Deck 14: Capital Structure and Leverage

Question 1

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

Answer 1

True

Question 2

Provided a firm does not use an extreme amount of debt, operating leverage typically affects only EPS, while financial leverage affects both EPS and EBIT.

Answer 2

False

Question 3

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

Answer 3

True

Question 4

Modigliani and Miller's first article led to the conclusion that capital structure is "irrelevant" because it has no effect on a firm's value. However, that article was criticized because it assumed that no taxes existed. MM then revised their original article to include corporate taxes, and this model led to the conclusion that a firm's value would be maximized if it used (almost) 100% debt.

Question 5

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.

Question 6

Financial risk refers to the extra risk stockholders bear as a result of a firm's use of debt as compared with their risk if the firm had used no debt.

Question 7

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.

Question 8

A firm's capital structure does not affect its free cash flows as discussed in the text, because FCF reflects only operating cash flows, which are available to service debt, to pay dividends to stockholders, and for other purposes.

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

It is possible for Firms A and B to have identical financial and operating leverage, yet for Firm A to have more risk as measured by the variability of EPS. This would occur if Firm A has more business risk than Firm B.

Question 11

According to Modigliani and Miller (MM), in a world with corporate income taxes the optimal capital structure calls for approximately 100% debt financing.

Question 12

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

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

According to Modigliani and Miller (MM), in a world without corporate income taxes the use of debt has no effect on the firm's value.

Question 15

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

Question 16

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

Question 17

Modigliani and Miller's first article led to the conclusion that capital structure is extremely important, and that efirm has an optimal capital structure that maximizes its value and minimizes its cost of capital.

Question 18

Modigliani and Miller's first article led to the conclusion that capital structure is "irrelevant" because it has no effect on a firm's value.

Question 19

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.

Question 20

According to Modigliani and Miller (MM), in a world without taxes the optimal capital structure for a firm is approximately 100% debt financing.

Question 21

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

Question 22

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

A) The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company's earnings per share (EPS).
B) The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company's stock price.
C) The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company's cost of equity.
D) The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company's cost of debt.
E) The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company's cost of preferred stock.

Question 23

Some people--including the current chairman of the Federal Reserve Board of Governors--have argued that one advantage of corporate debt from the stockholders' standpoint is that the existence of debt forces managers to focus on cash flow and to refrain from spending too much of the firm's money on private plane and other "perks." This is one of the factors that led to the rise of LBOs and private equity firms.

Question 24

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

A) Debt = 40%; Equity = 60%; EPS = $2.95; Stock price = $26.50.
B) Debt = 50%; Equity = 50%; EPS = $3.05; Stock price = $28.90.
C) Debt = 60%; Equity = 40%; EPS = $3.18; Stock price = $31.20.
D) Debt = 80%; Equity = 20%; EPS = $3.42; Stock price = $30.40.
E) Debt = 70%; Equity = 30%; EPS = $3.31; Stock price = $30.00.

Question 25

Modigliani and Miller (MM), in their second article, took account of taxes, bankruptcy, and other factors that were assumed away in their original article. Once they took account of all these assumptions, they concluded that efirm has a unique optimal capital structure. Moreover, a manager can use the second MM model to determine his or her firm's optimal debt ratio.

Question 26

The Modigliani and Miller (MM) articles implicitly assumed, among other things, that outside stockholders have the same information about a firm's future prospects as its managers. That was called "symmetric information," and it is questionable. The introduction of "asymmetric information" led to the development of the "signaling" theory of capital structure, which postulated that firms are reluctant to issue new stock because investors will interpret such an act as a signal that the firm's managers are worried about its future. Other actions give off different signals, and the end result is that capital structure is affected by managers' perceptions about how their financing decisions will affect investors' views of the firm and thus its value.

Question 27

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

A) The costs associated with filing for bankruptcy increase.
B) The corporate tax rate is increased.
C) The personal tax rate is increased.
D) The Federal Reserve tightens interest rates in an effort to fight inflation.
E) The company's stock price hits a new low.

Question 28

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

Question 29

Other things held constant, firms that use assets that can be sold easily (like trucks) tend to use more debt than firms whose assets are

Question 30

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.

Question 31

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

Question 32

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.

Question 33

Which of the following statements is CORRECT?

A) The capital structure that maximizes expected EPS also maximizes the price per share of common stock.
B) The capital structure that minimizes the interest rate on debt also maximizes the expected EPS.
C) The capital structure that minimizes the required return on equity also maximizes the stock price.
D) The capital structure that minimizes the WACC also maximizes the price per share of common stock.
E) The capital structure that gives the firm the best bond rating also maximizes the stock price.

Question 34

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?

A) Demand variability.
B) Sales price variability.
C) The extent to which operating costs are fixed.
D) The extent to which interest rates on the firm's debt fluctuate.
E) Input price variability.

Question 35

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 corporate tax rate.
B) An increase in the personal tax rate.
C) An increase in the company's operating leverage.
D) The Federal Reserve tightens interest rates in an effort to fight inflation.
E) The company's stock price hits a new high.

Question 36

Modigliani and Miller's second article, which assumed the existence of corporate income taxes, led to the conclusion that a firm's value would be maximized, and its cost of capital minimized, if it used (almost) 100% debt. However, this model did not take account of bankruptcy costs. The existence of bankruptcy costs leads to the assumption of an optimal capital structure where the debt ratio is less than 100%.

Question 37

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

Question 38

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

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

Question 39

Which of the following statements is CORRECT?

A) Since debt financing raises the firm's financial risk, increasing the target debt ratio will always increase the WACC.
B) Since debt financing is cheaper than equity financing, raising a company's debt ratio will always reduce its WACC.
C) Increasing a company's debt ratio will typically reduce the marginal costs of both debt and equity financing. However, this action still may raise the company's WACC.
D) Increasing a company's debt ratio will typically increase the marginal costs of both debt and equity financing. However, this action still may lower the company's WACC.
E) Since a firm's beta coefficient is not affected by its use of financial leverage, leverage does not affect the cost of equity.

Question 40

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.

Question 41

Which of the following statements is CORRECT?

A) Increasing its use of financial leverage is one way to increase a firm's basic earning power (BEP).
B) If a firm lowered its fixed costs but increased its variable costs by just enough to hold total costs at the present level of sales constant, this would increase its operating leverage.
C) The debt ratio that maximizes expected EPS generally exceeds the debt ratio that maximizes share price.
D) If a company were to issue debt and use the money to repurchase common stock, this would reduce its basic earning power ratio. (Assume that the repurchase has no impact on the company's operating income.)
E) If a change in the bankruptcy code made bankruptcy less costly to corporations, this would tend to reduce corporations' debt ratios.

Question 42

Companies HD and LD have identical tax rates, total assets, and basic earning power ratios, and their basic earning power exceeds their before-tax cost of debt, rd. 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 higher net income than Company LD.
B) Company HD has a lower ROA than Company LD.
C) Company HD has a lower ROE than Company LD.
D) The two companies have the same ROA.
E) The two companies have the same ROE.

Question 43

Your firm is currently 100% equity financed. The CFO is considering a recapitalization plan under which the firm would issue long-term debt with a yield of 9% and use the proceeds to repurchase some of its common stock. The recapitalization would not change the company's total assets, nor would it affect the firm's basic earning power, which is 15%. The CFO believes that this recapitalization would reduce the firm's WACC and increase its stock price. Which of the following would be likely to occur if the company goes ahead with the recapitalization plan?

A) The company's net income would increase.
B) The company's earnings per share would decline.
C) The company's cost of equity would increase.
D) The company's ROA would increase.
E) The company's ROE would decline.

Question 44

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, both companies' basic earning power (BEP) ratios exceed their cost of debt (rd). Which of the following statements is CORRECT?

A) HD should have a higher return on assets (ROA) than LD.
B) HD should have a higher times interest earned (TIE) ratio than LD.
C) 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.
D) Given that BEP > rd, HD's stock price must exceed that of LD.
E) Given that BEP > rd, LD's stock price must exceed that of HD.

Question 45

Longstreet Inc. has fixed operating costs of $470,000, variable costs of $2.80 per unit produced, and its product sells 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 46

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?

A) Its sales are projected to become less stable in the future.
B) The bankruptcy laws are changed in a way that would make bankruptcy more costly to the firm and its stockholders.
C) Management believes that the firm's stock is currently overvalued.
D) The firm decides to automate its factory with specialized equipment and thus increase its use of operating leverage.
E) The corporate tax rate is increased.

Question 47

The firm's target capital structure should do which of the following?

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

Question 48

Southwest U's campus book store sells course packs for $16 each. The variable cost per pack is $10, and at current annual sales of 50,000 packs, the store earns $75,000 before taxes on course packs. How much are the fixed costs of producing the course packs?

A) $164,025
B) $182,250
C) $202,500
D) $225,000
E) $247,500

Question 49

A major contribution of the Miller model is that it demonstrates, other things held constant, that

A) personal taxes increase the value of using corporate debt.
B) personal taxes lower the value of using corporate debt.
C) personal taxes have no effect on the value of using corporate debt.
D) financial distress and agency costs reduce the value of using corporate debt.
E) debt costs increase with financial leverage.

Question 50

Which of the following statements is CORRECT, holding other things constant?

A) Firms whose assets are relatively liquid tend to have relatively low bankruptcy costs, hence they tend to use relatively little debt.
B) An increase in the personal tax rate is likely to increase the debt ratio of the average corporation.
C) If changes in the bankruptcy code make bankruptcy less costly to corporations, then this would likely lead to lower debt ratios for corporations.
D) An increase in the company's degree of operating leverage would tend to encourage the firm to use more debt in its capital structure so as to keep its total risk unchanged.
E) An increase in the corporate tax rate would in theory encourage companies to use more debt in their capital structures.

Question 51

Which of the following statements is CORRECT?

A) 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.
B) The capital structure that minimizes a firm's weighted average cost of capital is also the capital structure that maximizes its stock price.
C) The capital structure that minimizes the firm's weighted average cost of capital is also the capital structure that maximizes its earnings per share.
D) If a firm finds that the cost of debt is less than the cost of equity, increasing its debt ratio must reduce its WACC.
E) Other things held constant, if corporate tax rates declined, then the Modigliani-Miller tax-adjusted theory would suggest that firms should increase their use of debt.

Question 52

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?

A) Since the proposed plan increases the firm's financial risk, the stock price might fall even if EPS increases.
B) If the plan reduces the WACC, the stock price is likely to decline.
C) Since the plan is expected to increase EPS, this implies that net income is also expected to increase.
D) If the plan does increase the EPS, the stock price will automatically increase at the same rate.
E) 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.

Question 53

Which of the following statements is CORRECT?

A) The capital structure that maximizes the stock price is also the capital structure that minimizes the cost of equity from retained earnings (rs).
B) The capital structure that maximizes the stock price is also the capital structure that maximizes earnings per share.
C) The capital structure that maximizes the stock price is also the capital structure that maximizes the firm's times interest earned (TIE) ratio.
D) If a company increases its debt ratio, this will typically increase the marginal costs of both debt and equity, but it still may reduce the company's WACC.
E) 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.

Question 54

Southwest U's campus book store sells course packs for $15 each, the variable cost per pack is $9, fixed costs to produce the packs are $200,000, and expected annual sales are 50,000 packs. What are the pre-tax profits from sales of course packs?

A) $72,900
B) $81,000
C) $90,000
D) $100,000
E) $110,000

Question 55

Which of the following statements is CORRECT?

A) A firm's business risk is determined solely by the financial characteristics of its industry.
B) The factors that affect a firm's business risk include industry characteristics and economic conditions, both of which are generally beyond the firm's control.
C) One of the benefits to a firm of being at or near its target capital structure is that this generally minimizes the risk of bankruptcy.
D) A firm's financial risk can be minimized by diversification.
E) The amount of debt in its capital structure can under no circumstances affect a company's EBIT and business risk.

Question 56

Which of the following statements is CORRECT?

A) As a rule, the optimal capital structure is found by determining the debt-equity mix that maximizes expected EPS.
B) The optimal capital structure simultaneously maximizes EPS and minimizes the WACC.
C) The optimal capital structure minimizes the cost of equity, which is a necessary condition for maximizing the stock price.
D) The optimal capital structure simultaneously minimizes the cost of debt, the cost of equity, and the WACC.
E) The optimal capital structure simultaneously maximizes the stock price and minimizes the WACC.

Question 57

Firms U and L each have the same amount of assets, and both have a basic earning power ratio of 20%. 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 a before-tax cost of 8%. Both firms have positive net income. Which of the following statements is CORRECT?

A) The two companies have the same times interest earned (TIE) ratio.
B) Firm L has a lower ROA than Firm U.
C) Firm L has a lower ROE than Firm U.
D) Firm L has the higher times interest earned (TIE) ratio.
E) Firm L has a higher EBIT than Firm U.

Question 58

Which of the following statements is CORRECT? As a firm increases the operating leverage used to produce a given quantity of output, this

A) normally leads to an increase in its fixed assets turnover ratio.
B) normally leads to a decrease in its business risk.
C) normally leads to a decrease in the standard deviation of its expected EBIT.
D) normally leads to a decrease in the variability of its expected EPS.
E) normally leads to a reduction in its fixed assets turnover ratio.

Question 59

Your uncle is considering investing in a new company that will produce high quality stereo speakers. The sales price would be set at 1.5 times the variable cost per unit; the variable cost per unit is estimated to be $75.00; and fixed costs are estimated at $1,200,000. What sales volume would be required to break even, i.e., to have EBIT = zero?

A) 28,880
B) 30,400
C) 32,000
D) 33,600
E) 35,280

Question 60

Your firm has $500 million of total assets, its basic earning power is 15%, and it currently has no debt in its capital structure. The CFO is contemplating a recapitalization where it would issue debt at a cost of 10% and use the proceeds to buy back some of its common stock, paying book value. If the company goes ahead with the recapitalization, its operating income, total assets, and tax rate would remain unchanged. Which of the following is most likely to occur as a result of the recapitalization?

A) The ROA would increase.
B) The ROA would remain unchanged.
C) The basic earning power ratio would decline.
D) The basic earning power ratio would increase.
E) The ROE would increase.

Question 61

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?

A) 0.71
B) 0.75
C) 0.79
D) 0.83
E) 0.87

Question 62

Senate Inc. is considering two alternative methods for producing playing cards. Method 1 involves using a machine with a fixed cost (mainly depreciation) of $12,000 and variable costs of $1.00 per deck of cards. Method 2 would use a less expensive machine with a fixed cost of only $5,000, but it would require a variable cost of $1.50 per deck. The sale price per deck would be the same under each method. At what unit output level would the two methods provide the same operating income (EBIT)?

A) 12,600
B) 14,000
C) 15,400
D) 16,940
E) 18,634

Question 63

As a consultant to First Responder Inc., you have obtained the following data (dollars in millions)(WACC - g)Oper. income (EBIT)New cost of equity (rs)Interest rate (rd) 8.00%

A) $2,982
B) $3,314
C) $3,682
D) $4,091
E) $4,545

Question 64

Your company, which is financed entirely with common equity, plans to manufacture a new product, a cell phone that can be worn like a wristwatch. Two robotic machines are available to make the phone, Machine A and Machine B. The price per phone will be $250.00 regardless of which machine is used to make it. The fixed and variable costs associated with the two machines are shown below, along with the capital (all equity) that must be invested to purchase each machine. The expected sales level is 25,000 units. Your company has tax loss carry-forwards that will cause its tax rate to be zero for the life of the project, so T = 0. How much higher or lower will the project's ROE be if you select the machine that produces the higher ROE, i.e., what is ROEB - ROEA? (Hint: Since the firm uses no debt and its tax rate is zero, ROE = EBIT/Required investment.)

A) 6.00%
B) 6.67%
C) 7.00%
D) 7.35%
E) 7.72%

Question 65

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?

A) $1.00
B) $1.11
C) $1.23
D) $1.37
E) $1.50

Question 66

Assume that you and your brother plan to open a business that will make and sell a newly designed type of sandal. Two robotic machines are available to make the sandals, Machine A and Machine B. The price per pair will be $20.00 regardless of which machine is used. The fixed and variable costs associated with the two machines are shown below. What is the difference between the breakeven points for Machines A and B? (Hint: Find BEB - BEA)

A) 3,154
B) 3,505
C) 3,894
D) 4,327
E) 4,760

Question 67

A group of venture investors is considering putting money into Lemma Books, which wants to produce a new reader for electronic books. The variable cost per unit is estimated at $250, the sales price would be set at twice the VC/unit, or $500, and fixed costs are estimated at $750,000. 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 the minimum profit goal? (Hint: Use the breakeven formula, but include the required profit in the numerator.)

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

Question 68

Confu Inc. expects to have the following data during the coming year. What is the firm's expected ROE? Assets $200,000 Interest rate 8%
Debt/Assets, book value 65% Tax rate 40%
EBIT $25,000

A) 12.51%
B) 13.14%
C) 13.80%
D) 14.49%
E) 15.21%

Question 69

Gator Fabrics Inc. currently has zero debt. It is a zero growth company, and it has the data shown below. Now the company is considering using some debt, moving to the new debt/assets ratio indicated below. The money raised would be used to repurchase stock at the current price. It is estimated that the increase in risk resulting from the additional leverage would cause the required rate of return on equity to rise somewhat, as indicated below. If this plan were carried out, by how much would the WACC change, i.e., what is WACCOld - WACCNew? New Debt/Assets 55% Orig. cost of equity, rs 10.0%
New Equity/Assets 45% New cost of equity = rs 11.0%
Interest rate new = rd 7.0% Tax rate 40%

A) 2.74%
B) 3.01%
C) 3.32%
D) 3.65%
E) 4.01%

Question 70

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?

A) 5.85%
B) 6.14%
C) 6.45%
D) 6.77%
E) 7.11%

Question 71

Your company plans to produce a new product, a wireless computer mouse. Two machines can be used to make the mouse, Machines A and B. The price per mouse will be $25.00 regardless of which machine is used. The fixed and variable costs associated with the two machines are shown below. At the expected sales level of 75,000 units, how much higher or lower will the firm's expected EBIT be if it uses high fixed cost Machine B rather than low fixed cost Machine A, i.e., what is EBITB - EBITA?

A) $123,019
B) $136,688
C) $151,875
D) $168,750
E) $185,625