Chapter 13: Capital Structure and Leverage
Copyright Cengage Learning. Powered by Cognero.
Page 21
50. Firms U and L each have the same amount of assets, investor-supplied capital, and both have a return on investors’
capital (ROIC) of 12%. Firm U is unleveraged, i.e., it is 100% equity financed, while Firm L is financed with 50% debt
and 50% equity. Firm L’s debt has an after-tax cost of 8%. Both firms have positive net income and a 35% tax rate. Which
of the following statements is CORRECT?
a. The two companies have the same times interest earned (TIE) ratio.
b. Firm L has a lower ROA than Firm U.
c. Firm L has a lower ROE than Firm U.
d. Firm L has the higher times interest earned (TIE) ratio.
e. Firm L has a higher EBIT than Firm U.
51. Your firm is currently 100% equity financed. The CFO is considering a recapitalization plan under which the firm
would issue long-term debt with an after-tax yield of 9% and use the proceeds to repurchase some of its common stock.
The recapitalization would not change the company’s total investor-supplied capital, the size of the firm (i.e., total assets),
and it would not affect the firm’s return on investors’ capital (ROIC), which is 15%. The CFO believes that this
recapitalization would reduce the firm’s WACC and increase its stock price. Which of the following would be likely to
occur if the company goes ahead with the recapitalization plan?
a. The company’s net income would increase.
b. The company’s earnings per share would decline.
c. The company’s cost of equity would increase.
d. The company’s ROA would increase.
e. The company’s ROE would decline.
Copyright Cengage Learning. Powered by Cognero.
Page 23
54. Other things held constant, which of the following events would be most likely to encourage a firm to increase the
amount of debt in its capital structure?
a. Its sales are projected to become less stable in the future.
b. The bankruptcy laws are changed in a way that would make bankruptcy more costly to the firm and its
stockholders.
c. Management believes that the firm’s stock is currently overvalued.
d. The firm decides to automate its factory with specialized equipment and thus increase its use of operating
leverage.
e. The corporate tax rate is increased.
55. Which of the following statements is CORRECT?
a. A firm can use retained earnings without paying a flotation cost. Therefore, while the cost of retained earnings is
not zero, its cost is generally lower than the after-tax cost of debt.
b. The capital structure that minimizes a firm’s weighted average cost of capital is also the capital structure that
maximizes its stock price.
c. The capital structure that minimizes the firm’s weighted average cost of capital is also the capital structure that
maximizes its earnings per share.
d. If a firm finds that the cost of debt is less than the cost of equity, increasing its debt ratio must reduce its WACC.
e. Other things held constant, if corporate tax rates declined, then the Modigliani-Miller tax-adjusted theory would
suggest that firms should increase their use of debt.
56. Which of the following statements is CORRECT?
Chapter 13: Capital Structure and Leverage
Copyright Cengage Learning. Powered by Cognero.
Page 24
a. The capital structure that maximizes the stock price is also the capital structure that minimizes the cost of equity
from retained earnings (rS).
b. The capital structure that maximizes the stock price is also the capital structure that maximizes earnings per share.
c. The capital structure that maximizes the stock price is also the capital structure that maximizes the firm’s times
interest earned (TIE) ratio.
d. If a company increases its debt ratio, this will typically increase the marginal costs of both debt and equity, but it
still may reduce the company’s WACC.
e. If Congress were to pass legislation that increases the personal tax rate but decreases the corporate tax rate, this
would encourage companies to increase their debt ratios.
57. Which of the following statements is CORRECT?
a. In general, a firm with low operating leverage also has a small proportion of its total costs in the form of fixed
costs.
b. There is no reason to think that changes in the personal tax rate would affect firms’ capital structure decisions.
c. A firm with a relatively high business risk is more likely to increase its use of financial leverage than a firm with
low business risk, assuming all else equal.
d. If a firm’s after-tax cost of equity exceeds its after-tax cost of debt, it can always reduce its WACC by increasing
its use of debt.
e. Suppose a firm has less than its optimal amount of debt. Increasing its use of debt to the point where it is at its
optimal capital structure will decrease the costs of both debt and equity.
Copyright Cengage Learning. Powered by Cognero.
Page 25
58. Companies HD and LD have identical amounts of assets, investor-supplied capital, operating income (EBIT), tax
rates, and business risk. Company HD, however, has a higher debt ratio than LD. Company HD’s return on investors’
capital (ROIC) exceeds its after-tax cost of debt, rd(1 – T). Which of the following statements is CORRECT?
a. Company HD has a higher return on assets (ROA) than Company LD.
b. Company HD has a higher times interest earned (TIE) ratio than Company LD.
c. Company HD has a higher return on equity (ROE) than Company LD, and its risk as measured by the standard
deviation of ROE is also higher than LD’s.
d. The two companies have the same ROE.
e. Company HD’s ROE would be higher if it had no debt.
59. Companies HD and LD have the same total assets, total investor-supplied capital, operating income (EBIT), tax rate,
and business risk. Company HD, however, has a much higher debt ratio than LD. Also, both companies’ returns on
investors’ capital (ROIC) exceed their after-tax costs of debt, rd(1 – T). Which of the following statements is CORRECT?
a. HD should have a higher return on assets (ROA) than LD.
b. HD should have a higher times interest earned (TIE) ratio than LD.
c. HD should have a higher return on equity (ROE) than LD, but its risk, as measured by the standard deviation of
ROE, should also be higher than LD’s.
d. Given that ROIC > rd(1 – T), HD’s stock price must exceed that of LD.
e. Given that ROIC > rd(1 – T), LD’s stock price must exceed that of HD.
60. Which of the following statements is CORRECT?
Chapter 13: Capital Structure and Leverage
Copyright Cengage Learning. Powered by Cognero.
Page 26
a. If Congress lowered corporate tax rates while other things were held constant, and if the Modigliani-Miller tax-
adjusted theory of capital structure were correct, this would tend to cause corporations to decrease their use of debt.
b. A change in the personal tax rate should not affect firms’ capital structure decisions.
c. “Business risk” is differentiated from “financial risk” by the fact that financial risk reflects only the use of debt,
while business risk reflects both the use of debt and such factors as sales variability, cost variability, and operating
leverage.
d. The optimal capital structure is the one that simultaneously (1) maximizes the price of the firm’s stock, (2)
minimizes its WACC, and (3) maximizes its EPS.
e. If changes in the bankruptcy code made bankruptcy less costly to corporations, this would likely reduce the
average corporation’s debt ratio.
61. Which of the following statements is CORRECT?
a. When a company increases its debt ratio, the costs of equity and debt both increase. Therefore, the WACC must
also increase.
b. The capital structure that maximizes the stock price is generally the capital structure that also maximizes earnings
per share.
c. All else equal, an increase in the corporate tax rate would tend to encourage companies to increase their debt
ratios.
d. Since debt financing raises the firm’s financial risk, increasing a company’s debt ratio will always increase its
WACC.
e. Since the cost of debt is generally fixed, increasing the debt ratio tends to stabilize net income.
Copyright Cengage Learning. Powered by Cognero.
Page 27
62. Which of the following statements is CORRECT?
a. Generally, debt ratios do not vary much among different industries, although they do vary among firms within a
given industry.
b. Electric utilities generally have very high common equity ratios because their revenues are more volatile than
those of firms in most other industries.
c. Airline companies tend to have very volatile earnings, and as a result they generally have high target debt-to–
equity ratios.
d. Wide variations in capital structures exist both between industries and among individual firms within given
industries. These differences are caused by differing business risks and also managerial attitudes.
e. Since most stocks sell at or very close to their book values, book value capital structures are typically adequate for
use in estimating firms’ weighted average costs of capital.
63. Longstreet Inc. has fixed operating costs of $670,000, variable costs of $2.75 per unit produced, and its product sells
for $3.95 per unit. What is the company’s break-even point, i.e., at what unit sales volume would income equal costs?
a. 558,333
b. 491,333
c. 686,750
d. 653,250
e. 446,667
Chapter 13: Capital Structure and Leverage
Copyright Cengage Learning. Powered by Cognero.
Page 30
calculations. (Hint: Find BEB – BEA)
Machine A Machine B
Price per pair (P) $25.50 $25.50
Fixed costs (F) $25,000 $100,000
Variable cost/unit (V) $7.00 $4.00
a. 3,762
b. 3,135
c. 2,640
d. 3,564
e. 3,300
68. Your company plans to produce a new product, a wireless computer mouse. Two machines can be used to make the
mouse, Machines A and B. The price per mouse will be $23.00 regardless of which machine is used. The fixed and
variable costs associated with the two machines are shown below. At the expected sales level of 40,000 units, how much
higher or lower will the firm’s expected EBIT be if it uses Machine B with high fixed costs rather than Machine A with
low fixed costs, i.e., what is EBITB – EBITA ?
Machine A Machine B
Price per mouse (P) $23.00 $23.00
Fixed costs (F) $100,000 $400,000
Variable cost/unit (V) $16.00 $8.00
Exp. unit sales (Q) 40,000 40,000
a. $17,600
b. $18,400
c. $18,600
d. $18,000
Chapter 13: Capital Structure and Leverage
Copyright Cengage Learning. Powered by Cognero.
Page 31
e. $20,000
69. Your company, which is financed entirely with common equity, plans to manufacture a new product, a cell phone that
can be worn like a wristwatch. Two robotic machines are available to make the phone, Machine A and Machine B. The
price per phone will be $250.00 regardless of which machine is used to make it. The fixed and variable costs associated
with the two machines are shown below, along with the capital (all equity) that must be invested to purchase each
machine. The expected sales level is 33,000 units. Your company has tax loss carry-forwards that will cause its tax rate to
be zero for the life of the project, so T = 0. How much higher or lower will the project’s ROE be if you select the machine
that produces the higher ROE, i.e., what is ROEB – ROEA? (Hint: Since the firm uses no debt and its tax rate is zero, ROE
= EBIT/Required investment.)
Machine A Machine B
Price per phone (P) $250.00 $250.00
Fixed costs (F) $1,000,000 $2,000,000
Variable cost/unit (V) $200.00 $150.00
Expected unit sales (Q) 33,000 33,000
Required equity investment $2,500,000 $3,000,000
a. 20.97%
b. 15.77%
c. 19.76%
d. 16.29%
e. 17.33%
