Deck 15: Capital Structure Decisions

Question 1

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.
E) In general, a firm with low operating leverage also has a small proportion of its total costs in the form of fixed costs.

Answer 1

In general, a firm with low operating leverage also has a small proportion of its total costs in the form of fixed costs.

Question 2

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.

Answer 2

True

Question 3

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.

Answer 3

An increase in the corporate tax rate is likely to encourage a company to use more debt in its capital structure.

Question 4

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.

Question 5

Which of these items will not generally be affected by an increase in the debt ratio?

A) Total risk.
B) Financial risk.
C) Market risk.
D) The firm's beta.
E) Business risk.

Question 6

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.

Question 7

As the text indicates, a firm's financial risk has identifiable market risk and diversifiable risk components.

Question 8

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.

Question 9

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.

Question 10

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.

Question 11

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.

Question 12

Barette Consulting currently has no debt in its capital structure, has $500 million of total assets, and its return on invested operating capital (ROIC) is 14.5%.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 ROIC would decline.
C) The ROIC would increase.
D) The ROE would increase.
E) The ROA would increase.

Question 13

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.

Question 14

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.
E) The percentage change in net operating income will be greater than a given percentage change in net income.

Question 15

Whenever a firm borrows money, it is using financial leverage.

Question 16

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.

Question 17

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.

Question 18

A firm's capital structure does not affect its calculated free cash flows, because FCF reflects only operating cash flows.

Question 19

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.

Question 20

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 return on invested capital (ROIC), 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.

Question 21

The trade-off theory states that the capital structure decision involves a tradeoff between the costs and benefits of debt financing.

Question 22

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

Question 23

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

Question 24

The Miller model begins with the MM model with corporate taxes and then adds personal taxes.

Question 25

The MM model with corporate taxes is the same as the Miller model, but with zero personal taxes.

Question 26

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

Question 27

The major contribution of the Miller model is that it demonstrates that

A) personal taxes decrease the value of using corporate debt.
B) financial distress and agency costs reduce the value of using corporate debt.
C) equity costs increase with financial leverage.
D) debt costs increase with financial leverage.
E) personal taxes increase the value of using corporate debt.

Question 28

Refer to the data for Eccles Incorporated.What is the firm's cost of equity according to MM with corporate taxes?

A) 21.0%
B) 23.3%
C) 25.9%
D) 28.8%
E) 32.0%

Question 29

The MM model is the same as the Miller model, but with zero corporate taxes.

Question 30

Refer to the data for Eccles Incorporated.What is the value of the firm according to MM with corporate taxes?

A) $480,938
B) $534,375
C) $593,750
D) $653,125
E) $718,438

Question 31

Refer to the data for Eccles Incorporated.Assume that the firm's gain from leverage according to the Miller model is $126,667.If the effective personal tax rate on stock income is T_S = 20%, what is the implied personal tax rate on debt income?

A) 12.8%
B) 14.2%
C) 15.8%
D) 17.6%
E) 19.6%

Question 32

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.

Question 33

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.

Question 34

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.

Question 35

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.
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.

Question 36

Which of the following statements concerning capital structure theory is NOT CORRECT?

A) Under MM with zero taxes, financial leverage has no effect on a firm's value.
B) Under MM with corporate taxes, the value of a levered firm exceeds the value of the unlevered firm by the product of the tax rate times the market value dollar amount of debt.
C) Under MM with corporate taxes, r_s increases with leverage, and this increase exactly offsets the tax benefits of debt financing.
D) Under MM with corporate taxes, the effect of business risk is automatically incorporated because r_sL is a function of r_sU.
E) The major contribution of Miller's theory is that it demonstrates that personal taxes decrease the value of using corporate debt.

Question 37

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.

Question 38

A venture capital investment group received a proposal from Wireless Solutions to produce a new smart phone.The variable cost per unit is estimated at $250, the sales price would be set at twice the VC/unit, fixed costs are estimated at $750,000, and the investors will put up the funds if the project is likely to have an operating income of $500,000 or more.What sales volume would be required in order to meet this profit goal?

A) 4,513
B) 4,750
C) 5,000
D) 5,250
E) 5,513

Question 39

The Miller model begins with the MM model without corporate taxes and then adds personal taxes.

Question 40

After an intensive research and development effort, two methods for producing playing cards have been identified by the Turner Company.One method involves using a machine having a fixed cost of $10,000 and variable costs of $1.00 per deck of cards.The other method would use a less expensive machine (fixed cost = $5,000), but it would require greater variable costs ($1.50 per deck of cards).If the selling price per deck of cards will be the same under each method, at what level of output will the two methods produce the same net operating income (EBIT)?

A) 5,000 decks
B) 10,000 decks
C) 15,000 decks
D) 20,000 decks
E) 25,000 decks

Question 41

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.

Question 42

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 return on invested capital.(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 return on invested capital.

Question 43

Companies HD and LD have identical tax rates, total assets, and return on invested capital (ROIC), and their ROIC exceeds their after-tax cost of debt, (1-T) r_d.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.

Question 44

Laramie Trucking's CEO is considering a change to the company's capital structure, which currently consists of 25% debt and 75% equity.The CFO believes the firm should use more debt, but the CEO is reluctant to increase the debt ratio.The risk-free rate, r_RF, is 5.0%, the market risk premium, RP_M, is 6.0%, and the firm's tax rate is 25%.Currently, the cost of equity, r_s, is 11.5% as determined by the CAPM.What would be the estimated cost of equity if the firm used 60% debt? (Hint: You must first find the current beta and then the unlevered beta to solve the problem.)

A) 11.50%
B) 12.50%
C) 13.58%
D) 14.77%
E) 16.05%

Question 45

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 return on invested capital (ROIC) exceeds its after-tax cost of debt, (1-T) r_d.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.

Question 46

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.

Question 47

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.

Question 48

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 return on invested capital (ROIC) exceeds its after-tax cost of debt, (1-T)r_d.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 ROIC > (1-T) r_d, HD's stock price must exceed that of LD.
D) Given that ROIC > (1-T) r_d, LD's stock price must exceed that of HD.
E) HD should have a higher return on assets (ROA) than LD.

Question 49

The firm's target capital structure should be consistent with which of the following statements?

A) Minimize the cost of debt (r_d).
B) Obtain the highest possible bond rating.
C) Minimize the cost of equity (r_s).
D) Minimize the weighted average cost of capital (WACC).
E) Maximize the earnings per share (EPS).

Question 50

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.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.

Question 51

Cartwright Communications is considering making a change to its capital structure to reduce its cost of capital and increase firm value.Right now, Cartwright has a capital structure that consists of 20% debt and 80% equity, based on market values.(Its D/S ratio is 0.25.) The risk-free rate is 6% and the market risk premium, r_M − r_RF, is 5%.Currently the company's cost of equity, which is based on the CAPM, is 12% and its tax rate is 25%.What would be Cartwright's estimated cost of equity if it were to change its capital structure to 50% debt and 50% equity?

A) 13.00%
B) 13.65%
C) 14.84%
D) 15.58%
E) 16.00%

Question 52

Morales Publishing's tax rate is 25%, its beta is 1.10, and it uses no debt.However, the CFO is considering moving to a capital structure with 30% debt and 70% equity.If the risk-free rate is 5.0% and the market risk premium is 6.0%, by how much would the capital structure shift change the firm's cost of equity?

A) 1.91%
B) 2.12%
C) 2.33%
D) 2.57%
E) 2.82%

Question 53

An all-equity firm with 200,000 shares outstanding, Antwerther Inc., has $2,000,000 of EBIT, which 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).Its tax rate is 25%. ​
The company is considering issuing $5,000,000 of 10.0% bonds and using the proceeds to repurchase stock.The risk-free rate is 6.5%, the market risk premium is 5.0%, and the beta is currently 0.90, but the CFO believes beta would rise to 1.10 if the recapitalization occurs.
​
Assuming that the shares can be repurchased at the price that existed prior to the recapitalization, what would the price be following the recapitalization?

A) $70.31
B) $74.01
C) $77.71
D) $81.60
E) $85.68

Question 54

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.

Question 55

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).

Question 56

Bailey and Sons has a levered beta of 1.10, its capital structure consists of 40% debt and 60% equity, and its tax rate is 25%.What would Bailey's beta be if it used no debt, i.e., what is its unlevered beta?

A) 0.60
B) 0.63
C) 0.66
D) 0.70
E) 0.73

Question 57

Serendipity Inc.is re-evaluating its debt level.Its current capital structure consists of 80% debt and 20% common equity, its beta is 1.60, and its tax rate is 25%.However, the CFO thinks the company has too much debt, and he is considering moving to a capital structure with 40% debt and 60% equity.The risk-free rate is 5.0% and the market risk premium is 6.0%.By how much would the capital structure shift change the firm's cost of equity?

A) −5.40%
B) −6.00%
C) −6.60%
D) −7.26%
E) −7.99%

Question 58

Firms U and L both have a return on invested capital (ROIC) of 12% 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 an after-tax cost of 4.8%.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.

Question 59

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.

Question 60

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.

Question 61

Merriwether Building has operating income of $20 million, a tax rate of 25%, and no debt.It pays out all of its net income as dividends and has a zero growth rate.The current stock price is $27 per share, and it has 5 million shares of stock outstanding.If it moves to a capital structure that has 40% debt and 60% equity (based on market values), its investment bankers believe its weighted average cost of capital would be 10%.What would its stock price be if it changes to the new capital structure?

A) $28
B) $30
C) $33
D) $35
E) $40

Question 62

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.

Question 63

When a firm has risky debt, its debt can be viewed as an option on the total value of the firm with an exercise price equal to the face value of the equity.

Question 64

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).

Question 65

When a firm has risky debt, its equity can be viewed as an option on the total value of the firm with an exercise price equal to the face value of the debt.

Question 66

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