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Chapter 12 – Capital Structure
60. If debt financing is used, which of the following is correct?
a. The percentage change in net operating income is greater than a given percentage change in net income.
b. The percentage change in net operating income is equal to a given percentage change in net income.
c. The percentage change in net operating income depends on the interest rate charged on debt.
d. The percentage change in net operating income is less than the percentage change in net income.
e. The degree of operating leverage is greater than 1.
61. Which of the following statements is correct?
a. The degree of operating leverage (DOL) depends on a company’s fixed costs, variable costs, and sales. The
DOL formula assumes (1) that fixed costs are constant and (2) that variable costs are a constant proportion
of sales.
b. The degree of total leverage (DTL) is equal to the DOL plus the degree of financial leverage (DFL).
c. Arithmetically, financial leverage and operating leverage offset one another so as to keep the degree of total
leverage constant.
d. The above statements are all true.
e. The above statements are all false.
62. Which of the following statements is correct?
a. Suppose Company A’s EPS is expected to experience a larger percentage change in response to a given
percentage change in sales than Company B’s EPS. Other things held constant, Company A would appear to
have more business risk than Company B.
b. Statement a would be correct if the term “EBIT” were substituted for “EPS.”
c. Statement a would be correct if the term “EBIT” were substituted for “sales.”
d. Statement a would be correct if the words “financial risk” were substituted for “business risk.”
e. The above statements are all false.
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Chapter 12 – Capital Structure
63. Which of the following are practical difficulties associated with capital structure and degree of leverage analyses?
a. It is nearly impossible to determine exactly how P/E ratios or equity capitalization rates (rs values) are
affected by different degrees of financial leverage.
b. Managers’ attitudes toward risk differ and some managers may set a target capital structure other than the
one that would maximize stock price.
c. Managers often have a responsibility to provide continuous service; they must preserve the long-run viability
of the enterprise. Thus, the goal of employing leverage to maximize short-run stock price and minimize capital
cost may conflict with long–run viability.
d. All of the above.
e. None of the above represent a serious impediment to the practical application of leverage analysis to capital
structure determination.
64. Which of the following statements is correct?
a. When financial leverage is used, the graphical probability distribution of net income would tend to be more
peaked than a distribution where no leverage is present, other things held constant.
b. From an operational standpoint the goal of maintaining financial flexibility translates into maintaining adequate
reserve borrowing capacity.
c. While business risk varies form one industry to another and can change over time, it affects all firms equally
within a particular industry.
d. The optimal capital structure is the one that maximizes EBIT, and this always calls for a debt ratio which is
lower than the one that maximizes expected EPS.
e. The above statements are all false.
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Chapter 12 – Capital Structure
65. Which of the following statements is correct?
a. There have been no significant observed differences in the capital structures of U.S. corporations in
comparison to their German and Japanese counterparts.
b. Different countries use essentially the same international accounting conventions with respect to reporting
assets on a historical versus replacement cost basis.
c. An analysis of both bankruptcy and equity reporting costs leads to the conclusion that U.S. firms should have
more equity and less debt than firms in Japan and Germany.
d. Equity monitoring costs are higher in the United States than in Japan and Germany.
e. Debt monitoring costs are probably lower in the United States than in Japan and Germany.
66. Which of the following is not one of the four primary factors that influence capital structure decisions?
a. The firm‘s business risk.
b. The firm’s tax position.
c. The firm‘s financial flexibility.
d. The firm’s inventory valuation method.
e. The firm‘s managerial attitude.
67. The optimal capital structure is the one that maximizes , and this will always be lower than the debt/equity ratio
that maximizes .
a. expected EPS; the firm’s stock price
b. net income, expected EPS
c. book value of the firm; net income
d. expected EPS; book value of the firm
e. the firm’s stock price; expected EPS
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Chapter 12 – Capital Structure
68. If a change in sales results in a greater relative change in operating income (EBIT), we know that the firm has
a. a degree of operating leverage greater than one.
b. a degree of financial leverage greater than one.
c. a degree of operating leverage less than one.
d. a degree of financial leverage less than one.
e. none of the above.
69. If a given change in EBIT results in a larger relative change in EPS then we can definitely say that the firm has
a. a degree of operating leverage greater than one.
b. a degree of operating leverage less than one.
c. a degree of financial leverage greater than one.
d. a degree of financial leverage less than one.
e. a degree of total leverage less than one.
70. If a given change in sales results in a larger relative change in EPS then we can definitely say that the firm has
a. a degree of financial leverage greater than one.
b. a degree of operating leverage less than one.
c. a degree of total leverage less than one.
d. a degree of financial leverage less than one.
e. a degree of total leverage greater than one.
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Chapter 12 – Capital Structure
71. All else equal, if a firm increases its leverage (either operating, financial, or both), its weighted average cost of
capital probably will
a. increase because risk increases.
b. decrease because risk decreases.
c. increase because risk decreases.
d. remain about the same because risk does not change.
e. change somehow, but more information is needed to determine the direction.
72. is the situation where investors and managers have the same (identical) information about the firm’s future
prospects.
a. Symmetric information
b. Asymmetric information
c. Leverage
d. Target capital structure
73. Which of the following is correct?
a. Generally, debt to total assets ratios do not vary much among different industries although they do vary for
firms within a particular industry.
b. Utilities generally have very high common equity ratios due to their need for vast amounts of equity supported
capital.
c. The drug industry has a high debt to common equity ratio because their earnings are very stable and thus, can
support the large interest costs associated with higher debt levels.
d. Wide variations in capital structures exist between industries and also between individual firms within
industries and are influenced by unique firm factors including managerial attitudes.
e. Since most stocks sell at or around their book values, using accounting values provides an accurate picture of
a firm’s capital structure.
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Chapter 12 – Capital Structure
74. Quick Launch Rocket Company, a satellite launching firm, expects its sales to increase by 50 percent in the coming
year as a result of NASA’s recent problems with the space shuttle. The firm’s current EPS is $3.25. Its degree of
operating leverage is 1.6, while its degree of financial leverage is 2.1. What is the firm’s projected EPS for the
coming year using the DTL approach?
a. $3.25
b. $5.46
c. $10.92
d. $8.71
e. $19.63
75. A firm expects to have a 15 percent increase in sales over the coming year. If it has operating leverage equal to 1.25
and financial leverage equal to 3.50, then what will be the percentage change in EPS?
a. 30%
b. 47%
c. 66%
d. 15%
e. 22%
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Chapter 12 – Capital Structure
76. Howell Enterprises is forecasting EPS of $4.00 per share for next year. The firm has 10,000 shares outstanding, it
pays 12 percent interest on its debt, and it faces a 40 percent marginal tax rate. Its estimated fixed costs are $80,000
while its variable costs are estimated at 40 percent of revenue. The firm’s target capital structure is 40 percent
equity and 60 percent debt and it has total assets of $400,000. On what level of sales is Howell basing its EPS
forecast?
a. $1,000,000
b. $480,400
c. $316,722
d. $292,445
e. $105,280
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Chapter 12 – Capital Structure
77. If the debt ratio is 50 percent, the interest rate on all debt is 8 percent, the tax rate is 50 percent, and the return on
equity is 10 percent, then the ratio of earnings before interest and taxes (EBIT) to total assets, or the basic earning
power ratio, must be
a. 10%.
b. 14%.
c. 12%.
d. 8%.
e. 16%.
78. Assume that a firm has a DFL of 1.25. If sales increase by 20 percent, the firm will experience a 60 percent
increase in EPS, and it will have an EBIT of $100,000. What will be the EBIT for this firm if sales do not increase?
a. $113,412
b. $100,000
c. $84,375
d. $67,568
e. $42,115
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Chapter 12 – Capital Structure
79. The “degree of leverage” concept is designed to show how changes in sales will affect EBIT and EPS. If a 10
percent increase in sales causes EPS to increase from $1.00 to $1.50, and if the firm uses no debt, then what is its
degree of operating leverage?
a. 3.6
b. 4.2
c. 4.7
d. 5.0
e. 5.5
80. Bell Brothers has $3,000,000 in sales. Its fixed costs are estimated to be $100,000, and its variable costs are equal to
fifty cents for every dollar of sales. The company has $1,000,000 in debt outstanding at a before-tax cost of 10
percent. If Bell Brothers’ sales were to increase by 20 percent, how much of a percentage increase would you
expect in the company‘s net income?
a. 15.66%
b. 18.33%
c. 19.24%
d. 21.50%
e. 23.08%
81. Calculate the current price per share (P0) for Olson Corporation, given the following information. The data all pertain
to the year just ended.
Sales = 10,000 units
Sales price per unit = $10
Variable cost per unit = $5
Fixed cost = $10,000
Long–term debt outstanding = $15,000
kd on all long–term debt = 5%
Tax rate = 30%
Common stock shares outstanding = 10,000 shares
Beta = 1.5
kRF = 5%
kM = 9%
Dividend payout ratio = 40%
Growth rate in earnings and dividends = 7%
a. $39.20
b. $57.84
c. $29.43
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Chapter 12 – Capital Structure
d. $61.90
e. None of the above.
82. Given the information below, calculate the expected growth rate (g) of dividends, using the constant growth model
,
Beta = 1.75; rRF = 7 percent; rM = 11 percent; dividend payout ratio = 30 percent; rd = 10 percent (paid) on all long-
term debt; P/E ratio = 10; sales = 5,000 units; sales price per unit = $5; variable cost per unit = $2; fixed cost =
$1,000; common stock shares outstanding = 5,000; long-term debt outstanding = $10,000; tax rate = 40 percent.
Assume equilibrium exists in the market.
a. 11.34%
b. 6.54%
c. 11.0%
d. 10.68%
e. 10.19%
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Chapter 12 – Capital Structure
CFIN4
Chapter 12 – Capital Structure
Copybold Corporation
Copybold Corporation is a start-up firm considering two alternative capital structures one is conservative and the
other aggressive. The conservative capital structure calls for a D/A ratio = 0.25, while the aggressive strategy call
for D/A = 0.75. Once the firm selects its target capital structure it envisions two possible scenarios for its operations:
Feast or Famine. The Feast scenario has a 60 percent probability of occurring and forecast EBIT in this state is
$60,000. The Famine state has a 40 percent chance of occurring and the EBIT is expected to be $20,000. Further, if
the firm selects the conservative capital structure its cost of debt will be 10 percent, while with the aggressive capital
structure its debt cost will be 12 percent. The firm will have $400,000 in total assets, it will face a 40 percent
marginal tax rate, and the book value of equity per share under either scenario is $10.00 per share.
83. Refer to Copybold Corporation. What is the difference between the EPS forecasts for Feast and Famine under
the aggressive capital structure?
a. $0
b. $1.48
c. $0.62
d. $0.98
e. $2.40
84. Refer to Copybold Corporation. What is the difference between the EPS forecasts for Feast and Famine under
the conservative capital structure?
a. $1.00
b. $0.80
c. $2.20
d. $0.44
e. $0
85. Refer to Copybold Corporation. What is the coefficient of variation of expected EPS under the aggressive capital
structure plan?
a. 1.00
b. 1.18
c. 2.45
d. 2.88
e. 3.76
86. Refer to Copybold Corporation. What is the coefficient of variation of expected EPS under the conservative
capital structure plan?
a. 0.58
b. 0.39
c. 0.15
d. 0.23
e. 1.00