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Exam 13: Capital Structure and Leverage

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Question 1

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Which of the following statements is CORRECT?

A) When a company increases its debt ratio, the costs of equity and debt both increase. Therefore, the WACC must also increase.
B) The capital structure that maximizes the stock price is generally the capital structure that also maximizes earnings per share.
C) All else equal, an increase in the corporate tax rate would tend to encourage companies to increase their debt ratios.
D) Since debt financing raises the firm's financial risk, increasing a company's debt ratio will always increase its WACC.
E) Since the cost of debt is generally fixed, increasing the debt ratio tends to stabilize net income.

F) D) and E)
G) A) and B)

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Question 2

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If a firm utilizes debt financing, a 10% decline in earnings before interest and taxes (EBIT) will result in a decline in earnings per share that is larger than 10%, and the higher the debt ratio, the larger this difference will be.

A) True
B) False

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Question 3

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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.

You plan to invest in one of two home delivery pizza companies, High and Low, that were recently founded and are about to commence operations. They are identical except for their use of debt (wd) and the interest rates on their debt-High uses more debt and thus must pay a higher interest rate. Based on the data given below, how much higher or lower will High's expected EPS be versus that of Low, i.e., what is EPSHigh ? EPSLow? $\begin{array}{c}\begin{array}{cc}\underline{\text { Applicable to Both Firms} } \\\text { Capital } \quad \$ 3,000,000 \\\text { EBIT } \quad \$ 500,000 \\\text { Tax rate } \quad 35 \%\end{array}\begin{array}{cc}\underline{\text { Firm High's Data }} \\\mathrm{w}_{\mathrm{d}} \quad 70 \% \\\text { Shares } \quad 90,000 \\\text { Int. rate } \quad 12 \% \end{array}\begin{array}{cc}\underline{\text { Firm Low's Data} }\\\mathrm{w}_{\mathrm{d}} \quad 20 \% \\\text { Shares } \quad 240,000 \\\text { Int. rate } \quad 10 \% \end{array}\end{array}$

Your firm is currently 100% equity financed. The CFO is considering a recapitalization plan under which the firm would issue long-term debt with an after-tax yield of 9% and use the proceeds to repurchase some of its common stock. The recapitalization would not change the company's total investor-supplied capital, the size of the firm (i.e., total assets) , and it would not affect the firm's return on investors' capital (ROIC) , 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?

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.

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

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

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?

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 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.

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

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

Some people-including the former chairman of the Federal Reserve Board of Governors (Ben Bernanke)-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.

Which of the following statements is CORRECT?

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

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

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 sales 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) ?

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