CHAPTER 16—CAPITAL STRUCTURE DECISIONS
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.
a.
True
b.
False
True
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.
a.
True
b.
False
False
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.
a.
True
b.
False
True
4. As the text indicates, a firm’s financial risk has identifiable market risk and diversifiable risk components.
a.
True
b.
False
CHAPTER 16—CAPITAL STRUCTURE DECISIONS
False
5. A firm’s capital structure does not affect its calculated free cash flows, because FCF reflects only operating cash flows.
a.
True
b.
False
True
6. Whenever a firm borrows money, it is using financial leverage.
a.
True
b.
False
True
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.
a.
True
b.
False
False
CHAPTER 16—CAPITAL STRUCTURE DECISIONS
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.
a.
True
b.
False
False
9. The trade-off theory states that the capital structure decision involves a tradeoff between the costs and benefits of debt
financing.
a.
True
b.
False
True
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.
a.
True
b.
False
True
CHAPTER 16—CAPITAL STRUCTURE DECISIONS
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.
a.
True
b.
False
False
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.
a.
True
b.
False
False
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.
a.
True
b.
False
True
CHAPTER 16—CAPITAL STRUCTURE DECISIONS
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.
a.
True
b.
False
True
Difficulty: Moderate
INTE.GENE.16.106 – LO: 16-3
United States – BUSPROG: Reflective Thinking
United States – AK – DISC: Capital structure
United States – OH – Default City – TBA
Bankruptcy costs
15. Which of these items will not generally be affected by an increase in the debt ratio?
a.
b.
c.
d.
e.
Difficulty: Easy
INTE.GENE.16.105 – LO: 16-2
United States – BUSPROG: Analytic
United States – AK – DISC: Capital structure
United States – OH – Default City – TBA
Business risk
TYPE: Multiple Choice: Conceptual
16. 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.
Difficulty: Easy
Operating and financial leverage
CHAPTER 16—CAPITAL STRUCTURE DECISIONS
17. 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.
Difficulty: Easy
INTE.GENE.16.106 – LO: 16-3
United States – BUSPROG: Analytic
United States – AK – DISC: Capital structure
United States – OH – Default City – TBA
Target debt ratio
TYPE: Multiple Choice: Conceptual
18. 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.
Difficulty: Easy
INTE.GENE.16.106 – LO: 16-3
United States – BUSPROG: Analytic
United States – AK – DISC: Capital structure
United States – OH – Default City – TBA
Leverage and capital structure
TYPE: Multiple Choice: Conceptual
INTE.GENE.16.105 – LO: 16-2
United States – BUSPROG: Analytic
United States – AK – DISC: Capital structure
United States – OH – Default City – TBA
Business risk
TYPE: Multiple Choice: Conceptual
CHAPTER 16—CAPITAL STRUCTURE DECISIONS
19. 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.
c
Difficulty: Easy
INTE.GENE.16.107 – LO: 16-5
United States – BUSPROG: Analytic
United States – AK – DISC: Capital structure
United States – OH – Default City – TBA
Capital structure and WACC
TYPE: Multiple Choice: Conceptual
20. 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.
c
Difficulty: Easy
INTE.GENE.16.107 – LO: 16-5
United States – BUSPROG: Analytic
United States – AK – DISC: Capital structure
United States – OH – Default City – TBA
Optimal capital structure
TYPE: Multiple Choice: Conceptual
21. 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.
CHAPTER 16—CAPITAL STRUCTURE DECISIONS
Difficulty: Easy
INTE.GENE.16.107 – LO: 16-5
United States – BUSPROG: Analytic
United States – AK – DISC: Capital structure
United States – OH – Default City – TBA
Optimal capital structure
TYPE: Multiple Choice: Conceptual
22. 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).
Difficulty: Easy
INTE.GENE.16.107 – LO: 16-5
United States – BUSPROG: Analytic
United States – AK – DISC: Capital structure
United States – OH – Default City – TBA
Optimal capital structure
TYPE: Multiple Choice: Conceptual
23. 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.
Difficulty: Easy
INTE.GENE.16.108 – LO: 16-6
United States – BUSPROG: Analytic
CHAPTER 16—CAPITAL STRUCTURE DECISIONS
24. 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.
Difficulty: Easy
INTE.GENE.16.107 – LO: 16-5
United States – BUSPROG: Analytic
United States – AK – DISC: Capital structure
United States – OH – Default City – TBA
Optimal capital structure
TYPE: Multiple Choice: Conceptual
25. 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).
Difficulty: Moderate
INTE.GENE.16.107 – LO: 16-5
United States – BUSPROG: Analytic
United States – AK – DISC: Capital structure
United States – OH – Default City – TBA
Target capital structure
TYPE: Multiple Choice: Conceptual
26. 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.
United States – AK – DISC: Capital structure
United States – OH – Default City – TBA
Financial leverage and EPS
TYPE: Multiple Choice: Conceptual
CHAPTER 16—CAPITAL STRUCTURE DECISIONS
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.
Difficulty: Moderate
INTE.GENE.16.107 – LO: 16-5
United States – BUSPROG: Analytic
United States – AK – DISC: Capital structure
United States – OH – Default City – TBA
Business & fin. risk & cap. struc.
TYPE: Multiple Choice: Conceptual
27. 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.
Difficulty: Moderate
INTE.GENE.16.105 – LO: 16-2
United States – BUSPROG: Analytic
United States – AK – DISC: Capital structure
United States – OH – Default City – TBA
Operating leverage
TYPE: Multiple Choice: Conceptual
28. 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.
CHAPTER 16—CAPITAL STRUCTURE DECISIONS
e.
The percentage change in net operating income will be greater than a given percentage change in net income.
Difficulty: Moderate
INTE.GENE.16.105 – LO: 16-2
United States – BUSPROG: Analytic
United States – AK – DISC: Capital structure
United States – OH – Default City – TBA
Use of financial leverage
TYPE: Multiple Choice: Conceptual
29. 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.
INTE.GENE.16.105 – LO: 16-2
United States – BUSPROG: Analytic
United States – AK – DISC: Capital structure
United States – OH – Default City – TBA
Leverage and capital structure
TYPE: Multiple Choice: Conceptual
30. 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.
Difficulty: Moderate
INTE.GENE.16.105 – LO: 16-2
United States – BUSPROG: Analytic
CHAPTER 16—CAPITAL STRUCTURE DECISIONS
31. 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.
Difficulty: Moderate
INTE.GENE.16.105 – LO: 16-2
United States – BUSPROG: Analytic
United States – AK – DISC: Capital structure
United States – OH – Default City – TBA
Leverage and capital structure
TYPE: Multiple Choice: Conceptual
32. 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.
Difficulty: Moderate
INTE.GENE.16.105 – LO: 16-2
United States – BUSPROG: Analytic
United States – AK – DISC: Capital structure
United States – OH – Default City – TBA
Capital structure, ROA, and ROE
United States – AK – DISC: Capital structure
United States – OH – Default City – TBA
Leverage and capital structure
TYPE: Multiple Choice: Conceptual
CHAPTER 16—CAPITAL STRUCTURE DECISIONS
33. 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).
Difficulty: Moderate
INTE.GENE.16.107 – LO: 16-5
United States – BUSPROG: Analytic
United States – AK – DISC: Capital structure
United States – OH – Default City – TBA
Financial leverage and EPS
TYPE: Multiple Choice: Conceptual
34. 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.
a
Difficulty: Moderate
INTE.GENE.16.107 – LO: 16-5
United States – BUSPROG: Analytic
United States – AK – DISC: Capital structure
United States – OH – Default City – TBA
Financial leverage and ratios
TYPE: Multiple Choice: Conceptual
35. 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
TYPE: Multiple Choice: Conceptual
CHAPTER 16—CAPITAL STRUCTURE DECISIONS
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.
Difficulty: Moderate
INTE.GENE.16.107 – LO: 16-5
United States – BUSPROG: Analytic
United States – AK – DISC: Capital structure
United States – OH – Default City – TBA
Financial leverage and ratios
TYPE: Multiple Choice: Conceptual
36. 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.
Difficulty: Moderate
INTE.GENE.16.107 – LO: 16-5
United States – BUSPROG: Analytic
United States – AK – DISC: Capital structure
United States – OH – Default City – TBA
Financial leverage and ratios
TYPE: Multiple Choice: Conceptual
37. 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.
CHAPTER 16—CAPITAL STRUCTURE DECISIONS
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.
Difficulty: Moderate
INTE.GENE.16.106 – LO: 16-3
United States – BUSPROG: Analytic
United States – AK – DISC: Capital structure
United States – OH – Default City – TBA
Capital structure and WACC
TYPE: Multiple Choice: Conceptual
38. 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).
Difficulty: Moderate
INTE.GENE.16.108 – LO: 16-6
United States – BUSPROG: Analytic
United States – AK – DISC: Capital structure
United States – OH – Default City – TBA
Capital structure, WACC, TIE, and EPS
TYPE: Multiple Choice: Conceptual
39. 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.
CHAPTER 16—CAPITAL STRUCTURE DECISIONS
e.
In general, a firm with low operating leverage also has a small proportion of its total costs in the form of fixed
costs.
Difficulty: Challenging
INTE.GENE.16.105 – LO: 16-2
United States – BUSPROG: Analytic
United States – AK – DISC: Capital structure
United States – OH – Default City – TBA
Miscellaneous capital structure concepts
TYPE: Multiple Choice: Conceptual
40. 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.
Difficulty: Challenging
INTE.GENE.16.105 – LO: 16-2
United States – BUSPROG: Analytic
United States – AK – DISC: Capital structure
United States – OH – Default City – TBA
Miscellaneous capital structure concepts
TYPE: Multiple Choice: Conceptual
41. 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.
CHAPTER 16—CAPITAL STRUCTURE DECISIONS
Difficulty: Challenging
INTE.GENE.16.107 – LO: 16-5
United States – BUSPROG: Analytic
United States – AK – DISC: Capital structure
United States – OH – Default City – TBA
Leverage and capital structure
TYPE: Multiple Choice: Conceptual
42. 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.
Difficulty: Challenging
INTE.GENE.16.107 – LO: 16-5
United States – BUSPROG: Analytic
United States – AK – DISC: Capital structure
United States – OH – Default City – TBA
Financial leverage and ratios
TYPE: Multiple Choice: Conceptual
43. 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.
Difficulty: Challenging
CHAPTER 16—CAPITAL STRUCTURE DECISIONS
44. 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
Difficulty: Easy
INTE.GENE.16.105 – LO: 16-2
United States – BUSPROG: Analytic
United States – AK – DISC: Capital structure
United States – OH – Default City – TBA
Breakeven point–nonalgorithmic
TYPE: Multiple Choice: Problem
45. 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
a
INTE.GENE.16.109 – LO: 16-4
United States – BUSPROG: Analytic
United States – AK – DISC: Capital structure
United States – OH – Default City – TBA
Variations in capital structures
TYPE: Multiple Choice: Conceptual
CHAPTER 16—CAPITAL STRUCTURE DECISIONS
46. 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
c
Difficulty: Moderate
INTE.GENE.16.105 – LO: 16-2
United States – BUSPROG: Analytic
United States – AK – DISC: Capital structure
United States – OH – Default City – TBA
Breakeven analysis
TYPE: Multiple Choice: Problem
47. 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%
Difficulty: Easy
INTE.GENE.16.105 – LO: 16-2
United States – BUSPROG: Analytic
United States – AK – DISC: Capital structure
United States – OH – Default City – TBA
Breakeven analysis
TYPE: Multiple Choice: Problem