Chapter 14: Capital Structure Management in Practice
48.
TCA Cable has fixed operating cost of $2.6 million, and its variable cost ratio is 0.30. TCA has $4.0 in bonds
outstanding with a coupon interest rate of 12%. TCA has 1.0 million common shares and 1,000,000 shares of
$1.75 preferred stock outstanding. Total revenues for TCA Cable are $14.2 million. If TCA has a marginal tax
rate of 40%, what is its degree of combined leverage?
a.
2.1
b.
1.0
c. 1.9
d. 2.5
49. Borkstran has sales of $7.8 million, a variable cost ratio of 0.6, EBIT of $1.1 million, and a degree of combined
leverage of 3.4. What is Borkstran’s degree of financial leverage?
a.
1.20
b.
0.73
c.
2.29
d.
0.84
50. Archive Storage earned $3.20 a share on sales of $13.6 million. Archive has determined that its degree of
operating leverage is 1.87 and its degree of financial leverage is 2.91. If sales are expected to increase 15%,
what will be the EPS forecast?
a. $2.61
b. $4.60
c. $5.81
d. $3.68
Chapter 14: Capital Structure Management in Practice
51. Last year Alpine Growers experienced a 34% increase in earnings per share on 11% increase in sales. If
management knows that Alpine’s DOL is 1.5, what is its DFL?
a. 3.09
b. 2.06
c. 3.55
d. 1.67
52. If a firm sees its EPS increase 27% on a 12% increase in sales, what is the firm’s DOL. During the same period
the firm saw its EBIT increase only 8%.
a.
1.50
b.
3.38
c.
1.34
d.
0.67
53. Given the following financial data for Boston Technology, compute the firm’s degree of combined leverage.
Assume a marginal tax rate of 40%.
2010
2011
Sales
$700,000
$760,000
Fixed costs
175,000
190,000
Variable costs
406,000
448,000
EBIT
119,000
122,000
Interest
42,000
46,000
Shares outstanding
100,000
102,000
a. 0.29
b. –0.38
c. –0.15
d. 0.38
42,000
77,000
30,800
Chapter 14: Capital Structure Management in Practice
54. ASG expects next year’s operating income (EBIT) to equal $22 million, with a standard deviation of $16
million. The coefficient of variation of operating income is equal to 0.73. Interest expenses will be $9 million
next year and debt retirement will require a principal payment of $2.5 million. ASG’s marginal tax rate is 40%.
If EBIT is normally distributed, what is the probability that ASG will have a negative EPS next year?
a. 20.9%
b. 25.5%
c. 23.3%
d. 25.8%
55. Sulzar’s capital structure consists only of common stock (20 million shares), but the firm is planning a major
expansion which will require $100 million of new capital. Sulzar has a choice of obtaining the needed capital
through the sale of 5 million shares of common stock at $20 per share or the sale of $100 million of first
mortgage bonds that would have a coupon rate of 9%. If Sulzar has a marginal tax rate of 40%, calculate the
EBIT-EPS indifference point.
a. $45 million
b. $36 million
c. $5 million
d. $9 million
56. Given the following financial data for Cosmos, compute the firm’s degree of combined leverage.
2010
2011
$780,000
$874,000
195,000
218,500
460,200
524,400
124,800
131,100
46,800
52,400
$0.42
$0.51
Chapter 14: Capital Structure Management in Practice
57. Given the following financial data for Cosmos, compute the firm’s degree of financial leverage.
Sales
Last Year
$780,000
This Year
$874,000
Fixed costs
195,000
218,500
Variable costs
460,200
524,400
EBIT
124,800
131,100
Interest
46,800
52,400
EPS
$0.42
$0.51
a. 23.81
b. 4.24
c. 0.42
d. 2.18
58. Higgins currently has 2 million shares of common stock outstanding that are selling for $32 per share. Higgins
also has a $20 million mortgage bond outstanding that has an 11 percent coupon rate. Higgins is considering
two alternatives to financing a major expansion. Plan A is to sell $10 million of additional long-term debt with
a 12.5 percent coupon. Plan B is to sell 200,000 shares of common stock at $30 per share and $4 million in
long-term debt with an 11.25 percent coupon. What is the EBIT indifference level between these two
alternatives? Assume the marginal tax rate is 40 percent.
a. $1,374,000
b. $11,450,000
c. $4,554,000
d. $2,650,000
59. Onyx expects to have an EBIT of $240,000 with a standard deviation of $110,000. The distribution of
operating income is approximately normal. If Onyx has interest expenses of $50,000, what is the probability
that it will have an operating income that is below $0?
a. 4.27%
b. 1.46%
c. 0.02%
d. 2.4%
Chapter 14: Capital Structure Management in Practice
60. Midwest Can Company is considering opening a new plant in St. Louis that is expected to produce an average
EBIT of $3 million per year. To finance this new plant, Midwest is considering two financing plans. The first
plan is to sell 600,000 shares of common stock at $15 each. The second plan is to sell 200,000 shares of
common stock at $15 each and $6 million of 13 percent long-term debt. If Midwest has a marginal tax rate of
40 percent, what is the EBIT-EPS indifference point for this plant?
a. $702,000
b. $234,000
c. $2,234,000
d. $1,170,000
61.
Ipsy Dipsy Preschools, Inc. has a capital structure that consists of 60% common equity (2.0 million shares),
30% long-term debt ($10 million with 12% coupon), and 10% preferred stock ($50 par value with $4.75
dividend). The company is planning a major plant expansion and is undecided between the following two
financing plans:
1)
Equity financing: Sale of 400,000 shares of common at $10 each.
2)
Debt financing: Sale of$4 million of 12.5 percent long-term bonds.
Calculate the EBIT–EPS indifference point. Assume the marginal tax rate is 40%.
a.
$4.253 million
b.
$3.051 million
c.
$3.654 million
d.
$4.728 million
Chapter 14: Capital Structure Management in Practice
62.
River Rafts has determined that its expected EBIT for the coming year is $8.3 million. The EBIT is
approximately normally distributed with a standard deviation of $5.1 million. If River Rafts has $1.9 million in
annual interest payments, what is the probability that the firm will have negative earnings?
a. 4.65%
b. 10.47%
c. 5.16%
d. 35.20%
63.
Twin City Printing is considering two financial alternatives for financing a major expansion program. Under
either alternative EBIT is expected to be $15.6 million. Currently the firm’s capital structure consists of 4
million shares of common stock and $35 million in 11% long-term bonds. Under the debt financing alternative
$10 million in 12% long- term bonds will be sold and under the equity financing alternative the firm would sell
500,000 shares of common stock. The PIE under the debt alternative would be 15 and the PIE under the equity
alternative would be 16. The firm’s marginal tax rate is 40%. Which alternative would produce the higher stock
price?
a.
debt-stock price of $23.70
b.
debt-stock price of $32.29
c.
equity-stock price of $25.12
d.
equity-stock price of $33.28
Chapter 14: Capital Structure Management in Practice
64.
Sitco has a total of $12 million in cash and marketable securities. Free cash flows during the coming year are
expected to be $47 million with a standard deviation of$31 million. Assume that Sitco’s free cash flows are
approximately normally distributed. What is the probability that Sitco will run out of cash during the coming
year?
a. 29.98%
b. 34.83%
c. 97.13%
d. 2.87%
65.
Crown Data (CD) has a current capital structure that consists of$120 million in common equity (15 million
shares)
and $80 million in long-term debt with an average interest rate of 11 percent. CD is considering an
expansion project that will cost $22 million. The project will be financed either by issuing long-term debt at a
cost of 12.5 percent, or
the sale of new common stock at $35 per share. The firm’s marginal tax rate is 40%.
What is the EBIT indifference point between the two financing options?
a.
$71.5 million
b.
$77.2 million
c.
$68.3 million
d.
$1.0 million
66.
In considering EBIT-EPS analysis, which of the following statements is/are correct?
a. If the expected earnings are above the indifference point, the debt option is preferred.
b. If the expected earnings are below the indifference point, the equity option is preferred.
c.
Both statements a and b are correct.
d.
Neither statement a nor b is correct.
67.
What type of security is used to purchase a target company in a leveraged buy-out?
a. common stock
b. dividends
c.
debt
d.
retained earnings
Chapter 14: Capital Structure Management in Practice
68.
A change in EBIT is magnified into a larger change in EPS. This means that financial leverage is using as
its fulcrum.
a.
short-term costs
b.
fixed costs
c.
variable costs
d.
retained earnings
69.
In using Nestle Corporation as a model, when a subsidiary is first formed, about one-half of the financing
needed to acquired fixed assets comes from:
a.
debt
b.
federal funds
c.
tax breaks
d.
equity from the parent company
70. Some companies use debt or preferred stock financing instead of common stock financing. The purpose is:
a. to retain control
b. to facilitate record-keeping
c. to maintain privacy
d. to prevent audit problems
71. There are three categories of costs: fixed costs, variable costs and semi-variable costs. Which of the following
is a semi-variable cost?
a. depreciation
b. labor costs
c. raw materials
d. management salaries
Chapter 14: Capital Structure Management in Practice
72. Fanny Nanny Weight Monitors, Inc. is considering two financial alternatives for financing a major expansion
program. Under either alternative, EBIT is expected to be $12.5million. Currently the firm’s capital structure
consists of 2 million shares of common stock and $15 million in 6% long-term bonds. Under the debt financing
alternative $8 million in 4% long-term bonds will be sold and under the equity financing alternative the firm
would sell 150,000 shares of common stock. The P/E under the debt alternative would be 21 and the P/E under
the equity alternative would be 22. The firm’s marginal tax rate is 40%. Which alternative would produce the
higher stock price?
a. debt–stock price of $57.36
b. debt–stock price of $70.98
c. equity–stock price of $71.28
d. equity–stock price of $85.32
73.
Dippity Doodle Noodle Makers has a capital structure that consists of2.0 million shares outstanding and $2.0
million of debt at 8% interest. The company is planning a major plant expansion must decide between the
following two financing plans. Option 1 is to increase debt by $1.0 million at 9% interest and sell 10,000 new
shares of stock at $50 per share. Option 2 is to sell 30,000 new shares of stock at $50 per share. What would be
the indifference point and considering that EBIT is expected to be $10,000,000 which option would be best
a.
Indifference of $10,750,000. Use stock option.
b.
Indifference of $1,600,000. Use stock option.
c.
Indifference of $16,270,000. Use the debt option.
d.
Indifference of $9,250,000. Use the debt option.
Chapter 14: Capital Structure Management in Practice
74.
What is the degree of operating leverage for Flippin’ Out Company, a maker of scuba flippers, if the firm sells
its finished product for $50 per unit with variable costs per unit of $15? The company has fixed operating costs
of $2,000,000 and sells 200,000 units (the answer is rounded).
a.
2.0
b.
3.7
c.
6.5
d.
1.4
75.
Magnificent Manes Hair Salons is forecasting a 17% increase in sales. What would be its degree of operating
leverage if it anticipates that its EBIT will go from $150,000 to $175,000 during the same time frame?
a.
1.76
b.
2.5
c.
.98
d.
1.11
76.
What would be the degree of financial leverage for Foggy Futures Weather Forecasters if the company has
earnings before interest and taxes of$750,000, has a 4.5% loan on $1,000,000 and is in the 38% tax bracket?
The firm does not have any preferred stock outstanding.
a.
1.22
b.
1.78
c.
1.06
d.
97
Chapter 14: Capital Structure Management in Practice
77.
What would be the degree of financial leverage for Under A Cloud Skydiving School if the company will have
earnings before interest and taxes of $750,000 which would be a 15% increase? The firm had EPS of $1.25 but,
with the increased earnings, anticipates paying $1.37.
a. .80
b. 1.08
c. 2.01
d. 1.25
78.
In evaluating degree of operating leverage, it is best that the firm’s DOL is:
a.
higher than 1
b.
higher than 2
c.
lower than 1
d.
equal to 1
79.
In evaluating a firm’s degree of financial leverage, financial risk is with an increase in DFL.
a.
increased
b.
decreased
c.
not impacted
d.
reflective of excess inventory
80.
What are the effects of leverage on shareholder wealth and the cost of capital?
81. Explain the difference between short-run costs and long-run costs.
Chapter 14: Capital Structure Management in Practice
82. Why does a firm use operating and financial leverage? In what ways does it help the firm, in what ways does it
hurt the firm?
83. List the five steps developed to assist financial managers in making capital structure decisions.
84. Some firms prefer to use debt or preferred stock for financing to retain control. Explain the rationale behind
this method.
85. In what way does management’s willingness to assume risk impact the firm?