CHAPTER 13: CAPITAL STRUCTURE AND LEVERAGE
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
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
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.
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, 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 former 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
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
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
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.
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.
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.
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.
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.
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.
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.
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.
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.
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
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
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%