Deck 10: Leverage and Capital Structure

Question 1

The higher financial leverage causes_________to increase more for a given increase in_________

A) EBIT, sales
B) EBIT, EPS
C) EPS, EBIT
D) EPS, sales

Answer 1

EPS, EBIT

Question 2

The preferred approach to break-even analysis for the multiproduct firm is the

A) break-even point expressed in dollars.
B) overall break-even point.
C) cash break-even point.
D) break-even point expressed in units.

Answer 2

break-even point expressed in dollars.

Question 3

The controversy over the existence of an optimal capital structure is debated between those_________who believe a traditional approach exists and those _________, who do not believe one exists. In the _________approach to capital structure, the optimal capital structure occurs where the_________is minimized.

A) traditionalists; supporters of Modigliani and Miller; traditional; cost of capital
B) traditionalists; supporters of Modigliani and Miller; traditional; degree of financial leverage
C) supporters of Modigliani and Miller; traditionalists; Modigliani and Miller; cost of capital
D) supporters of Modigliani and Miller; traditionalists; Modigliani and Miller; degree of financial leverage.

Answer 3

traditionalists; supporters of Modigliani and Miller; traditional; cost of capital

Question 4

Noncash charges such as depreciation and amortization_________the firm's break-even point.

A) do not affect
B) decrease
C) overstate
D) understate

Question 5

Fixed financial charges include

A) stock repurchase expense.
B) bond interest expense and preferred stock dividends.
C) common stock dividends and bond interest expense.
D) common stock dividends and preferred stock dividends.

Question 6

The cost of debt financing results from

A) the agency costs of the lender's monitoring and controlling the firm's actions.
B) the costs associated with managers having more information about the firm's prospects than do investors.
C) the increased profitability of bankruptcy caused by debt obligations.
D) all of the above.

Question 7

_________is the potential use of fixed operating costs to magnify the effects of changes in sales on earnings before interest and taxes.

A) Financial leverage
B) Total leverage
C) Operating leverage
D) Ratio analysis

Question 8

In 1999, the overall debt ratio for all Canadian industries is_________percent which is the result of_________companies being included.

A) 74.9%; manufacturing
B) 12.1%; wholesaling
C) 74.9%; financial
D) 12.1%; retailing

Question 9

In theory, the firm should maintain financial leverage consistent with a capital structure that

A) maximizes the earnings per share.
B) meets the industry standard.
C) maximizes dividends.
D) maximizes the owner's wealth.

Question 10

M and M Proposition II states that

A) the value of a firm's assets and operations does not change with changes in the firm's capital structure.
B) the value of the firm is maximized when the WACC after-tax is minimized.
C) the cost of equity is a positive linear function of its capital structure.
D) the only risk relevant in measuring the cost of equity is business risk.

Question 11

The major shortcoming of the EBIT-EPS approach to capital structure is that

A) the technique does not consider the cost of capital.
B) the technique does not promote the maximization of shareholder wealth.
C) the technique only considers leverage-related risk.
D) the technique does not maximize earnings per share.

Question 12

With the existence of fixed operating costs, an increase in sales will result in___________increase inEBIT.

A) a proportional
B) a more than proportional
C) a less than proportional
D) an equal

Question 13

At the operating break-even point,_________equals zero.

A) sales revenue
B) earnings before interest and taxes
C) variable operating costs
D) fixed operating costs

Question 14

M and M Proposition I states that

A) the value of a firm's assets and operations does not change with changes in the firm's capital structure.
B) the value of the firm is maximized when the WACC after-tax is minimized.
C) the cost of equity is a positive linear function of its capital structure.
D) the only risk relevant in measuring the cost of equity is business risk.

Question 15

A firm has a current capital structure consisting of $400,000 of 12 percent annual interest debt and50,000 shares of common stock. The firm's tax rate is 40 percent on ordinary income. If the EBIT isexpected to be $200,000, two EBIT-EPS coordinates for the firm's existing capital structure are

A) ($0, $48,000) and ($200,000, $1.82)
B) ($152,000, $3.50) and ($150,000, $1.82)
C) ($36,000, $0) and ($200,000, $3.04)
D) ($48,000, $0) and ($200,000, $1.82)

Question 16

An increase in fixed operating costs will result in_________in the degree of operating leverage.

A) an undetermined change
B) a decrease
C) an increase
D) no change

Question 17

A corporation borrows $1,000,000 at 10 percent annual rate of interest. The firm has a 40 percent taxrate. The yearly, aftertax cost of this debt is ___________ .

A) $166,667
B) $100,000
C) $40,000
D) $60,000

Question 18

Using debt to raise capital is frequently viewed as a___________signal by the financial community.

A) negative
B) weak
C) neutral
D) positive

Question 19

With the existence of fixed operating costs, a decrease in sales will result in_________in EBIT.

A) a less than proportional decrease
B) an equal increase
C) a more than proportional decrease
D) a proportional increase

Question 20

_________leverage is concerned with the relationship between earnings before interest and taxes and earnings per share.

A) Variable
B) Financial
C) Total
D) Operating

Question 21

As fixed operating costs increase and all other factors are held constant, the degree of operating leverage will

A) remain unchanged.
B) decrease.
C) change in an undetermined direction.
D) increase.

Question 22

If a firm's fixed financial costs decrease, the firm's operating break-even point will

A) change in an undetermined direction.
B) increase.
C) remain unchanged.
D) decrease.

Question 23

Hammel Corporation is comparing two different capital structures, an all-equity plan and alevered plan. Under the all-equity plan, Hammel would have 80,000 shares of stock outstanding.Under the levered plan, there would be 50,000 shares outstanding and $300,000 in debtoutstanding. A share of stock is valued to be $10 regardless of the plan. The interest rate on the debt is 8%. Ignoring taxes, at EBIT equal to $100,000, shareholders of Hammel Corporation would

A) prefer the levered plan.
B) be indifferent to which plan is selected.
C) prefer the all-equity plan.
D) which plan is better cannot be determined with the information provided

Question 24

A corporation has $5,000,000 in 8 percent preferred stock outstanding and a 40 percent tax rate. The aftertax cost of the preferred stock is___________.

A) $160,000
B) $666,667
C) $240,000
D) $400,000

Question 25

The risk of debt capital is less than that of other long-term contributors of capital because

A) it has far stronger legal pressure against the company to make payment than do preferred and common stockholders.
B) it has a higher priority of claim against any earnings or assets available for payment.
C) the tax-deductibility of interest payments lowers the debt cost to the firm substantially.
D) of all of the above.

Question 26

The three basic types of leverage are:

A) operating, production, and financial.
B) operating, financial, and total.
C) operating, production, and total.
D) production, financial, and total.

Question 27

A firm has fixed operating costs of $10,000, the sale price per unit of its product is $25, and its variable cost per unit is $15. The firm's operating break-even point in units is___________ and its breakeven point in dollars is___________ .

A) 400; $10,000
B) 250; $ 6,250
C) 667; $16,675
D) 1,000; $25,000

Question 28

If a firm's sale price per unit decreases, the firm's operating break-even point will

A) remain unchanged.
B) change in an undetermined direction.
C) decrease.
D) increase.

Question 29

The optimal capital structure is the one that balances

A) return and risk factors in order to maximize profits.
B) return and risk factors in order to maximize market value.
C) return and risk factors in order to maximize earnings per share.
D) return and risk factors in order to maximize dividends.

Question 30

The firm's ___________is the mix of long-term debt and equity utilized by the firm, which maysignificantly affect its value by affecting return and risk.

A) working capital
B) dividend policy
C) capital budget
D) capital structure

Question 31

Poor capital structure decisions can result in___________the cost of capital, resulting in___________acceptable investments. Effective capital structure decisions can___________ the cost of capital,resulting in ___________acceptable investments.

A) increasing; more; lower, fewer
B) decreasing; fewer; higher; more
C) decreasing; more; higher; fewer
D) increasing; fewer; lower; more

Question 32

A firm has fixed operating costs of $150,000, total sales of $1,500,000, and total variable costs of$1,275,000. The firm's operating break-even point in dollars is___________ .

A) $1,425,000
B) $176,471
C) $1,000,000
D) $150,000

Question 33

___________leverage is concerned with the relationship between sales revenue and earnings per share.

A) Financial
B) Variable
C) Operating
D) Total

Question 34

Management has just discovered an excellent investment for which it needs additional funding.Relative to the discussion on asymmetric information the firm should

A) finance with new common stock if management believes the firm is undervalued.
B) finance with preferred stock if the firm is at value.
C) finance with debt if management believes the firm is undervalued.
D) finance with debt if management believes the firm is overvalued.

Question 35

Probability of bankruptcy is determined by

A) business risk.
B) total risk.
C) interest rate risk.
D) financial risk.

Question 36

Operating and financial constraints placed on a corporation by loan provisions are

A) agency costs to the firm.
B) necessary to control the risk of the firm.
C) agency costs to the lender.
D) interest rate costs to the firm.

Question 37

One function of break-even analysis is to

A) evaluate the profitability of various sales levels.
B) create profits.
C) describe leverage.
D) determine the amount of financing needed by the firm.

Question 38

A firm's operating break-even point is sensitive to all of the following variables EXCEPT

A) fixed operating costs.
B) interest payments.
C) sales price per unit.
D) the variable operating cost per unit.

Question 39

A firm has fixed operating costs of $525,000, of which $125,000 is depreciation expense. The firm's sales price per unit is $35 and its variable cost per unit is $22.50. The firm's cash operatingbreak-even point in units is ____________.

A) 23,330
B) 42,000
C) 32,000
D) 52,000

Question 40

Which of the following is NOT a variable cost?

A) direct labor
B) rent
C) materials used
D) delivery costs

Question 41

After satisfying obligations to creditors, the government, and preferred stockholders, any remaining earnings will most likely be allocated to any of the following EXCEPT

A) retention by the firm for future investment.
B) common shareholders as cash dividends.
C) common shareholders as stock dividends.
D) a combination of retained earnings and cash dividends.

Question 42

As debt is substituted for equity in the capital structure and the debt ratio increases, all of thefollowing statements about the component costs of capital are true EXCEPT

A) the cost of debt continually increases.
B) the overall cost of capital continually increases.
C) the cost of equity continually increases.
D) the overall cost of capital first declines, reaches a minimum, and then rises again.

Question 43

Business risk is affected by all of the following EXCEPT

A) operating leverage.
B) earnings per share.
C) revenue stability.
D) cost stability.

Question 44

In the EBIT-EPS approach to capital structure, risk is represented by

A) shifts in the times-interest-earned ratio.
B) the slope of the capital structure line.
C) shifts in the cost of debt capital.
D) shifts in the cost of equity capital.

Question 45

Generally,__________in leverage result in,__________return and,__________risk.

A) increases, increased, increased
B) increases, decreased, increased
C) decreases, increased, decreased
D) increases, decreased, decreased

Question 46

A firm has fixed operating costs of $25,000, a per unit sales price of $5, and a variable cost per unit of $3. What is its operating break-even point if it desires net operating income of $10,000, not $0 (zero)?

A) 15,000 units
B) 17,500 units
C) 12,500 units
D) 25,000 units

Question 47

As debt is substituted for equity in the capital structure and the debt ratio increases, the behavior of the overall cost of capital is partially explained by

A) the reduction in risk as perceived by the common shareholders.
B) the tax-deductibility of interest payments.
C) the increase in the number of common shares outstanding.
D) the decrease in the cost of equity.

Question 48

__________is the potential use of fixed costs, both operating and financial, to magnify the effect of changes in sales on the firm's earnings per share.

A) Operating leverage
B) Debt service
C) Total leverage
D) Financial leverage

Question 49

A decrease in fixed financial costs will result in___________in financial risk

A) no change
B) an undetermined change
C) a decrease
D) an increase

Question 50

The firm's operating break-even point is the point at which

A) EBIT is less than sales.
B) total operating costs equal total fixed costs.
C) EBIT is zero.
D) total operating costs are zero.

Question 51

In the EBIT-EPS approach to capital structure, a constant level of EBIT is assumed

A) to emphasize the relationship between interest expenses and taxes.
B) to ease the calculations of owners' equity.
C) to isolate the impact on returns of the financing costs associated with alternative capital structures.
D) to concentrate on the effect of revenue and expense on capital structure decisions.

Question 52

A firm has fixed operating costs of $253,750, a sales price per unit of $100, and a variable cost perunit of $65. The firm's operating break-even point in dollars is__________ .

A) $700,000
B) $725,000
C) $390,385
D) $906,250

Question 53

Because the degree of total leverage is multiplicative and not additive, when a firm has very high operating leverage it can moderate its total risk by

A) using more financial leverage.
B) increasing EBIT.
C) using a lower level of financial leverage.
D) increasing sales.

Question 54

A major assumption of break-even analysis and one which causes severe limitations in its use is that

A) revenues and operating costs are linear.
B) all costs are really semi-variable.
C) fixed costs really are fixed.
D) total revenue is nonlinear.

Question 55

A firm has an operating profit of $300,000, interest of $35,000, and a tax rate of 40 percent. The firm has an after-tax cost of debt of 5 percent and a cost of equity of 15 percent. The firm's target capital structure is set at a mix of 40 percent debt and 60 percent equity. According to the traditional approach to capital structure, the value of the firm is

A) $1.4 million.
B) $6.0 million.
C) $2.7 million.
D) $2.0 million.

Question 56

The firm's__________ is the level of sales necessary to cover all operating costs, i.e., the point at which EBIT = $0.

A) total break-even point
B) cash break-even point
C) financial break-even point
D) operating break-even point

Question 57

Through the effects of financial leverage, when EBIT increases, earnings per share will

A) decrease.
B) remain unchanged.
C) increase.
D) change in an undetermined direction.

Question 58

Earnings before interest and taxes (EBIT) is a descriptive label for

A) gross profits.
B) operating profits.
C) net profits before taxes.
D) earnings per share.

Question 59

At a base sales level of $400,000, a firm has a degree of operating leverage of 2 and a degree offinancial leverage of 1.5. The firm's degree of total leverage is ____________.

A) 1.3
B) 0.5
C) 3.0
D) 3.5

Question 60

The per dollar contribution toward fixed operating costs and profits provided by each dollar ofsales is the

A) expense ratio.
B) contribution margin.
C) fixed coverage ratio.
D) profit margin.

Question 61

If a firm's variable costs per unit increase, the firm's operating break-even point will

A) increase.
B) remain unchanged.
C) decrease.
D) change in an undetermined direction.

Question 62

A corporation has $5,000,000 in 10 percent bonds and $3,000,000 in 12 percent preferred stockoutstanding. The firm's financial break-even (assuming a 40 percent tax rate) is __________.

A) $1,100,000
B) $1,400,000
C) $716,000
D) $860,000

Question 63

A firm is analyzing two possible capital structures-30 and 50 percent debt ratios. The firm has total assets of $5,000,000 and common stock valued at $50 per share. The firm has a marginal tax rate of40 percent on ordinary income. If the interest rate on debt is 7 percent and 9 percent for the 30 percent and the 50 percent debt ratios, respectively, the amount of interest on the debt under each of the capital structures being considered would be

A) 30 percent debt ratio: $135,000 and 50 percent debt ratio: $175,000.
B) 30 percent debt ratio: $245,000 and 50 percent debt ratio: $225,000.
C) 30 percent debt ratio: $105,000 and 50 percent debt ratio: $250,000.
D) 30 percent debt ratio: $105,000 and 50 percent debt ratio: $225,000.

Question 64

The inexpensive nature of long-term debt in a firm's capital structure is due to the fact that

A) dividend payments are tax-deductible.
B) equity capital has a fixed return.
C) creditors have a higher position in the priority of claims.
D) the equity holders are the true owners of the firm.

Question 65

A decrease in fixed operating costs will result in__________in the degree of financial leverage

A) an undetermined change
B) an increase
C) no change
D) a decrease

Question 66

The conflict resulting from a manager's desire to increase the firm's risk without increasing currentborrowing costs and a lenders' desire to limit lending is one effect of the_________problem.

A) agency
B) capital
C) variable cost
D) leverage

Question 67

The lower risk nature of long-term debt in a firm's capital structure is due to the fact that

A) dividend payments are tax-deductible.
B) equity capital has a fixed return.
C) creditors have a higher position in the priority of claims.
D) the equity holders are the true owners of the firm.

Question 68

Break-even analysis is used by the firm

A) to determine the level of operations necessary to cover all operating costs.
B) to evaluate the profitability associated with various levels of sales.
C) for both A and B.
D) for none of the above.

Question 69

In order to enhance the wealth of stockholders and to send positive signals to the market,corporations generally raise funds using the following order

A) equity, retained earnings, debt.
B) debt, retained earnings, equity.
C) retained earnings, equity, debt.
D) retained earnings, debt, equity.

Question 70

The long-term funds of the firm are called

A) equity.
B) debt.
C) assets.
D) capital.

Question 71

The key differences between debt and equity capital include all of the following EXCEPT

A) maturity.
B) a voice in management.
C) tax treatment.
D) effect on operating leverage.

Question 72

The_________approach to capital structure proposes that an optimal capital structure be selected which_________.

A) M and M; maximizes the weighted average cost of capital
B) residual theory; minimizes dividends
C) EBIT-EPS; maximizes the EPS
D) traditional; minimizes the cost of debt

Question 73

All of the following affect business risk EXCEPT

A) revenue stability.
B) interest rate stability.
C) operating leverage.
D) cost stability.

Question 74

The basic shortcoming of the EBIT-EPS approach to capital structure is

A) its disregard for the firm's dividend policy.
B) that the optimal capital structure is difficult to compute.
C) its disregard for the presence of preferred stock in the capital structure.
D) that it concentrates on the maximization of EPS rather than the maximization of owner's wealth.

Question 75

If a firm's fixed operating costs decrease, the firm's operating break-even point will

A) decrease.
B) change in an undetermined direction.
C) increase.
D) remain unchanged.

Question 76

Which of the following is NOT a reason why debt capital is considered to be the least risky source of capital?

A) It does not normally have to be repaid at a specific future date.
B) It has a strong legal position.
C) It has a high priority claim against assets and earnings.
D) It is a low cost source of capital because interest payments are tax deductible.

Question 77

A firm has fixed operating costs of $175,000, total sales revenue of $3,000,000 and total variable costs of $2,250,000.The firm's degree of operating leverage is __________ .

A) 0.81
B) 4.29
C) 0.77
D) 1.30

Question 78

A firm is analyzing two possible capital structures-30 and 50 percent debt ratios. The firm has totalassets of $5,000,000 and common stock valued at $50 per share. The firm has a marginal tax rate of40 percent on ordinary income. The number of common shares outstanding for each of the capital structures would be

A) 30 percent debt ratio: 50,000 shares and 50 percent debt ratio: 70,000 shares.
B) 30 percent debt ratio: 70,000 shares and 50 percent debt ratio: 100,000 shares.
C) 30 percent debt ratio: 70,000 shares and 50 percent debt ratio: 50,000 shares.
D) 30 percent debt ratio: 30,000 shares and 50 percent debt ratio: 50,000 shares.

Question 79

According to the traditional approach to capital structure, the value of the firm will be maximized when

A) the dividend payout is maximized.
B) the weighted average cost of capital is minimized.
C) the cost of debt is minimized.
D) the financial leverage is maximized.

Question 80

A firm has interest expense of $145,000, preferred dividends of $25,000, and a tax rate of 40 percent.The firm's financial break-even point is _________.

A) $186,667
B) $ 25,000
C) $170,000
D) $145,000