Exam 13: Capital Structure and Leverage

According to the signaling theory of capital structure, firms first use common equity for their capital, then use debt if and only if they can raise no more equity on "reasonable" terms. This occurs because the use of debt financing signals to investors that the firm's managers think that the future does not look good.

Your firm has $500 million of investor-supplied capital, its return on investors' capital (ROIC) is 15%, and it currently has no debt in its capital structure . The CFO is contemplating a recapitalization where it would issue debt at an after-tax cost of 10% and use the proceeds to buy back some of its common stock, such that the percentage of common equity in the capital structure (wc) is 1 − wd. If the company goes ahead with the recapitalization, its operating income, the size of the firm (i.e., total assets), total investor-supplied capital, and tax rate would remain unchanged. Which of the following is most likely to occur as a result of the recapitalization?

A firm's CFO is considering increasing the target debt ratio, which would also increase the company's interest expense. New bonds would be issued and the proceeds would be used to buy back shares of common stock. Neither total assets nor operating income would change, but expected earnings per share (EPS) would increase. Assuming the CFO's estimates are correct, which of the following statements is CORRECT?

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 investors' capital (ROIC) exceed their after-tax costs of debt, rd(1 − T). Which of the following statements is CORRECT?

El Capitan Foods has a capital structure of 40% debt and 60% equity, its tax rate is 35%, and its beta (leveraged) is 1.25. Based on the Hamada equation, what would the firm's beta be if it used no debt, i.e., what is its unlevered beta, bU?

Monroe Inc. is an all-equity firm with 500,000 shares outstanding. It has $2,000,000 of EBIT, and EBIT is expected to remain constant in the future. The company pays out all of its earnings, so earnings per share (EPS) equal dividends per shares (DPS), and its tax rate is 40%. The company is considering issuing $5,000,000 of 9.00% bonds and using the proceeds to repurchase stock. The risk-free rate is 4.5%, the market risk premium is 5.0%, and the firm's beta is currently 0.90. However, the CFO believes the beta would rise to 1.10 if the recapitalization occurs. Assuming the shares could be repurchased at the price that existed prior to the recapitalization, what would the price per share be following the recapitalization? (Hint: P0 = EPS/rs because EPS = DPS.)

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.

Which of the following statements is CORRECT?

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.

Southeast U's campus book store sells course packs for $15.00 each, the variable cost per pack is $11.00, fixed costs for this operation are $300,000, and annual sales are 100,000 packs. The unit variable cost consists of a $4.00 royalty payment, VR, per pack to professors plus other variable costs of VO = $7.00. The royalty payment is negotiable. The book store's directors believe that the store should earn a profit margin of 10% on sales, and they want the store's managers to pay a royalty rate that will produce that profit margin. What royalty per pack would permit the store to earn a 10% profit margin on course packs, other things held constant?

An increase in the debt ratio will generally have no effect on which of these items?

Which of the following statements is CORRECT?

A firm's treasurer likes to be in a position to raise funds to support operations whenever such funds are needed, even in "bad times." This is called "financial flexibility," and the lower the firm's debt ratio, the greater its financial flexibility, other things held constant.

Which of the following statements is CORRECT?

Companies HD and LD have identical tax rates, total assets, total investor-supplied capital, and returns on investors' capital (ROIC), and their ROICs exceed their after-tax costs of debt, rd(1 − T). However, Company HD has a higher debt ratio and thus more interest expense than Company LD. Which of the following statements is CORRECT?

Business risk is affected by a firm's operations. Which of the following is NOT directly associated with (or does not directly contribute to) business risk?

Which of the following statements is CORRECT?

Which of the following would tend to increase a firm's target debt ratio, other things held constant?

Based on the information below, what is the firm's optimal capital structure?

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