Exam 18: Financial and Operating Leverage: Analysis and Calculation

Recycler Battery Corporation (RBC) issued zero coupon bonds 5 years ago at a price of $214.50 per bond. RBC's zeros had a 20-year original maturity, with a $1,000 par value. The bonds were callable 10 years after the issue date at a price 7% over their accrued value on the call date. If the bonds sell for $240 in the market today, what annual rate of return should an investor who buys the bonds today expect to earn on them?

Monroe Corporation currently sells 150,000 units a year at a price of $4.00 a unit. Its variable costs are approximately 30% of sales, and its fixed costs amount to 50% of revenues at its current output level. Although fixed costs are based on revenues at the current output level, the cost level is fixed. What is Marcus's degree of operating leverage in sales dollars?

Assume that the City of Tampa sold an issue of $1,000 maturity value, tax-exempt (muni), zero coupon bonds 5 years ago. The bonds had a 25-year maturity when they were issued, and the interest rate built into the issue was a nominal 10%, but with semiannual compounding. The bonds are now callable at a premium of 10% over the accrued value. What effective annual rate of return would an investor who bought the bonds when they were issued and who still owns them earn if they were called today?

Sunshine Inc. has two equally-sized divisions. Division A has a beta of 0.8 and Division B has a beta of 1.2. The company is 100% equity financed. The risk-free rate is 6% and the market risk premium is 5%. Sunshine assigns different hurdle rates to each division based on each division's market risk. Which of the following statements is CORRECT?

Interstate Transport has a target capital structure of 50% debt and 50% common equity. The firm is considering a new independent project that has a return of 13% and is not related to transportation. However, a pure-play proxy firm has been identified that has a beta of 1.38. Both firms have a marginal tax rate of 40%, and Interstate's before- tax cost of debt is 12%. The risk-free rate is 10% and the market risk premium is 5%. The firm should:

A 15-year, $1,000 face value, zero coupon bond has a yield to maturity of 8%. What is the amount of tax an investor in the 33% tax bracket will pay the first year of the bond?

Which of the following is a key benefit of using the degree of leverage concept in financial analysis?

If the firm is being operated so as to maximize shareholder wealth, and if our basic assumptions concerning the relationship between risk and return are true, then which of the following should be true?

Refer to Exhibit 8A.1. Calculate both stocks' betas. What is the difference between the betas? That is, what is the value of betaR − betaS? (Hint: The graphical method of calculating the rise over run, or (Y2 − Y1) divided by (X2 − X1) may aid you.)

Lincoln Lodging Inc. estimates that if its sales increase 10% then its net income will increase 18%. The company's EBIT equals $2.4 million, and its interest expense is $400,000. The company's operating costs include fixed and variable costs. What is the level of the company's fixed operating costs?

Schiffauer Electronics plans to issue 10-year, zero coupon bonds with a par value of $1,000 and a yield to maturity of 9.5%. The company has a tax rate of 30%. How much extra in taxes would the company pay (or save) the second year (at t = 2) if it goes ahead and issues the bonds?

Refer to Exhibit 8A.1. Set up the SML equation and use it to calculate both stocks' required rates of return, and compare those required returns with the expected returns given above. You should invest in the stock whose expected return exceeds its required return by the widest margin. What is the widest positive margin, or greatest excess return (expected return − required return)?

The "degree of leverage" concept is designed to show how changes in sales will affect EBIT and EPS. If a 10% increase in sales causes EPS to increase from $1.00 to $1.50, and if the firm uses no debt, then what is its degree of operating leverage?

Northern Conglomerate has two divisions, Division A and Division B. Northern looks at competing pure-play firms to estimate the betas of each of the two divisions. After this analysis, Northern concludes that Division A has a beta of 0)8 and Division B has a beta of 1.5. The two divisions are the same size. The risk-free rate is 5% and the market risk premium is 6%. Assume that Northern is 100% equity financed. What is the overall composite WACC for Northern Conglomerate?

On January 1st Julie bought a 7-year, zero coupon bond with a face value of $1,000 and a yield to maturity of 6%. Assume that Julie's tax rate is 25%. How much tax will Julie have to pay on the bond the first year she owns it?

Vogril Company issued 20-year, zero coupon bonds with an expected yield to maturity of 9%. The bonds have a par value of $1,000 and were sold for $178.43 each. What is the expected interest expense on these bonds for Year 8?

How much should you be willing to pay for an account today that will have a value of $1,000 in 10 years under continuous compounding if the nominal rate is 10%?

Which of the following statements is CORRECT?

Assume that a firm currently has EBIT of $2,000,000, a degree of total leverage of 7.5, and a degree of financial leverage of 1.875. If sales decline by 20% next year, then what will be the firm's expected EBIT in one year?

Which of the following statements is CORRECT?