Question 1

Monroe Inc. is an all-equity firm with 500,000 shares outstanding. It has $2,000,000 of EBIT, and EBIT is expected to remain constant in the future. The company pays out all of its earnings, so earnings per share (EPS)  equal dividends per shares (DPS) , and its tax rate is 40%. The company is considering issuing $5,000,000 of 9.00% bonds and using the proceeds to repurchase stock. The risk-free rate is 4.5%, the market risk premium is 5.0%, and the firm's beta is currently 0.90. However, the CFO believes the beta would rise to 1.10 if the recapitalization occurs. Assuming the shares could be repurchased at the price that existed prior to the recapitalization, what would the price per share be following the recapitalization? (Hint: P0 = EPS/rs because EPS = DPS.)

Accepted Answer

A)   $28.27
B)   $29.76
C)   $31.25
D)   $32.81
E)   $34.45F) A) and D)
G) A) and C)

Question 2

Which of the following statements is CORRECT?

Accepted Answer

A)   Increasing its use of financial leverage is one way to increase a firm's return on investors' capital (ROI
C)  .
B)   If a firm lowered its fixed costs but increased its variable costs by just enough to hold total costs at the present level of sales constant, this would increase its operating leverage.
C)   The debt ratio that maximizes expected EPS generally exceeds the debt ratio that maximizes share price.
D)   If a company were to issue debt and use the money to repurchase common stock, this would reduce its return on investors' capital (ROI
C)  . (Assume that the repurchase has no impact on the company's operating income.) 
E)   If a change in the bankruptcy code made bankruptcy less costly to corporations, this would tend to reduce corporations' debt ratios.F) All of the above
G) C) and E)

Question 3

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?

Accepted Answer

A)   Demand variability.
B)   Sales price variability.
C)   The extent to which operating costs are fixed.
D)   The extent to which interest rates on the firm's debt fluctuate.
E)   Input price variability.F) A) and B)
G) None of the above

Question 4

Which of the following statements is CORRECT?

Accepted Answer

A)   The capital structure that maximizes expected EPS also maximizes the price per share of common stock.
B)   The capital structure that minimizes the interest rate on debt also maximizes the expected EPS.
C)   The capital structure that minimizes the required return on equity also maximizes the stock price.
D)   The capital structure that minimizes the WACC also maximizes the price per share of common stock.
E)   The capital structure that gives the firm the best bond rating also maximizes the stock price.F) A) and B)
G) B) and D)

Question 5

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.

Accepted Answer

A) True 
 B)False

Question 6

Which of the following would tend to increase a firm's target debt ratio, other things held constant?

Accepted Answer

A)   The costs associated with filing for bankruptcy increase.
B)   The corporate tax rate is increased.
C)   The personal tax rate is increased.
D)   The Federal Reserve tightens interest rates in an effort to fight inflation.
E)   The company's stock price hits a new low.F) B) and C)
G) All of the above

Question 7

Southeast U's campus book store sells course packs for $15.00 each, the variable cost per pack is $11.00, fixed costs for this operation are $300,000, and annual sales are 100,000 packs. The unit variable cost consists of a $4.00 royalty payment, VR, per pack to professors plus other variable costs of VO = $7.00. The royalty payment is negotiable. The book store's directors believe that the store should earn a profit margin of 10% on sales, and they want the store's managers to pay a royalty rate that will produce that profit margin. What royalty per pack would permit the store to earn a 10% profit margin on course packs, other things held constant?

Accepted Answer

A)   $2.55
B)   $2.84
C)   $3.15
D)   $3.50
E)   $3.85F) A) and D)
G) A) and C)

Question 8

Based on the information below, what is the firm's optimal capital structure?

Accepted Answer

A)   Debt = 40%; Equity = 60%; EPS = $2.95; Stock price = $26.50.
B)   Debt = 50%; Equity = 50%; EPS = $3.05; Stock price = $28.90.
C)   Debt = 60%; Equity = 40%; EPS = $3.18; Stock price = $31.20.
D)   Debt = 80%; Equity = 20%; EPS = $3.42; Stock price = $30.40.
E)   Debt = 70%; Equity = 30%; EPS = $3.31; Stock price = $30.00.F) A) and D)
G) A) and B)

Question 9

Companies HD and LD have identical tax rates, total assets, total investor-supplied capital, and returns on investors' capital (ROIC) , and their ROICs exceed their after-tax costs of debt, rd(1 − T) . However, Company HD has a higher debt ratio and thus more interest expense than Company LD. Which of the following statements is CORRECT?

Accepted Answer

A)   Company HD has a higher net income than Company LD.
B)   Company HD has a lower ROA than Company LD.
C)   Company HD has a lower ROE than Company LD.
D)   The two companies have the same ROA.
E)   The two companies have the same ROE.F) All of the above
G) None of the above

Question 10

Modigliani and Miller's first article led to the conclusion that capital structure is extremely important, and that every firm has an optimal capital structure that maximizes its value and minimizes its cost of capital.

Accepted Answer

A) True 
 B)False

Question 11

If two firms have the same expected earnings per share (EPS) and the same standard deviation of expected EPS, then they must have the same amount of business risk.

Accepted Answer

A) True 
 B)False

Question 12

Which of the following statements is CORRECT?

Accepted Answer

A)   The capital structure that maximizes the stock price is also the capital structure that minimizes the cost of equity from retained earnings (rs) .
B)   The capital structure that maximizes the stock price is also the capital structure that maximizes earnings per share.
C)   The capital structure that maximizes the stock price is also the capital structure that maximizes the firm's times interest earned (TI
E)   ratio.
D)   If a company increases its debt ratio, this will typically increase the marginal costs of both debt and equity, but it still may reduce the company's WACC.
E)   If Congress were to pass legislation that increases the personal tax rate but decreases the corporate tax rate, this would encourage companies to increase their debt ratios.F) A) and B)
G) B) and C)

Question 13

Other things held constant, firms with more stable and predictable sales tend to use more debt than firms with less stable sales.

Accepted Answer

A) True 
 B)False

Question 14

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?

Accepted Answer

A)   Since the proposed plan increases the firm's financial risk, the stock price might fall even if EPS increases.
B)   If the plan reduces the WACC, the stock price is likely to decline.
C)   Since the plan is expected to increase EPS, this implies that net income is also expected to increase.
D)   If the plan does increase the EPS, the stock price will automatically increase at the same rate.
E)   Under the plan there will be more bonds outstanding, and that will increase their liquidity and thus lower the interest rate on the currently outstanding bonds.F) A) and B)
G) C) and E)

Question 15

A firm's treasurer likes to be in a position to raise funds to support operations whenever such funds are needed, even in "bad times." This is called "financial flexibility," and the lower the firm's debt ratio, the greater its financial flexibility, other things held constant.

Accepted Answer

A) True 
 B)False

Question 16

Your firm has $500 million of investor-supplied capital, its return on investors' capital (ROIC)  is 15%, and it currently has no debt in its capital structure . The CFO is contemplating a recapitalization where it would issue debt at an after-tax cost of 10% and use the proceeds to buy back some of its common stock, such that the percentage of common equity in the capital structure (wc)  is 1 − wd. If the company goes ahead with the recapitalization, its operating income, the size of the firm (i.e., total assets) , total investor-supplied capital, and tax rate would remain unchanged. Which of the following is most likely to occur as a result of the recapitalization?

Accepted Answer

A)   The ROA would increase.
B)   The ROA would remain unchanged.
C)   The return on investors' capital would decline.
D)   The return on investors' capital would increase.
E)   The ROE would increase.F) All of the above
G) C) and D)

Question 17

An increase in the debt ratio will generally have no effect on which of these items?

Accepted Answer

A)   Business risk.
B)   Total risk.
C)   Financial risk.
D)   Market risk.
E)   The firm's beta.F) B) and E)
G) C) and E)

Question 18

El Capitan Foods has a capital structure of 40% debt and 60% equity, its tax rate is 35%, and its beta (leveraged)  is 1.25. Based on the Hamada equation, what would the firm's beta be if it used no debt, i.e., what is its unlevered beta, bU?

Accepted Answer

A)   0.71
B)   0.75
C)   0.79
D)   0.83
E)   0.87F) B) and D)
G) A) and B)

Question 19

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, rd(1 − T) . Which of the following statements is CORRECT?

Accepted Answer

A)   HD should have a higher return on assets (RO
A)   than LD.
B)   HD should have a higher times interest earned (TI
E)   ratio than LD.
C)   HD should have a higher return on equity (RO
E)   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 E)
G) A) and D)

Question 20

Which of the following statements is CORRECT?

Accepted Answer

A)   As a rule, the optimal capital structure is found by determining the debt-equity mix that maximizes expected EPS.
B)   The optimal capital structure simultaneously maximizes EPS and minimizes the WACC.
C)   The optimal capital structure minimizes the cost of equity, which is a necessary condition for maximizing the stock price.
D)   The optimal capital structure simultaneously minimizes the cost of debt, the cost of equity, and the WACC.
E)   The optimal capital structure simultaneously maximizes the stock price and minimizes the WACC.F) A) and C)
G) C) and E)

Exam 13: Capital Structure and Leverage

Correct Answer
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Correct Answer
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If two firms have the same expected earnings per share (EPS) and the same standard deviation of expected EPS, then they must have the same amount of business risk.

Correct Answer
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Modigliani and Miller's first article led to the conclusion that capital structure is extremely important, and that every firm has an optimal capital structure that maximizes its value and minimizes its cost of capital.

Correct Answer
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Which of the following would tend to increase a firm's target debt ratio, other things held constant?

Correct Answer
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Which of the following statements is CORRECT?

Correct Answer
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Correct Answer
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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?

Correct Answer
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Which of the following statements is CORRECT?

Correct Answer
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Which of the following statements is CORRECT?

Correct Answer
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An increase in the debt ratio will generally have no effect on which of these items?

Correct Answer
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El Capitan Foods has a capital structure of 40% debt and 60% equity, its tax rate is 35%, and its beta (leveraged) is 1.25. Based on the Hamada equation, what would the firm's beta be if it used no debt, i.e., what is its unlevered beta, bU?

Correct Answer
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Which of the following statements is CORRECT?

Correct Answer
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Other things held constant, firms with more stable and predictable sales tend to use more debt than firms with less stable sales.

Correct Answer
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A firm's treasurer likes to be in a position to raise funds to support operations whenever such funds are needed, even in "bad times." This is called "financial flexibility," and the lower the firm's debt ratio, the greater its financial flexibility, other things held constant.

Correct Answer
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Based on the information below, what is the firm's optimal capital structure?

Correct Answer
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Exam 13: Capital Structure and Leverage

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

If two firms have the same expected earnings per share (EPS) and the same standard deviation of expected EPS, then they must have the same amount of business risk.

Correct AnswerverifiedShow Answer

Modigliani and Miller's first article led to the conclusion that capital structure is extremely important, and that every firm has an optimal capital structure that maximizes its value and minimizes its cost of capital.

Correct AnswerverifiedShow Answer

Which of the following would tend to increase a firm's target debt ratio, other things held constant?

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

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?

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

An increase in the debt ratio will generally have no effect on which of these items?

Correct AnswerverifiedShow Answer

El Capitan Foods has a capital structure of 40% debt and 60% equity, its tax rate is 35%, and its beta (leveraged) is 1.25. Based on the Hamada equation, what would the firm's beta be if it used no debt, i.e., what is its unlevered beta, bU?

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

Other things held constant, firms with more stable and predictable sales tend to use more debt than firms with less stable sales.

Correct AnswerverifiedShow Answer

A firm's treasurer likes to be in a position to raise funds to support operations whenever such funds are needed, even in "bad times." This is called "financial flexibility," and the lower the firm's debt ratio, the greater its financial flexibility, other things held constant.

Correct AnswerverifiedShow Answer

Based on the information below, what is the firm's optimal capital structure?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

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