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Chapter 13: Capital Structure and Leverage
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.
Chapter 13: Capital Structure and 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.
Chapter 13: Capital Structure and Leverage
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.
Chapter 13: Capital Structure and Leverage
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
Chapter 13: Capital Structure and Leverage
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
Chapter 13: Capital Structure and Leverage
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 $300,000, variable costs of $2.50 per unit produced, and its product sells
for $3.70 per unit. What is the company's break-even point, i.e., at what unit sales volume would income equal costs?
Chapter 13: Capital Structure and Leverage
a.
250,000
b.
232,500
c.
222,500
d.
220,000
e.
255,000
64. Your uncle is considering investing in a new company that will produce high quality stereo speakers. The sales price
would be set at 1.70 times the variable cost per unit; the variable cost per unit is estimated to be $75.00; and fixed costs
are estimated at $1,170,000. What sales volume would be required to break even, i.e., to have EBIT = zero?
a.
23,400
b.
25,851
c.
18,051
d.
17,160
e.
22,286
Chapter 13: Capital Structure and Leverage
65. Southwest U's campus book store sells course packs for $18 each, the variable cost per pack is $8, fixed costs to
produce the packs are $200,000, and expected annual sales are 51,000 packs. What are the pre-tax profits from sales of
course packs?
a.
$285,200
b.
$310,000
c.
$306,900
d.
$248,000
e.
$372,000
Chapter 13: Capital Structure and Leverage
66. Southwest U's campus book store sells course packs for $19 each. The variable cost per pack is $12, and at current
annual sales of 43,000 packs, the store earns $75,000 before taxes on course packs. How much are the fixed costs of
producing the course packs?
a.
$203,400
b.
$277,980
c.
$253,120
d.
$226,000
e.
$221,480
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 $30.00
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? Do not round your intermediate
calculations. (Hint: Find BEB - BEA)
Machine A
Machine B
Price per pair (P)
$30.00
$30.00
Fixed costs (F)
$25,000
$100,000
Variable cost/unit (V)
$7.00
$4.00
a.
3,035
b.
2,235
c.
2,069
d.
2,621
e.
2,759
Chapter 13: Capital Structure and Leverage
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 30,000 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)
$17.00
$11.00
Exp. unit sales (Q)
30,000
30,000
a.
$-102,000
b.
$-129,600
c.
$-93,600
d.
$-118,800
e.
$-120,000
Chapter 13: Capital Structure and Leverage
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 $260.00 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 27,000 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)
$260.00
$260.00
Fixed costs (F)
$1,000,000
$2,000,000
Variable cost/unit (V)
$210.00
$160.00
Expected unit sales (Q)
27,000
27,000
Required equity investment
$2,500,000
$3,000,000
a.
11.20%
b.
8.87%
c.
7.84%
d.
7.75%
e.
9.33%
Chapter 13: Capital Structure and Leverage
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 $510,000. 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? Do
not round your intermediate calculations.
0% Debt, U
60% Debt, L
Oper. income (EBIT)
$510,000
$510,000
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.
10.65%
b.
10.14%
c.
8.11%
d.
12.68%
e.
7.10%
Chapter 13: Capital Structure and Leverage
71. You work for the CEO of a new company that plans to manufacture and sell a new type of laptop computer. The issue
now is how to finance the company, with only equity or with a mix of debt and equity. Expected operating income is
$600,000. Other data for the firm are shown below. How much higher or lower will the firm's expected EPS be if it uses
some debt rather than only equity, i.e., what is EPSL - EPSU?
0% Debt, U
60% Debt, L
Oper. income (EBIT)
$690,000
$690,000
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
Shares issued, $10/share
250,000
100,000
Interest rate
NA
10.00%
Tax rate
35%
35%
a.
$1.29
b.
$1.97
c.
$2.23
d.
$1.72
Chapter 13: Capital Structure and Leverage
e.
$1.63
72. Confu Inc. expects to have the following data during the coming year. What is the firm's expected ROE?
Capital
$200,000
Interest rate
8%
Debt/Capital, book value
65%
Tax rate
40%
EBIT
$25,000
a.
10.51%
b.
14.52%
c.
14.39%
d.
12.51%
e.
12.39%
Chapter 13: Capital Structure and Leverage
73. Senate Inc. is considering two alternative methods for producing playing cards. Method 1 involves using a machine
with a fixed cost (mainly depreciation) of $17,000 and variable costs of $1.00 per deck of cards. Method 2 would use a
less expensive machine with a fixed cost of only $5,000, but it would require a variable cost of $1.50 per deck. The sales
price per deck would be the same under each method. At what unit output level would the two methods provide the same
operating income (EBIT)?
a.
24,960
b.
28,080
c.
24,000
d.
26,880
e.
28,320
Chapter 13: Capital Structure and Leverage
74. A group of venture investors is considering putting money into Lemma Books, which wants to produce a new reader
for electronic books. The variable cost per unit is estimated at $250, the sales price would be set at twice the VC/unit, or
$500, and fixed costs are estimated at $350,000. The investors will put up the funds if the project is likely to have an
operating income of $500,000 or more. What sales volume would be required in order to meet the minimum profit goal?
(Hint: Use the break-even formula, but include the required profit in the numerator.)
a.
3,706
b.
3,400
c.
2,958
d.
3,094
e.
4,216
