Deck 15: Capital Structure Decisions: Part I

Question 1

The firm's financial risk may have both market risk and diversifiable risk components.

Answer 1

True

Question 2

Which of the following events is likely to encourage a company to raise its target debt ratio?

A) An increase in the corporate tax rate.
B) An increase in the personal tax rate.
C) An increase in the company's operating leverage.
D) Statements a and c are correct.
E) All of the statements above are correct.

Answer 2

A

Question 3

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.

Answer 3

False

Question 4

Which of the following statements is most correct?

A) Since debt financing raises the firm's financial risk, raising a company's debt ratio will always increase the company's WACC.
B) Since debt financing is cheaper than equity financing, raising a company's debt ratio will always reduce the company's WACC.
C) Increasing a company's debt ratio will typically reduce the marginal cost of both debt and equity financing; however, it still may raise the company's WACC.
D) Statements a and c are correct.
E) None of the statements above is correct.

Question 5

Financial leverage affects both EPS and EBIT, while operating leverage only affects EBIT.

Question 6

The graphical probability distribution of net income, when financial leverage is used, would tend to be more peaked than a distribution where no leverage is present, other things held constant.

Question 7

The firm's business risk is largely determined by the financial characteristics of its industry.

Question 8

Financial risk refers to the extra risk stockholders bear as a result of the use of debt as compared with the risk they would bear if no debt were used.

Question 9

Because creditors can foresee, to at least some extent, the costs of bankruptcy, they charge a higher rate of interest to compensate for the present value of bankruptcy costs.

Question 10

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.

Question 11

If Miller and Modigliani had considered the cost of bankruptcy, it is unlikely that they would have concluded that 100 percent debt financing is optimal for the firm.

Question 12

If debt financing is used, which of the following is true?

A) The percentage change in net operating income is greater than a given percentage change in net income.
B) The percentage change in net operating income is equal to a given percentage change in net income.
C) The percentage change in net income relative to the percentage change in net operating income depends on the interest rate charged on debt.
D) The percentage change in net operating income is less than the percentage change in net income.
E) The degree of operating leverage is greater than 1.

Question 13

A firm's capital structure can never affect its free cash flows.

Question 14

Company A and Company B have the same total assets, operating income (EBIT), tax rate, and business risk. Company A, however, has a much higher debt ratio than Company B. Company A's basic earning power (BEP) exceeds its cost of debt financing (rd). Which of the following statements is most correct?

A) Company A has a higher return on assets (ROA) than Company B.
B) Company A has a higher times interest earned (TIE) ratio than Company B.
C) Company A has a higher return on equity (ROE) than Company B, and its risk, as measured by the standard deviation of ROE, is also higher than Company B's.
D) Statements b and c are correct.
E) All of the statements above are correct.

Question 15

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

Question 16

Whenever a firm goes into debt, it is using financial leverage.

Question 17

If a firm utilizes debt financing, a decrease in earnings before interest and taxes (EBIT) will result in a more than proportionate decrease in earnings per share.

Question 18

Which of the following statements is false? As a firm increases its operating leverage for a given quantity of output, this

A) changes its operating cost structure.
B) increases its business risk.
C) increases the standard deviation of its EBIT.
D) increases the variability in earnings per share.
E) decreases its financial leverage.

Question 19

Ridgefield Enterprises has total assets of $300 million. The company currently has no debt in its capital structure. The company's basic earning power is 15 percent. The company is contemplating a recapitalization where it will issue debt at 10 percent and use the proceeds to buy back shares of the company's common stock. If the company proceeds with the recapitalization, its operating income, total assets, and tax rate will remain the same. Which of the following will occur as a result of the recapitalization?

A) The company's ROA will decline.
B) The company's ROE will increase.
C) The company's basic earning power will decline.
D) Answers a and b are correct.
E) All of the above answers are correct.

Question 20

Two firms could have identical financial and operating leverage, yet have different degrees of risk as measured by the variability of EPS.

Question 21

What is AJC's current total market value and weighted average cost of capital?

A) $600,000; 7.5%
B) $600,000; 8.0%
C) $800,000; 7.0%
D) $800,000; 7.5%
E) $800,000; 8.0%

Question 22

Simon Software Co. is trying to estimate its optimal capital structure. Right now, Simon has a capital structure that consists of 20 percent debt and 80 percent equity, based on market values. (Its D/S ratio is 0.25.) The risk-free rate is 6 percent and the market risk premium, rM - rRF, is 5 percent. Currently the company's cost of equity, which is based on the CAPM, is 12 percent and its tax rate is 40 percent. What would be Simon's estimated cost of equity if it were to change its capital structure to 50 percent debt and 50 percent equity?

A) 14.35%
B) 30.00%
C) 14.72%
D) 15.60%
E) 13.64%

Question 23

Elephant Books sells paperback books 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 24

Now assume that AJC is considering changing from its original capital structure to a new capital structure with 50 percent debt and 50 percent equity. If it makes this change, its resulting market value would be $820,000. What would be its new stock price per share?

A) $58
B) $59
C) $60
D) $61
E) $62

Question 25

The firm is considering moving to a capital structure that is comprised of 40 percent debt and 60 percent equity, based on market values. The new funds would be used to replace the old debt and to repurchase stock. It is estimated that the increase in riskiness resulting from the leverage increase would cause the required rate of return on debt to rise to 7 percent, while the required rate of return on equity would increase to 9.5 percent. If this plan were carried out, what would be AJC's new WACC and total value?

A) 7.38%; $800,008
B) 7.38%; $813,008
C) 7.50%; $813,008
D) 7.50%; $790,008
E) 7.80%; $790,008

Question 26

Dabney Electronics currently has no debt. Its operating income is $20 million and its tax rate is 40 percent. It pays out all of its net income as dividends and has a zero growth rate. The current stock price is $40 per share, and it has 2.5 million shares of stock outstanding. If it moves to a capital structure that has 40 percent debt and 60 percent equity (based on market values), its investment bankers believe its weighted average cost of capital would be 10 percent. What would its stock price be if it changes to the new capital structure?

A) $40
B) $48
C) $52
D) $54
E) $60

Question 27

Which of the following statements is most correct?

A) A firm can use retained earnings without paying a flotation cost. Therefore, while the cost of retained earnings is not zero, the cost of retained earnings is generally lower than the after-tax cost of debt financing.
B) The capital structure that minimizes the firm's cost of capital is also the capital structure that maximizes the firm's stock price.
C) The capital structure that minimizes the firm's cost of capital is also the capital structure that maximizes the firm's earnings per share.
D) If a firm finds that the cost of debt financing is currently less than the cost of equity financing, an increase in its debt ratio will always reduce its cost of capital.
E) Statements a and b are correct.

Question 28

Now assume that AJC is considering changing from its original capital structure to a new capital structure that results in a stock price of $64 per share. The resulting capital structure would have a $336,000 total market value of equity and $504,000 market value of debt. How many shares would AJC repurchase in the recapitalization?

A) 4,250
B) 4,500
C) 4,750
D) 5,000
E) 5,250
 

Question 29

The Congress Company has identified two methods for producing playing cards. 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?

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