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Exam 14: Capital Structure and Leverage

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Question 1

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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.

A) True
B) False

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Question 2

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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 harder to sell (like those engaged in research and development).

A) True
B) False

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Question 3

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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.

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 $260.00 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 27,000 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 ROE_B - ROE_A? (Hint: Since the firm uses no debt and its tax rate is zero,ROE = EBIT/Required investment. ) $\begin{array}{lrr}& \text { Machine A } & \text { Machine B } \\\text { Price per phone (P) } & \$ 260.00 & \$ 260.00 \\\text { Fixed costs (F) } & \$ 1,000,000 & \$ 2,000,000 \\\text { Variable costinit (V) } & \$ 210.00 & \$ 160.00 \\\text { Expected unit sales (Q) } & 27,000 & 27,000 \\\text { Required equity investment } & \$ 2,500,000 & \$ 3,000,000\end{array}$ ?

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.

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

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?

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?

Confu Inc.expects to have the following data during the coming year.What is the firm's expected ROE? $\begin{array} { l r l r } \text { Capital } & \$ 200,000 & \text { Interest rate } & 8 \% \\\text { Debt/Capital, book value } & 65 \% & \text { Tax rate } & 40 \% \\\text { EBIT } & \$ 25,000 & &\end{array}$ ?

Which of the following statements is CORRECT?

Companies HD and LD have the same total assets,total investor-supplied capital,operating income (EBIT) ,tax rate,and business risk.Company HD,however,has a much higher debt ratio than LD.Also,both companies' returns on investors' capital (ROIC) exceed their after-tax costs of debt,r_d(1 - T) .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 $17,000 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) ?

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.

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 $350,000.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 break-even formula,but include the required profit in the numerator. )

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.

Which of the following statements is CORRECT?

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

Companies HD and LD have identical amounts of assets,investor-supplied capital,operating income (EBIT) ,tax rates,and business risk.Company HD,however,has a higher debt ratio than LD.Company HD's return on investors' capital (ROIC) exceeds its after-tax cost of debt,r_d(1 - T) .Which of the following statements is CORRECT?

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

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?