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Exam 15: Capital Structure

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Question 21

Multiple Choice

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Companies HD and LD have the same total assets, total investor-supplied capital, operating income 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 ROIC > rd(1 - T) , HD's stock price must exceed that of LD.
E) Given that ROIC > rd(1 - T) , LD's stock price must exceed that of HD.

F) A) and D)
G) B) and C)

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Question 22

Multiple Choice

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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.

F) None of the above
G) C) and D)

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Question 23

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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 every firm 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.

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?

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?

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.

Some people--including the current 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.

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?

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.

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?

Firms HD and LD are identical except for their use of debt and the interest rates they pay--HD has more debt and thus must pay a higher interest rate. Based on the data given below, how much higher or lower will HD's ROE be versus that of LD, i.e., what is ROEHD - ROELD?

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.

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?

Confu Inc. expects to have the following data during the coming year. What is the firm's expected ROE?

Dyson Inc. currently finances with 20.0% debt (i.e., wd = 20%) , but its new CFO is considering changing the capital structure so wd = 60.0% by issuing additional bonds and using the proceeds to repurchase and retire common shares so the percentage of common equity in the capital structure (wc) = 1 - wd. Given the data shown below, by how much would this recapitalization change the firm's cost of equity? (Hint: You must unlever the current beta and then use the unlevered beta to solve the problem.)

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 Machine B with high fixed costs rather than Machine A with low fixed costs, i.e., what is EBITB - EBITA?

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) ?

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%.