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Exam 13: Capital Structure and Leverage

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Question 21

True/False

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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.

A) True
B) False

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Question 22

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

A) personal taxes increase the value of using corporate debt.
B) personal taxes lower the value of using corporate debt.
C) personal taxes have no effect on the value of using corporate debt.
D) financial distress and agency costs reduce the value of using corporate debt.
E) debt costs increase with financial leverage.

F) B) and E)
G) B) and C)

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Question 23

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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.

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.

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.

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.

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) ?

You were hired as the CFO of a new company that was founded by three professors at your university.The company plans to manufacture and sell a new product,a cell phone that can be worn like a wrist watch.The issue now is how to finance the company,with equity only or with a mix of debt and equity.The price per phone will be $250.00 regardless of how the firm is financed.The expected fixed and variable operating costs,along with other data,are shown below.How much higher or lower will the firm's expected ROE be if it uses 60% debt rather than only equity,i.e. ,what is ROE_L - ROE_U? ​

Which of the following statements is CORRECT?

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.However,that article was criticized because it assumed that no taxes existed.MM then revised their original article to include corporate taxes,and this model led to the conclusion that a firm's value would be maximized if it used (almost)100% debt.

Longstreet Inc.has fixed operating costs of $300,000,variable costs of $2.50 per unit produced,and its product sells for $3.70 per unit.What is the company's break-even point,i.e. ,at what unit sales volume would income equal costs?

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.

You work for the CEO of a new company that plans to manufacture and sell a new product,a watch that has an embedded TV set and a magnifying glass crystal.The issue now is how to finance the company,with only equity or with a mix of debt and equity.Expected operating income is $510,000.Other data for the firm are shown below.How much higher or lower will the firm's expected ROE be if it uses some debt rather than all equity,i.e. ,what is ROE_L - ROE_U? Do not round your intermediate calculations. ​

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?

Which of the following statements is CORRECT,holding other things constant?

In a world with no taxes,Modigliani and Miller (MM)show that a firm's capital structure does not affect its value.However,when taxes are considered,MM show a positive relationship between debt and value,i.e. ,the firm's value rises as it uses more and more debt,other things held constant.

Which of the following statements is CORRECT?

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 75,000 packs.The unit variable cost consists of a $4.00 royalty payment,V_R ,per pack to professors plus other variable costs of V_O = $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? Do not round your intermediate calculations.

Which of the following statements is CORRECT?

Gator Fabrics Inc.currently has zero debt .It is a zero growth company,and additional firm data are shown below.Now the company is considering using some debt,moving to the new capital structure indicated below.The money raised would be used to repurchase stock at the current price.It is estimated that the increase in risk resulting from the additional leverage would cause the required rate of return on equity to rise somewhat,as indicated below.If this plan were carried out,by how much would the WACC change,i.e. ,what is WACC_Old - WACC_New? Do not round your intermediate calculations. ​