Deck 5: Long-Term Financing Decisions

Question 1

The sales break-even point is defined as:

A) the level of sales that a firm must reach to cover operating costs.
B) the level of income that a firm must reach to cover variable costs.
C) the point where operating income equals fixed costs.
D) the level of sales that a firm must reach to cover fixed costs.

Answer 1

the level of sales that a firm must reach to cover operating costs.

Question 2

Firms with high fixed operating costs:

A) tend to have low operating leverage.
B) tend to have low sales levels.
C) tend to have high variable costs.
D) tend to have low variable costs.

Answer 2

tend to have low variable costs.

Question 3

Given fixed costs of $100,000, variable costs of $7.00 per unit, and a sales price per unit of $10.00, calculate the break-even point in units.

A) 10,000
B) 14,286
C) 33,333
D) 5,882

Answer 3

33,333

Question 4

Given fixed costs of $200,000, variable costs of $6.00 per unit, and a sales price per unit of $7.00, calculate the break-even point in units.

A) 33,333
B) 200,000
C) 15,385
D) 28,571

Question 5

Firms with relatively low fixed operating costs and high variable operating costs can best be described as:

A) having a low degree of operating leverage.
B) having no operating leverage.
C) having a high degree of operating leverage.
D) having a normal degree of operating leverage.

Question 6

If variable costs = $10.00 per unit; and the selling price = $13.00 per unit, and the break-even point in units = 100,000, calculate the fixed costs.

A) $4,348
B) $50,000
C) $300,000
D) $33,333

Question 7

Degree of operating leverage can best be defined as:

A)
B)
C)
D)

Question 8

If sales in 1990 were $100,000 and in 2000 sales were $125,000;If operating income in 1999 were $50,000 and in 2000 were $75,000;If net income in 1999 were $10,000 and in 2000 were projected to
Be $15,000; calculate DOL.

A) 6
B) 2
C) 0.5
D) 1

Question 9

Total variable costs are $15,000, sales $50,000, and fixed costs $15,000; calculate DOL.

A) 0.69
B) 1.75
C) 1.45
D) 2

Question 10

Whenever fixed costs are greater than zero, DOL is:

A) greater than 1.
B) equal to 0.
C) nonexistent.
D) less than 1.

Question 11

Operating leverage has the effect of triggering:

A) a larger percentage change in EBIT when a given percentage change in sales occurs.
B) a smaller given percentage change in EBIT when a smaller percentage change in sales occurs.
C) a smaller percentage change in EBIT when a given percentage change in sales occurs.
D) a smaller given percentage change in EBIT when a larger percentage change in sales occurs.

Question 12

You are provided with the following information: Firm X and Firm Y both sell the same products at the same price; both firms are the same size with identical sales levels; Firm X has lower fixed costs and higher variable operating costs than Firm Y. Which firm has the greatest variability in its operating profits?

A) Firm X
B) Firm Y
C) Operating profits would vary equally in both firms.
D) It would depend on the tax effect of net income.

Question 13

If Firm A has a greater variability in operating earnings than Firm B , which firm has the lower DOL?

A) Firm X
B) Firm Y
C) DOL is equal for both.
D) There is no way to tell from the information given.

Question 14

The total degree of business risk that a company faces is:

A) a function of fixed costs only.
B) a function of variability of sales only.
C) a function of fixed costs, variable costs, and variability of net income.
D) a function of fixed costs and variability of sales.

Question 15

Degree of financial leverage can best be described as:

A)
B)
C)
D)

Question 16

Which of the following statements best describes a firm's financial risk? It:

A) is unaffected by long-term debt.
B) decreases with an increase in long-term debt.
C) increases with an increase in long-term debt.
D) decreases with a decrease in stockholder's equity.

Question 17

Your firm has a DOL of 1.25 and an EBIT of $500,000. If sales increase by 10%, calculate the percent change in EBIT.

A) 12%
B) 1.25%
C) 0.125%
D) 12.5%

Question 18

Calculate DFL.

A) 1.36
B) 1.09
C) 0.01
D) 2.20

Question 19

Calculate DFL.

A) 1.03
B) 0.98
C) 4
D) 1

Question 20

The financial risk of a firm:

A) compounds the effect of business risk and intensifies volatility of net income.
B) depends on its business risk.
C) lowers the effect of business risk and intensifies volatility of EBIT.
D) decreases the effect of business risk and intensifies volatility of net income.

Question 21

Degree of combined leverage can best be described as:

A)
B)
C)
D)

Question 22

Calculate DCL.

A) 1.14
B) 1.13
C) 0.89
D) 1.2

Question 23

A prudent firm with higher than average operating leverage for their industry will generally tend to have:

A) less risk and higher profit potential.
B) higher interest expense.
C) higher financial leverage.
D) lower financial leverage.

Question 24

All else constant, a leveraged buyout will usually result in:

A) an increase in DFL.
B) a decrease in DCL.
C) a decrease in DFL.
D) an increase in DOL.

Question 25

A leveraged buyout can hurt the holders of previously issued bonds because:

A) there is no effect as old debt will be part of the buyout.
B) they are not hurt because the increased debt means their bonds are riskier and the yields to maturity must rise.
C) the increased debt levels make existing debt riskier.
D) it creases the DOL.

Question 26

With respect to financial risk, Modigliani and Miller concluded that:

A) if an interest payment is tax deductible, an all debt capital structure is optimal.
B) an all-debt structure is theoretically not feasible.
C) if an interest payment is not tax deductible, a no debt capital structure is optimal.
D) if an interest payment is tax deductible, debt and equity should be evenly divided.

Question 27

As a firm moves to a capital structure with higher debt:

A) financial risk of the firm decreases if interest payments are tax deductible.
B) financial risk of the firm is unaffected if interest payments are tax deductible.
C) financial risk of the firm increases.
D) DOL increases.

Question 28

Capital structure can best be described as:

A) the combination of long-term debt, preferred stock, common stock, and retained earnings.
B) the combination of everything on the income statement.
C) the combination of common stock, retained earnings, current liabilities, and long-term debt.
D) the combination of everything on the left-hand side of the balance sheet.

Question 29

Calculate DFL.

A) 1.00
B) 1.67
C) 1.12
D) 1.05

Question 30

Calculate DCL.

A) 2.08
B) 1.95
C) 1.12
D) 1.67

Question 31

The mixture of funding sources that a firm uses to finance its assets is:

A) capital structure.
B) financial leverage.
C) financial operations.
D) operating leverage.

Question 32

A small group of investors using borrowed funds to purchase all the shares of a publicly traded company is called:

A) underwriting.
B) leveraged buyout.
C) equity carve-out.
D) initial public offering.

Question 33

Which of the following factors would NOT directly affect the optimal capital structure?

A) the cost of debt, preferred stock, and common equity
B) investor perceptions
C) market conditions
D) the number of common shares outstanding

Question 34

Which of the following statements is true?

A) The optimal capital structure can be determined using a complicated formula and managerial expertise.
B) Leveraged buyouts decrease bondholder (creditor) risk.
C) The interest payment tax shield lowers the cost of debt.
D) The risk on debt for investors is higher than the risk on equity.

Question 35

Fixed costs affect:

A) leveraged buyouts.
B) operating leverage.
C) financial leverage.
D) capital structure.

Question 36

Calculate the break-even point in units for: (treat each scenario independently)
a. fixed costs decrease to $450,000
b. variable cost decreases to $37 per unit
c. sales price increases to $55/unit
d. changes for a, b, c, occur simultaneously

Question 37

Company X has a sales price of $4.00 per unit and a variable cost of $3.40 per unit; fixed costs are $13,000, no debt, and sales of 250,000 units per year. Company Y has a sales price of $10.00 per unit and a variable cost of $7.00 per unit with fixed costs of $135,000 and sales of 200,000 units per year. Company Y also has interest payments of $60,000 annually. Both companies are in the 40% tax bracket.
a. compute DOL, DFL, and DCL for Company X
b. compute DOL, DFL, and DCL for Company Y
c. compare the relative risk of both companies

Question 38

A firm has fixed expenses of $3,500 per month and will sell its product for $30.00. Variable expenses are $28.00 per unit.
a. How many units must be sold for the firm to break even?

Question 39

Explain how a firm can establish its optimal capital structure.

Question 40

What is the difference between DOL and DFL?

Question 41

Given a net income of $50,000, sales of $2,000,000, variable costs of $25,000, fixed operating costs of $175,000, price per unit of $5.00, interest expense of $20,000, and EBIT of $1,800,000:
a. calculate DOL
b. calculate DFL
c. calculate DCL

Question 42

Explains what happens to a firm's break-even point if it is able to lower its fixed operating costs but keeps its variable operating costs per unit constant.

Question 43

If a firm has a DOL of 5, explain what this number actually means.

Question 44

Why is the Modigliani and Miller theory of capital structure not really practical for firms in the real world?

Question 45

Explain how a firm's DOL affects its financing decisions.

Question 46

Which firm has a higher degree of operating leverage: an oil refinery or a lawnmower assembly plant? Why?

Question 47

Debt financing is often called a two-edged sword. What does this mean?

Question 48

Why is debt less expensive than equity as a form of funding?

Question 49

If debt is the cheapest form of capital, why does a corporation's minimal WACC occur at a debt level well below that where debt is 99.99% of the capital structure?

Question 50

An indenture is best described as:

A) a prospectus.
B) a contract.
C) a bond rating.
D) a bond.

Question 51

A legal document that gives the provisions of a bond issue is called:

A) a covenant.
B) a term-loan agreement.
C) an indenture
D) a debenture.

Question 52

A bond rated Baa3 or above by Moody's would be considered to be:

A) junk.
B) speculative.
C) in default.
D) investment grade.

Question 53

To be classified as a secured bond, the bond indenture would have to include:

A) a claim on specific assets in the event of default.
B) an independent trustee.
C) no restrictive covenants.
D) a plan for paying off the bond at maturity.

Question 54

A bond with staggered maturities would best be described as:

A) a term bond.
B) a sinking fund bond.
C) a capital appreciation bond.
D) a serial bond.

Question 55

The required regular payments into a fund that is used to buy back outstanding bonds is referred to as a:

A) a call premium.
B) a sinking fund.
C) an escrow account.
D) a serial bond retirement account.

Question 56

A medium-grade bond according to Moody's has a rating of:

A) A
B) B
C) Baa
D) Aaa

Question 57

A firm might call an outstanding bond:

A) when its cost of capital increases.
B) when it needs to raise new funds.
C) when interest rates fall.
D) when interest rates rise.

Question 58

The call price will exceed the par value by an amount called:

A) the percentage of price.
B) the redemption price.
C) the call premium.
D) the call discount.

Question 59

Using the call premium to issue new bonds to replace old bonds is called:

A) a serial redemption.
B) a sinking fund redemption.
C) a provisional call.
D) a refunding operation.

Question 60

With respect to a refunding operation, the primary incremental cash inflow comes from:

A) interest savings.
B) the call premium.
C) capital budgeting cash flows.
D) flotation costs.

Question 61

Restrictive covenants would likely prohibit the issuing firm from doing any of the following except:

A) increasing current liabilities.
B) paying dividends.
C) issuing common stock.
D) issuing future debt.

Question 62

Which of the following is an example of a secured bond:

A) refunded bond.
B) subordinated debenture.
C) debenture.
D) mortgage bond.

Question 63

A senior debenture or subordinated debenture can best described as:

A) unsecured by assets but representing a general claim on the firm's assets.
B) secured by specific assets of the firm.
C) unsecured by assets and not representing a claim on any of the firm's assets.
D) unsecured by assets and not representing a claim of any sort on the firm.

Question 64

A convertible bond enables the holder to:

A) convert the bond to cash on demand.
B) convert the bond into shares of common stock or for some issues another type of security.
C) convert the annual interest payments to semiannual payments.
D) convert the bond coupon into shares of common stock.

Question 65

Conversion value equals:

A) conversion ratio/stock price.
B) call premium times the stock price.
C) stock price/conversion ratio.
D) conversion ratio times the stock price.

Question 66

The straight bond value of a convertible bond is:

A) its value at maturity.
B) its value based on the underlying price of the common stock.
C) its value based on yield to maturity.
D) its value based on the call premium.

Question 67

A convertible bond should always be worth at least:

A) the conversion value.
B) the convertible premium.
C) the straight debt value.
D) whichever is greater: the conversion value or straight debt value.

Question 68

A putable bond can best be described as:

A) a bond that the investor can force to be retired early.
B) a junk bond that is refundable.
C) a secured mortgage bond.
D) a bond that the issuer can retire early.

Question 69

Which of the following could not describe a junk bond?

A) investment grade bond
B) fallen angel
C) high yield bond
D) leveraged-buyout bond

Question 70

A bond denominated in the currency of the issuing company's home country and sold in another country would be:

A) Eurobond.
B) foreign bond.
C) foreign currency bond.
D) Yankee bond.

Question 71

With respect to sources of long-term funds, which is used the least?

A) long-term bonds
B) preferred stock
C) common stock
D) bank loans

Question 72

Cash dividends on preferred stock:

A) are generally fixed.
B) are paid after common stock dividends.
C) are personally tax exempt.
D) fluctuate with earnings.

Question 73

With respect to preferred stock, if a dividend is missed and must be paid at a later date before Common Share dividends are paid, it is:

A) a fixed payment preferred stock.
B) a cumulative preferred stock.
C) a rarely used feature.
D) a continuous preferred stock.

Question 74

Which of the following statements best describes preferred stock?

A) It must be paid its dividend before the common shareholders can receive a dividend.
B) It enables the holder to have voting rights.
C) Since it is a form of debt, its dividends must be paid each year.
D) It has a fluctuating claim on earnings.

Question 75

Which of the following statements is NOT true about an operating lease?

A) It can usually be cancelled by the lessee.
B) It does not appear on the income statement.
C) It has a term shorter than the useful life of the asset.
D) It does not appear on the balance sheet.

Question 76

Which of the following is never used to define a capital lease?

A) The present value of the lease payments equals 90% or more of the fair market value of the asset at time the lease is originated.
B) There is an option for the lessee to buy the asset as a bargain purchase price at the end of the lease period.
C) The lease period is less than or equal to 75% of the estimated useful life of the asset.
D) Ownership of the asset is transferred to the lessee at the end of the lease's term.

Question 77

The most attractive feature of an operating lease is:

A) you enjoy tax benefits during the life of the lease and can sell the asset at the end of the lease.
B) lease payments reduce taxes payable at the end of the year.
C) only interest payments must be deducted from income.
D) lease payments provide an immediate tax saving.

Question 78

Whether to lease or buy would be indicated by:

A) the alternative with the greater tax and depreciation benefit.
B) the alternative with the greater depreciation benefit.
C) the alternative with the lower present value of cash outflows after taxes.
D) the alternative with the greater tax benefit.

Question 79

If a long-term lease cannot be canceled by the lessee, it is called:

A) a capital budgeting lease.
B) a tax-deductible lease.
C) an operating lease.
D) a capital lease.

Question 80

A ________ oversees the bond issue and makes sure all the provisions are adhered to.

A) indenture supervisor
B) trustee
C) senior mortgage officer
D) underwriter