CAP#TA$ %T&CT&E CHAPTEA'D !" $EEAE
(Difficulty: (Difficul ty: E = Easy, M = Medium, and T = Tough) Tough)
Multiple Choice: Conceptual Easy: Easy: Business risk 1
.
Fina Financ ncia ial l risk risk. . Tota Total l ris risk. k. Busi Busine ness ss risk risk. . Mark Market et ris risk. k. None None of the the above above is cor corre rect ct. . above.!
Business risk .
Answer: d
Diff: E
&e#and &e#and variab variabili ility. ty. 'ales 'ales rice rice vari variabi abilit lity. y. The etent etent to which oerat oerating ing costs costs are fied. fied. )hanges )hanges in re*uired re*uired returns returns due to financing financing decision decisions. s. The ability ability to to change change rices rices as costs costs change. change.
Business risk .
(It (It will will affec affect t each each tye tye of risk risk
Busi Busine ness ss risk risk is conc concer erne ned d with with the the oer oerat atio ions ns of the the fir# fir#. . $hic $hich h of the the following is not associated with (or not a art of! business risk% a. b. c. d. e.
+
Diff: E
A dec decre reas ase e in in the the debt debt rati ratio o wil will l gen gener eral ally ly have have no eff effec ect t on . a. b. c. d. e.
"
Answer: c
Answer: d
Diff: E
N
$hic $hich h of of the the foll follow owin ing g fac facto tors rs woul would d aff affec ect t a co# co#a any ny,s ,s bus busin ines ess s ris risk% k% a. b. c. d. e.
The level level of uncertainty uncertainty regardi regarding ng the de#and de#and for its roduct. roduct. The degree degree of oerating oerating leverage. leverage. The a#ount a#ount of debt in its caital caital structu structure. re. 'tate# 'tate#ent ents s a and b are are correc correct. t. All of of the state# state#ents ents above above are are correct. correct.
Chapter 13- Page 1
Business and financial risk -
.
Answer: d
Di Diff: E
$hic $hich h of of the the foll follow owin ing g stat state# e#en ents ts is #ost #ost corr correc ect% t% a. A fir# fir#,s ,s busin usines ess s ris risk is sole solely ly det deter#i er#ine ned d by the the fina financ ncia ial l characteristics of its industry. b. The factors factors that affect affect a fir#,s busines business s risk are deter#ine deter#ined d artly by indu indus stry try char charac acte teri rist stic ics s and and art artly ly by econ econo# o#ic ic condi onditi tion ons. s. nfortunately/ these and other factors that affect a fir#,s business risk are not sub0ect to any degree of #anagerial control. c. ne of the benef benefits its to a fir# of being being at or near its targe target t caital caital structure is that financial fleibility beco#es #uch less i#ortant. d. The fir#,s fir#,s financial financial risk #ay have both both #arket risk risk and diversifiab diversifiable le risk co#onents. e. None of the state#ents state#ents above is correct. correct.
Optimal capital structure 2
.
Answer: e
Diff: E
$hic $hich h of of the the foll follow owin ing g stat state# e#en ents ts is #ost #ost corr correc ect% t% a. As a rule/ rule/ the oti#a oti#al l caita caital l struct structure ure is found by deter# deter#ini ining ng the debt3e*uity #i that #ai#i4es eected 56'. b. The The oti oti#a #al l cai caita tal l stru struct ctur ure e si#u si#ult ltan aneo eous usly ly #ai #ai#i #i4e 4es s 56' 56' and and #ini#i4es the $A)). c. The oti#al oti#al caital caital structure structure #ini#i4 #ini#i4es es the cost of e*uity/ e*uity/ which which is a necessary condition for #ai#i4ing the stock rice. d. The oti#al oti#al caita caital l struct structure ure si#ultan si#ultaneou eously sly #ini#i4e #ini#i4es s the cost of debt/ the cost of e*uity/ and the $A)). e. None of the state#ents state#ents above is correct. correct.
Optimal capital structure 7
.
Answer: c
Fro Fro# the info infor r#ati #ation on belo below/ w/ Minnow 5ntertain#ent )o#any. a. b. c. d. e.
&ebt &ebt &ebt &ebt &ebt
8 8 8 8 8
-9:; -9:; 29:; 29:; 79:; 79:; >9:; >9:; ?9:; ?9:;
5*uity 5*uity 5*uity 5*uity 5*uity 5*uity 5*uity 5*uity 5*uity 5*uity
8 8 8 8 8
79:; 29:; -9:; "9:; +9:;
sele selec ct
56' 56' 56' 56' 56'
8 8 8 8 8
the
<".=2; <" .=2; <+.92; <+.92; <+.1>; <+.1>; <+.-"; <+.-"; <+.+1; <+.+1;
oti oti# #al
'tock 'tock 'tock 'tock 'tock 'tock 'tock 'tock 'tock 'tock
cai caita tal l
rice rice rice rice rice rice rice rice rice rice
Optimal capital structure ?
.
$hi $hich of the structure%
foll follow owin ing g
8 8 8 8 8
stru struct ctur ure e
best best
desc descr ribes ibes
for
<"7.29. <"7.29. <">.=9. <">.=9. <+1."9. <+1."9. <+9.-9. <+9.-9. <+9.99. <+9.99.
Answer: e stat state# e#en ents ts
Diff: E
the the
oti oti#a #al l
Diff: E cait aital al
a. The oti#al oti#al caital caital structure structure is is the #i of debt/ debt/ e*uity/ e*uity/ and referred stock that #ai#i4es the co#any,s earnings er share (56'!. b. The oti#al oti#al caital caital structure structure is the #i #i of debt/ e*uity/ e*uity/ and referred referred stock that #ai#i4es the co#any,s stock rice. c. The oti#al oti#al caital caital structure structure is the #i #i of debt/ e*uity/ e*uity/ and referred referred stock that #ini#i4es the co#any,s co#any,s weighted weighted average average cost of caital caital ($A))!. d. 'tate# 'tate#ent ents s a and b are are correc correct. t. e. 'tate# 'tate#ent ents s b and c are are correc correct. t.
Chapter 13 - Page 2
Business and financial risk -
.
Answer: d
Di Diff: E
$hic $hich h of of the the foll follow owin ing g stat state# e#en ents ts is #ost #ost corr correc ect% t% a. A fir# fir#,s ,s busin usines ess s ris risk is sole solely ly det deter#i er#ine ned d by the the fina financ ncia ial l characteristics of its industry. b. The factors factors that affect affect a fir#,s busines business s risk are deter#ine deter#ined d artly by indu indus stry try char charac acte teri rist stic ics s and and art artly ly by econ econo# o#ic ic condi onditi tion ons. s. nfortunately/ these and other factors that affect a fir#,s business risk are not sub0ect to any degree of #anagerial control. c. ne of the benef benefits its to a fir# of being being at or near its targe target t caital caital structure is that financial fleibility beco#es #uch less i#ortant. d. The fir#,s fir#,s financial financial risk #ay have both both #arket risk risk and diversifiab diversifiable le risk co#onents. e. None of the state#ents state#ents above is correct. correct.
Optimal capital structure 2
.
Answer: e
Diff: E
$hic $hich h of of the the foll follow owin ing g stat state# e#en ents ts is #ost #ost corr correc ect% t% a. As a rule/ rule/ the oti#a oti#al l caita caital l struct structure ure is found by deter# deter#ini ining ng the debt3e*uity #i that #ai#i4es eected 56'. b. The The oti oti#a #al l cai caita tal l stru struct ctur ure e si#u si#ult ltan aneo eous usly ly #ai #ai#i #i4e 4es s 56' 56' and and #ini#i4es the $A)). c. The oti#al oti#al caital caital structure structure #ini#i4 #ini#i4es es the cost of e*uity/ e*uity/ which which is a necessary condition for #ai#i4ing the stock rice. d. The oti#al oti#al caita caital l struct structure ure si#ultan si#ultaneou eously sly #ini#i4e #ini#i4es s the cost of debt/ the cost of e*uity/ and the $A)). e. None of the state#ents state#ents above is correct. correct.
Optimal capital structure 7
.
Answer: c
Fro Fro# the info infor r#ati #ation on belo below/ w/ Minnow 5ntertain#ent )o#any. a. b. c. d. e.
&ebt &ebt &ebt &ebt &ebt
8 8 8 8 8
-9:; -9:; 29:; 29:; 79:; 79:; >9:; >9:; ?9:; ?9:;
5*uity 5*uity 5*uity 5*uity 5*uity 5*uity 5*uity 5*uity 5*uity 5*uity
8 8 8 8 8
79:; 29:; -9:; "9:; +9:;
sele selec ct
56' 56' 56' 56' 56'
8 8 8 8 8
the
<".=2; <" .=2; <+.92; <+.92; <+.1>; <+.1>; <+.-"; <+.-"; <+.+1; <+.+1;
oti oti# #al
'tock 'tock 'tock 'tock 'tock 'tock 'tock 'tock 'tock 'tock
cai caita tal l
rice rice rice rice rice rice rice rice rice rice
Optimal capital structure ?
.
$hi $hich of the structure%
foll follow owin ing g
8 8 8 8 8
stru struct ctur ure e
best best
desc descr ribes ibes
for
<"7.29. <"7.29. <">.=9. <">.=9. <+1."9. <+1."9. <+9.-9. <+9.-9. <+9.99. <+9.99.
Answer: e stat state# e#en ents ts
Diff: E
the the
oti oti#a #al l
Diff: E cait aital al
a. The oti#al oti#al caital caital structure structure is is the #i of debt/ debt/ e*uity/ e*uity/ and referred stock that #ai#i4es the co#any,s earnings er share (56'!. b. The oti#al oti#al caital caital structure structure is the #i #i of debt/ e*uity/ e*uity/ and referred referred stock that #ai#i4es the co#any,s stock rice. c. The oti#al oti#al caital caital structure structure is the #i #i of debt/ e*uity/ e*uity/ and referred referred stock that #ini#i4es the co#any,s co#any,s weighted weighted average average cost of caital caital ($A))!. d. 'tate# 'tate#ent ents s a and b are are correc correct. t. e. 'tate# 'tate#ent ents s b and c are are correc correct. t.
Chapter 13 - Page 2
Target capital structure >
.
The fir#,s following% a. b. c. d. e.
Mai#u# Mai#u# Mini#u Mini#u# # Mini Mini#u #u# # Mini#u Mini#u# # Mini#u# Mini#u#
target
Answer: e caital
structure
is
consistent
.
the
Answer: d
Di Diff: E
An increas increase e in the the cororate cororate ta rate. rate. An increas increase e in the the ersonal ersonal ta ta rate. rate. A decrease decrease in the co#any,s co#any,s degree degree of oeratin oerating g leverage. leverage. 'tate# 'tate#ent ents s a and c are are correc correct. t. All of of the state# state#ents ents above above are are correct. correct.
Leverage and capital structure .
of
$hic $hich h of the the fol follo lowi wing ng is is like likely ly to to enco encour urag age e a co# co#an any y to use use #or #ore e debt debt in its caital structure% a. b. c. d. e.
19
which
earnin earnings gs er er share share (56'!. (56'!. cost cost of of debt debt (k (kd!. risk risk. . cost cost of of e*uit e*uity y (ks!. weighted weighted average average cost of of caital caital ($A))!. ($A))!.
Leverage and capital structure =
with
Diff: E
Answer: e
Di Diff: E
$hic $hich h of of the the foll follow owin ing g sta state te#e #ent nts s is is #os #ost t cor corre rect ct% % a. A reductio reduction n in the coror cororate ate ta rate rate is likely likely to increas increase e the debt debt ratio of the average cororation. b. An increas increase e in the erson ersonal al ta rate is likely likely to increase increase the debt debt ratio of the average cororation. c. If chan change ges s in the the bank bankru rut tcy cy code code #ake #ake bank bankru rut tcy cy less less cost costly ly to coror cororati ations ons/ / then then this this would would likely likely reduce reduce the debt debt ratio ratio of the average cororation. d. All of of the state# state#ents ents above above are are correct. correct. e. None of the state#ents state#ents above is correct. correct.
Leverage and capital structure 11
.
$hich of the following state#ents is likely to increase its debt ratio in its caital structure% a. b. c. d. e.
.
encourage
a
Di Diff: E fir#
to
Its sales sales beco#e beco#e less stable stable over ti#e. ti#e. Its cororate cororate ta rate declines. declines. Manage#ent Manage#ent believe believes s that the fir#,s fir#,s stock is overvalu overvalued. ed. 'tate# 'tate#ent ents s a and b are are correc correct. t. None of the state#ents state#ents above is correct. correct.
Leverage and capital structure 1"
Answer: e
Answer: a
Di Diff: E
$hic $hich h of the the foll follow owin ing g fact factor ors s is like likely ly to enc encou oura rage ge a cor coror orat atio ion n to increase the roortion of debt in its caital structure% a. b. c. d.
An increas increase e in the the cororate cororate ta rate. rate. An increas increase e in the the ersonal ersonal ta ta rate. rate. An increase increase in the co#any, co#any,s s degree of oerati oerating ng leverage. leverage. The co#an co#any,s y,s assets assets beco#e beco#e less li*uid. li*uid.
Chapter 13- Page 3
e. An increase increase in in eected eected bankru bankrutcy tcy costs. costs.
Leverage and capital structure 1+
.
Answer: e
$hic $hich h of the the fol follo lowi wing ng wou would ld inc incre reas ase e the the like likeli liho hood od tha that t a co# co#an any y woul would d increase its debt ratio in its caital structure% a. b. c. d. e.
An increase increase in costs costs incurred incurred when filing filing for bankrut bankrutcy. cy. An increas increase e in the the cororate cororate ta rate. rate. An increas increase e in the the ersonal ersonal ta ta rate. rate. A decrease decrease in the fir#,s fir#,s business business risk. risk. 'tate# 'tate#ent ents s b and d are are correc correct. t.
Leverage and capital structure 1-
.
$hich of the following increase its debt ratio% a. b. c. d. e.
Answer: a factors
is
likely
to
.
a
co#any
to
Answer: c
Di Diff: E
N
An increas increase e in the the cororate cororate ta rate. rate. An increas increase e in the the ersonal ersonal ta ta rate. rate. Its assets assets beco#e beco#e less li*uid. li*uid. Both state#ents state#ents a and c are correct. correct. All of of the state# state#ents ents above above are are correct. correct.
The The The The The
co#an co#any,s y,s co#any, co#any,s s co#any co#any,s ,s co#any,s co#any,s co#any,s co#any,s
net net inco#e inco#e will will increase increase. . earnings earnings er share share will will decrease. decrease. cost cost of e*uity e*uity will will increase. increase. A will increase. increase. 5 will decrease. decrease.
Leverage and capital structure .
N
@on @ones )o. )o. cur curre rent ntly ly is is 199 199 er ercent cent e*u e*uit ity y fina financ nced ed. . The The co# co#an any y is considering changing its caital structure. More secifically/ secifically/ @ones, @ones, )F is considering a recaitali4ation lan in which the fir# would issue long3 ter# debt with a yield of = ercent and use the roceeds to reurchase co##on co##on stock. The recaital recaitali4ati i4ation on would not change change the co#any co#any,s ,s total assets nor would it affect the co#any,s basic earning ower/ which is currently currently 12 ercent ercent. . The )F esti#at esti#ates es that the recai recaitali4 tali4ation ation will will reduce reduce the co#an co#any,s y,s $A)) $A)) and increase increase its stock stock rice. rice. $hich $hich of the follow following ing is also also likely likely to occur occur if the co#an co#any y goes goes ahead ahead with with the lanned recaitali4ation% a. b. c. d. e.
17
Di Diff: E
encourage
Leverage and capital structure 12
Di Diff: E
Answer: e
Di Diff: E
N
$hic $hich h of of the the foll follow owin ing g sta state te#e #ent nts s is is #os #ost t cor corre rect ct% % a. $hen a co#any co#any increases increases its its debt ratio/ ratio/ the costs costs of both e*uity e*uity and debt caital caital increase. Therefore/ the weighted average average cost of caital ($A))! #ust also increase. b. The The cai caita tal l stru struct ctur ure e that that #ai #ai#i #i4e 4es s stoc stock k ric rice e is gene genera rall lly y the the caital structure that also #ai#i4es earnings er share. c. 'ince 'ince debt debt financ financing ing is cheae cheaer r than than e*uity e*uity financin financing/ g/ increasi increasing ng a co#any,s debt ratio will always reduce the co#any,s $A)). d. The The cai caita tal l stru struct ctur ure e that that #ai #ai#i #i4e 4es s stoc stock k ric rice e is gene genera rall lly y the the caital structure that also #ai#i4es the co#any,s $A)).
Chapter 13 - Page 4
e. None of the state#ents state#ents above is correct. correct.
Leverage and capital structure 1?
.
Answer: c
Di Diff: E
$hic $hich h of of the the foll follow owin ing g sta state te#e #ent nts s is is #os #ost t cor corre rect ct% % a. $hen a co#any co#any increases increases its its debt ratio/ ratio/ the costs costs of e*uity and and debt caital both increase. Therefore/ the weighted average cost of caital ($A))! #ust also increase. b. The The cai caita tal l stru struct ctur ure e that that #ai #ai#i #i4e 4es s stoc stock k ric rice e is gene genera rall lly y the the caital structure that also #ai#i4es earnings er share. c. All else else e*ual/ e*ual/ an increa increase se in the cororat cororate e ta rate would would tend to encourage a co#any to increase its debt ratio. d. 'tate# 'tate#ent ents s a and b are are correc correct. t. e. 'tate# 'tate#ent ents s a and c are are correc correct. t.
Capital structure and WACC 1>
.
Answer: e
Diff: E
$hic $hich h of of the the foll follow owin ing g sta state te#e #ent nts s is is #os #ost t cor corre rect ct% % a. 'ince 'ince debt debt financ financing ing raises raises the fir#,s fir#,s financ financial ial risk/ risk/ increa increasin sing g a co#any,s debt ratio will always increase the co#any,s $A)). b. 'ince 'ince debt debt financ financing ing is cheae cheaer r than than e*uity e*uity financin financing/ g/ increasi increasing ng a co#any,s debt ratio will always reduce the co#any,s $A)). c. Increa Increasin sing g a co#an co#any,s y,s debt ratio will tyica tyically lly reduce reduce the #arginal #arginal costs of both debt and e*uity financing; however/ it still #ay raise the co#any,s $A)). d. 'tate# 'tate#ent ents s a and c are are correc correct. t. e. None of the state#ents state#ents above is correct. correct.
Capital structure, OA, and OE 1=
.
Answer: d
idg idgef efie ield ld 5nt 5nter err ris ises es has has tot total al ass asset ets s of <+9 <+99 9 #ill #illio ion. n. The The co# co#an any y curr curren entl tly y has no debt debt in its its cai caita tal l stru struct ctur ure. e. The The co# co#an any, y,s s basi basic c earning ower is 12 ercent. The co#any is conte#lating a reca recai ita tali li4a 4ati tion on wher where e it will will issu issue e debt debt at 19 erc ercen ent t and and use use the the roceeds roceeds to buy back shares shares of the the co#any,s co#any,s co##on co##on stock. If the co#any co#any roceeds with the recaitali34ation its oerating inco#e/ total assets/ and ta rate will re#ain the sa#e. $hich of the following will occur as a result of the recaitali4ation% a. b. c. d. e.
The co#any,s co#any,s A will decline. decline. The co#any,s co#any,s 5 will increase. increase. The co#any, co#any,s s basic earnin earning g ower will will decline. decline. 'tate# 'tate#ent ents s a and b are are correc correct. t. All of of the state# state#ents ents above above are are correct. correct.
Capital structure, WACC, T!E, and E"# "9
.
Di D iff: E
Answer: a
Diff: E
$hic $hich h of of the the foll follow owin ing g sta state te#e #ent nts s is is #os #ost t cor corre rect ct% % a. The caital caital structu structure re that #ai#i4 #ai#i4es es structure that #ini#i4es the weighted b. The caital caital structu structure re that #ai#i4 #ai#i4es es structure that #ai#i4es earnings er c. The caital caital structu structure re that #ai#i4 #ai#i4es es
stock rice rice average cost stock rice rice share. stock rice rice
is also the caita caital l of caital ($A))!. is also the caita caital l is also the caita caital l
Chapter 13- Page 5
structure that #ai#i4es the fir#,s ti#es interest earned (TI5! ratio. d. 'tate#ents a and b are correct. e. 'tate#ents b and c are correct.
Capital structure t$e%r& "1
.
Answer: d
Diff: E
$hich of the following state#ents about caital structure theory is #ost correct% a. 'ignaling theory suggests fir#s should in nor#al ti#es #aintain reserve borrowing caacity that can be used if an esecially good invest#ent oortunity co#es along. b. In general/ an increase in the cororate ta rate would cause fir#s to use less debt in their caital structures. c. According to the trade3off theory/C an increase in the costs of bankrutcy would lead fir#s to reduce the a#ount of debt in their caital structures. d. 'tate#ents a and c are correct. e. All of the state#ents above are correct.
'iscellane%us capital structure c%ncepts ""
.
Answer: c
Diff: E
N
$hich of the following state#ents is #ost correct% a. If )ongress were to ass legislation that increases the ersonal ta rate/ but decreases the cororate ta rate/ this would encourage co#anies to increase their debt ratios. b. If a co#any were to issue debt and use the #oney to reurchase co##on stock/ this action would have no i#act on the co#any,s return on assets. (Assu#e that the reurchase has no i#act on the co#any,s oerating inco#e.! c. If a co#any were to issue debt and use the #oney to increase assets/ this action would increase the co#any,s return on e*uity. (Assu#e that the co#any,s return on assets re#ains unchanged.! d. 'tate#ents a and b are correct. e. 'tate#ents b and c are correct.
(inancial leverage and E"# "+
.
Answer: a
Diff: E
Dolga 6ublishing is considering a roosed increase in its debt ratio/ which will also increase the co#any,s interest eense. The lan would involve the co#any issuing new bonds and using the roceeds to buy back shares of its co##on stock. The co#any,s )F eects that the lan will not change the co#any,s total assets or oerating inco#e. Eow3ever/ the co#any,s )F does esti#ate that it will increase the co#any,s earnings er share (56'!. Assu#ing the )F,s esti#ates are correct/ which of the following state#ents is #ost correct% a. 'ince the roosed lan increases Dolga,s financial risk/ the co#any,s stock rice still #ight fall even though its 56' is eected to increase. b. If the lan reduces the co#any,s $A))/ the co#any,s stock rice is also likely to decline. c. 'ince the lan is eected to increase 56'/ this i#lies that net inco#e is also eected to increase.
Chapter 13 - Page 6
d. 'tate#ents a and b are correct. e. 'tate#ents a and c are correct.
Chapter 13- Page 7
(inancial leverage and E"# "-
.
Answer: c
Diff: E
$hich of the following state#ents is #ost correct% a. Increasing financial leverage is one way to increase a fir#,s basic earning ower (B56!. b. Fir#s with lower fied costs tend to have greater oerating leverage. c. The debt ratio that #ai#i4es 56' generally eceeds the debt ratio that #ai#i4es share rice. d. 'tate#ents a and b are correct. e. 'tate#ents a and c are correct.
(inancial leverage and rati%s "2
.
Answer: d
)o#any A and )o#any B have the sa#e ta rate/ the sa#e total assets/ and the sa#e basic earning ower. Both co#anies have a basic earning ower that eceeds their before3ta costs of debt/ kd. Eowever/ )o#any A has a higher debt ratio and higher interest eense than )o#any B. $hich of the following state#ents is #ost correct% a. b. c. d. e.
)o#any A has a lower net inco#e than B. )o#any A has a lower A than B. )o#any A has a lower 5 than B. 'tate#ents a and b are correct. None of the state#ents above is correct.
(inancial leverage and rati%s "7
.
Diff: E
Answer: )
Diff: E
Fir# and Fir# each have the sa#e total assets. Both fir#s also have a basic earning ower of "9 ercent. Fir# is 199 ercent e*uity financed/ while Fir# is financed with 29 ercent debt and 29 ercent e*uity. Fir# ,s debt has a before3ta cost of > ercent. Both fir#s have ositive net inco#e. $hich of the following state#ents is #ost correct% a. b. c. d. e.
The two co#anies have Fir# has a lower A Fir# has a lower 5 'tate#ents a and b are 'tate#ents b and c are
the sa#e ti#es interest earned (TI5! ratio. than Fir# . than Fir# . correct. correct.
Medium: Optimal capital structure "?
.
Answer: d
Diff: '
As a general rule/ the caital structure that a. Mai#i4es eected 56' also #ai#i4es the rice er share of co##on stock. b. Mini#i4es the interest rate on debt also #ai#i4es the eected 56'. c. Mini#i4es the re*uired rate on e*uity also #ai#i4es the stock rice. d. Mai#i4es the rice er share of co##on stock also #ini#i4es the weighted average cost of caital. e. None of the state#ents above is correct.
Chapter 13 - Page 8
Operating and financial leverage ">
.
Answer: e
Diff: '
$hich of the following state#ents is #ost correct% a. Fir#s whose sales are very sensitive to changes in the business cycle are #ore likely to rely on debt financing. b. Fir#s with large ta loss carry forwards are #ore likely to rely on debt financing. c. Fir#s with a high oerating leverage are #ore likely to rely on debt financing. d. 'tate#ents a and c are correct. e. None of the state#ents above is correct.
(inancial leverage and rati%s "=
.
Answer: c
Diff: '
)o#any A and )o#any B have the sa#e total assets/ oerating inco#e (5BIT!/ ta rate/ and business risk. )o#any A/ however/ has a #uch higher debt ratio than )o#any B. )o#any A,s basic earning ower (B56! eceeds its cost of debt financing (kd!. $hich of the following state#ents is #ost correct% a. )o#any A has a higher return on assets (A! than )o#any B. b. )o#any A has a higher ti#es interest earned (TI5! ratio than )o#any B. c. )o#any A has a higher return on e*uity (5! than )o#any B/ and its risk/ as #easured by the standard deviation of 5/ is also higher than )o#any B,s. d. 'tate#ents b and c are correct. e. All of the state#ents above are correct.
Limits %f leverage +9
.
Answer: d
Diff: '
$hich of the following are ractical difficulties associated with caital structure and degree of leverage analyses% a. It is nearly i#ossible to deter#ine eactly how 6G5 ratios or e*uity caitali4ation rates (ks values! are affected by different degrees of financial leverage. b. Managers, attitudes toward risk differ and so#e #anagers #ay set a target caital structure other than the one that would #ai#i4e stock rice. c. Managers often have a resonsibility to rovide continuous service; they #ust reserve the long3run viability of the enterrise. Thus/ the goal of e#loying leverage to #ai#i4e short3run stock rice and #ini#i4e caital cost #ay conflict with long3run viability. d. All of the state#ents above are correct. e. None of the state#ents above reresents a serious i#edi#ent to the ractical alication of leverage analysis in caital structure deter#ination.
Chapter 13- Page 9
#ignaling t$e%r& +1
.
Answer: )
Diff: '
If you know that your fir# is facing relatively oor rosects but needs new caital/ and you know that investors do not have this infor#ation/ signaling theory would redict that you would a. Issue debt to #aintain the returns of e*uity holders. b. Issue e*uity to share the burden of decreased e*uity returns between old and new shareholders. c. Be indifferent between issuing debt and e*uity. d. 6ostone going into caital #arkets until your fir#,s rosects i#rove. e. )onvey your inside infor#ation to investors using the #edia to eli#inate the infor#ation asy##etry.
Capital structure and WACC +"
.
Answer: d
Diff: '
$hich of the following state#ents is #ost correct% a. The oti#al caital structure #ini#i4es the $A)). b. If the after3ta cost of e*uity financing eceeds the after3ta cost of debt financing/ fir#s are always able to reduce their $A)) by increasing the a#ount of debt in their caital structure. c. Increasing the a#ount of debt in a fir#,s caital structure is likely to increase the costs of both debt and e*uity financing. d. 'tate#ents a and c are correct. e. 'tate#ents b and c are correct.
Capital structure and WACC ++
.
Answer: )
Diff: '
$hich of the following state#ents is #ost correct% a. A fir# can use retained earnings without aying a flotation cost. Therefore/ while the cost of retained earnings is not 4ero/ the cost of retained earnings is generally lower than the after3ta cost of debt financing. b. The caital structure that #ini#i4es the fir#,s weighted average cost of caital is also the caital structure that #ai#i4es the fir#,s stock rice. c. The caital structure that #ini#i4es the fir#,s weighted average cost of caital is also the caital structure that #ai#i4es the fir#,s earnings er share. d. If a fir# finds that the cost of debt financing is currently less than the cost of e*uity financing/ an increase in its debt ratio will always reduce its weighted average cost of caital. e. 'tate#ents a and b are correct.
Chapter 13 - Page 10
'iscellane%us capital structure c%ncepts +-
.
Answer: a
Diff: '
$hich of the following state#ents is #ost correct% a. In general/ a fir# with low oerating leverage has a s#all roortion of its total costs in the for# of fied costs. b. An increase in the ersonal ta rate would not affect fir#s, caital structure decisions. c. A fir# with high business risk is #ore likely to increase its use of financial leverage than a fir# with low business risk/ assu#ing all else e*ual. d. 'tate#ents a and b are correct. e. All of the state#ents above are correct.
'iscellane%us capital structure c%ncepts +2
.
Answer: c
Diff: '
$hich of the following state#ents is correct% a. Business riskC is differentiated fro# financial riskC by the fact that financial risk reflects only the use of debt/ while business risk reflects both the use of debt and such factors as sales variability/ cost variability/ and oerating leverage. b. If cororate ta rates were decreased while other things were held constant/ and if the Modigliani3Miller ta3ad0usted tradeoff theory of caital structure were correct/ this would tend to cause cororations to increase their use of debt. c. If cororate ta rates were decreased while other things were held constant/ and if the Modigliani3Miller ta3ad0usted tradeoff theory of caital structure were correct/ this would tend to cause cororations to decrease their use of debt. d. The oti#al caital structure is the one that si#ultaneously (1! #ai#i4es the rice of the fir#,s stock/ ("! #ini#i4es its $A))/ and (+! #ai#i4es its 56'. e. None of the state#ents above is correct.
Tough: *ariati%ns in capital structures +7
.
Answer: d
Diff: T
$hich of the following is correct% a. Henerally/ debt to total assets ratios do not vary #uch a#ong different industries although they do vary for fir#s within a articular industry. b. tilities generally have very high co##on e*uity ratios due to their need for vast a#ounts of e*uity3suorted caital. c. The drug industry has a high debt to co##on e*uity ratio because their earnings are very stable and thus/ can suort the large interest costs associated with higher debt levels. d. $ide variations in caital structures eist between industries and also between individual fir#s within industries and are influenced by uni*ue fir# factors including #anagerial attitudes. e. 'ince #ost stocks sell at or around their book values/ using accounting values rovides an accurate icture of a fir#,s caital structure.
Chapter 13- Page 11
Chapter 13 - Page 12
Multiple Choice: P*o+lems Easy: Determining price fr%m EB!T +?
.
<".99 <-.-2 <2.99 <2.+? <7."1
Breakeven price .
Diff: E
The 6rice )o#any will roduce 22/999 widgets net year. Dariable costs will e*ual -9 ercent of sales/ while fied costs will total <119/999. At what rice #ust each widget be sold for the co#any to achieve an 5BIT of <=2/999% a. b. c. d. e.
+>
Answer: e
Answer: a
Diff: E
Teas 6roducts Inc. has a division that #akes burla bags for the citrus industry. The division has fied costs of <19/999 er #onth/ and it eects to sell -"/999 bags er #onth. If the variable cost er bag is <".99/ what rice #ust the division charge in order to break even% a. b. c. d. e.
<"."<".-? <".>" <+.12 <".99
Medium: New financing +=
.
Answer: a
Diff: '
The Alt#an )o#any has a debt ratio of ++.++ ercent/ and it needs to raise <199/999 to eand. Manage#ent feels that an oti#al debt ratio would be 17.7? ercent. 'ales are currently
199: e*uity 199: debt "9 ercent debt/ >9 ercent e*uity -9 ercent debt/ 79 ercent e*uity 29 ercent debt/ 29 ercent e*uity
Chapter 13- Page 13
Net %perating inc%me -9
.
2/999 19/999 12/999 "9/999 "2/999
decks decks decks decks decks
C$ange in )reakeven v%lume .
Diff: '
The )ongress )o#any has identified two #ethods for roducing laying cards. ne #ethod involves using a #achine having a fied cost of <19/999 and variable costs of <1.99 er deck of cards. The other #ethod would use a less eensive #achine (fied cost 8 <2/999!/ but it would re*uire greater variable costs (<1.29 er deck of cards!. If the selling rice er deck of cards will be the sa#e under each #ethod/ at what level of outut will the two #ethods roduce the sa#e net oerating inco#e% a. b. c. d. e.
-1
Answer: )
Answer: )
Diff: '
Eensley )ororation uses breakeven analysis to study the effects of eansion ro0ects it considers. )urrently/ the fir#,s lastic bag business seg#ent has fied costs of <1"9/999/ while its unit rice er carton is <1."9 and its variable unit cost is <9.79. The fir# is considering a new bag #achine and an auto#atic carton folder as #odifications to its eisting roduction lines. $ith the eansion/ fied costs would rise to <"-9/999/ but variable cost would dro to <9.-1 er unit. ne key benefit is that Eensley can lower its wholesale rice to its distributors to <1.92 er carton (that is/ its selling rice!/ and this would likely #ore than double its #arket share/ as it will beco#e the lowest cost roducer. $hat is the change in the breakeven volu#e with the roosed ro0ect% a. 199/999 units b. 1?2/999 units c. ?2/999 units d. "99/999 units e. 9 units
Breakeven and e+pansi%n -"
.
Answer: c
Diff: '
Martin )ororation currently sells 1>9/999 units er year at a rice of er unit. If Martin eands/ it eects to sell "?9/999 units at
< 1>+/+++ < -27/299 < >92/227 < =19/77? <1/"99/999
Chapter 13 - Page 14
Breakeven -+
.
Answer: d
5lehant Books sells aerback books for
<799/999 <-77/77? <+++/+++ <"99/999 <1?2/""2
Operating decisi%n --
.
Answer: d
No/ 5BIT decreases by <7/999. No/ 5BIT decreases by <"29. es/ 5BIT increases by <11/299. es/ 5BIT increases by <>/929. es/ 5BIT increases by <2/929.
Capital structure and st%ck price .
Diff: '
Musgrave )ororation has fied costs of <-7/999 and variable costs that are +9 ercent of the current sales rice of <".12. At a rice of <".12/ Musgrave sells -9/999 units. Musgrave can increase sales by 19/999 units by cutting its unit rice fro# <".12 to <1.=2/ but variable cost er unit won,t change. 'hould it cut its rice% a. b. c. d. e.
-2
Diff: '
Answer: c
Diff: '
The following infor#ation alies to ott 5nterrisesJ erating inco#e (5BIT! &ebt Interest eense Ta rate
<+99/999 <199/999 < 19/999 -9:
'hares outstanding 56' 'tock rice
1"9/999 <1.-2 <1?.-9
The co#any is considering a recaitali4ation where it would issue <+->/999 worth of new debt and use the roceeds to buy back <+->/999 worth of co##on stock. The buyback will be undertaken at the re3 recaitali4ation share rice (<1?.-9!. The recaitali4ation is not eected to have an effect on oerating inco#e or the ta rate. After the recaitali4ation/ the co#any,s interest eense will be <29/999. Assu#e that the recaitali4ation has no effect on the co#any,s rice earnings (6G5! ratio. $hat is the eected rice of the co#any,s stock following the recaitali4ation% a. b. c. d. e.
<12.+9 <1?.?2 <1>.99 <1=.9+ <"9.->
Chapter 13- Page 15
Capital structure and st%ck price -7
.
A consultant 6ublishingJ
has
collected
Total assets <+/999 erating inco#e (5BIT! <>99 Interest eense <9 Net inco#e <->9 'hare rice
Answer: e the
following
#illion #illion #illion #illion <+".99
infor#ation
Diff: '
regarding
Ta rate &ebt ratio $A)) MGB ratio 56' 8 &6'
oung
-9: 9: 19: 1.99K <+."9
The co#any has no growth oortunities (g 8 9!/ so the co#any ays out all of its earnings as dividends (56' 8 &6'!. oung,s stock rice can be calculated by si#ly dividing earnings er share by the re*uired return on e*uity caital/ which currently e*uals the $A)) because the co#any has no debt. The consultant believes that the co#any would be #uch better off if it were to change its caital structure to -9 ercent debt and 79 ercent e*uity. After #eeting with invest#ent bankers/ the consultant concludes that the co#any could issue <1/"99 #illion of debt at a before3ta cost of ? ercent/ leaving the co#any with interest eense of <>- #illion. The <1/"99 #illion raised fro# the debt issue would be used to reurchase stock at <+" er share. The reurchase will have no effect on the fir#,s 5BIT; however/ after the reurchase/ the cost of e*uity will increase to 11 ercent. If the fir# follows the consultant,s advice/ what will be its esti#ated stock rice after the caital structure change% a. b. c. d. e.
<+".99 <++.-> <+1."= <+".2= <+-.?"
Tough: amada e-uati%n and c%st %f e-uit& -?
.
Answer: a
Diff: T
'i#on 'oftware )o. is trying to esti#ate its oti#al caital structure. ight now/ 'i#on has a caital structure that consists of "9 ercent debt and >9 ercent e*uity. (Its &G5 ratio is 9."2.! The risk3free rate is 7 ercent and the #arket risk re#iu#/ kM L kF/ is 2 ercent. )urrently the co#any,s cost of e*uity/ which is based on the )A6M/ is 1" ercent and its ta rate is -9 ercent. $hat would be 'i#on,s esti#ated cost of e*uity if it were to change its caital structure to 29 ercent debt and 29 ercent e*uity% a. b. c. d. e.
1-.+2: +9.99: 1-.?": 12.79: 1+.7-:
Chapter 13 - Page 16
Optimal capital structure and amada e-uati%n ->
.
Answer: d
Diff: T
Aaron Athletics is trying to deter#ine its oti#al caital structure. The co#any,s caital structure consists of debt and co##on stock. In order to esti#ate the cost of debt/ the co#any has roduced the following tableJ &ebt3to3total3
5*uity3to3total3
&ebt3to3e*uity
Bond
Before3ta
assets ratio (wd!
assets ratio (wc!
ratio (&G5!
rating
cost of debt
9.19
9.=9
9.19G9.=9 8 9.11
AA
9."9
9.>9
9."9G9.>9 8 9."2
A
?."
9.+9
9.?9
9.+9G9.?9 8 9.-+
A
>.9
9.-9
9.79
9.-9G9.79 8 9.7?
BB
>.>
9.29
9.29
9.29G9.29 8 1.99
B
=.7
?.9:
The co#any,s ta rate/ T/ is -9 ercent. The co#any uses the )A6M to esti#ate its cost of co##on e*uity/ ks. The risk3free rate is 2 ercent and the #arket risk re#iu# is 7 ercent. Aaron esti#ates that if it had no debt its beta would be 1.9. (Its unlevered beta/C b/ e*uals 1.9.! n the basis of this infor#ation/ what is the co#any,s oti#al caital structure/ and what is the fir#,s weighted average cost of caital ($A))! at this oti#al caital structure% a. b. c. d. e.
wc 8 wc 8 wc 8 wc 8 wc 8
9.=; 9.>; 9.?; 9.7; 9.2;
wd 8 wd 8 wd 8 wd 8 wd 8
9.1; 9."; 9.+; 9.-; 9.2;
$A)) $A)) $A)) $A)) $A))
8 8 8 8 8
1-.=7: 19.=7: ?.>+: 19.12: 19.1>:
Capital structure and st%ck price -=
.
Answer: d
Diff: T
iy 6asta )ororation (6)! has a constant growth rate of ? ercent. The co#any retains +9 ercent of its earnings to fund future growth. 6),s eected 56' (56'1! and ks for various caital structures are given below. $hat is the oti#al caital structure for 6)% &ebtGTotal Assets "9: +9 -9 29 ?9 a. b. c. d. e.
&ebtGTotal &ebtGTotal &ebtGTotal &ebtGTotal &ebtGTotal
Assets Assets Assets Assets Assets
8 8 8 8 8
5ected 56' <".29 +.99 +."2 +.?2 -.99
ks 12.9: 12.2 17.9 1?.9 1>.9
"9: +9: -9: 29: ?9:
Chapter 13- Page 17
Capital structure and st%ck price 29
.
a. b. c. d. e.
9: debt; 199: "2: debt; ?2: -9: debt; 79: 29: debt; 29: ?2: debt; "2:
&ividends 6er 'hare <2.29 7.99 7.29 ?.99 ?.29
)ost of 5*uity (ks! 11.2: 1".9 1+.9 1-.9 12.9
e*uity e*uity e*uity e*uity e*uity
Capital structure and st%ck price .
Diff: T
Hiven the following choices/ what is the oti#al caital structure for )hi )o.% (Assu#e that the co#any,s growth rate is " ercent.!
&ebt atio 9: "2 -9 29 ?2
21
Answer: )
Answer: a
Diff: T
Flood Motors is an all3e*uity fir# with "99/999 shares outstanding. The co#any,s 5BIT is <"/999/999/ and 5BIT is eected to re#ain constant over ti#e. The co#any ays out all of its earnings each year/ so its earnings er share e*uals its dividends er share. The co#any,s ta rate is -9 ercent. The co#any is considering issuing <" #illion worth of bonds (at ar! and using the roceeds for a stock reurchase. If issued/ the bonds would have an esti#ated yield to #aturity of 19 ercent. The risk3free rate in the econo#y is 7.7 ercent/ and the #arket risk re#iu# is 7 ercent. The co#any,s beta is currently 9.=/ but its invest#ent bankers esti#ate that the co#any,s beta would rise to 1.1 if it roceeds with the recaitali4ation. Assu#e that the shares are reurchased at a rice e*ual to the stock #arket rice rior to the recaitali4ation. $hat would be the co#any,s stock rice following the recaitali4ation% a. b. c. d. e.
<21.1<2+.>2 <27.9" <7>.=?
Chapter 13 - Page 18
Capital structure and st%ck price 2"
.
Answer: a
Diff: T
5tchabarren 5lectronics has #ade the following forecast for the uco#ing year based on the co#any,s current caitali4ationJ Interest eense erating inco#e (5BIT! 5arnings er share
<"/999/999 <"9/999/999 <+.79
The co#any has <"9 #illion worth of debt outstanding and all of its debt yields 19 ercent. The co#any,s ta rate is -9 ercent. The co#any,s rice earnings (6G5! ratio has traditionally been 1"×/ so the co#any forecasts that under the current caitali4ation its stock rice will be <-+."9 at year end. The co#any,s invest#ent bankers have recaitali4e. Their suggestion is to issue 19 ercent to reurchase 1 #illion shares the stock can be reurchased at today,s <-9
suggested that the co#any enough new bonds at a yield of of co##on stock. Assu#e that stock rice.
Assu#e that the reurchase will have no effect on the co#any,s oerating inco#e; however/ the reurchase will increase the co#any,s dollar interest eense. Also/ assu#e that as a result of the increased financial risk the co#any,s rice earnings (6G5! ratio will be 11.2 after the reurchase. Hiven these assu#tions/ what would be the eected year3 end stock rice if the co#any roceeded with the recaitali4ation% a. b. c. d. e.
<->.+9 <-".27 <--.?7 <-9.+<-7.=9
Capital structure and st%ck price 2+
.
Answer: d
Diff: T
ascheid 5nterrises is an all3e*uity fir# with 1?2/999 shares outstanding. The co#any,s stock rice is currently <>9 a share. The co#any,s 5BIT is <"/999/999/ and 5BIT is eected to re#ain constant over ti#e. The co#any ays out all of its earnings each year/ so its earnings er share e*uals its dividends er share. The fir#,s ta rate is +9 ercent. The co#any is considering issuing <>99/999 worth of bonds and using the roceeds for a stock reurchase. If issued/ the bonds would have an esti#ated yield to #aturity of > ercent. The risk3free rate is 2 ercent and the #arket risk re#iu# is also 2 ercent. The co#any,s beta is currently 1.9/ but its invest#ent bankers esti#ate that the co#any,s beta would rise to 1." if it roceeded with the recaitali4ation. $hat would be the co#any,s stock rice following the reurchase transaction% a. b. c. d.
<197.7? <19".7+ < ??.1< ?-.7?
Chapter 13- Page 19
e. < ?9.-9
Capital structure and E"# 2-
.
Answer: d
Buchanan Brothers anticiates that its net inco#e at the end of the year will be <+.7 #illion (before any recaitali4ation!. The co#any currently has =99/999 shares of co##on stock outstanding and has no debt. The co#any,s stock trades at <-9 a share. The co#any is considering a recaitali4ation/ where it will issue <19 #illion worth of debt at a yield to #aturity of 19 ercent and use the roceeds to reurchase co##on stock. Assu#e the stock rice re#ains unchanged by the transaction/ and the co#any,s ta rate is +- ercent. $hat will be the co#any,s earnings er share/ if it roceeds with the recaitali4ation% a. b. c. d. e.
<"."+ <".-2 <+."7 <-.2" <2.2-
Capital structure and E"# 22
.
Diff: T
Answer: a
Diff: T
T)E )ororation is considering two alternative caital structures with the following characteristics.
&ebtGAssets ratio kd
A 9.+ 19:
B 9.? 1-:
The fir# will have total assets of <299/999/ a ta rate of -9 ercent/ and a book value er share of <19/ regardless of the caital structure. 5BIT is eected to be <"99/999 for the co#ing year. $hat is the difference in earnings er share (56'! between the two alternatives% a. b. c. d. e.
<".>? <+.9+ <1.1=
Capital structure, leverage, and WACC 27
.
Answer: d
Diff: T
N
6ennington Airlines currently has a beta of 1.". The co#any,s caital structure consists of .2 ercent. The co#any,s ta rate is -9 ercent. The risk3free rate is 7 ercent and the #arket risk re#iu# is ? ercent. $hat is the co#any,s esti#ated $A)) if it goes ahead with the lan% a.
>.+2:
Chapter 13 - Page 20
b. =.?2: c. 1"."?: d. 19.=9: e. 11.-2:
Chapter 13- Page 21
Multiple Part: (The following information applies to the next four problems.)
)oybold )ororation is a start3u fir# considering two alternative caital structures/ one is conservative and the other aggressive. The conservative caital structure calls for a &GA ratio 8 9."2/ while the aggressive strategy calls for &GA 8 9.?2. nce the fir# selects its target caital structure/ it envisions two ossible scenarios for its oerationsJ Feast or Fa#ine. The Feast scenario has a 79 ercent robability of occurring and forecasted 5BIT in this state is <79/999. The Fa#ine state has a -9 ercent chance of occurring and eected 5BIT is <"9/999. Further/ if the fir# selects the conservative caital structure its cost of debt will be 19 ercent/ while with the aggressive caital structure its debt cost will be 1" ercent. The fir# will have <-99/999 in total assets/ it will face a -9 ercent #arginal ta rate/ and the book value of e*uity er share under either scenario is <19.99 er share.
Capital structure and E"# 2?
.
< 9 <1.-> <9.7" <9.=> <".-9
Capital structure and E"# .
Diff: '
<1.99 <9.>9 <"."9 <9.-< 9
Capital structure and C* %f E"# .
Answer: )
$hat is the difference between the 56' forecasts for Feast and Fa#ine under the conservative caital structure% a. b. c. d. e.
2=
Diff: '
$hat is the difference between the 56' forecasts for Feast and Fa#ine under the aggressive caital structure% a. b. c. d. e.
2>
Answer: e
Answer: c
Diff: '
$hat is the coefficient of variation of eected 56' under the aggressive caital structure% a. b. c. d. e.
1.99 1.1> ".-2 ".>> +.?7
Chapter 13 - Page 22
Capital structure and C* %f E"# 79
.
$hat is the coefficient of conservative caital structure% a. b. c. d. e.
Answer: a variation
of
eected
56'
Diff: '
under
the
9.2> 9.+= 9.12 9."+ 1.99 (The following information applies to the next three problems.)
)urrently/ the Fotooulos )ororation,s balance sheet is as followsJ Assets
<2 billion
Total assets
<2 billion
&ebt )o##on e*uity Total debt co##on e*uity
<1 billion - billion <2 billion
The book value of the co#any (both debt and co##on e*uity! e*uals its #arket value (both debt and co##on e*uity!. Further#ore/ the co#any has deter#ined the following infor#ationJ The The The The The
• • • • •
co#any esti#ates that its before3ta cost of debt is ?.2 ercent. co#any esti#ates that its levered beta is 1.1. risk3free rate is 2 ercent. #arket risk re#iu#/ kM L kF/ is 7 ercent. co#any,s ta rate is -9 ercent.
In addition/ the Fotooulos )ororation is considering a recaitali4ation. The roosed lan is to issue <1 billion worth of debt and to use the #oney to reurchase <1 billion worth of co##on stock. As a result of this recaitali4ation/ the fir#,s si4e will not change.
Capital structure and WACC 71
.
Answer: c
Diff: E
N
$hat is Fotooulos, current $A)) (before the roosed recaitali4ation!% a. 2.=": b. =.>>: c. 19.1>: d. 19.?>: e. 11.+>:
amada e-uati%n and unlevered )eta 7"
.
$hat is Fotooulos, recaitali4ation!% a. b. c. d. e.
current
Answer: c unlevered
beta
(before
Diff: E
the
N
roosed
9.7"1+ 9.>=7" 9.=272 1.99-1 1."?99
Chapter 13- Page 23
amada e-uati%n and c%st %f c%mm%n e-uit& 7+
.
Answer: e
Diff: '
N
$hat will be the co#any,s new cost of co##on e*uity if it roceeds with the recaitali4ation% (EintJ Be sure that the beta you use is carried out to - deci#al laces.! a. b. c. d. e.
19.?-: 11.7": 1"."?: 1".7": 1+.9+: (The following information applies to the next two problems.)
An analyst has )ororationJ •
collected
the
following
infor#ation
regarding
the
Milbrett
Total assets 8 <199 #illion. Basic earning ower (B56! 8 "9:. Ta rate 8 -9:.
• •
)urrently/ the co#any has no debt or referred stock and its interest eense and referred dividends e*ual 4ero. The book value and #arket value of co##on e*uity e*uals <199 #illion. The co#any has 2 #illion outstanding shares of co##on stock/ and its stock rice is <"9 a share. Milbrett is considering a recaitali4ation/ where they will issue <"9 #illion of debt and use the roceeds to buy back co##on stock at the current rice of <"9 a share. As a result of the recaitali4ation/ the si4e of the fir# will not change. Assu#e that the newly3issued debt will have a before3ta cost of > ercent. Assu#e that the recaitali4ation will have no effect on the co#any,s basic earning ower.
Capital structure, financial leverage, and rati%s 7-
.
N
The co#any,s net inco#e will increase. The co#any,s A will increase. The co#any,s oerating inco#e will decrease. The co#any,s 5 will increase. None of the state#ents above is correct.
Capital structure and E"# .
Diff: E
$hich of the following is likely to occur following the recaitali4ation% a. b. c. d. e.
72
Answer: d
Answer: c
Diff: T
N
Assu#e that after the recaitali4ation the co#any,s ti#es3interest3 earned ratio will be 1".2. $hat is Milbrett,s eected earnings er share following the recaitali4ation% a. b. c. d. e.
<".-<".7" <".?7 <".>9 <".>>
Chapter 13 - Page 24
(The following information applies to the next two problems.)
Financial analysts for Naulls Industries have revealed the following infor#ation about the co#anyJ •
Naulls Industries currently has a caital structure that consists of ?2 ercent co##on e*uity and "2 ercent debt. The risk3free rate/ kF/ is 2 ercent. The #arket risk re#iu# / kM 3 kF/ is 7 ercent. Naulls,s co##on stock has a beta of 1.". Naulls has "93year bonds outstanding with an annual couon rate of 1" ercent and a face value of <1/999. The bonds sell today for <1/"99. The co#any,s ta rate is -9 ercent.
• • • • •
amada e-uati%n and unlevered )eta 77
.
N
Answer: c
Diff: '
N
9.-+ 9.=+ 1.99 1.97 1.--
amada e-uati%n and c%st %f c%mm%n e-uit& .
Diff: E
$hat is the co#any,s unlevered beta% a. b. c. d. e.
7?
Answer: c
$hat would be the co#any,s new cost of co##on e*uity (using the )A6M! if it were to change its caital structure to -9 ercent debt and 79 ercent co##on e*uity% (NoteJ Eere we are asking for the new cost of co##on e*uity/ not the $A))O! a. b. c. d. e.
11.+7: 1".7": 1+.-9: 1-.+9: 17.-9: (The following information applies to the next four problems.)
'tewart Inc. has <-/999/999 in total assets. The co#any,s current caital structure consists of "2 ercent debt and ?2 ercent co##on e*uity. )urrently/ the co#any,s before3ta cost of debt is > ercent. The risk3free rate (kF! is 2 ercent and the #arket risk re#iu# (kM L kF! is also 2 ercent. At the fir#,s current caital structure/ the co#any,s beta is 1.12 (i.e./ its current cost of co##on e*uity is 19.?2 ercent!. 'tewart,s oerating inco#e (5BIT! is <+99/999/ its interest eense is <>9/999/ and its ta rate is -9 ercent. The co#any has >9/999 outstanding shares of co##on stock. The co#any,s net inco#e is currently <1+"/999/ and its earnings er share (56'! is <1.72. The co#any ays out all of its earnings as dividends (56' 8 &6'!/ and hence its growth rate is 4ero. Thus/ its stock rice is si#ly 56'Gks; where ks is the cost of co##on e*uity. It follows that the co#any,s stock rice is currently <12.+->> (<1.72G9.19?2!.
Chapter 13- Page 25
Capital structure, leverage, and WACC 7>
.
Answer: c
Diff: E
N
Answer: )
Diff: '
N
Answer: d
Diff: '
N
$hat is the co#any,s $A))% a. 7."=: b. >.>7: c. =."7: d. 19.97: e. 19.?9:
amada e-uati%n and unlevered )eta 7=
.
$hat is the co#any,s unlevered beta% a. b. c. d. e.
9.-19? 9.=2>+ 1.9999 1.91-? 1.+>99
amada e-uati%n and c%st %f c%mm%n e-uit& ?9
.
The co#any is considering changing its caital structure. 'ecifically/ the fir# is considering a caital structure that consists of 29 ercent debt and 29 ercent co##on e*uity. In order to #ake this change/ the co#any would issue additional debt and use the roceeds to reurchase co##on stock. Assu#e that if the fir# adots this change/ its total interest eense would now be <"99/999. Assu#e that the caital structure change would have no effect on the co#any,s total assets/ oerating inco#e/ or ta rate. Assu#e that all co##on shares will be reurchased at <17 a share/ which is slightly above the current stock rice of <12.+->>. $hat would be the co#any,s new cost of co##on e*uity if it adots a caital structure that consists of 29 ercent debt and 29 ercent co##on e*uity% a. b. c. d. e.
11."+: 11.?1: 1"."2: 1".7?: 1+.99:
Capital structure, leverage, and E"# ?1
.
Answer: c
Diff: '
N
$hat would be the co#any,s earnings er share/ if it adots a caital structure with 29 ercent debt and 29 ercent co##on e*uity% a. b. c. d. e.
<9.?2 <".-7 <+.-+ <-.9<7.>7
Chapter 13 - Page 26
e+ Appendi- !"A Multiple Choice: Conceptual Easy: DOL, D(L, and DTL 1+A3?".
Answer: c
Diff: E
$hich of the following state#ents is #ost correct% a. An increase in fied costs/ (holding sales and variable costs constant! will reduce the co#any,s degree of oerating leverage. b. An increase in interest eense will reduce the co#any,s degree of financial leverage. c. If the co#any has no debt outstanding/ then its degree of total leverage e*uals its degree of oerating leverage. d. Answers a and b are correct. e. Answers b and c are correct.
Medium: (inancial leverage 1+A3?+.
Diff: '
The use of financial leverage by the fir# has a otential i#act on which of the following% (1! ("! (+! (-! (2! a. b. c. d. e.
The The The The The 1/ 1/ "/ "/ 1/
+/ "/ +/ +/ "/
risk associated with the fir#. return eerienced by the shareholder. variability of net inco#e. degree of oerating leverage. degree of financial leverage. 2 2 2 -/ 2 +/ 2
(inancial leverage 1+A3?-.
Answer: e
Answer: d
Diff: '
If a fir# uses debt financing (&ebt ratio 8 9.-9! and sales change fro# the current level/ which of the following state#ents is #ost correct% a. The ercentage change in net oerating inco#e (5BIT! resulting fro# the change in sales will eceed the ercentage change in net inco#e (NI!. b. The ercentage change in 5BIT will e*ual the ercentage change in net inco#e. c. The ercentage change in net inco#e relative to the ercentage change in sales (and in 5BIT! will not deend on the interest rate aid on the debt. d. The ercentage change in net oerating inco#e will be less than the ercentage change in net inco#e. e. 'ince debt is used/ the degree of oerating leverage #ust be greater
Chapter 13- Page 27
than 1.
Chapter 13 - Page 28
(inancial risk 1+A3?2.
Answer: )
Diff: '
$hich of the following state#ents is #ost correct% a. 'uose )o#any APs 56' is eected to eerience a larger ercentage change in resonse to a given ercentage change in sales than )o#any BPs 56'. ther things held constant/ )o#any A would aear to have #ore business risk than )o#any B. b. 'tate#ent a would be correct if the ter# 5BITC were substituted for 56'.C c. 'tate#ent a would be correct if the ter# 5BITC were substituted for sales.C d. 'tate#ent a would be correct if the words financial riskC were substituted for business risk.C e. The state#ents above are false.
Operating and financial leverage 1+A3?7.
Answer: a
Diff: '
$hich of the following state#ents is #ost correct% a. The degree of oerating leverage (&! deends on a co#anyPs fied costs/ variable costs/ and sales. The & for#ula assu#es (1! that fied costs are constant and ("! that variable costs are a constant roortion of sales. b. The degree of total leverage (&T! is e*ual to the & lus the degree of financial leverage (&F!. c. Arith#etically/ financial leverage and oerating leverage offset one another so as to kee the degree of total leverage constant. Therefore/ the for#ula shows that the greater the degree of financial leverage/ the s#aller the degree of oerating leverage. d. The state#ents above are true. e. The state#ents above are false.
Operating and financial leverage 1+A3??.
Answer: e
Diff: '
$hich of the following state#ents is #ost correct% a. All else being e*ual/ an increase in a fir#Ps fied costs will increase its degree of oerating leverage. b. Fir#s that have large fied costs and low variable costs have a higher degree of financial leverage than do fir#s with low fied costs and high variable costs. c. If a fir#Ps net inco#e rises 19 ercent every ti#e its 5BIT rises 19 ercent/ this i#lies the fir# has no debt outstanding. d. None of the state#ents above is correct. e. Answers a and c are correct.
Chapter 13- Page 29
DOL 1+A3?>.
Answer: c The degree of characteristics%
oerating
leverage
has
which
of
the
Diff: ' following
a. The closer the fir# is oerating to breakeven *uantity/ the s#aller the &. b. A change in *uantity de#anded will roduce the sa#e ercentage change in 5BIT as an identical change in rice er unit of outut/ other things held constant. c. The & is not a fied nu#ber for a given fir#/ but will deend uon the ti#e 4ero values of the econo#ic variables Q (Quantity!/ 6 (6rice!/ and D (Dolu#e!. d. The & relates the change in net inco#e to the change in net oerating inco#e. e. If the fir# has no debt/ the & will e*ual 1.
De)t rati% and DOL 1+A3?=.
Answer: a
Diff: '
)o#any & has a 29 ercent debt ratio/ whereas )o#any 5 has no debt financing. The two co#anies have the sa#e level of sales/ and the sa#e degree of oerating leverage. $hich of the following state#ents is #ost correct% a. If sales increase 19 ercent for both co#anies/ then )o#any & will have a larger ercentage increase in its net inco#e. b. If sales increase 19 ercent for both co#anies/ then )o#any & will have a larger ercentage increase in its oerating inco#e (5BIT!. c. If 5BIT increases 19 ercent for both co#anies/ then )o#any &,s net inco#e will rise by #ore than 19 ercent/ while )o#any 5,s net inco#e will rise by less than 19 ercent. d. Answers a and c are correct. e. None of the answers above is correct.
Degree %f leverage 1+A3>9.
Answer: a
Diff: '
$hich of the following is a key benefit of using the degree of leverage concet in financial analysis% a. It allows decision #akers a relatively clear assess#ent conse*uences of alternative actions. b. It establishes the oti#al caital structure for the fir#. c. It shows how a given change in leverage will affect sales. d. All of the state#ents above. e. nly state#ents a and c above are correct.
Chapter 13 - Page 30
of
the
Multiple Choice: P*o+lems Easy: DOL and c$anges in EB!T 1+A3>1.
1": 1-: 17: 1>: "9:
DTL and f%recast E"#
Answer: d
Diff: E
Quick aunch ocket )o#any/ a satellite launching fir#/ eects its sales to increase by 29 ercent in the co#ing year as a result of NA'APs recent roble#s with the sace shuttle. The fir#Ps current 56' is <+."2. Its degree of oerating leverage is 1.7/ while its degree of financial leverage is ".1. $hat is the fir#Ps ro0ected 56' for the co#ing year using the &T aroach% a. b. c. d. e.
< +."2 < 2.-7 <19.=" < >.?1 <1=.7+
C$ange in E"# 1+A3>+.
Diff: E
Mavill Motors has annual sales of <12/999. Its variable costs e*ual 79 ercent of its sales/ and its fied costs e*ual <1/999. If the co#any,s sales increase 19 ercent/ what will be the ercentage increase in the co#any,s earnings before interest and taes (5BIT!% a. b. c. d. e.
1+A3>".
Answer: a
Answer: )
Diff: E
our fir#Ps 56' last year was <1.99. ou eect sales to increase by 12 ercent during the co#ing year. If your fir# has a degree of oerating leverage e*ual to 1."2 and a degree of financial leverage e*ual to +.29/ then what is its eected 56'% a. b. c. d. e.
<1.+->1 <1.727+ <1.=>1+ <"."-"? <".2>-+
Chapter 13- Page 31
Medium: DOL c$ange 1+A3>-.
Answer: a
+.?2 -."9 +.29 -.7? +.++
DOL
Answer: d
Diff: '
The Rdegree of leverageR concet is designed to show how changes in sales will affect 5BIT and 56'. If a 19 ercent increase in sales causes 56' to increase fro# <1.99 to <1.29/ and if the fir# uses no debt/ then what is its degree of oerating leverage% a. b. c. d. e.
+.7 -." -.? 2.9 2.2
DOL in sales d%llars 1+A3>7.
'tro#burg )ororation #akes surveillance e*ui#ent for intelligence organi4ations. Its sales are
1+A3>2.
Diff: '
Answer: c
Diff: '
Marcus )ororation currently sells 129/999 units a year at a rice of <-.99 a unit. Its variable costs are aroi#ately +9 ercent of sales/ and its fied costs a#ount to 29 ercent of revenues at its current outut level. Although fied costs are based on revenues at the current outut level/ the cost level is fied. $hat is MarcusPs degree of oerating leverage in sales dollars% a. b. c. d. e.
1.9 "." +.2 -.9 2.9
Chapter 13 - Page 32
DOL, D(L, and DTL 1+A3>?.
1.12 1.99 1."" 1.1" ".7>
DTL and interest e+pense
Answer: d
Diff: '
)oats )or. generates <19/999/999 in sales. Its variable costs e*ual >2 ercent of sales and its fied costs are <299/999. Therefore/ the co#any,s oerating inco#e (5BIT! e*uals <1/999/999. The co#any esti#ates that if its sales were to increase 19 ercent/ its net inco#e and 56' would increase 1?.2 ercent. $hat is the co#any,s interest eense% (Assu#e that the change in sales would have no effect on the co#any,s ta rate.! a. b. c. d. e.
<199/999 <192/>?<111/2><1-"/>2? <>2?/1-"
DTL 1+A3>=.
Diff: '
6Q Manufacturing )ororation has <1/299/999 in debt outstanding. The co#anyPs before3ta cost of debt is 19 ercent. 'ales for the year totaled <+/299/999 and variable costs were 79 ercent of sales. Net inco#e was e*ual to <799/999 and the co#anyPs ta rate was -9 ercent. If 6QPs degree of total leverage is e*ual to 1.-9/ what is its degree of oerating leverage% a. b. c. d. e.
1+A3>>.
Answer: c
Answer: e
Diff: '
Alvare4 Technologies has sales of <+/999/999. The co#any,s fied oerating costs total <299/999 and its variable costs e*ual 79 ercent of sales/ so the co#any,s current oerating inco#e is
1.?1+.199 +."29 +.299 7.999
Chapter 13- Page 33
DTL and c$ange in N! 1+A3=9.
12.77: 1>.++: 1=."-: "1.29: "+.9>:
E+pected EB!T
Diff: '
<"/-99/999 <1/799/999 < -99/999 <+/799/999 <1/+29/999
E+pected EB!T
Answer: d
Diff: '
Assu#e that a fir# has a degree of financial leverage of 1."2. If sales increase by "9 ercent/ the fir# will eerience a 79 ercent increase in 56'/ and it will have an 5BIT of <199/999. $hat will be the 5BIT for this fir# if sales do not increase% a. b. c. d. e.
<11+/-1" <199/999 < >-/+?2 < 7?/27> < -"/112
E+pected EB!T 1+A3=+.
Answer: c
Assu#e that a fir# currently has 5BIT of <"/999/999/ a degree of total leverage of ?.2/ and a degree of financial leverage of 1.>?2. If sales decline by "9 ercent net year/ then what will be the fir#Ps eected 5BIT in one year% a. b. c. d. e.
1+A3=".
Diff: '
Bell Brothers has <+/999/999 in sales. Its fied costs are esti#ated to be <199/999/ and its variable costs are e*ual to fifty cents for every dollar of sales. The co#any has <1/999/999 in debt outstanding at a before3ta cost of 19 ercent. If Bell BrothersP sales were to increase by "9 ercent/ how #uch of a ercentage increase would you eect in the co#anyPs net inco#e% a. b. c. d. e.
1+A3=1.
Answer: e
Answer: e
Diff: '
Sulwicki )ororation wants to deter#ine the effect of an eansion of its sales on its oerating inco#e (5BIT!. The fir#Ps current degree of oerating leverage is ".2. It ro0ects new unit sales to be 1?9/999/ an increase of -2/999 over last yearPs level of 1"2/999 units. ast yearPs 5BIT was <79/999. Based on a degree of oerating leverage of ".2/ what is this yearPs eected 5BIT with the increase in sales% a. b. c. d. e.
< 79/999 <1?2/999 <199/999 < =9/999 <11-/999
Chapter 13 - Page 34
Degree %f financial leverage 1+A3=-.
Answer: d
Diff: '
A co#any currently sells ?2/999 units annually. At this sales level/ its 5BIT is <- #illion/ and its degree of total leverage is ".9. The fir#Ps debt consists of <12 #illion in bonds with a =.2 ercent couon. The co#any is considering a new roduction #ethod which will entail an increase in fied costs but a decrease in variable costs/ and will result in a degree of oerating leverage of 1.7. The resident/ who is concerned about the stand3alone risk of the fir#/ wants to kee the degree of total leverage at ".9. If 5BIT re#ains at <- #illion/ what a#ount of bonds #ust be retired to acco#lish this% a. b. c. d. e.
<>.-" <=.1= <-.--
#illion #illion #illion #illion #illion
Tough: (inancial leverage, DOL, and DTL 1+A3=2.
Diff: T
A co#any has an 5BIT of <- #illion/ and its degree of total leverage is ".-. The fir#,s debt consists of <"9 #illion in bonds with a 19 ercent yield to #aturity. The co#any is considering a new roduction rocess that will re*uire an increase in fied costs but a decrease in variable costs. If adoted/ the new rocess will result in a degree of oerating leverage of 1.-. The resident wants to kee the degree of total leverage at ".-. If 5BIT re#ains at <- #illion/ what a#ount of bonds #ust be outstanding to acco#lish this (assu#ing the yield to #aturity re#ains at 19 ercent!% a. b. c. d. e.
<17.? <1>.2 <1=." <1=.> <"9.1
#illion #illion #illion #illion #illion
DOL, D(L, and fi+ed %perating c%sts 1+A3=7.
Answer: a
Answer: c
Diff: T
incoln odging Inc. esti#ates that if its sales increase 19 ercent then its net inco#e will increase 1> ercent. The co#any,s 5BIT e*uals <".- #illion/ and its interest eense is <-99/999. The co#any,s oerating costs include fied and variable costs. $hat is the level of the co#any,s fied oerating costs% a. b. c. d. e.
< -29/999 < 777/77? <1/"99/999 <"/999/999 <"/1"2/999
Chapter 13- Page 35
A'%E% A'D %.$&T#.'% CHAPTE !"
1.
Business risk
Answer: c
Diff: E
".
Business risk
Answer: d
Diff: E
+.
Business risk
Answer: d
Diff: E
N
The correct answer is state#ent d. 'tate#ents a and b are correct. Both relate directly to the business side of the fir#. 'tate#ent c/ on the other hand/ is related to the financial risk of the fir#. 'ince state#ents a and b are correct/ state#ent d is the correct choice. -.
Business and financial risk
Answer: d
Diff: E
2.
Optimal capital structure
Answer: e
Diff: E
The oti#al caital structure #ai#i4es the fir#,s stock rice and #ini#i4es the fir#,s $A)). 7
.
Optimal capital structure
Answer: c
Diff: E
?.
Optimal capital structure
Answer: e
Diff: E
>.
Target capital structure
Answer: e
Diff: E
=.
Leverage and capital structure
Answer: d
Diff: E
19Both an increase in the cororate ta rate and a decrease in the co#any,s degree of oerating leverage will encourage the fir# to use #ore debt in its caital structure. Therefore/ the correct choice is state#ent d.
.
Leverage and capital structure
Answer: e
Diff: E
'tate#ent e is the correct choice. owering the cororate ta rate reduces the ta advantages of debt leading fir#s to use less debt financing. If the ersonal ta rate were to increase/ individuals would now find interest received on cororate debt less attractive/ causing fir#s to utili4e less debt financing. An increase in the costs of bankrutcy would lead fir#s to use less debt in order to reduce the robability of having to incur these higher costs. 11.
Leverage and capital structure
Answer: e
Diff: E
'tate#ent e is correct. ess stable sales would lead a fir# to reduce its debt ratio. A lower cororate ta rate reduces the ta advantage of the deductibility of interest eense. This reduction in the ta shield rovided by debt would encourage less use of debt. If #anage#ent believes the fir#,s stock is overvalued/ then it would want to issue e*uity rather than debt/ thereby increasing the fir#,s e*uity ratio. 1".
Leverage and capital structure
Answer: a
Diff: E
'tate#ent a is correct; all the other state#ents are false. 'ince interest is ta deductible/ it would #ake sense to increase debt if the cororate ta rate rises. Interest received by individual investors is not ta ee#t/ so an increase in the ersonal ta rate would not encourage a fir# to increase its debt level in the caital structure. Increasing oerating leverage would discourage a co#any fro# increasing debt. If a co#any,s assets beco#e less li*uid/ it would hurt the co#any,s financial osition/ #aking it less likely that the fir# could #ake interest ay#ents when necessary. An increase in
eected bankrutcy costs would encourage a co#any to use less debt. 1+.
Leverage and capital structure
Answer: e
Diff: E
If the costs incurred when filing for bankrutcy increased/ fir#s would be enali4ed #ore if they filed for bankrutcy and would be less willing to take that risk. Therefore/ they would reduce debt levels to hel avoid bankrutcy risk/ so state#ent a is false. An increase in the cororate ta rate would #ean that fir#s would get larger ta breaks for interest ay#ents. Therefore/ fir#s have an incentive to increase interest ay#ents/ in order to reduce taes. Therefore/ they will increase their debt ratios/ so state#ent b is true. An increase in the ersonal ta rate decreases the after3ta return that investors will receive. Fir#s will have to issue debt at higher interest rates in order to rovide investors with the sa#e after3ta returns they used to receive. This will raise fir#s, costs of debt/ which will increase their $A))s/ so fir#s will not increase their debt ratios. Therefore/ state#ent c is false. If a fir#,s business risk decreases/ then this will tend to increase its debt ratio. Therefore/ state#ent d is true. 'ince both state#ents b and d are true/ the correct choice is state#ent e. 1-.
Leverage and capital structure
Answer: a
Diff: E
N
The correct answer is state#ent a. If cororate ta rates increase/ then co#anies get a larger ta advantage fro# debt in their caital structure/ so they will increase their debt ratios. If ersonal taes increase/ bondholders will ay #ore taes and will de#and a higher rate of return fro# co#anies to co#ensate the#. Therefore/ co#anies will need to ay higher interest rates/ which #akes debt #ore eensive. Therefore/ an increase in the ersonal ta rate will not encourage cororations to increase their debt ratios. If their assets beco#e less li*uid/ co#anies will have to ay a higher interest rate on their bonds. (e#e#ber/ k 8 k U I6 U &6 U M6 U 6. If assets are less li*uid/ 6 increases.! This #akes the debt #ore eensive and #akes co#anies less likely to increase their debt ratios.
12.
Leverage and capital structure
Answer: c
Diff: E
N
The correct answer is state#ent c. The co#any will have higher debt interest ay#ents/ so net inco#e will decline. Thus/ state#ent a is false. The effect on 56' is a#biguous. 5arnings decline (NI!/ but so will the nu#ber of shares. Therefore/ state#ent b is false. The fir#,s recaitali4ation will not change total assets. Eowever/ since net inco#e declines/ A will decrease; so state#ent d is false. As long as the B56 ratio is greater than the cost of debt/ 5 will increase. Eowever/ you don,t have enough infor#ation to deter#ine the cost of debt/ so you can #ake no deter#ination about 5. Thus/ state#ent e is false. The increase in debt will increase the risk to shareholders/ so the cost of e*uity will increase. Therefore/ state#ent c is correct. 17.
Leverage and capital structure
Answer: e
Diff: E
N
The correct answer is state#ent e. 'tate#ent a is incorrect. Tyically/ the cost of debt rises slower than the cost of e*uity. Also/ the fir# is substituting cheaer debt for #ore eensive e*uity. At so#e oint/ increasing
debt will likely lead to an increase in the $A)). But this is not true across all levels of debt. VThink of a fir# with no debtJ increasing the debt ratio to 0ust 19: will robably lower the $A))W. This also elains why state#ent c is incorrect. A fir# with a high debt ratio (i.e./ =9:! will likely increase its $A)) by further increasing its debt. 'tate#ent b is incorrect. Although 56' is #ai#i4ed/ the total value of the co#any #ay be co#ro#ised. This contrasts with state#ent d. The caital structure that #ai#i4es stock rice should #ini#i4e the $A)). 'o/ state#ent d is also incorrect. 1?.
Leverage and capital structure
Answer: c
Diff: E
k
$A))
•
&GA ratio
'tate#ent a is false. The $A)) does not necessarily increase. e#e#ber/ you are relacing high cost e*uity with low cost debt. $hen there is very little debt in the caital structure/ the $A)) will actually decrease. ('ee the diagra# above.! The caital structure that #ai#i4es stock rice is not necessarily the caital structure that #ai#i4es 56'/ so state#ent b is false. If the cororate ta rate increases/ co#anies will obtain a bigger ta advantage for their interest ay#ents. Thus/ they #ay increase their debt levels to take advantage of this situation/ and this would raise debt ratios. Therefore/ the correct answer is state#ent c. 1>.
Capital structure and WACC
Answer: e
Diff: E
'tate#ent a is false; if you are to the left of the fir#,s oti#al caital structure on the $A)) curve/ increasing a co#any,s debt ratio will actually decrease the fir#,s $A)). 'tate#ent b is false; if you are to the right of the fir#,s oti#al caital structure on the $A)) curve/ increasing a co#any,s debt ratio will actually increase the fir#,s $A)). 'tate#ent c is false; as you increase the fir#,s debt ratio the cost of debt will increase because you,re using #ore debt. Because you,re using #ore debt the cost of e*uity also increases because the fir#,s financial risk has increased. Fro# state#ents a and b you can see that whether the $A)) is increased deends on where you are on the $A)) curve relative to the fir#,s oti#al caital structure. Therefore/ the correct answer is state#ent e. 1=.
Capital structure, OA, and OE
Answer: d
Diff: E
'tate#ents a and b are correct; therefore/ state#ent d is the aroriate choice. A 8 NIGTA. If total assets re#ain the sa#e/ but NI decreases (because of the new interest ay#ent!/ A will decrease. NI will fall/ but not as #uch in co#arison to the a#ount that co##on e*uity will fall because B56 X kd/ thus 5 8 NIG)5 will rise. B56 will re#ain the sa#e. B56 8 5BITGTA/ where TA and 5BIT re#ain the sa#e (which was given in the roble#!. "9
.
Capital structure, WACC, T!E, and E"#
Answer: a
Diff: E
'tate#ent a is correct; the other state#ents are false. The caital structure that #ai#i4es the fir#,s stock rice generally calls for a debt ratio that is lower than the one that #ai#i4es 56'. The fir# could #ai#i4e its TI5 by having no debt (that is 4ero interest ay#ents!. But/ this caital structure would robably not #ai#i4e the fir#,s stock rice. "1.
Capital structure t$e%r&
Answer: d
Diff: E
'tate#ents a and c are correct; therefore/ state#ent d is the correct choice. An increase in the cororate ta rate reduces the after3ta cost of debt #aking it #ore attractive relative to e*uity. Thus/ fir#s #ight be eected to use #ore debt in their caital structure rather than less debt. "".
'iscellane%us capital structure c%ncepts
Answer: c
Diff: E
N
The correct answer is state#ent c. 'tate#ent a is not correct. @ust the oosite is true33we would eect co#anies to use less debt. 'tate#ent b is not correct. The additional debt would result in an increase in interest eense and a decrease in net inco#e. 'ince assets are unchanged/ the co#anyPs A #ust decrease. 'tate#ent c is correct. The additional debt would be used to urchase additional assets. $e are told that the A stays the sa#e. Therefore/ if assets increase/ it #ust #ean that net inco#e also increases. There is no change in e*uity/ so the 5 of the fir# #ust increase.
"+
.
(inancial leverage and Answer: a Diff: E
E"#
'tate#ent a is true; a higher 56' does not always #ean that the stock rice will increase. 'tate#ent b is false; a lower $A)) will #ean a higher stock rice. 'tate#ent c is false; 56' can increase 0ust because shares outstanding decline. (The fir#,s net inco#e will decline because its interest eense increases.! "-.
(inancial leverage and E"#
Answer: c
Diff: E
'tate#ent a is false because B56 8 5BITGTotal assets. The etent to which the fir# uses debt financing does not affect 5BIT or total assets. 'tate#ent b is false because fir#s with a high ercentage of fied costs have a high degree of oerating leverage by definition. "2.
(inancial leverage and rati%s
Answer: d
Diff: E
B56 8 5BITGTA. 'ince they both have the sa#e total assets and the sa#e B56/ then 5BIT #ust be the sa#e for both co#anies. If A has a higher debt ratio and higher interest eense than B/ and they both have the sa#e 5BIT and ta rate/ then A #ust have a lower NI than B. Therefore/ state#ent a is true. If A has a lower NI than B but both have the sa#e total assets/ then A,s A (NIGTA! #ust be lower than B,s A. Therefore/ state#ent b is true. If both co#anies have the sa#e total assets but A,s debt ratio is higher than B,s/ then A,s e*uity #ust be lower (since Total assets 8 Total debt U Total e*uity!. If A has less e*uity/ and a lower NI than B/ it is not ossible to 0udge which co#any,s 5 (NIG5Q! is higher. "7.
(inancial leverage and rati%s
Answer: )
Diff: E
B56 8 5BITGTA. If both fir#s have the sa#e B56 ratio and sa#e total assets/ then they #ust have the sa#e 5BIT. 'ince Fir# has no debt in its caital structure/ Fir# will have higher net inco#e than Fir# because has no
interest eense and does. The TI5 ratio is 5BITGInt. If the two co#anies have the sa#e 5BIT/ the one with the lower interest eense (Fir# !/ will have a higher TI5. Therefore/ state#ent a is false. Fir#s and have the sa#e 5BIT/ but Fir# has a higher interest eense/ so its net inco#e will be lower than Fir# . 'ince A is e*ual to NIGTA/ and the two fir#s have the sa#e total assets/ Fir# will have a lower A than Fir# . Therefore/ state#ent b is true. everage will increase 5 if B56 X kd. 'ince B56 is "9 ercent and kd is > ercent/ leverage will increase Fir# ,s 5. Therefore/ state#ent c is false. "?.
Optimal capital structure
Answer: d
Diff: '
">.
Operating and financial leverage
Answer: e
Diff: '
"=.
(inancial leverage and rati%s
Answer: c
Diff: '
'tate#ent a is false; A,s net inco#e is lower than B,s due to higher interest eense/ but its assets are e*ual to B,s/ so A,s A #ust be lower than B,s A. 'tate#ent b is false; A has the sa#e 5BIT as B/ but higher interest ay#ents than B; therefore/ A,s TI5 is lower than B,s. 'tate#ent c is correct. +9.
Limits %f leverage
Answer: d
Diff: '
+1.
#ignaling t$e%r&
Answer: )
Diff: '
+".
Capital structure and WACC
Answer: d
Diff: '
Answer: )
Diff: '
'tate#ent b is false because it is not always true. ++.
Capital structure and WACC
'tate#ent b is true; the other state#ents are false. The cost of retained earnings should be higher than debt financing. 56' is #ai#i4ed at a higher caital structure than the one that #ini#i4es the fir#,s weighted average cost of caital. Increasing debt increases the risk of bankrutcy/ which can increase the costs of both debt and e*uity. +-.
'iscellane%us capital structure c%ncepts
Answer: a
Diff: '
'tate#ent a is true; the other state#ents are false. If the ersonal ta rate were increased/ investors would refer to receive less of their inco#e as interest33i#lying fir#s would substitute e*uity for debt. Eigh business risk is associated with high oerating leverage; therefore/ fir#s with high business risk would use less debt. +2
.
'iscellane%us capital structure c%ncepts
Answer: c
Diff: '
If cororate ta rates were decreased while other things were held constant/ and if the MM ta3ad0usted tradeoff theory of caital structure were correct/ cororations would decrease their use of debt because the ta shelter benefit would not be as great as when ta rates are high. Business risk is the riskiness of the fir#,s oerations if it uses no debt. The oti#al caital structure does not #ai#i4e 56'/ and the degree of total leverage shows how a given change in sales will affect earnings er share. +7
.
*ariati%ns in capital structures
Answer: d
Diff: T
+?.
Determining price fr%m EB!T
Answer: e
Diff: E
5BIT <=2/999 <"92/999 <"92/999 6
8 8 8 8 8
6Q 3 DQ 3 F) 6(22/999! 3 (9.-!6(22/999! 3 <119/999 (9.7!(22/999!6 ++/9996 <7."1.
+>
.
Breakeven price
Answer: a
Diff: E
Answer: a
Diff: '
Total costs 8 <19/999 U <"(-"/999! 8 <=-/999. 6rice 8 <=-/999G-"/999 8 <"."-. +=
.
New financing
ld debt ratio 8 9.++++; New debt ratio 8 9.177?. 'ales 8 ?.2. TA
.
Net %perating inc%me
Answer: )
Diff: '
Answer: )
Diff: '
Total costMethod 1 8 <1.99(Q! U <19/999. Total costMethod " 8 <1.29(Q! U <2/999. 'et e*ual and Q U <19/999 8 <2/999 8 19/999 8
solve for QJ <1.29(Q! U <2/999 <9.2(Q! Q.
-1
.
C$ange in )reakeven v%lume
)alculate the old and new breakeven volu#es using the old data ro0ectionsJ ld QB5 8 <1"9/999G(<1."9 3 <9.79! 8 <1"9/999G<9.79 8 "99/999 units. New QB5 8 <"-9/999G(<1.92 3 <9.-1! 8 <"-9/999G<9.7- 8 +?2/999 units. )hange in breakeven volu#e 8 +?2/999 3 "99/999 8 1?2/999 units. -".
Breakeven and e+pansi%n
Answer: c
)alculate the initial breakeven volu#e in dollarsJ <-99/999 F) F) ld 'B5 8
13
D) 'ales
8
13
D)Gunit 6riceGunit
8
1 3
<-."9
and
Diff: '
new
8
<-99/999 1 3 9.79
8 <1/999/999.
)alculate the new breakeven volu#e in sales dollarsJ <729/999 <729/999 <-.-> 8 New 'B5 8 8 <1/>92/227. 1 3 1 3 9.792/227 3 <1/999/999 8 <>92/227.
-+.
Breakeven
Answer: d
Diff: '
.
Operating decisi%n
Answer:
d
Diff: '
)alculate 5BIT1 at -9/999 units using the current sales riceJ 5BIT1 8 ' 3 D) 3 F) 8 -9/999(<".12! 3 9.+9(-9/999!(<".12! 3 <-7/999 8 <>7/999 3 <"2/>99 3 <-7/999 8 <1-/"99. )alculate 5BIT" at 29/999 units using the lower rice of <1.=2J 5BIT" 8 29/999(<1.=2! 3 9.+9(29/999!(<1.=2! 3 <-7/999 8 <=?/299 3 <"=/"29 3 <-7/999 8 <""/"29. The change in 5BIT 8 <""/"29 3 <1-/"99 8 U<>/929. rice/ 5BIT increases by <>/929.
es/ Musgrave should cut its
-2
.
Capital structure and st%ck price
Answer: c
Diff: '
$e can do this roble# by using the 6G5 before and after the recaitali4ation. ecall that 6G5 8 6riceG56'.
5BIT Interest 5BT Ta (-9:! NI 'hares 56' 6G5
Before reca. <+99/999 319/999 <"=9/999 117/999 <1?-/999 1"9/999 <1?-/999G1"9/999 8 <1.-2. <1?.-9G1.-2 8 1"×.
After reca. <+99/999 329/999 <"29/999 199/999 <129/999 199/999 <129/999G199/999 8 <1.29.
1"9/999 3 (<+->/999G<1?.-9! 8 199/999 shares. As 6G5 8 1" after the recaitali4ation (recall the *uestion states that it does not change!/ we know 1" 8 6riceG<1.29; 6rice 8 1" × <1.29 8 <1>.99.
-7.
-?.
Capital structure and st%ck price
Answer: e
Diff: '
'te 1J
Find the current nu#ber of shares outstandingJ 'hares 8 NIG56' 8 <->9 #illionG<+."9 8 129 #illion shares.
'te "J
Find the nu#ber of shares after the reurchaseJ New shares 8 129 L <1/"99G<+" 8 129 L +?.2 8 11".2 #illion shares.
'te +J
Find the new 56' after the reurchaseJ 56' 8 V(5BIT L INT!(1 3 T!WGNew shares 8 V(<>99 L <>-! × 9.7WG11".2 8 <+.>1>77?.
'te -J
Find the new stock riceJ 'tock rice 8 56'GNew $A)) 8 <+.>1>77?G9.11 8 <+-.?".
amada e-uati%n and c%st %f e-uit& Facts givenJ
Answer: a
Diff: T
ks 8 1":; &G5 8 9."2; kF 8 7:; 6M 8 2:; T 8 -9:.
'te 1J
Find the fir#,s current levered beta using the )A6MJ ks 8 kF U 6M(b! 1": 8 7: U 2:(b! b 8 1.".
'te "J
Find the b 8 1." 8 1." 8 1.9-+2 8
'te +J
Find the new levered beta given the new caital structure using the Ea#ada e*uationJ b 8 bV1 U (1 3 T!(&G5!W b 8 1.9-+2V1 U (9.7!(1!W b 8 1.77=7.
'te -J
Find ks 8 ks 8 ks 8
fir#,s unlevered beta using the Ea#ada e*uationJ bV1 U (1 3 T!(&G5!W bV1 U (9.7!(9."2!W 1.12b b.
the fir#,s new cost of e*uity given its new beta and the )A6MJ kF U 6M(b! 7: U 2:(1.77=7! 1-.+2:.
->.
Optimal capital structure and amada e-uati%n
Answer: d
Diff: T
kF 8 2:; kM 3 kF 8 7:; ks 8 kF U (kM 3 kF!b; $A)) 8 wdkd(1 3 T! U wcks. ou need to use the &G5 ratio given for each caital structure to find the levered beta using the Ea#ada e*uation. Then/ use each of these betas with the )A6M to find the ks for that caital structure. se this ks and kd for each caital structure to find the $A)). The oti#al caital structure is the one that #ini#i4es the $A)). (&G5!
b 8 bV1 U (1 3 T!(&G5!W
ks 8 kF U (kM 3 kF!b
wc
kd
9.11 9."2 9.-+
1.977? 1.1299 1."2?1
/.01 1.99
2.3/// 1.7999
wd
$A))
11.-999: 11.=999 1".2-"=
9.= 9.> 9.?
?.9: ?." >.9
9.1 9." 9.+
19.7>: 19.+> 19.""
24.3/// 1-.7999
/.0 9.2
5.5 =.7
/.3 9.2
2/.26 19.1>
For ea#le/ if the &G5 is 9.11J b 8 1.9V1 U (1 3 T!(&G5!W 8 1.9V1 U (1 3 9.-!(9.1111!W 8 1.977?. ks 8 kF U (kM 3 kF!b 8 2: U 7:(1.977?! 8 11.-9:. The weights are given at 9.= and 9.1 for e*uity and debt/ resectively/ and the kd for that caital structure is given as ? ercent. $A)) 8 wdkd(1 3 T! U wcks 8 (9.1!(?:!(1 3 9.-! U (9.=!(11.-9:! 8 19.7>:. &o the sa#e calculation for each of the caital structures and find each $A)). The oti#al caital structure is the one that #ini#i4es the $A))/ which is 19.12:. Therefore/ the oti#al caital structure is -9: debt and 79: e*uity. -=.
Capital structure and st%ck price
Answer: d
Diff: T
The oti#al caital structure #ai#i4es the fir#,s stock rice. $hen the debt ratio is "9:/ eected 56' is <".29. Hiven the fir#,s olicy of retaining +9: of earnings/ the eected dividend er share &1 is <".29 × 9.?9 8 <1.?2. The stock rice 69 is <1.?2G(12: 3 ?:! or <"1.>>. $hen the debt ratio is +9:/ eected 56' is <+.99 and eected &1 is <+.99 × 9.?9 8 <".19. The stock rice 69 is <".19G(12.2: 3 ?:! 8 <"-.?1. 'i#ilarly/ when the debt ratio is -9:/ &1 8 <"."?2 and 69 8 <"2.">. $hen the debt ratio is 29:/ &1 8 <".7"2 and 69 8 <"7."2. $hen the debt ratio is ?9:/ &1 8 <".>9 and 69 8 <"2.-2. The stock rice is highest when the debt ratio is 29:. 29
.
Capital structure and st%ck price
Answer: )
Diff: T
First/ calculate the stock rice for each debt level using the dividend growth #odel/ 69 8 &1G(k' 3 g!J &ebt 9:
&ivGshare <2.29
k' 11.2:
69 <2.29G(9.112 3 9.9"! 8 <2?.>=.
76
0.//
27./
80.//9/.27 ; /./7<
-9 29 ?2
7.29 ?.99 ?.29
1+.9 1-.9 12.9
<7.29G(9.1+ 3 9.9"!
= 80/.//. 8 <2=.9=. 8 <2>.++. 8 <2?.7=.
)learly/ <79.99 is the highest rice/ so "2: debt and ?2: e*uity is the oti#al caital structure.
21.
Capital structure and st%ck price
Answer: a
Diff: T
First/ find the co#any,s current cost of caital/ dividends er share/ stock riceJ ks 8 9.977 U (9.97!9.= 8 1":. To find the stock rice/ you still need dividends er share or &6' 8 (<"/999/999(1 3 9.-!!G"99/999 8 <7.99. Thus/ stock rice is 69 8 <7.99G9.1" 8 <29.99. Thus/ by issuing <"/999/999 in debt the co#any can reurchase <"/999/999G<29.99 8 -9/999 shares.
and the the new
Now after recaitali4ation/ the new cost of caital/ &6'/ and stock rice can be foundJ ks 8 9.977 U (9.97!1.1 8 1+."9:. &6' for the re#aining ("99/999 3 -9/999! 8 179/999 shares are thus V(<"/999/999 3 (<"/999/999 × 9.19!!(1 3 9.-!WG 179/999 8 <7.?2. And/ finally/ 69 8 <7.?2G9.1+" 8 <21.1-. 2".
Capital structure and st%ck price
Answer: a
Diff: T
To answer this we need to deter#ine the followingJ 1. Eow #any shares are currently outstanding% ". $hat are the interest eense and net inco#e/ before and after the change% Before recaitali4ationJ 5BIT <"9/999/999 Interest "/999/999 5BT <1>/999/999 Taes (-9:! ?/"99/999 NI <19/>99/999 56' 8 <+.79. 'hares outstanding 8 <19/>99/999G<+.79 8 +/999/999 shares. After recaitali4ationJ New shares 8 + #illion 3 1 #illion 8 " #illion shares. Total debt 8 <"9/999/999 U (<1/999/999!(<-9! 8 <79/999/999. Interest ay#ent 8 (<79/999/999!(9.1! 8 <7/999/999. Net inco#eJ 5BIT Interest 5BT Taes (-9:! NI
<"9/999/999 7/999/999 <1-/999/999 2/799/999 < >/-99/999
56' 8 <>/-99/999G"/999/999 8 <-."9.
6G5 8 11.2.
69 8 (<-."9!(11.2! 8 <->.+9.
2+
.
Capital structure and st%ck price
Answer: d
Diff: T
The bonds used in the reurchase will create a new interest eense for the co#any. This will change net inco#e. &ividends er share will change because net inco#e changes and the nu#ber of shares outstanding changes. New interest eenseJ <>99/999 × >: 8 <7-/999. New net inco#eJ (<"/999/999 3 <7-/999!(1 3 9.+! 8 <1/+22/"99. 'hares reurchasedJ <>99/999G>9 8 19/999 shares. New shares outstandingJ 1?2/999 3 19/999 8 172/999 shares. New dividends er shareJ <1/+22/"99G172/999 8 <>."1++. $e #ust also calculate a new cost of e*uityJ 2: U (2:!1." 8 11:. New stock riceJ <>."1G11: 8
Capital structure and E"#
Answer: d
Diff: T
After issuing the debt/ the co#any can reurchase <19/999/999G<-9 8 "29/999 shares leaving 729/999 shares outstanding. $e still need to find the eected
NI after issuing the debt. $e,re given the anticiated NI is <+.7 #illion. Thus/ the 5BIT (before the debt issue! can be found as followsJ <+/799/999 8 5BIT(1 3 9.+-! or 5BIT 8 <2/-2-/2-2.-2. The co#any will ay <1/999/999 in interest after issuing the debt so the new 5BT will be <2/-2-/2-2.-2 3 <1/999/999 8 <-/-2-/2-2.-2. The new NI figure will be <-/-2-/2-2.-2(1 3 9.+-! 8 <"/=-9/999. Finally/ 56' 8 <"/=-9/999G729/999 8 <-.2" after the recaitali4ation. 22.
Capital structure and E"#
Answer: a
Diff: T
)aital structure AJ The fir# will have debt of <299/999(9.+! 8 <129/999 and e*uity of <+29/999. $e,re told the shares have a book value of <19 so the nu#ber of shares outstanding is <+29/999G<19 8 +2/999. Interest eense will be <129/999(19:! 8 <12/999. $e can co#ute 5BT as 5BIT 3 I or <"99/999 3 <12/999 8 <1>2/999. Also/ we can co#ute NI as 5BT(1 3 T! or <1>2/999(1 3 9.-! 8 <111/999. Finally/ 56' 8 <111/999G+2/999 8 <+.1?. )aital structure BJ The fir# will have debt of <299/999(9.?! 8 <+29/999 and e*uity of <129/999. The nu#ber of shares outstanding is <129/999G<19 8 12/999. Interest eense will be <+29/999(1-:! 8 <-=/999. $e can co#ute 5BT as <"99/999 3 <-=/999 8 <121/999. Also/ we can co#ute NI as <121/999(1 3 9.-! 8 <=9/799. Finally/ 56' 8 <=9/799G12/999 8 <7.9-. The difference in 56' between caital structure A and caital structure B is <7.9- 3 <+.1? 8 <".>?. 27.
Capital structure, leverage, and WACC
Answer: d
Diff: T
N
ou need to find the beta with no debt and the new ks with the new caital structure before you can calculate the fir#,s $A)).
2?.
'te 1J
)alculate the fir#,s unlevered beta using the Ea#ada e*uationJ b 8 bV1 U (1 3 T!(&G5!W 1." 8 bV1 U (9.7!(<+G
'te "J
)alculate the fir#,s new beta with the new caital structureJ b 8 bV1 U (1 3 T!(&G5!W b 8 9.=2-2-2V1 U (9.7!(<2G<2!W b 8 1.2"?+.
'te +J
)alculate the fir#,s structureJ ks 8 kF U (6!b ks 8 7: U ?:(1.2"?+! ks 8 17.7=9=:.
'te -J
)alculate the fir#,s new $A))J $A)) 8 wdkd(1 3 T! U wcks $A)) 8 9.2(>.2:!(9.7! U 9.2(17.7=9=:! $A)) 8 19.>=22: ≈ 19.=9:.
new
cost
Capital structure and E"#
of
e*uity
with
the
Answer: e
new
caital
Diff: '
&ebt 8 ?2: 8 <+99/999; 5*uity 8 "2: 8 <199/999; BD6' 8 <19; Total assets 8 <-99/999.
6robability 5BIT essJ Interest
Feast 9.7 <79/999 +7/999
Fa#ine 9.<"9/999 +7/999
5BT essJ Taes (-9:! NI Y shares 56'
<"-/999 =/799 <1-/-99 19/999 <1.--
(<17/999! (7/-99! (< =/799! 19/999 3<9.=7
&ifference in 56' for aggressive caital structureJ 56'Feast 3 56'Fa#ine 8 <1.-- 3 (<9.=7! 8 <".-9. 2>
.
Capital structure and E"#
Answer: )
Diff: '
&ebt 8 "2: 8 <199/999; 5*uity 8 ?2: 8 <+99/999; BD6' 8 <19; Total assets 8 <-99/999.
6robability 5BIT essJ Interest 5BT essJ Taes (-9:! NI Y shares 56'
Feast 9.7 <79/999 19/999 <29/999 "9/999 <+9/999 +9/999 <1.99
Fa#ine 9.<"9/999 19/999 <19/999 -/999 < 7/999 +9/999 <9."9
&ifference in 56' for conservative caital structureJ 56'Feast 3 56'Fa#ine 8 <1.99 3 <9."9 8 <9.>9. 2=
.
Capital structure and C* %f E"#
Answer: c
Diff: '
)alculate coefficient of variation. 5ected 56'AggressiveJ 5(56'! 8 9.7 56'Feast U 9.- 56'Fa#ine 8 (9.7!(<1.--! U 9.-(3<9.=7! 8 <9.->. 'tandard deviationJ '&56'3aggressive 8 V9.7(<1.-- 3 <9.->!" U 9.-(3<9.=7 3 <9.->!"WZ 8 V9.22+9 U 9.>"=-W1G" 8 1.1?7. )DAggressive 8 1.1?7G9.->
≈ ".-2.
79
.
Capital structure and C* %f E"#
Answer: a
Diff: '
)alculate coefficient of variation. 5ected 56' conservativeJ 5(56'! 8 9.7(<1.99! U 9.-(<9."9! 8 <9.7>. 'tandard deviationJ '&56'3)onservative 8 V9.7(<1.99 3 <9.7>!" U 9.-(<9."9 3 <9.7>!"WZ 8 V9.971- U 9.9=""W1G" 8 9.+=1=. )D)onservative 8 9.+=1=G9.7> 8 9.2?7 71.
Capital structure and WACC
≈ 9.2>.
Answer: c
Diff: E
N
First/ we will calculate the cost of co##on e*uity and then use that to solve for the $A)). ks 8 kF U (kM 3 kF!b ks 8 2: U (7:!1.1 ks 8 11.7:. $A)) 8 wdkd(1 3 T! U wcks $A)) 8 (9."!(?.2:!(1 3 9.-! U (9.>!(11.7:! $A)) 8 19.1>:. 7".
amada e-uati%n and unlevered )eta
Answer: c
Diff: E
N
To unlever the beta/ we #ust use the Ea#ada e*uation/ substituting the known values. b 1.1 1.1 b 7+.
8 8 8 8
bV1 U (1 3 T!(&G5!W bV1 U (1 3 9.-!(1G-!W bV1.12W 9.=272.
amada e-uati%n and c%st %f c%mm%n e-uit&
Answer: e
Diff: '
N
First/ we #ust find the levered beta after the recaitali4ation/ using the unlevered beta calculated in the revious roble#. b 8 b 8 b 8 b 8
bV1 U (1 3 T!(&G5!W 9.=272V1 U (1 3 9.-!("G+!W 9.=272V1.-W 1.++=1.
ks 8 kF U (kM L kF!b ks 8 2: U (7:!1.++=1 ks 8 1+.9+:.
7-.
Capital structure, financial leverage, and rati%s
Answer: d
Diff: E
N
The correct answer is state#ent d. 'tate#ent a is incorrect; since oerating inco#e is unchanged and interest eense goes u/ net inco#e #ust decrease. 'tate#ent b is incorrect; if net inco#e decreases and assets re#ain the sa#e/ A #ust decrease. 'tate#ent c is incorrect; we are told the fir#,s basic earning ower (B56! and assets do not change/ so oerating inco#e #ust also re#ain the sa#e. 'tate#ent d is correct; since B56 X kd/ the use of debt to buy back stock will increase 5. 72.
Capital structure and E"#
Answer: c
Total assets 8 <199/999/999; B56 8 "9:; TI5 8 1".2; T 8 -9:. 'te 1J
&eter#ine the fir#,s oerating inco#eJ B56 8 5BITGTA 9."9 8 5BITG<199/999/999 5BIT 8 <"9/999/999.
Diff: T
N
'te "J
&eter#ine the fir#,s interest eense/ given the TI5 and 5BITJ 5BIT TI5 8 Interest 1".2 8
<"9/999/999
Interest 1".2Interest 8 <"9/999/999 <1/799/999 8 Interest.
'te +J
&eter#ine the fir#,s erating inco#e Interest eense 5BT Taes (-9:! Net inco#e
net inco#eJ <"9/999/999 1/799/999 <1>/-99/999 ?/+79/999 <11/9-9/999
'te -J
&eter#ine the nu#ber of shares outstanding after recaitali4ationJ If the fir# reurchased <"9 #illion worth of stock and the stock rice is <"9/ then the fir# bought 1 #illion shares. 'hares outstanding now 8 2/999/999 L 1/999/999 8 -/999/999.
'te 2J
&eter#ine the fir#,s 56' after recaitali4ationJ 56' 8 NIGY of shares 56' 8 <11/9-9/999G-/999/999 56' 8 <".?7.
.
77
amada
e-uati%n
and
unlevered
Answer: c b 8 1."8 1."8 b 8
7?
Diff: E
)eta N
bV1 U (1 3 T!(&G5!W bV1 U (9.79!(9."2G9.?2!W bV1."W 1.99.
.
amada
e-uati%n
and
c%st
%f
Answer: c
c%mm%n Diff: '
e-uit& N
b 8 1.99 was calculated reviously in the roble# above.
7>.
'te 1J
)alculate the new levered beta using unlevered beta calculated reviouslyJ b 8 bV1 U (1 3 T!(&G5!W b 8 1.99V1 U (9.79!(9.-9G9.79!W b 8 1.-9.
'te "J
)alculate the new cost of e*uity using the )A6M e*uation and the new levered betaJ ks 8 2: U (7:!1.-9 8 1+.-9:.
Capital structure, leverage, and WACC
the
Ea#ada
Answer: c
e*uation
Diff: E
and
the
N
wd 8 "2:; ws 8 ?2:; kd 8 >:; ks 8 19.?2:; T 8 -9:. The after3ta cost of debt is >.9: × (1 3 9.-9! 8 -.>:. Its cost of co##on e*uity is (given as! 19.?2:. 'o/ the $A)) 8 9."2(-.>:! U 9.?2(19.?2:! 8
=."7"2: 7=.
≈ =."7:.
amada e-uati%n and unlevered )eta
Answer: )
Diff: '
N
Answer: d
Diff: '
N
b 8 1.12; T 8 -9:; & 8 "2:; 5 8 ?2:. b 1.12 1.12 9.=2>+ ?9.
8 8 8 8
bV1 U (1 3 T!(&G5!W bV1 U (9.7!(9."2G9.?2!W bV1."W b.
amada e-uati%n and c%st %f c%mm%n e-uit& 'te 1J
)alculate the new levered beta for the fir#/ using the new caital structureJ b 8 9.=2>+; New & 8 29:; New 5 8 29:; T 8 -9:. b 8 bV1 U (1 3 T!(&G5!W 8 9.=2>+V1 U (9.79!(9.29G9.29!W 8 1.2+++.
'te "J
)alculate the fir#,s new cost of co##on e*uityJ kF 8 2:; kM L kF 8 2:; b 8 1.2+++. k' 8 2: U (2:!1.2+++ 8 1".777:
?1.
≈ 1".7?:.
Capital structure, leverage, and E"# 'te 1J
)alculate followsJ
net
5BIT Interest 5BT Taes (-9:! NI 'te "J
inco#e
under
<+99/999 "99/999 <199/999 -9/999 < 79/999
Answer: c the
fir#,s
new
Diff: '
caital
N
structure
as
(given! (given!
)alculate 56' under the fir#,s new caital structureJ The fir# has assets of <- #illion. riginally/ <+ #illion was in co##on e*uity and <1 #illion was in debt. Now/ that a#ount is slit evenly/ <" #illion in co##on e*uity and <" #illion in debt. The fir# will borrow <1 #illion and use the roceeds to reurchase <1 #illion worth of co##on e*uity. At the reurchase rice of <17Gshare/ the fir# will buy back <1/999/999G<17 8 7"/299 shares/ leaving >9/999 L 7"/299 8 1?/299 shares outstanding. 56' 8 NIGY shares 8 <79/999G1?/299 8 <+.-">7
≈ <+.-+.
E/ APPE'D#0 !"A %.$&T#.'% ?"24A;. DOL, D(L, and DTL
Answer: c
Diff: E
?+24A;. (inancial leverage
Answer: e
Diff: '
?-24A;. (inancial leverage
Answer: d
Diff: '
?224A;. (inancial risk
Answer: )
Diff: '
?724A;. Operating and financial leverage
Answer: a
Diff: '
??24;.
Operating and financial leverage
Answer: e
Diff: '
?>24;.
DOL
Answer: c
Diff: '
?=24;.
De)t rati% and DOL
Answer: a
Diff: '
'tate#ent a is correct; the other state#ents are false. After the sales increase/ the ercentage increase in 5BIT will be the sa#e for both co#anies. )o#any 5Ps net inco#e will rise by eactly 19:. >924;.
Degree %f leverage
Answer: a
Diff: '
>124;.
DOL and c$anges in EB!T
Answer: a
Diff: E
First/ find 5BIT before sales increaseJ 5BIT 8 'ales 3 ('ales × D):! 3 F) 8 <12/999 3 (<12/999 × 9.79! 3 <1/999
8 <2/999. Now/ assu#ing sales increase by 19: or to <12/999 × 1.19 8 <17/299/ calculate the new 5BIT. 5BIT 8 <17/299 3 (<17/299 × 9.79! 3 <1/999 8 <2/799. 'o/ the ercentage increase is V(<2/799 3 <2/999!G<2/999W >"24;.
DTL and f%recast E"# 56'1 8 8 8 8
>+24;.
× 199
8 1":.
Answer: d
Diff: E
Answer: )
Diff: E
Answer: a
Diff: '
56'9 U 56'9V&T × (ercent change in sales!W <+."2V1 U (1.7!(".1!(9.2!W <+."2(".7>! <>.?1.
C$ange in E"# 56'9 8 <1.99. & 8 1."2. :∆' 8 12:. &F 8 +.29.
56'1 8 %
&T 8 &(&F! 8 1."2(+.29! 8 -.+?2. 56'1
>-24;.
8 56'9V1.9 U (&T!(:∆'ales!W 8 <1.99V1.9 U (-.+?2!(9.12!W 8 <1.99(1.727+! 8 <1.727+.
DOL c$ange
)alculate & using new sales/ new variable cost ercentage/ and new fied costsJ '9 8 224;.
199 3 "2 199 3 "2 3 22
8
?2 "9
8 +.?2.
DOL
Answer: d
Diff: '
<1.29/ on
a 19 ercent
Answer: c
Diff: '
These two e*uations could be usedJ &T 8 (&!(&F!. 56'1 8 56'9V1 U (&T!(:∆'ales!W. Note that 56' rises by 29 increase in sales/ so 1.29 8 1.99V1 U (&T!(9.1!W 1.29 8 1 U 9.1 &T 9.1 &T 8 9.29 &T 8 2.99.
ercent/ fro# <1.99 to
Now &T 8 2 8 (&!(&F! But if &ebt 8 9/ then &F 8 1/ so & 8 &T 8 2.9. >724;.
DOL in sales d%llars
se the infor#ation rovided and the for#ula for & in sales dollarsJ &' 8 &' 8
129/999(<-! 3 9.+(129/999!(<-! 129/999(<-! 3 9.+(129/999!(<-! 3 9.2(129/999!(<-!
<799/999 <799/999
−
−
<1>9/999
<1>9/999
−
<+99/999
&' 8
<-"9/999 <1"9/999
8 +.2.
Alternate #ethodJ 5ress 6 as 1.9 or 199: of rice and D and F) as a ercent of riceJ Q(6 − D! 129/999(1.9 3 9.+! 9.? &Q 8 8 8 8 +.29. 129/999V(1.9 3 9.+! 3 9.2W 9." Q(6 − D! − F) >?24;.
DOL, D(L, and DTL
Answer: c
Diff: '
First/ calculate 6QPs &F as 5BITG(5BIT 3 I!. Interest eense (I! on the debt is <1/299/999(19:! 8 <129/999. $e can work backwards fro# NI to find 5BIT as followsJ 5BT 8 NIG(1 3 T! or <799/999G9.7 8 <1/999/999. 5BIT 8 5BT U I or <1/999/999 U <129/999 8 <1/129/999. &F is thus <1/129/999G(<1/129/999 3 <129/999! 8 1.12. ecogni4ing &T 8 &F × &/ we can solve 1.-9 8 1.12 × & for & 8 1."".
>>24;.
DTL and interest e+pense
Answer: d
Diff: '
Answer: e
Diff: '
Answer: e
Diff: '
ecall that &T 8 : change in NIG: change in sales 8 9.1?2G9.19 8 1.?2.
&T 8 1.?2 8 1.?2 8
' '
−
D)
−
D)
−
F)
−
I
<19/999/999 <19/999/999
−
<>/299/999
<>/299/999
−
−
<299/999
−
I
<1/299/999 <1/999/999
−
I
<1/299/999 8 <1/?29/999 3 1.?2I I 8 <1-"/>2?.1- [ <1-"/>2?. >=24;.
DTL &T
=924;.
8 (' 3 D)!G(5BIT 3 I! 8 (<+/999/999 3 <1/>99/999!G(
DTL and c$ange in N! 'te 1J
Find &egree of total leverage (&T! ' − D &T 8 ' − D − F − I 8 8
<+/999/999 3 9.2(<+/999/999! <+/999/999 3 9.2(<+/999/999! 3 <199/999 3 9.1(<1/999/999!
<1/299/999 <1/+99/999
8 1.12+>. 'te "J
=124;.
Find ercentage increase in net inco#eJ :∆NI 8 (9."9!(&T! 8 (9."9!(1.12+>! 8 9."+9> 8 "+.9>:.
E+pected EB!T
Answer: c
Diff: '
& 8 &TG&F 8 ?.2G1.>?2 8 -.9. ∆5BIT
8 (39."9!(-.9!(<"/999/999! 8 3<1/799/999.
5BIT 8 <"/999/999 3 <1/799/999 8 <-99/999.
="24;.
E+pected EB!T
Answer: d
Diff: '
&T 8 :∆56'G:∆'ales 8 79:G"9: 8 +.9. & 8 &TG&F 8 +.9G1."2 8 ".-9. ld 5BIT 8 <199/999GV1 U (9."9!(".-9!W 8 <199/999G1.-> 8 <7?/27>. Alternate solutionJ se &F eression to calculate change in 5BIT and revious 5BITJ &F 8 1."2 8 :∆56'G:∆5BIT 1."2 8 9.79GV∆5BITG(<199/999 3 ∆5BIT!W 1."2 8 V9.79(<199/999! 3 9.79(∆5BIT!WG∆5BIT 1."2∆5BIT 8 <79/999 3 9.79(∆5BIT! 1.>2∆5BIT 8 <79/999 ∆5BIT 8 <+"/-+". ld 5BIT 8 <199/999 3 <+"/-+" 8 <7?/27>. =+24;.
E+pected EB!T
Answer: e
Diff: '
'et u the & e*uation/ letting \ be the unknown new 5BITJ et \ 8 New 5BIT. \ − 79/999 \ − 79/999 79/999 &Q 8 ".2 8 8 79/999 1?9/999 3 1"2/999 9.+7 1"2/999 ".2(9.+7! 8 9.=9 8
\
−
79/999
79/999 \
−
79/999
79/999
<2-/999 8 \ 3 <79/999 \ 8 <11-/999. New 5BIT 8 <11-/999. =-24;.
Degree %f financial leverage &T 8 (&!(&F! ".9 8 1.7(&F! 1."2 8 &F.
Answer: d
Diff: '
