Exam 13: Capital Structure

Firm A is very aggressive in its use of debt to leverage up its earnings for common stockholders, whereas Firm NA is not aggressive and uses no debt. The two firms' operations are identical--they have the same total investor-supplied capital, sales, operating costs, and EBIT. Thus, they differ only in their use of financial leverage (wd). Based on the following data, how much higher or lower is A's ROE than that of NA, i.e., what is ROEA - ROENA?

Confu Inc. expects to have the following data during the coming year. What is the firm's expected ROE?

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 $400,000. 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?

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.

Which of the following statements is CORRECT?

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.

Other things held constant, firms with more stable and predictable sales tend to use more debt than firms with less stable sales.

Other things held constant, an increase in financial leverage will increase a firm's market (or systematic) risk as measured by its beta coefficient.

Which of the following statements best describes the optimal capital structure?

Firms HD and LD are identical except for their use of debt and the interest rates they pay--HD has more debt and thus must pay a higher interest rate. Based on the data given below, how much higher or lower will HD's ROE be versus that of LD, i.e., what is ROEHD - ROELD?

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?

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.

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?

Other things held constant, the lower a firm's tax rate, the more logical it is for the firm to use debt.

Which of the following statements is CORRECT?

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.

Modigliani and Miller (MM) won Nobel Prizes for their work on capital structure theory.

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.

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.

As the text indicates, a firm's financial risk can and should be divided into separate market and diversifiable risk components.