CHAPTER 15—CAPITAL STRUCTURE DECISIONS
TRUE/FALSE
1. Different borrowers have different risks of bankruptcy, and bankruptcy is costly to lenders. Therefore,
lenders charge higher rates to borrowers judged to be more at risk of going bankrupt.
2. 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.
3. Financial risk refers to the extra risk stockholders bear as a result of using debt as compared with the
risk they would bear if no debt were used.
4. As the text indicates, a firm’s financial risk has identifiable market risk and diversifiable risk
components.
5. A firm’s capital structure does not affect its calculated free cash flows, because FCF reflects only
operating cash flows.
6. Whenever a firm borrows money, it is using financial leverage.
7. 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.
8. Provided a firm does not use an extreme amount of debt, financial leverage typically affects both EPS
and EBIT, while operating leverage only affects EBIT.
9. The trade-off theory states that the capital structure decision involves a tradeoff between the costs and
benefits of debt financing.
10. If a firm utilizes debt financing, an X% decline in earnings before interest and taxes (EBIT) will result
in a decline in earnings per share that is larger than X.
11. Firm A has a higher degree of business risk than Firm B. Firm A can offset this by using less financial
leverage. Therefore, the variability of both firms’ expected EBITs could actually be identical.
12. Two firms, although they operate in different industries, have the same expected earnings per share
and the same standard deviation of expected EPS. Thus, the two firms must have the same business
risk.
13. It is possible that two firms could have identical financial and operating leverage, yet have different
degrees of risk as measured by the variability of EPS.
14. If Miller and Modigliani had incorporated the costs of bankruptcy into their model, it is unlikely that
they would have concluded that 100% debt financing is optimal.
MULTIPLE CHOICE
1. Which of these items will not generally be affected by an increase in the debt ratio?
a.
Total risk.
b.
Financial risk.
c.
Market risk.
d.
The firm’s beta.
e.
Business risk.
2. Which of the following is NOT associated with (or does not contribute to) business risk? Recall that
business risk is affected by a firm’s operations.
a.
Sales price variability.
b.
The extent to which operating costs are fixed.
c.
The extent to which interest rates on the firm’s debt fluctuate.
d.
Input price variability.
e.
Demand variability.
3. 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 personal tax rate.
b.
An increase in the company‘s operating leverage.
c.
The Federal Reserve tightens interest rates in an effort to fight inflation.
d.
The company’s stock price hits a new high.
e.
An increase in the corporate tax rate.
4. Which of the following would increase the likelihood that a company would increase its debt ratio,
other things held constant?
a.
An increase in the corporate tax rate.
b.
An increase in the personal tax rate.
c.
The Federal Reserve tightens interest rates in an effort to fight inflation.
d.
The company’s stock price hits a new low.
e.
An increase in costs incurred when filing for bankruptcy.
5. Which of the following statements is CORRECT?
a.
Since debt financing is cheaper than equity financing, raising a company’s debt ratio will
always reduce its WACC.
b.
Increasing a company’s debt ratio will typically reduce the marginal cost of both debt and
equity financing. However, this action still may raise the company’s WACC.
c.
Increasing a company’s debt ratio will typically increase the marginal cost of both debt and
equity financing. However, this action still may lower the company’s WACC.
d.
Since a firm’s beta coefficient it not affected by its use of financial leverage, leverage does
not affect the cost of equity.
e.
Since debt financing raises the firm’s financial risk, increasing a company’s debt ratio will
always increase its WACC.
6. Which of the following statements is CORRECT?
a.
The capital structure that minimizes the interest rate on debt also maximizes the expected
EPS.
b.
The capital structure that minimizes the required return on equity also maximizes the stock
price.
c.
The capital structure that minimizes the WACC also maximizes the price per share of
common stock.
d.
The capital structure that gives the firm the best credit rating also maximizes the stock
price.
e.
The capital structure that maximizes expected EPS also maximizes the price per share of
common stock.
7. Based on the information below for Benson Corporation, what is the optimal capital structure?
a.
Debt = 50%; Equity = 50%; EPS = $3.05; Stock price = $28.90.
b.
Debt = 60%; Equity = 40%; EPS = $3.18; Stock price = $31.20.
c.
Debt = 80%; Equity = 20%; EPS = $3.42; Stock price = $30.40.
d.
Debt = 70%; Equity = 30%; EPS = $3.31; Stock price = $30.00.
e.
Debt = 40%; Equity = 60%; EPS = $2.95; Stock price = $26.50.
8. Which of the following statements best describes the optimal capital structure? The optimal capital
structure is the mix of debt, equity, and preferred stock that maximizes the company’s ____.
a.
stock price.
b.
cost of equity.
c.
cost of debt.
d.
cost of preferred stock.
e.
earnings per share (EPS).
9. Daylight Solutions is considering a recapitalization that would increase its debt ratio and increase its
interest expense. The company would issue new bonds and use the proceeds to buy back shares of its
common stock. The company’s CFO thinks the plan will not change total assets or operating income,
but that it will increase earnings per share (EPS). Assuming the CFO’s estimates are correct, which of
the following statements is CORRECT?
a.
If the plan reduces the WACC, the stock price is also likely to decline.
b.
Since the plan is expected to increase EPS, this implies that net income is also expected to
increase.
c.
If the plan does increase the EPS, the stock price will automatically increase at the same
rate.
d.
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.
e.
Since the proposed plan increases Daylight’s financial risk, the company’s stock price still
might fall even if EPS increases.
10. Which of the following statements is CORRECT?
a.
The optimal capital structure simultaneously maximizes EPS and minimizes the WACC.
b.
The optimal capital structure minimizes the cost of equity, which is a necessary condition
for maximizing the stock price.
c.
The optimal capital structure simultaneously minimizes the cost of debt, the cost of equity,
and the WACC.
d.
The optimal capital structure simultaneously maximizes stock price and minimizes the
WACC.
e.
As a rule, the optimal capital structure is found by determining the debt-equity mix that
maximizes expected EPS.
11. The firm’s target capital structure should be consistent with which of the following statements?
a.
Minimize the cost of debt (rd).
b.
Obtain the highest possible bond rating.
c.
Minimize the cost of equity (rs).
d.
Minimize the weighted average cost of capital (WACC).
e.
Maximize the earnings per share (EPS).
12. Which of the following statements is CORRECT?
a.
The factors that affect a firm’s business risk are affected by industry characteristics and
economic conditions. Unfortunately, these factors are generally beyond the control of the
firm’s management.
b.
One of the benefits to a firm of being at or near its target capital structure is that this
eliminates any risk of bankruptcy.
c.
A firm’s financial risk can be minimized by diversification.
d.
The amount of debt in its capital structure can under no circumstances affect a company’s
business risk.
e.
A firm’s business risk is determined solely by the financial characteristics of its industry.
13. Which of the following statements is CORRECT? As a firm increases the operating leverage used to
produce a given quantity of output, this will
a.
normally lead to a decrease in its business risk.
b.
normally lead to a decrease in the standard deviation of its expected EBIT.
c.
normally lead to a decrease in the variability of its expected EPS.
d.
normally lead to a reduction in its fixed assets turnover ratio.
e.
normally lead to an increase in its fixed assets turnover ratio.
14. If debt financing is used, which of the following is CORRECT?
a.
The percentage change in net operating income will be equal to a given percentage change
in net income.
b.
The percentage change in net income relative to the percentage change in net operating
income will depend on the interest rate charged on debt.
c.
The percentage change in net income will be greater than the percentage change in net
operating income.
d.
The percentage change in sales will be greater than the percentage change in EBIT, which
in turn will be greater than the percentage change in net income.
e.
The percentage change in net operating income will be greater than a given percentage
change in net income.
15. Which of the following statements is CORRECT, holding other things constant?
a.
An increase in the personal tax rate is likely to increase the debt ratio of the average
corporation.
b.
If changes in the bankruptcy code make bankruptcy less costly to corporations, then this
would likely reduce the debt ratio of the average corporation.
c.
An increase in the company‘s degree of operating leverage is likely to encourage a
company to use more debt in its capital structure.
d.
An increase in the corporate tax rate is likely to encourage a company to use more debt in
its capital structure.
e.
Firms whose assets are relatively liquid tend to have relatively low bankruptcy costs,
hence they tend to use relatively little debt.
16. Other things held constant, which of the following events is most likely to encourage a firm to increase
the amount of debt in its capital structure?
a.
The costs that would be incurred in the event of bankruptcy increase.
b.
Management believes that the firm’s stock has become overvalued.
c.
Its degree of operating leverage increases.
d.
The corporate tax rate increases.
e.
Its sales become less stable over time.
17. Blueline Publishers is considering a recapitalization plan. It is currently 100% equity financed but
under the plan it would issue long-term debt with a yield of 9% and use the proceeds to repurchase
common stock. The recapitalization would not change the company’s total assets, nor would it affect
the firm’s basic earning power, which is currently 15%. The CFO believes that this recapitalization
would reduce the WACC and increase stock price. Which of the following would also be likely to
occur if the company goes ahead with the recapitalization plan?
a.
The company’s earnings per share would decline.
b.
The company’s cost of equity would increase.
c.
The company’s ROA would increase.
d.
The company’s ROE would decline.
e.
The company’s net income would increase.
18. Barette Consulting currently has no debt in its capital structure, has $500 million of total assets, and its
basic earning power is 15%. The CFO is contemplating a recapitalization where it will issue debt at a
cost of 10% and use the proceeds to buy back shares of the company’s common stock, paying book
value. If the company proceeds with the recapitalization, its operating income, total assets, and tax rate
will remain unchanged. Which of the following is most likely to occur as a result of the
recapitalization?
a.
The ROA would remain unchanged.
b.
The basic earning power ratio would decline.
c.
The basic earning power ratio would increase.
d.
The ROE would increase.
e.
The ROA would increase.
19. Which of the following statements is CORRECT?
a.
If a firm lowered its fixed costs while increasing its variable costs, holding total costs at
the present level of sales constant, this would decrease its operating leverage.
b.
The debt ratio that maximizes EPS generally exceeds the debt ratio that maximizes share
price.
c.
If a company were to issue debt and use the money to repurchase common stock, this
action would have no impact on its basic earning power ratio. (Assume that the repurchase
has no impact on the company’s operating income.)
d.
If changes in the bankruptcy code made bankruptcy less costly to corporations, this would
likely reduce the average corporation’s debt ratio.
e.
Increasing financial leverage is one way to increase a firm’s basic earning power (BEP).
20. Companies HD and LD have identical tax rates, total assets, and basic earning power ratios, and their
basic earning power exceeds their before-tax cost of debt, rd. 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 lower ROA than Company LD.
b.
Company HD has a lower ROE than Company LD.
c.
The two companies have the same ROA.
d.
The two companies have the same ROE.
e.
Company HD has a higher net income than Company LD.
21. Firms U and L both have a basic earning power ratio of 20% and each has the same amount of assets.
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 a before-tax cost of 8%. Both firms have positive net income. Which of
the following statements is CORRECT?
a.
Firm L has a lower ROA than Firm U.
b.
Firm L has a lower ROE than Firm U.
c.
Firm L has the higher times interest earned (TIE) ratio.
d.
Firm L has a higher EBIT than Firm U.
e.
The two companies have the same times interest earned (TIE) ratio.
22. Two operationally similar companies, HD and LD, have the same total assets, operating income
(EBIT), tax rate, and business risk. Company HD, however, has a much higher debt ratio than LD.
Also HD’s basic earning power (BEP) exceeds its cost of debt (rd). Which of the following statements
is CORRECT?
a.
HD should have a higher times interest earned (TIE) ratio than LD.
b.
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.
c.
Given that BEP > rd, HD’s stock price must exceed that of LD.
d.
Given that BEP > rd, LD’s stock price must exceed that of HD.
e.
HD should have a higher return on assets (ROA) than LD.
23. Which of the following statements is CORRECT?
a.
The capital structure that minimizes a firm’s weighted average cost of capital is also the
capital structure that maximizes its stock price.
b.
The capital structure that minimizes the firm’s weighted average cost of capital is also the
capital structure that maximizes its earnings per share.
c.
If a firm finds that the cost of debt is less than the cost of equity, increasing its debt ratio
must reduce its WACC.
d.
Other things held constant, if corporate tax rates declined, then the Modigliani-Miller tax-
adjusted tradeoff theory would suggest that firms should increase their use of debt.
e.
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.
24. Which of the following statements is CORRECT?
a.
The capital structure that maximizes the stock price is also the capital structure that
maximizes earnings per share.
b.
The capital structure that maximizes the stock price is also the capital structure that
maximizes the firm’s times interest earned (TIE) ratio.
c.
Increasing a company’s debt ratio will typically reduce the marginal costs of both debt and
equity financing; however, this still may raise the company’s WACC.
d.
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.
e.
The capital structure that maximizes the stock price is also the capital structure that
minimizes the weighted average cost of capital (WACC).
25. Which of the following statements is CORRECT?
a.
There is no reason to think that changes in the personal tax rate would affect firms’ capital
structure decisions.
b.
A firm with high business risk is more likely to increase its use of financial leverage than a
firm with low business risk, assuming all else equal.
c.
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.
d.
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 financing.
e.
In general, a firm with low operating leverage also has a small proportion of its total costs
in the form of fixed costs.
26. Which of the following statements is CORRECT?
a.
A change in the personal tax rate should not affect firms’ capital structure decisions.
b.
“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.
c.
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.
d.
If changes in the bankruptcy code make bankruptcy less costly to corporations, then this
would likely reduce the debt ratio of the average corporation.
e.
If corporate tax rates were decreased while other things were held constant, and if the
Modigliani-Miller tax-adjusted tradeoff theory of capital structure were correct, this would
tend to cause corporations to decrease their use of debt.
27. Which of the following statements is CORRECT?
a.
The capital structure that maximizes the stock price is generally the capital structure that
also maximizes earnings per share.
b.
All else equal, an increase in the corporate tax rate would tend to encourage a company to
increase its debt ratio.
c.
Since debt financing raises the firm’s financial risk, increasing a company’s debt ratio will
always increase its WACC.
d.
Since debt is cheaper than equity, increasing a company’s debt ratio will always reduce its
WACC.
e.
When a company increases its debt ratio, the costs of equity and debt both increase.
Therefore, the WACC must also increase.
28. Two operationally similar companies, HD and LD, have identical amounts of assets, operating income
(EBIT), tax rates, and business risk. Company HD, however, has a much higher debt ratio than LD.
Company HD’s basic earning power ratio (BEP) exceeds its cost of debt (rd). Which of the following
statements is CORRECT?
a.
Company HD has a higher times interest earned (TIE) ratio than Company LD.
b.
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.
c.
The two companies have the same ROE.
d.
Company HD’s ROE would be higher if it had no debt.
e.
Company HD has a higher return on assets (ROA) than Company LD.
29. Which of the following statements is CORRECT?
a.
Electric utilities generally have very high common equity ratios because their revenues are
more volatile than those of firms in most other industries.
b.
Drug companies (prescription, not illegal!) generally have high debt-to-equity ratios
because their earnings are very stable and, thus, they can cover the high interest costs
associated with high debt levels.
c.
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.
d.
Since most stocks sell at or very close to their book values, book value capital structures
are almost always adequate for use in estimating firms’ costs of capital.
e.
Generally, debt-to–total-assets ratios do not vary much among different industries,
although they do vary among firms within a given industry.
30. The world-famous discounter, Fernwood Booksellers, specializes in selling paperbacks for $7 each.
The variable cost per book is $5. At current annual sales of 200,000 books, the publisher is just
breaking even. It is estimated that if the authors’ royalties are reduced, the variable cost per book will
drop by $1. Assume authors’ royalties are reduced and sales remain constant; how much more money
can the publisher put into advertising (a fixed cost) and still break even?
a.
$600,000
b.
$466,667
c.
$333,333
d.
$200,000
e.
None of the above
31. Larsen Films’ is analyzing its cost structure. Its fixed operating costs are $470,000, its variable costs of
$2.80 per unit produced, and its products sell for $4.00 per unit. What is the company’s breakeven
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
32. A new company to produce state-of-the-art car stereo systems is being considered by Jagger
Enterprises. The sales price would be set at 1.5 times the variable cost per unit; the VC/unit is
estimated to be $2.50; and fixed costs are estimated at $120,000. What sales volume would be required
in order to break even, i.e., to have an EBIT of zero for the stereo business?
a.
86,640
b.
91,200
c.
96,000
d.
100,800
e.
105,840
33. Hernandez Corporation expects to have the following data during the coming year. What is
Hernandez’s expected ROE?
Assets
$200,000
Interest rate
8%
D/A
65%
Tax rate
40%
EBIT
$25,000
a.
12.51%
b.
13.14%
c.
13.80%
d.
14.49%
e.
15.21%
34. After an intensive research and development effort, two methods for producing playing cards have
been identified by the Turner Company. One method involves using a machine having a fixed cost of
$10,000 and variable costs of $1.00 per deck of cards. The other method would use a less expensive
machine (fixed cost = $5,000), but it would require greater variable costs ($1.50 per deck of cards). If
the selling price per deck of cards will be the same under each method, at what level of output will the
two methods produce the same net operating income (EBIT)?
a.
5,000 decks
b.
10,000 decks
c.
15,000 decks
d.
20,000 decks
e.
25,000 decks
Assets
D/A
65%
EBIT
Interest rate
Tax rate
40%
EBIT
EBT
$14,600
35. Bailey and Sons has a levered beta of 1.10, its capital structure consists of 40% debt and 60% equity,
and its tax rate is 40%. What would Bailey’s beta be if it used no debt, i.e., what is its unlevered beta?
a.
0.64
b.
0.67
c.
0.71
d.
0.75
e.
0.79
D/A
Tax rate
40%
D/E = (D/A)/(1 − D/A)
36. The following information has been presented to you about the Gibson Corporation.
Total assets
$3,000 million
Tax rate
40%
Operating income (EBIT)
$800 million
Debt ratio
0%
Interest expense
$0 million
WACC
10%
Net income
$480 million
M/B ratio
1.00
Share price
$32.00
EPS = DPS
$3.20
The company has no growth opportunities (g = 0), so the company pays out all of its earnings as
dividends (EPS = DPS). The consultant believes that if the company moves to a capital structure
financed with 20% debt and 80% equity (based on market values) that the cost of equity will increase
to 11% and that the pre-tax cost of debt will be 10%. If the company makes this change, what would
be the total market value (in millions) of the firm?
a.
$3,200
b.
$3,600
c.
$4,000
d.
$4,200
e.
$4,800
Step 1:
Find the new WACC:
WACC = wcrs + wd(1 − T)rd = (0.8(0.11)) + (0.2(1 − 0.4)0.10) = 0.10.
capital, hence FCF is equal to NOPAT: