Currently, the firm has a
20 percent debt ratio and the firm expects to generate a dividend next year of $5.44 per share.
Dividends are expected to remain at this level indefinitely. Stockholders currently require a 12.1
percent return on their investment. Harry is considering changing its capital structure if it would
benefit shareholders. The firm estimates that if it increases the debt ratio to 30 percent, it will
increase its expected dividend to $5.82 per share. Again, dividends are expected to remain at this
new level indefinitely. However, because of the added risk, the required return demanded by
stockholders will increase to 12.6 percent. Based on this information, should Harry make the
change?
A) Yes, since the value of the firm will increase by $1.23 per share.
B) No, since the value of the firm will decrease by $1.23 per share.
C) Yes, since the value of the firm will increase by $0.25 per share.
D) No, since the value of the firm will decrease by $0.25 per share.
21) The reason why maximizing share value and maximizing EPS do not give the same optimal
capital structure is because ________.
A) EPS maximization does not consider risk
B) share value maximization does not consider risk
C) EPS maximization considers cash flows
D) EPS maximization does consider risk
22) 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 expected to 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.