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Chapter 13: Capital Structure True/False Page 475
(Difficulty Levels: Easy, Easy/Medium, Medium, Medium/Hard, and Hard)
Note that there is some overlap between the T/F and the multiple choice questions, as some T/F
statements are used in the MC questions. See the preface for information on the AACSB letter
indicators (F, M, etc.) on the subject lines.
Multiple Choice: True/False
1. A firm's business risk is largely determined by the financial
characteristics of its industry, especially by the amount of debt the
average firm in the industry uses.
a. True
b. False
2. Financial risk refers to the extra risk borne by stockholders as a
result of a firm's use of debt as compared with their risk if the firm
had used no debt.
a. True
b. False
3. A firm’s capital structure does not affect its free cash flows as
discussed in the text, because FCF reflects only operating cash flows,
which are available to service debt, to pay dividends to stockholders,
and for other purposes.
a. True
b. False
4. If a firm borrows money, it is using financial leverage.
a. True
b. False
5. Other things held constant, an increase in financial leverage will
increase a firm's market (or systematic) risk as measured by its beta
coefficient.
a. True
b. False
CHAPTER 13
CAPITAL STRUCTURE AND LEVERAGE
Page 476 True/False Chapter 13: Capital Structure
6. The graphical probability distribution of ROE for a firm that uses
financial leverage would tend to be more peaked than the distribution
if the firm used no leverage, other things held constant.
a. True
b. False
7. Provided a firm does not use an extreme amount of debt, operating
leverage typically affects only EPS, while financial leverage affects
both EPS and EBIT.
a. True
b. False
8. The trade-off theory states that capital structure decisions involve a
tradeoff between the costs and benefits of debt financing.
a. True
b. False
9. Different borrowers have different risks of bankruptcy, and if a
borrower goes bankrupt, its lenders will probably not get back the full
amount of funds that they loaned. Therefore, lenders charge higher
rates to borrowers judged to be more likely to go bankrupt.
a. True
b. False
10. Modigliani and Miller (MM) won Nobel Prizes for their work on capital
structure theory.
a. True
b. False
11. Modigliani and Miller's first article led to the conclusion that
capital structure is "irrelevant" because it has no effect on a firm's
value.
a. True
b. False
12. Modigliani and Miller's first article led to the conclusion that
capital structure is extremely important, and that every firm has an
optimal capital structure that maximizes its value and minimizes its
cost of capital.
a. True
b. False
Chapter 13: Capital Structure True/False Page 477
13. It is possible for Firms A and B to have identical financial and
operating leverage, yet for Firm A to have more risk as measured by the
variability of EPS. This would occur if Firm A has more business risk
than Firm B.
a. True
b. False
14. As the text indicates, a firm's financial risk can and should be
divided into separate market and diversifiable risk components.
a. True
b. False
15. If two firms have the same expected earnings per share (EPS) and the
same standard deviation of expected EPS, then they must have the same
amount of business risk.
a. True
b. False
16. In a world with no taxes, Modigliani and Miller (MM) show that a firm's
capital structure does not affect its value. However, when taxes are
considered, MM show a positive relationship between debt and value,
i.e., the firm's value rises as it uses more and more debt, other
things held constant.
a. True
b. False
17. According to Modigliani and Miller (MM), in a world without taxes the
optimal capital structure for a firm is approximately 100% debt
financing.
a. True
b. False
18. According to Modigliani and Miller (MM), in a world with corporate
income taxes the optimal capital structure calls for approximately 100%
debt financing.
a. True
b. False
19. According to Modigliani and Miller (MM), in a world without corporate
income taxes the use of debt has no effect on the firm's value.
Page 478 True/False Chapter 13: Capital Structure
a. True
b. False
20. Modigliani and Miller's first article led to the conclusion that
capital structure is "irrelevant" because it has no effect on a firm's
value. However, that article was criticized because it assumed that no
taxes existed. MM then revised their original article to include
corporate taxes, and this model led to the conclusion that a firm's
value would be maximized if it used (almost) 100% debt.
a. True
b. False
21. Modigliani and Miller's second article, which assumed the existence of
corporate income taxes, led to the conclusion that a firm's value would
be maximized, and its cost of capital minimized, if it used (almost)
100% debt. However, this model did not take account of bankruptcy
costs. The existence of bankruptcy costs leads to the assumption of an
optimal capital structure where the debt ratio is less than 100%.
a. True
b. False
22. The Miller model begins with the Modigliani and Miller (MM) model with
corporate taxes and then adds personal taxes.
a. True
b. False
23. The Miller model begins with the Modigliani and Miller (MM) model
without corporate taxes and then adds personal taxes.
a. True
b. False
24. The Modigliani and Miller (MM) articles implicitly assumed that
bankruptcy did not exist. That led to the development of the "trade-
off" model, where the firm's value first rises with the use of debt due
to the tax shelter of debt, but later falls as more debt is added
because the potential costs of bankruptcy begin to more than offset the
tax shelter benefits. Under the trade-off theory, an optimal capital
structure exists.
a. True
b. False
25. Modigliani and Miller (MM), in their second article, took account of
taxes, bankruptcy, and other factors that were assumed away in their
original article. Once they took account of all these assumptions,
Chapter 13: Capital Structure True/False Page 479
they concluded that every firm has a unique optimal capital structure.
Moreover, a manager can use the second MM model to determine his or her
firm's optimal debt ratio.
a. True
b. False
26. Some people--including the current chairman of the Federal Reserve
Board of Governors (Ben Bernanke)--have argued that one advantage of
corporate debt from the stockholders' standpoint is that the existence
of debt forces managers to focus on cash flow and to refrain from
spending too much of the firm's money on private plane and other
"perks." This is one of the factors that led to the rise of LBOs and
private equity firms.
a. True
b. False
27. The Modigliani and Miller (MM) articles implicitly assumed, among other
things, that outside stockholders have the same information about a
firm's future prospects as its managers. That was called "symmetric
information," and it is questionable. The introduction of "asymmetric
information" led to the development of the "signaling" theory of
capital structure, which postulated that firms are reluctant to issue
new stock because investors will interpret such an act as a signal that
the firm's managers are worried about its future. Other actions give
off different signals, and the end result is that capital structure is
affected by managers' perceptions about how their financing decisions
will affect investors' views of the firm and thus its value.
a. True
b. False
28. According to the signaling theory of capital structure, firms first use
common equity for their capital, then use debt if and only if they can
raise no more equity on "reasonable" terms. This occurs because the
use of debt financing signals to investors that the firm's managers
think that the future does not look good.
a. True
b. False
29. Other things held constant, firms with more stable and predictable
sales tend to use more debt than firms with less stable sales.
a. True
b. False
Page 480 True/False Chapter 13: Capital Structure
30. Other things held constant, firms that use assets that can be sold
easily (like trucks) tend to use more debt than firms whose assets are
harder to sell (like those engaged in research and development).
a. True
b. False
Chapter 13: Capital Structure Conceptual M/C Page 481
31. Other things held constant, the lower a firm's tax rate, the more
logical it is for the firm to use debt.
a. True
b. False
32. A firm's treasurer likes to be in a position to raise funds to support
operations whenever such funds are needed, even in "bad times". This
is called "financial flexibility," and the lower the firm's debt ratio,
the greater its financial flexibility, other things held constant.
a. True
b. False
33. If a firm utilizes debt financing, a 10% decline in earnings before
interest and taxes (EBIT) will result in a decline in earnings per
share that is larger than 10%, and the higher the debt ratio, the
larger this difference will be.
a. True
b. False
Multiple Choice: Conceptual
34. An increase in the debt ratio will generally have no effect on which of
these items?
a. Business risk.
b. Total risk.
c. Financial risk.
d. Market risk.
e. The firm's beta.
35. Business risk is affected by a firm's operations. Which of the
following is NOT directly associated with (or does not directly
contribute to) business risk?
a. Demand variability.
b. Sales price variability.
c. The extent to which operating costs are fixed.
d. The extent to which interest rates on the firm's debt fluctuate.
e. Input price variability.
Page 482 Conceptual M/C Chapter 13: Capital Structure
36. Which of the following statements is CORRECT?
a. Since debt financing raises the firm's financial risk, increasing
the target debt ratio will always increase the WACC.
b. Since debt financing is cheaper than equity financing, raising a
company’s debt ratio will always reduce its WACC.
c. Increasing a company’s debt ratio will typically reduce the marginal
costs of both debt and equity financing. However, this action still
may raise the company’s WACC.
d. Increasing a company’s debt ratio will typically increase the
marginal costs of both debt and equity financing. However, this
action still may lower the company’s WACC.
e. Since a firm's beta coefficient is not affected by its use of
financial leverage, leverage does not affect the cost of equity.
37. Which of the following statements is CORRECT?
a. The capital structure that maximizes expected EPS also maximizes the
price per share of common stock.
b. The capital structure that minimizes the interest rate on debt also
maximizes the expected EPS.
c. The capital structure that minimizes the required return on equity
also maximizes the stock price.
d. The capital structure that minimizes the WACC also maximizes the
price per share of common stock.
e. The capital structure that gives the firm the best bond rating also
maximizes the stock price.
38. Based on the information below, what is the firm's optimal capital
structure?
a. Debt = 40%; Equity = 60%; EPS = $2.95; Stock price = $26.50.
b. Debt = 50%; Equity = 50%; EPS = $3.05; Stock price = $28.90.
c. Debt = 60%; Equity = 40%; EPS = $3.18; Stock price = $31.20.
d. Debt = 80%; Equity = 20%; EPS = $3.42; Stock price = $30.40.
e. Debt = 70%; Equity = 30%; EPS = $3.31; Stock price = $30.00.
39. Which of the following statements best describes the optimal capital
structure?
a. The optimal capital structure is the mix of debt, equity, and
preferred stock that maximizes the company’s earnings per share
(EPS).
b. The optimal capital structure is the mix of debt, equity, and
preferred stock that maximizes the company’s stock price.
c. The optimal capital structure is the mix of debt, equity, and
preferred stock that minimizes the company’s cost of equity.
d. The optimal capital structure is the mix of debt, equity, and
preferred stock that minimizes the company’s cost of debt.
Chapter 13: Capital Structure Conceptual M/C Page 483
e. The optimal capital structure is the mix of debt, equity, and
preferred stock that minimizes the company’s cost of preferred
stock.
40. Which of the following events is likely to encourage a company to raise
its target debt ratio, other things held constant?
a. An increase in the corporate tax rate.
b. An increase in the personal tax rate.
c. An increase in the company’s operating leverage.
d. The Federal Reserve tightens interest rates in an effort to fight
inflation.
e. The company's stock price hits a new high.
41. Which of the following would tend to increase a firm's target debt
ratio, other things held constant?
a. The costs associated with filing for bankruptcy increase.
b. The corporate tax rate is increased.
c. The personal tax rate is increased.
d. The Federal Reserve tightens interest rates in an effort to fight
inflation.
e. The company's stock price hits a new low.
42. Which of the following statements is CORRECT?
a. As a rule, the optimal capital structure is found by determining the
debt-equity mix that maximizes expected EPS.
b. The optimal capital structure simultaneously maximizes EPS and
minimizes the WACC.
c. The optimal capital structure minimizes the cost of equity, which is
a necessary condition for maximizing the stock price.
d. The optimal capital structure simultaneously minimizes the cost of
debt, the cost of equity, and the WACC.
e. The optimal capital structure simultaneously maximizes the stock
price and minimizes the WACC.
43. The firm’s target capital structure should do which of the following?
a. Maximize the earnings per share (EPS).
b. Minimize the cost of debt (rd).
c. Obtain the highest possible bond rating.
d. Minimize the cost of equity (rs).
e. Minimize the weighted average cost of capital (WACC).
44. Which of the following statements is CORRECT?
a. A firm’s business risk is determined solely by the financial
characteristics of its industry.
Page 484 Conceptual M/C Chapter 13: Capital Structure
b. The factors that affect a firm’s business risk include industry
characteristics and economic conditions, both of which are generally
beyond the firm's control.
c. One of the benefits to a firm of being at or near its target capital
structure is that this generally minimizes the risk of bankruptcy.
d. A firm’s financial risk can be minimized by diversification.
e. The amount of debt in its capital structure can under no
circumstances affect a company’s EBIT and business risk.
45. Which of the following statements is CORRECT? As a firm increases the
operating leverage used to produce a given quantity of output, this
a. normally leads to an increase in its fixed assets turnover ratio.
b. normally leads to a decrease in its business risk.
c. normally leads to a decrease in the standard deviation of its
expected EBIT.
d. normally leads to a decrease in the variability of its expected EPS.
e. normally leads to a reduction in its fixed assets turnover ratio.
46. A firm's CFO is considering increasing the target debt ratio, which
would also increase the company’s interest expense. New bonds would be
issued and the proceeds would be used to buy back shares of common
stock. Neither total assets nor operating income would change, but
expected earnings per share (EPS) would increase. Assuming the CFO’s
estimates are correct, which of the following statements is CORRECT?
a. Since the proposed plan increases the firm’s financial risk, the
stock price might fall even if EPS increases.
b. If the plan reduces the WACC, the stock price is likely to decline.
c. Since the plan is expected to increase EPS, this implies that net
income is also expected to increase.
d. If the plan does increase the EPS, the stock price will
automatically increase at the same rate.
e. Under the plan there will be more bonds outstanding, and that will
increase their liquidity and thus lower the interest rate on the
currently outstanding bonds.
47. Which of the following statements is CORRECT?
a. Increasing its use of financial leverage is one way to increase a
firm’s return on investors’ capital (ROIC).
b. If a firm lowered its fixed costs but increased its variable costs
by just enough to hold total costs at the present level of sales
constant, this would increase its operating leverage.
c. The debt ratio that maximizes expected EPS generally exceeds the
debt ratio that maximizes share price.
d. If a company were to issue debt and use the money to repurchase
common stock, this would reduce its return on investors’ capital
(ROIC). (Assume that the repurchase has no impact on the company’s
operating income.)
e. If a change in the bankruptcy code made bankruptcy less costly to
corporations, this would tend to reduce corporations' debt ratios.
Chapter 13: Capital Structure Conceptual M/C Page 485
48. Your firm has $500 million of investor-supplied capital, its return on
investors’ capital (ROIC) is 15%, and it currently has no debt in its
capital structure (i.e., wd = 0). The CFO is contemplating a
recapitalization where it would issue debt at an after-tax cost of 10%
and use the proceeds to buy back some of its common stock, such that
the percentage of common equity in the capital structure (wc) is 1 - wd.
If the company goes ahead with the recapitalization, its operating
income, the size of the firm (i.e., total assets), total investor-
supplied capital, and tax rate would remain unchanged. Which of the
following is most likely to occur as a result of the recapitalization?
a. The ROA would increase.
b. The ROA would remain unchanged.
c. The return on investors’ capital would decline.
d. The return on investors’ capital would increase.
e. The ROE would increase.
49. Companies HD and LD have identical tax rates, total assets, total
investor-supplied capital, and returns on investors’ capital (ROIC),
and their ROICs exceed their after-tax costs of debt, rd(1 – T).
However, Company HD has a higher debt ratio and thus more interest
expense than Company LD. Which of the following statements is CORRECT?
a. Company HD has a higher net income than Company LD.
b. Company HD has a lower ROA than Company LD.
c. Company HD has a lower ROE than Company LD.
d. The two companies have the same ROA.
e. The two companies have the same ROE.
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.
Page 486 Conceptual M/C Chapter 13: Capital Structure
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.
52. A major contribution of the Miller model is that it demonstrates, other
things held constant, that
a. personal taxes increase the value of using corporate debt.
b. personal taxes lower the value of using corporate debt.
c. personal taxes have no effect on the value of using corporate debt.
d. financial distress and agency costs reduce the value of using
corporate debt.
e. debt costs increase with financial leverage.
53. Which of the following statements is CORRECT, holding other things
constant?
a. Firms whose assets are relatively liquid tend to have relatively low
bankruptcy costs, hence they tend to use relatively little debt.
b. An increase in the personal tax rate is likely to increase the debt
ratio of the average corporation.
c. If changes in the bankruptcy code make bankruptcy less costly to
corporations, then this would likely lead to lower debt ratios for
corporations.
d. An increase in the company’s degree of operating leverage would tend
to encourage the firm to use more debt in its capital structure so
as to keep its total risk unchanged.
e. An increase in the corporate tax rate would in theory encourage
companies to use more debt in their capital structures.
Chapter 13: Capital Structure Conceptual M/C Page 487
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?
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.
Page 488 Conceptual M/C Chapter 13: Capital Structure
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.
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.
Chapter 13: Capital Structure Conceptual M/C Page 489
60. Which of the following statements is CORRECT?
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.
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.
Page 490 M/C Problems Chapter 13: Capital Structure
Multiple Choice: Problems
Some of these problems are conceptually difficult, and they are designated as HARD. Others are
not conceptually difficult, but they require a good bit of arithmetic. Please take this into account
when making up timed tests.
63. Longstreet Inc. has fixed operating costs of $470,000, variable costs
of $2.80 per unit produced, and its product sells for $4.00 per unit.
What is the company's break-even point, i.e., at what unit sales volume
would income equal costs?
a. 391,667
b. 411,250
c. 431,813
d. 453,403
e. 476,073
64. Your uncle is considering investing in a new company that will produce
high quality stereo speakers. The sales price would be set at 1.5
times the variable cost per unit; the variable cost per unit is
estimated to be $75.00; and fixed costs are estimated at $1,200,000.
What sales volume would be required to break even, i.e., to have EBIT =
zero?
a. 28,880
b. 30,400
c. 32,000
d. 33,600
e. 35,280
65. Southwest U's campus book store sells course packs for $15 each, the
variable cost per pack is $9, fixed costs to produce the packs are
$200,000, and expected annual sales are 50,000 packs. What are the
pre-tax profits from sales of course packs?
a. $ 72,900
b. $ 81,000
c. $ 90,000
d. $100,000
e. $110,000
66. Southwest U's campus book store sells course packs for $16 each. The
variable cost per pack is $10, and at current annual sales of 50,000
packs, the store earns $75,000 before taxes on course packs. How much
are the fixed costs of producing the course packs?
a. $164,025
b. $182,250
c. $202,500
d. $225,000
Chapter 13: Capital Structure M/C Problems Page 491
e. $247,500
67. Assume that you and your brother plan to open a business that will make
and sell a newly designed type of sandal. Two robotic machines are
available to make the sandals, Machine A and Machine B. The price per
pair will be $20.00 regardless of which machine is used. The fixed and
variable costs associated with the two machines are shown below. What
is the difference between the break-even points for Machines A and B?
(Hint: Find BEB - BEA)
Machine A Machine B
Price per pair (P) $20.00 $20.00
Fixed costs (F) $25,000 $100,000
Variable cost/unit (V) $7.00 $4.00
a. 3,154
b. 3,505
c. 3,894
d. 4,327
e. 4,760
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 $25.00 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 75,000 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) $25.00 $25.00
Fixed costs (F) $100,000 $400,000
Variable cost/unit (V) $15.25 $9.00
Exp. unit sales (Q) 75,000 75,000
a. $123,019
b. $136,688
c. $151,875
d. $168,750
e. $185,625
Page 492 M/C Problems Chapter 13: Capital Structure
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 25,000 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) 25,000 25,000
Required equity investment $2,500,000 $3,000,000
a. 6.00%
b. 6.67%
c. 7.00%
d. 7.35%
e. 7.72%
70. You work for the CEO of a new company that plans to manufacture and
sell a new product, a watch that has an embedded TV set and a
magnifying glass crystal. The issue now is how to finance the company,
with only equity or with a mix of debt and equity. Expected operating
income is $400,000. Other data for the firm are shown below. How much
higher or lower will the firm's expected ROE be if it uses some debt
rather than all equity, i.e., what is ROEL - ROEU?
0% Debt, U 60% Debt, L
Oper. income (EBIT) $400,000 $400,000
Required investment $2,500,000 $2,500,000
% Debt 0.0% 60.0%
$ of Debt $0.00 $1,500,000
$ of Common equity $2,500,000 $1,000,000
Interest rate NA 10.00%
Tax rate 35% 35%
a. 5.85%
b. 6.14%
c. 6.45%
d. 6.77%
e. 7.11%
