Chapter 13: Capital Structure and Leverage

Chapter 13: Capital Structure and Leverage
o A firm's business risk is largely determined by the financial

characteristics of its industry, especially by the amount of debt the
average firm in the industry uses.
o True
o False
ANSWER: False
o Financial risk refers to the extra risk borne by stockholders as a result of

a firm's use of debt as compared with their risk if the firm had used no
debt.
o True
o False
ANSWER: True
o A firm's capital structure does not affect its free cash flows as discussed
in the text, because FCF reflects only operating cash flows, which are
available to service debt, to pay dividends to stockholders, and for other
purposes.
o True
o False
ANSWER: True
o If a firm borrows money, it is using financial leverage.
o True
o False
ANSWER: True
o Other things held constant, an increase in financial leverage will increase

a firm's market (or systematic) risk as measured by its beta coefficient.
o True
o False
ANSWER: True
o The graphical probability distribution of ROE for a firm that uses financial
leverage would tend to be more peaked than the distribution if the firm
used no leverage, other things held constant.
o True
o False
ANSWER: False
o Provided a firm does not use an extreme amount of debt, operating

leverage typically affects only EPS, while financial leverage affects both
EPS and EBIT.
o True
o False
ANSWER: False
o The trade-off theory states that capital structure decisions involve a

tradeoff between the costs and benefits of debt financing.
o True
o False
ANSWER: True
o Different borrowers have different risks of bankruptcy, and if a borrower

goes bankrupt, its lenders will probably not get back the full amount of
funds that they loaned. Therefore, lenders charge higher rates to
borrowers judged to be more likely to go bankrupt.
o True
o False
ANSWER: True
o Modigliani and Miller (MM) won Nobel Prizes for their work on capital
structure theory.
o True
o False
ANSWER: True
o Modigliani and Miller's first article led to the conclusion that capital
structure is "irrelevant" because it has no effect on a firm's value.
o True
o False
ANSWER: True
structure is extremely important, and that every firm has an optimal
capital structure that maximizes its value and minimizes its cost of
capital.
o True
o False
ANSWER: False
o It is possible for Firms A and B to have identical financial and operating

leverage, yet for Firm A to have more risk as measured by the variability
of EPS. This would occur if Firm A has more business risk than Firm B.
o True
o False
ANSWER: True
RATIONALE: If Firm A's sales are more volatile than those of Firm B, then A
would have greater EPS variability in spite of identical financial and operating
leverage. Operating leverage is only one factor that affects business risk.
o As the text indicates, a firm's financial risk can and should be divided
into separate market and diversifiable risk components.
o True
o False
ANSWER: False
o If two firms have the same expected earnings per share (EPS) and the
same standard deviation of expected EPS, then they must have the same
amount of business risk.
o True
o False
ANSWER: False
o In a world with no taxes, Modigliani and Miller (MM) show that a firm's
capital structure does not affect its value. However, when taxes are
considered, MM show a positive relationship between debt and value,
i.e., the firm's value rises as it uses more and more debt, other things
held constant.
o True
o False
ANSWER: True
o According to Modigliani and Miller (MM), in a world without taxes the

optimal capital structure for a firm is approximately 100% debt
financing.
o True
o False
ANSWER: False
o According to Modigliani and Miller (MM), in a world with corporate

income taxes the optimal capital structure calls for approximately 100%
debt financing.
o True
o False
ANSWER: True
o According to Modigliani and Miller (MM), in a world without corporate

income taxes the use of debt has no effect on the firm's value.
o True
o False
ANSWER: True
structure is "irrelevant" because it has no effect on a firm's value.
However, that article was criticized because it assumed that no taxes
existed. MM then revised their original article to include corporate
taxes, and this model led to the conclusion that a firm's value would be
maximized if it used (almost) 100% debt.
o True
o False
ANSWER: True
o Modigliani and Miller's second article, which assumed the existence of

corporate income taxes, led to the conclusion that a firm's value would
be maximized, and its cost of capital minimized, if it used (almost) 100%
debt. However, this model did not take account of bankruptcy costs. The
existence of bankruptcy costs leads to the assumption of an optimal
capital structure where the debt ratio is less than 100%.
o True
o False
ANSWER: True
o The Miller model begins with the Modigliani and Miller (MM) model
with corporate taxes and then adds personal taxes.
o True
o False
ANSWER: True
o The Miller model begins with the Modigliani and Miller (MM) model
without corporate taxes and then adds personal taxes.
o True
o False
ANSWER: False
o The Modigliani and Miller (MM) articles implicitly assumed that

bankruptcy did not exist. That led to the development of the "trade-off"
model, where the firm's value first rises with the use of debt due to the
tax shelter of debt, but later falls as more debt is added because the
potential costs of bankruptcy begin to more than offset the tax shelter
benefits. Under the trade-off theory, an optimal capital structure exists.
o True
o False
ANSWER: True
o Modigliani and Miller (MM), in their second article, took account of

taxes, bankruptcy, and other factors that were assumed away in their
original article. Once they took account of all these assumptions, they
concluded that every firm has a unique optimal capital structure.
Moreover, a manager can use the second MM model to determine his or
her firm's optimal debt ratio.
o True
o False
ANSWER: False
o Some peopleincluding the former chairman of the Federal Reserve

Board of Governors (Ben Bernanke)have argued that one advantage
of corporate debt from the stockholders' standpoint is that the existence
of debt forces managers to focus on cash flow and to refrain from
spending too much of the firm's money on private plane and other
"perks." This is one of the factors that led to the rise of LBOs and private
equity firms.
o True
o False
ANSWER: True
o The Modigliani and Miller (MM) articles implicitly assumed, among other
things, that outside stockholders have the same information about a
firm's future prospects as its managers. That was called "symmetric
information," and it is questionable. The introduction of "asymmetric
information" led to the development of the "signaling" theory of capital
structure, which postulated that firms are reluctant to issue new stock
because investors will interpret such an act as a signal that the firm's
managers are worried about its future. Other actions give off different
signals, and the end result is that capital structure is affected by
managers' perceptions about how their financing decisions will affect
investors' views of the firm and thus its value.
o True
o False
ANSWER: True
o According to the signaling theory of capital structure, firms first use

common equity for their capital, then use debt if and only if they can
raise no more equity on "reasonable" terms. This occurs because the use
of debt financing signals to investors that the firm's managers think that
the future does not look good.
o True
o False
ANSWER: False
o Other things held constant, firms with more stable and predictable sales
tend to use more debt than firms with less stable sales.
o True
o False
ANSWER: True
o Other things held constant, firms that use assets that can be sold easily
(like trucks) tend to use more debt than firms whose assets are harder to
sell (like those engaged in research and development).
o True
o False
ANSWER: True
o Other things held constant, the lower a firm's tax rate, the more logical it
is for the firm to use debt.
o True
o False
ANSWER: False
RATIONALE: This is false. The lower the tax rate, the less valuable the tax
shelter from debt. Think about the cost of debt in the WACC: rd(1 T). If T is
low, then the cost of debt is not reduced as much as when T is high.
o A firm's treasurer likes to be in a position to raise funds to support

operations whenever such funds are needed, even in "bad times." This is
called "financial flexibility," and the lower the firm's debt ratio, the
greater its financial flexibility, other things held constant.
o True
o False
ANSWER: True
RATIONALE: This is true, because if times are bad which is when financial
flexibility is important investors are much more willing to lend a firm money
than to buy its stock, because if the firm fails, debt holders are first in line to
get their money back.
o If a firm utilizes debt financing, a 10% decline in earnings before interest
and taxes (EBIT) will result in a decline in earnings per share that is larger
than 10%, and the higher the debt ratio, the larger this difference will
be.
o True
o False
ANSWER: True
o An increase in the debt ratio will generally have no effect on which of

these items?
o Business risk.
o Total risk.
o Financial risk.
o Market risk.
o The firm's beta.
ANSWER: a
o Business risk is affected by a firm's operations. Which of the following

is NOT directly associated with (or does not directly contribute to)
business risk?
o Demand variability.
o Sales price variability.
o The extent to which operating costs are fixed.

o The extent to which interest rates on the firm's debt fluctuate.
o Input price variability.
ANSWER: d
o Which of the following statements is CORRECT?
o Since debt financing raises the firm's financial risk, increasing the
target debt ratio will always increase the WACC.
o Since debt financing is cheaper than equity financing, raising a

company's debt ratio will always reduce its WACC.
o Increasing a company's debt ratio will typically reduce the

marginal costs of both debt and equity financing. However, this
action still may raise the company's WACC.
o Increasing a company's debt ratio will typically increase the

marginal costs of both debt and equity financing. However, this
action still may lower the company's WACC.
o Since a firm's beta coefficient is not affected by its use of financial

leverage, leverage does not affect the cost of equity.
ANSWER: d
o The capital structure that maximizes expected EPS also maximizes

the price per share of common stock.
o The capital structure that minimizes the interest rate on debt also
maximizes the expected EPS.
o The capital structure that minimizes the required return on equity

also maximizes the stock price.
o The capital structure that minimizes the WACC also maximizes the
price per share of common stock.
o The capital structure that gives the firm the best bond rating also
maximizes the stock price.
ANSWER: d
o Based on the information below, what is the firm's optimal capital

structure?
o Debt = 40%; Equity = 60%; EPS = $2.95; Stock price = $26.50.
ANSWER: c
o Which of the following statements best describes the optimal capital

structure?
o The optimal capital structure is the mix of debt, equity, and

preferred stock that maximizes the company's earnings per share
(EPS).

preferred stock that maximizes the company's stock price.

preferred stock that minimizes the company's cost of equity.
preferred stock that minimizes the company's cost of debt.

preferred stock that minimizes the company's cost of preferred
stock.
ANSWER: b
o Which of the following events is likely to encourage a company to raise

its target debt ratio, other things held constant?
o An increase in the corporate tax rate.
o An increase in the personal tax rate.
o An increase in the company's operating leverage.
o The Federal Reserve tightens interest rates in an effort to fight

inflation.
o The company's stock price hits a new high.
ANSWER: a
o Which of the following would tend to increase a firm's target debt ratio,
other things held constant?
o The costs associated with filing for bankruptcy increase.
o The corporate tax rate is increased.
o The personal tax rate is increased.

o The Federal Reserve tightens interest rates in an effort to fight
inflation.
o The company's stock price hits a new low.
ANSWER: b
o As a rule, the optimal capital structure is found by determining the

debt-equity mix that maximizes expected EPS.
o The optimal capital structure simultaneously maximizes EPS and

minimizes the WACC.
o The optimal capital structure minimizes the cost of equity, which

is a necessary condition for maximizing the stock price.
o The optimal capital structure simultaneously minimizes the cost of

debt, the cost of equity, and the WACC.
o The optimal capital structure simultaneously maximizes the stock

price and minimizes the WACC.
ANSWER: e
o The firm's target capital structure should do which of the following?
o Maximize the earnings per share (EPS).
o Minimize the cost of debt (rd).
o Obtain the highest possible bond rating.
o Minimize the cost of equity (rs).

o Minimize the weighted average cost of capital (WACC).
ANSWER: e
o A firm's business risk is determined solely by the financial

characteristics of its industry.
o The factors that affect a firm's business risk include industry

characteristics and economic conditions, both of which are
generally beyond the firm's control.
o One of the benefits to a firm of being at or near its target capital

structure is that this generally minimizes the risk of bankruptcy.
o A firm's financial risk can be minimized by diversification.
o The amount of debt in its capital structure can under no

circumstances affect a company's EBIT and business risk.
ANSWER: b
o Which of the following statements is CORRECT? As a firm increases the

operating leverage used to produce a given quantity of output, this
o normally leads to an increase in its fixed assets turnover ratio.
o normally leads to a decrease in its business risk.
o normally leads to a decrease in the standard deviation of its

expected EBIT.
o normally leads to a decrease in the variability of its expected EPS.

o normally leads to a reduction in its fixed assets turnover ratio.
ANSWER: e
RATIONALE: More operating leverage generally means a greater use of

automation, which means more fixed assets. If fixed assets increase
proportionately more than sales, then the fixed assets turnover (S/FA) will
decline.
o A firm's CFO is considering increasing the target debt ratio, which would
also increase the company's interest expense. New bonds would be
issued and the proceeds would be used to buy back shares of common
stock. Neither total assets nor operating income would change, but
expected earnings per share (EPS) would increase. Assuming the CFO's
estimates are correct, which of the following statements is CORRECT?
o Since the proposed plan increases the firm's financial risk, the
stock price might fall even if EPS increases.
o If the plan reduces the WACC, the stock price is likely to decline.
o Since the plan is expected to increase EPS, this implies that net
income is also expected to increase.
o If the plan does increase the EPS, the stock price will automatically
increase at the same rate.
o Under the plan there will be more bonds outstanding, and that
will increase their liquidity and thus lower the interest rate on the
currently outstanding bonds.
ANSWER: a

o Increasing its use of financial leverage is one way to increase a
firm's return on investors' capital (ROIC).
o If a firm lowered its fixed costs but increased its variable costs by
just enough to hold total costs at the present level of sales
constant, this would increase its operating leverage.
o The debt ratio that maximizes expected EPS generally exceeds the
debt ratio that maximizes share price.
o If a company were to issue debt and use the money to repurchase

common stock, this would reduce its return on investors' capital
(ROIC). (Assume that the repurchase has no impact on the
company's operating income.)
o If a change in the bankruptcy code made bankruptcy less costly to

corporations, this would tend to reduce corporations' debt ratios.
ANSWER: c
o Your firm has $500 million of investor-supplied capital, its return on

investors' capital (ROIC) is 15%, and it currently has no debt in its capital
structure (i.e., wd = 0). The CFO is contemplating a recapitalization
where it would issue debt at an after-tax cost of 10% and use the
proceeds to buy back some of its common stock, such that the
percentage of common equity in the capital structure (wc) is 1 wd. If
the company goes ahead with the recapitalization, its operating income,
the size of the firm (i.e., total assets), total investor-supplied capital, and
tax rate would remain unchanged. Which of the following is most likely
to occur as a result of the recapitalization?
o The ROA would increase.
o The ROA would remain unchanged.

o The return on investors' capital would decline.
o The return on investors' capital would increase.
o The ROE would increase.
ANSWER: e
o Companies HD and LD have identical tax rates, total assets, total

investor-supplied capital, and returns on investors' capital (ROIC), and
their ROICs exceed their after-tax costs of debt, rd(1 T). However,
Company HD has a higher debt ratio and thus more interest expense
than Company LD. Which of the following statements is CORRECT?
o Company HD has a higher net income than Company LD.
o Company HD has a lower ROA than Company LD.
o Company HD has a lower ROE than Company LD.
o The two companies have the same ROA.
o The two companies have the same ROE.
ANSWER: b
o Firms U and L each have the same amount of assets, investor-supplied

capital, and both have a return on investors' capital (ROIC) of 12%. Firm
U is unleveraged, i.e., it is 100% equity financed, while Firm L is financed
with 50% debt and 50% equity. Firm L's debt has an after-tax cost of 8%.
Both firms have positive net income and a 35% tax rate. Which of the
following statements is CORRECT?
o The two companies have the same times interest earned (TIE)
ratio.
o Firm L has a lower ROA than Firm U.
o Firm L has a lower ROE than Firm U.
o Firm L has the higher times interest earned (TIE) ratio.
o Firm L has a higher EBIT than Firm U.
ANSWER: b
o Your firm is currently 100% equity financed. The CFO is considering a

recapitalization plan under which the firm would issue long-term debt
with an after-tax yield of 9% and use the proceeds to repurchase some
of its common stock. The recapitalization would not change the
company's total investor-supplied capital, the size of the firm (i.e., total
assets), and it would not affect the firm's return on investors' capital
(ROIC), which is 15%. The CFO believes that this recapitalization would
reduce the firm's WACC and increase its stock price. Which of the
following would be likely to occur if the company goes ahead with the
recapitalization plan?
o The company's net income would increase.
o The company's earnings per share would decline.
o The company's cost of equity would increase.
o The company's ROA would increase.
o The company's ROE would decline.
ANSWER: c
o A major contribution of the Miller model is that it demonstrates, other
things held constant, that
o personal taxes increase the value of using corporate debt.
o personal taxes lower the value of using corporate debt.
o personal taxes have no effect on the value of using corporate

debt.
o financial distress and agency costs reduce the value of using

corporate debt.
o debt costs increase with financial leverage.
ANSWER: b
o Which of the following statements is CORRECT, holding other things

constant?
o Firms whose assets are relatively liquid tend to have relatively low
bankruptcy costs, hence they tend to use relatively little debt.
o An increase in the personal tax rate is likely to increase the debt

ratio of the average corporation.
o If changes in the bankruptcy code make bankruptcy less costly to

corporations, then this would likely lead to lower debt ratios for
corporations.
o An increase in the company's degree of operating leverage would

tend to encourage the firm to use more debt in its capital
structure so as to keep its total risk unchanged.
o An increase in the corporate tax rate would in theory encourage

companies to use more debt in their capital structures.
ANSWER: e
o Other things held constant, which of the following events would be most
likely to encourage a firm to increase the amount of debt in its capital
structure?
o Its sales are projected to become less stable in the future.
o The bankruptcy laws are changed in a way that would make

bankruptcy more costly to the firm and its stockholders.
o Management believes that the firm's stock is currently

overvalued.
o The firm decides to automate its factory with specialized

equipment and thus increase its use of operating leverage.
o The corporate tax rate is increased.
ANSWER: e
o A firm can use retained earnings without paying a flotation cost.

Therefore, while the cost of retained earnings is not zero, its cost
is generally lower than the after-tax cost of debt.
o The capital structure that minimizes a firm's weighted average

cost of capital is also the capital structure that maximizes its stock
price.
o The capital structure that minimizes the firm's weighted average

cost of capital is also the capital structure that maximizes its
earnings per share.
o If a firm finds that the cost of debt is less than the cost of equity,
increasing its debt ratio must reduce its WACC.
o Other things held constant, if corporate tax rates declined, then
the Modigliani-Miller tax-adjusted theory would suggest that firms
should increase their use of debt.
ANSWER: b
o The capital structure that maximizes the stock price is also the
capital structure that minimizes the cost of equity from retained
earnings (rs).
capital structure that maximizes earnings per share.
capital structure that maximizes the firm's times interest earned
(TIE) ratio.
o If a company increases its debt ratio, this will typically increase the
marginal costs of both debt and equity, but it still may reduce the
company's WACC.
o If Congress were to pass legislation that increases the personal tax

rate but decreases the corporate tax rate, this would encourage
companies to increase their debt ratios.
ANSWER: d
o In general, a firm with low operating leverage also has a small

proportion of its total costs in the form of fixed costs.
o There is no reason to think that changes in the personal tax rate
would affect firms' capital structure decisions.
o A firm with a relatively high business risk is more likely to increase

its use of financial leverage than a firm with low business risk,
assuming all else equal.
o If a firm's after-tax cost of equity exceeds its after-tax cost of debt,

it can always reduce its WACC by increasing its use of debt.
o Suppose a firm has less than its optimal amount of debt.

Increasing its use of debt to the point where it is at its optimal
capital structure will decrease the costs of both debt and equity.
ANSWER: a
o Companies HD and LD have identical amounts of assets, investor-

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

LD.
o Company HD has a higher times interest earned (TIE) ratio than

Company LD.
o Company HD has a higher return on equity (ROE) than Company

LD, and its risk as measured by the standard deviation of ROE is
also higher than LD's.
o The two companies have the same ROE.
o Company HD's ROE would be higher if it had no debt.

ANSWER: c
o Companies HD and LD have the same total assets, total investor-supplied

capital, operating income (EBIT), tax rate, and business risk. Company
HD, however, has a much higher debt ratio than LD. Also, both
companies' returns on investors' capital (ROIC) exceed their after-tax
costs of debt, rd(1 T). Which of the following statements is CORRECT?
o HD should have a higher return on assets (ROA) than LD.
o HD should have a higher times interest earned (TIE) ratio than LD.
o HD should have a higher return on equity (ROE) than LD, but its
risk, as measured by the standard deviation of ROE, should also be
higher than LD's.
o Given that ROIC > rd(1 T), HD's stock price must exceed that of
LD.
o Given that ROIC > rd(1 T), LD's stock price must exceed that of
HD.
ANSWER: c
o If Congress lowered corporate tax rates while other things were

held constant, and if the Modigliani-Miller tax-adjusted theory of
capital structure were correct, this would tend to cause
corporations to decrease their use of debt.
o A change in the personal tax rate should not affect firms' capital
structure decisions.
o "Business risk" is differentiated from "financial risk" 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 operating leverage.
o The optimal capital structure is the one that simultaneously (1)

maximizes the price of the firm's stock, (2) minimizes its WACC,
and (3) maximizes its EPS.
o If changes in the bankruptcy code made bankruptcy less costly to

corporations, this would likely reduce the average corporation's
debt ratio.
ANSWER: a
o When a company increases its debt ratio, the costs of equity and
debt both increase. Therefore, the WACC must also increase.
o The capital structure that maximizes the stock price is generally

the capital structure that also maximizes earnings per share.
o All else equal, an increase in the corporate tax rate would tend to
encourage companies to increase their debt ratios.
o Since debt financing raises the firm's financial risk, increasing a

company's debt ratio will always increase its WACC.
o Since the cost of debt is generally fixed, increasing the debt ratio
tends to stabilize net income.
ANSWER: c
o Generally, debt ratios do not vary much among different

industries, although they do vary among firms within a given
industry.
o Electric utilities generally have very high common equity ratios

because their revenues are more volatile than those of firms in
most other industries.
o Airline companies tend to have very volatile earnings, and as a

result they generally have high target debt-to- equity ratios.
o Wide variations in capital structures exist both between industries

and among individual firms within given industries. These
differences are caused by differing business risks and also
managerial attitudes.
o Since most stocks sell at or very close to their book values, book
value capital structures are typically adequate for use in
estimating firms' weighted average costs of capital.
ANSWER: d
o Longstreet Inc. has fixed operating costs of $470,000, variable costs of

$2.80 per unit produced, and its product sells for $4.00 per unit. What is
the company's break-even point, i.e., at what unit sales volume would
income equal costs?
o 391,667
o 411,250
o 431,813
o 453,403
o 476,073
ANSWER: a
RATIONALE: Fixed operating costs (F) $470,000
Variable costs per unit (V) $2.80
Sales price per unit (P) $4.00
QBE = F/(P V) = 391,667
o Your uncle is considering investing in a new company that will produce

high quality stereo speakers. The sales price would be set at 1.5 times
the variable cost per unit; the variable cost per unit is estimated to be
$75.00; and fixed costs are estimated at $1,200,000. What sales volume
would be required to break even, i.e., to have EBIT = zero?
o 28,880
o 30,400
o 32,000
o 33,600
o 35,280
ANSWER: c
RATIONALE:
Price multiple over VC 1.50

Sales price per unit (P) $112.50
Fixed costs (F)
$1,200,000
QBE = F/(P V) = 32,000
o Southwest U's campus book store sells course packs for $15 each, the
variable cost per pack is $9, fixed costs to produce the packs are
$200,000, and expected annual sales are 50,000 What are the pre-tax
profits from sales of course packs?
o $ 72,900
o $ 81,000
o $ 90,000
o $100,000
o e. $110,000
ANSWER: d
RATIONALE: Sales price per unit (P) $15.00
Annual sales (Q) 50,000
Fixed costs (F) $200,000
Profit = PQ VQ F = EBIT = $750,000 $450,000 $200,000 = $100,000

o Southwest U's campus book store sells course packs for $16 The variable
cost per pack is $10, and at current annual sales of 50,000 packs, the
store earns $75,000 before taxes on course packs. How much are the
fixed costs of producing the course packs?
o a. $164,025
o $182,250
o c. $202,500
o $225,000
o e. $247,500
ANSWER: d
RATIONALE: Sales price per unit (P) $16.00
Profit = PQ VQ F $75,000
F = PQ VQ EBIT = $800,000 $500,000 75000 =

$225,000
o Assume that you and your brother plan to open a business that will
make and sell a newly designed type of Two robotic machines are
available to make the sandals, Machine A and Machine B. The price per
pair will be $20.00 regardless of which machine is used. The fixed and
variable costs associated with the two machines are shown below. What
is the difference between the break-even points for Machines A and B?
(Hint: Find BEB BEA)
Machine A Machine B
Price per pair (P) $20.00 $20.00
Fixed costs (F) $25,000 $100,000
Variable cost/unit (V) $7.00 $4.00
o 3,154
o 3,505
o 3,894
o 4,327
o 4,760
ANSWER: d
RATIONALE: MachineA
Machine B
Sales price per pair (P) $20.00 $20.00
Fixed costs (F) $25,000 $100,000
Variable costs per unit (V) $7.00 $4.00
QBE = F/(P V) 1,923 6,250
Difference = BEB BEA = 4,327

o Your company plans to produce a new product, a wireless computer
mouse. Two machines can be used to make the mouse, Machines A and
B. The price per mouse will be $25.00 regardless of which machine is
used. The fixed and variable costs associated with the two machines are
shown below. At the expected sales level of 75,000 units, how much
higher or lower will the firm's expected EBIT be if it uses Machine B with
high fixed costs rather than Machine A with low fixed costs, i.e., what is
EBITB EBITA?
Machine A Machine B
Price per mouse (P) $25.00 $25.00
Fixed costs (F) $100,000 $400,000
Exp. unit sales (Q) 75,000 75,000
o a. $123,019
o $136,688
o c. $151,875
o $168,750
o e. $185,625
ANSWER: d
RATIONALE: MachineA
Machine B
Sale price per mouse (P) $25.00 $25.00
Fixed costs (F) $100,000 $400,000

Expected unit sales (Q) 75,000 75,000
Expected EBIT = (P V)Q F $631,250 $800,000
Difference = EBITB EBITA = $168,750
o Your company, which is financed entirely with common equity, plans to

manufacture a new product, a cell phone that can be worn like a Two
robotic machines are available to make the phone, Machine A and
Machine B. The price per phone will be $250.00 regardless of which
machine is used to make it. The fixed and variable costs associated with
the two machines are shown below, along with the capital (all equity)
that must be invested to purchase each machine. The expected sales
level is 25,000 units. Your company has tax loss carry-forwards that will
cause its tax rate to be zero for the life of the project, so T = 0. How
much higher or lower will the project's ROE be if you select the machine
that produces the higher ROE, i.e., what is ROEB ROEA? (Hint: Since
the firm uses no debt and its tax rate is zero, ROE = EBIT/Required
investment.)
Machine A Machine B
Price per phone (P) $250.00 $250.00
Fixed costs (F) $1,000,000 $2,000,000

Required equity investment $2,500,000 $3,000,000
o 6.00%
o 6.67%
o 7.00%
o 7.35%
o 7.72%
ANSWER: b
RATIONALE: MachineA
Machine B
Sales price per phone (P) $250.00 $250.00
Fixed costs (F) $1,000,000 $2,000,000
Required equity investment $2,500,000 $3,000,000
Exp. profit = EBIT = (P V)Q F $250,000 $500,000
Return on investment = ROE 10.00% 16.67%
Difference = ROEB ROEA = 6.67%

o You work for the CEO of a new company that plans to manufacture and
sell a new product, a watch that has an embedded TV set and a
magnifying glass The issue now is how to finance the company, with only
equity or with a mix of debt and equity. Expected operating income is
$400,000. Other data for the firm are shown below. How much higher or
lower will the firm's expected ROE be if it uses some debt rather than all
equity, i.e., what is ROEL ROEU?
0% Debt, U 60% Debt, L
Oper. income (EBIT) $400,000 $400,000
Required investment $2,500,000 $2,500,000
% Debt 0.0% 60.0%
$ of Debt $0.00 $1,500,000
$ of Common equity $2,500,000 $1,000,000
Interest rate NA 10.00%
Tax rate 35% 35%
o 5.85%
o 6.14%
o 6.45%
o 6.77%
o 7.11%
ANSWER: a
RATIONALE:
% Debt 0.00% 60.00%
$ of Debt $0 $1,500,000
$ of Common equity $2,500,000 $1,000,000
Tax rate 35.00% 35.00%
Operating income (EBIT) $400,000 $400,000
Interest 0 150,000
Taxable income $400,000 $250,000
Taxes 140,000 87,500
Net Income $260,000 $162,500
ROE 10.40% 16.25%
Difference in ROEs = 5.85%
o You work for the CEO of a new company that plans to manufacture and
sell a new type of laptop The issue now is how to finance the company,
with only equity or with a mix of debt and equity. Expected operating
income is $600,000. Other data for the firm are shown below. How
much higher or lower will the firm's expected EPS be if it uses some debt
rather than only equity, i.e., what is EPSL EPSU?
Oper. income (EBIT) $600,000 $600,000
% Debt 0.0% 60.0%
$ of Debt $0.00 $1,500,000
$ of Common equity $2,500,000 $1,000,000
Shares issued, $10/share 250,000 100,000
Tax rate 35% 35%
o $1.00
o $1.11
o $1.23
o $1.37
o $1.50
ANSWER: d
RATIONALE:
% Debt 0.00% 60.00%

$ of Debt $0 $1,500,000
$ of Common equity $2,500,000 $1,000,000
Shares issued at $10/share 250,000 100,000
Tax rate 35.00% 35.00%
Operating income (EBIT) $600,000 $600,000
Interest 0 150,000
Taxable income $600,000 $450,000
Taxes 210,000 157,500
Net income $390,000 $292,500
Earnings per share (EPS) $1.56 $2.93
Difference in EPS = $1.37
o Confu expects to have the following data during the coming year. What
is the firm's expected ROE?
Capital $200,000 Interest rate 8%
Debt/Capital, book value 65% Tax rate 40%
EBIT $25,000
o 12.51%
o 13.14%
o 13.80%
o 14.49%
o 15.21%
ANSWER: a
RATIONALE: Capital $200,000 EBIT $25,000
Debt/Capital 65% Interest = rate debt

= 10,400
EBIT $25,000 Earnings before

taxes $14,600
Interest rate 8% Taxes 5,840
Tax rate 40% Net Income $ 8,760
Debt = (Debt/Capital)) Capital = $130,000 NI/Equity = ROE =

12.51%
Equity = Assets Debt = $70,000
o Senate Inc. is considering two alternative methods for producing playing

cards. Method 1 involves using a machine with a fixed cost (mainly
depreciation) of $12,000 and variable costs of $1.00 per deck of cards.
Method 2 would use a less expensive machine with a fixed cost of only
$5,000, but it would require a variable cost of $1.50 per deck. The sales
price per deck would be the same under each method. At what unit
output level would the two methods provide the same operating income
(EBIT)?
o 12,600
o 14,000
o c. 15,400
o 16,940
o e. 18,634
Method 1 Method 2
Price/unit (P) $2.00 $2.00
V $1.00 $1.50
F $12,000 $5,000
ANSWER: RATIONALE:
EBIT = PQ VQ F
Insert data for Methods 1 and 2, then set the 2 equations equal to one
another, and then solve for Q. EBIT1 = PQ Q(V1) F1
EBIT2 = PQ Q(V2) F2
The PQs cancel, divide by 1, and we are left with: Q(V1) + F1 = Q(V2) + F2
This reduces to:
Q(V2 V1) = F1 F2
Q = (F1 F2)/(V2 V1) = 14,000
o A group of venture investors is considering putting money into Lemma

Books, which wants to produce a new reader for electronic books. The
variable cost per unit is estimated at $250, the sales price would be set
at twice the VC/unit, or $500, and fixed costs are estimated at $750,000.
The investors will put up the funds if the project is likely to have an
operating income of $500,000 or more. What sales volume would be
required in order to meet the minimum profit goal? (Hint: Use the
break-even formula, but include the required profit in the numerator.)
o 4,513
o 4,750
o 5,000
o 5,250
o 5,513
ANSWER: c
RATIONALE: Variable costs per unit (V) $250
Sale price per unit (P) $500
Required minimum profit $500,000
Volume (units) required to meet profit goal = (F + Profit)/(P V) = 5,000

Check: Op profit = (P V) Units F = $500,000
o El Capitan Foods has a capital structure of 40% debt and 60% equity, its
tax rate is 35%, and its beta (leveraged) is 25. Based on the Hamada
equation, what would the firm's beta be if it used no debt, i.e., what is
its unlevered beta, bU?
o 0.71
o 0.75
o 0.79
o 0.83
o 0.87
ANSWER: e
RATIONALE: bL 1.25
wd 0.40
Tax rate 35%
D/E = wd/(1 wd) 0.67
bU = bL/(1 + (D/E) (1 T)) 0.87
o Gator Fabrics Inc. currently has zero debt (i.e., wd = 0). It is a zero
growth company, and additional firm data are shown below. Now the
company is considering using some debt, moving to the new capital
structure indicated The money raised would be used to repurchase stock
at the current price. It is estimated that the increase in risk resulting
from the additional leverage would cause the required rate of return on
equity to rise somewhat, as indicated below. If this plan were carried
out, by how much would the WACC change, i.e., what is WACCOld
WACCNew?
wd 55% Orig. cost of equity, rs 10.0

%
wc 45% New cost of equity =

rs 11.0%
Interest rate new = rd 7.0% Tax

rate 40%
o 2.74%
o 3.01%
o 3.32%
o 3.65%
o 4.01%
ANSWER: a
RATIONALE: wd 55% Interest rate = rd 7.0%
wc 45% New cost of equity =

rs 11.0%
Tax rate 40% Old cost of

equity 10.0%
WACCOLD = wd(1 T)rd + wcrs = 0.00% + 10.00% = 10.00% WACCNEW =
wd(1 T)rd + wcrs = 2.31% + 4.95% = 7.26%
Change in WACC = WACC Old WACC New = 2.74%
o As a consultant to First Responder Inc., you have obtained the following

data (dollars in millions). The company plans to pay out all of its earnings
as dividends, hence g = 0. Also, no net new investment in operating
capital is needed because growth is zero. The CFO believes that a move
from zero debt to 20.0% debt would cause the cost of equity to increase
from 10.0% to 12.0%, and the interest rate on the new debt would be
8.0%. What would the firm's total market value be if it makes this
change? Hints: Find the FCF, which is equal to NOPAT = EBIT(1 T)
because no new operating capital is needed, and then divide by (WACC
g).
Oper. income (EBIT) $800 Tax rate 40.0%
New cost of equity (rs) 12.00% New wd 20.0%
Interest rate (rd) 8.00%
o a. $2,982
o $3,314
o c. $3,682
o $4,091
o e. $4,545
ANSWER: e
RATIONALE: Operating income (EBIT) $800 Tax rate 40.0%
New cost of equity (rs) 12.00% New wd 20.0%
Interest rate (rd) 8.00%
New WACC = wd rd(1 T) + wc rs
= 0.96% + 9.60% = 10.56%
FCF = EBIT(1 T) because there is no investment in new operating capital. FCF

= EBIT(1 T) = $800 0.6 = $480.0
Firm value = FCF/(WACC g) = $480.0/10.56% = $4,545.45
o You plan to invest in one of two home delivery pizza companies, High
and Low, that were recently founded and are about to commence
operations. They are identical except for their use of debt (wd) and the
interest rates on their debtHigh uses more debt and thus must pay a
higher interest rate. Based on the data given below, how much higher or
lower will High's expected EPS be versus that of Low, i.e., what is
EPSHigh EPSLow?
Applicable to Both Firms Firm High's Data Firm Low's Data
Capital $3,000,000 wd 70% wd 20%
EBIT $500,000 Shares 90,000 Shares 240,000

Tax rate 35% Int. rate 12% Int. rate 10%
a. $0.49
b. $0.54
c. $0.60
d. $0.66
e. $0.73
ANSWER: c
RATIONALE: Applicable to Both Firms Firm High's

Data Firm Low's Data
Capital $3,000,000 wd 70% wd 20%
EBIT $500,000 Shares 90,000 Shares 240,000
Tax rate 35% Int. rate 12% Int. rate 10%
Debt $2,100,000 Debt $600,000
EBIT $500,000 $500,000
Interest = I = Debt rate 252,000 60,000
Taxable income = EBIT I $248,000 $440,000
Taxes 86,800 154,000
NI $161,200 $286,000
EPS = NI/Shares outstanding $1.79 $1.19
o Firms HD and LD are identical except for their use of debt and the
interest rates they pay HD has more debt and thus must pay a higher
interest Based on the data given below, how much higher or lower will
HD's ROE be versus that of LD, i.e., what is ROEHD ROELD?
Applicable to Both Firms Firm HD's Data Firm LD's Data
Capital $3,000,000 wd 70% wd 20%
EBIT $500,000 Int. rate 12% Int. rate 10%
Tax rate 35%
a. 5.41%
b. 5.69%
c. 5.99%
d. 6.29%
e. 6.61%
ANSWER: c
RATIONALE: Applicable to Both Firms Firm HD's Data Firm L

D's Data
Capital $3,000,000 wd 70% wd 20%

EBIT $500,000 Int.
12% Int. rate 10%
rate
Tax rate 35% Debt $2,100,000 Debt $600,000
EBIT $500,000 $500,000
Interest = I = Debt Rate 252,000 60,000
Taxes 86,800 154,000
NI $161,200 $286,000
Equity = (1 wd)(Capital) $900,000 $400,000
ROE = NI/Equity 17.91% 11.92%
o Firm A is very aggressive in its use of debt to leverage up its earnings for
common stockholders, whereas Firm NA is not aggressive and uses no
debt. The two firms' operations are identical they have the same total
investor-supplied capital, sales, operating costs, and EBIT. Thus, they
differ only in their use of financial leverage (wd). Based on the following
data, how much higher or lower is A's ROE than that of NA, i.e., what is
ROEA ROENA?
Applicable to Both Firms Firm A's Data Firm NA's Data
Capital $150,000 wd 50% wd 0%

Tax rate 35%
o 8.60%
o 9.06%
o 9.53%
o 10.01%
o 10.51%
ANSWER: c
RATIONALE: Applicable to Both Firms Firm A's Data Firm

NA's Data
Capital $150,000 wd 50% wd 0%
Tax rate 35% Debt $75,000 Debt $0
EBIT $40,000 $40,000
Interest = I = Debt Rate 9,000 0
Taxes 10,850 14,000
NI = (Taxable Income)(1 T) $20,150 $26,000
ROE = NI/Equity 26.87% 17.33%

o Your firm's debt ratio is only 5.00%, but the new CFO thinks that more
debt should be employed. She wants to sell bonds and use the proceeds
to buy back and retire common shares so the percentage of common
equity in the capital structure (wc) = 1 wd. Other things held
constant, and based on the data below, if the firm increases the
percentage of debt in its capital structure (wd) to 60.0%, by how much
would the ROE change, i.e., what is ROENew ROEOld?
Operating Data Other Data
Capital $150,000 Old wd 5%
ROIC = EBIT(1 T)/Capital 13.00% Old interest

rate 10%
Tax rate 35% New wd 60%
New interest rate 12%
o 6.73%
o 7.09%
o 7.46%
o 7.83%
o 8.22%
ANSWER: c
RATIONALE: Operating Data Other Data
Capital $150,000 New

wd 60%
ROIC = EBIT(1 T)/Capital 13.00% Old wd 5%
Tax rate 35% New interest

rate 12%
Old interest
rate 10%
New wd Old
wd
Debt $90,000 $7,500
EBIT = (ROIC Capital)/(1 T) $30,000 $30,000
Interest = Rate Debt 10,800 750
Taxes 6,720 10,238
NI $12,480 $19,013
ROE = NI/Equity 20.80% 13.34%

o You have been hired by a new firm that is just being The CFO wants to
finance with 60% debt, but the president thinks it would be better to
hold the percentage of debt in the capital structure (wd) to only 10%.
Other things held constant, and based on the data below, if the firm uses
more debt, by how much would the ROE change, i.e., what is ROENew
ROEOld?
Operating Data Other Data
Capital $4,000 Higher wd 60%
ROIC = EBIT(1 T)/Capital 13.00% Higher interest

rate 13%
Tax rate 35% Lower wd 10%
Lower interest rate 9%
o 5.44%
o 5.73%
o 6.03%
o 6.33%
o 6.65%
ANSWER: c
RATIONALE: Operating Data Other Data
Capital $4,000 Higher wd 60%
ROIC = EBIT(1 T)/Capital 13.00% New interest rate 13%

Tax rate 35% Lower wd 10%
Old interest rate 9%
Lower wd Higher wd
Debt $400 $2,400
EBIT = (ROIC Capital)/(1

T) $800.00 $800.00
Interest = Rate
Debt 36.00 312.00
Taxable income = EBIT

I $764.00 $488.00
Taxes 267.40
170.80
NI $496.60 $317.20
Equity = (1
wd)(Capital) $3,600.00 $1,600.00
ROE =
NI/Equity 13.79% 19.83
%
o Your girlfriend plans to start a new company to make a new type of cat
Her father will finance the operation, but she will have to pay him back.
You are helping her, and the issue now is how to finance the company,
with equity only or with a mix of debt and equity. The price per unit will
be $10.00 regardless of how the firm is financed. The expected fixed and
variable operating costs, along with other information, are shown below.
How much higher or lower will the firm's expected EPS be if it uses some
debt rather than only equity, i.e., what is EPSL EPSU?
Expected unit sales 225,000 225,000
Price per unit $10.00 $10.00
Fixed costs $1,000,000 $1,000,000
Variable cost/unit $3.50 $3.50
Shares issued at $10/share 250,000 100,000
% Debt 0.00% 60.00%
Debt, $ $0 $1,500,000
Equity, $ $2,500,000 $1,000,000
Tax rate 35.00% 35.00%
o $0.54
o $0.60
o $0.67
o $0.75
o $0.83
ANSWER: e
RATIONALE: 0% Debt, U 60% Debt, L
Expected unit
sales 225,000 225,000
Price per
unit $10.00 $10.00
Fixed operating
costs $1,000,000 $1,000,000
Variable operating
cost/unit $3.50 $3.50
Required
investment $2,500,000 $2,500,000
% Debt 0.00% 60.00%
Debt,
$ $0 $1,500,000
$ of common
equity $2,500,000 $1,000,000
Shares of stock issued at

$10/share 250,000 100,000
Tax rate 35.00% 35.00%

Sales
revenues $2,250,000 $2,250,000
Fixed
costs 1,000,000 1,000,000
Variable costs 787,500 787,500
Operating
income $ 462,500 $ 462,500
Interest 0 150,000
Taxable
income $ 462,500 $ 312,500
Taxes 161,875 109,375
Net
income $ 300,625 $ 203,125
Earnings per share

(EPS) $1.20 $2.03
o Southeast U's campus book store sells course packs for $15.00 each, the
variable cost per pack is $11.00, fixed costs for this operation are
$300,000, and annual sales are 100,000 The unit variable cost consists of
a $4.00 royalty payment, VR, per pack to professors plus other variable
costs of VO = $7.00. The royalty payment is negotiable. The book store's
directors believe that the store should earn a profit margin of 10% on
sales, and they want the store's managers to pay a royalty rate that will
produce that profit margin. What royalty per pack would permit the
store to earn a 10% profit margin on course packs, other things held
constant?
o $2.55
o $2.84
o $3.15
o $3.50
o $3.85
Sales price (P)

$15.00
Target profit margin 10%
Current royalty component of variable costs

$4.00
(VR)
Other variable costs (VO) 7.00
Total variable costs (V) $11.00
ANSWER: RATIONALE:
Current profit = PQ VRQ VOQ F
= $1,500,000 $400,000 $700,000 $300,000 = $100,000
Target profit (TP) = 0.10(PQ) = $150,000
Target profit (TP) = PQ VR Q VO Q F = 0.10(PQ) = $150,000
Target VR = P 0.1P VO F/Q = 0.9P VO F/Q = $3.50
Check: Profit with VR = P Q VR Q VO Q FC = 10% of Sales
= $1,500,000 $350,000 $700,000 $300,000 = $150,000
o Dye Industries currently uses no debt, but its new CFO is considering
changing the capital structure to 0% debt (wd) by issuing bonds and
using the proceeds to repurchase and retire common shares so the
percentage of common equity in the capital structure (wc) = 1 wd.
Given the data shown below, by how much would this recapitalization
change the firm's cost of equity, i.e., what is rL rU?
Risk-free rate, rRF 6.00% Tax rate, T 40%
Market risk premium, RPM 4.00% Current wd 0%

Current beta, bU 1.15 Target wd 40%
a. 1.66%
b. 1.84%
c. 2.02%
d. 2.23%
e. 2.45%
ANSWER: b
RATIONALE: Risk-free rate, rRF 6.00% Tax rate,

T 40%
Market risk premium, RPM 4.00% Current

wd 0%
Current beta, bU 1.15 Target

wd 40%
Target D/E = wd/(1 wd) 0.67
bL = bU[(1 + (D/E)(1 T)] 1.61
rsU = rRF + bU(RPM ) 10.60%
r sL = rRF + bL(RPM )
12.44%
Change in equity cost =
1.84%
o Dyson currently finances with 20.0% debt (i.e., wd = 20%), but its new
CFO is considering changing the capital structure so wd = 60.0% by
issuing additional bonds and using the proceeds to repurchase and retire
common shares so the percentage of common equity in the capital
structure (wc) = 1 wd. Given the data shown below, by how much
would this recapitalization change the firm's cost of equity? (Hint: You
must unlever the current beta and then use the unlevered beta to solve
the problem.)
Risk-free rate, rRF 5.00% Tax rate, T 40%
Current beta, bL1 1.15 Target wd 60%
a. 4.05%
b. 4.50%
c. 4.95%
d. 5.45%
e. 5.99%
ANSWER: b
RATIONALE: Risk-free rate, rRF 5.00% Tax rate, T 40%
Current beta, bL1 1.15 Target wd 60%
Current D/E = wd/(1 wd) 0.25

Target D/E using target wd = wd/(1 wd) 1.50
Unleveraged beta: Found with current data: bU = bL1/[1 + (1

T)(D/E)] 1.00
Beta at new capital structure = bL2 = bU[(1 + (D/E)(1 T)] 1.900
Original cost of equity = rsL1 = rRF + bL1(RPM

) 11.90%
New cost of equity = rsL2 = rRF + bL2(RPM

) 16.40%
Change in equity cost = 4.50%
o Monroe Inc. is an all-equity firm with 500,000 shares outstanding. It has

$2,000,000 of EBIT, and EBIT is expected to remain constant in the
future. The company pays out all of its earnings, so earnings per share
(EPS) equal dividends per shares (DPS), and its tax rate is 40%. The
company is considering issuing $5,000,000 of 9.00% bonds and using the
proceeds to repurchase stock. The risk-free rate is 4.5%, the market risk
premium is 5.0%, and the firm's beta is currently 0.90. However, the CFO
believes the beta would rise to 1.10 if the recapitalization occurs.
Assuming the shares could be repurchased at the price that existed prior
to the recapitalization, what would the price per share be following the
recapitalization? (Hint: P0 = EPS/rs because EPS = DPS.)
o $28.27
o $29.76
o $31.25
o $32.81
o $34.45
ANSWER: b
RATIONALE: Interest rate 9% Shares outstanding

initially 500,000
Risk-free rate,
rRF 4.5% EBIT $2,000,000
Market risk premium,
RPM 5.0% Dividend payout ratio 100%
Beta, before recap 0.90 Tax rate 40%
Beta, after recap 1.10 Bonds issued = stock
repurchased $5,000,000
Before the recapitalization
DPS = EPS = (EBIT)(1 T)/Shares

$2.40
rs = rRF + bold(RPM ) 9.00%
P0 = DPS/rs $26.67
Shares repurchased = Bonds issued/P0 187,500
After the recapitalization
DPS = EPS = (EBIT rd Bonds)(1 T)/Shares $2.98
rs = rRF + bNew(RPM ) 10.00%

P0 = DPS/rs $29.76
o You were hired as the CFO of a new company that was founded by three
professors at your university. The company plans to manufacture and
sell a new product, a cell phone that can be worn like a wrist watch. The
issue now is how to finance the company, with equity only or with a mix
of debt and equity. The price per phone will be $250.00 regardless of
how the firm is financed. The expected fixed and variable operating
costs, along with other data, are shown below. How much higher or
lower will the firm's expected ROE be if it uses 60% debt rather than only
equity, i.e., what is ROEL ROEU?
Price per phone (P) $250.00 $250.00
Fixed costs (F) $1,000,000 $1,000,000
% Debt 0.00% 60.00%
Debt, $ $0 $1,500,000
Equity, $ $2,500,000 $1,000,000

Tax rate 35.00% 35.00%
o 5.68%
o 5.94%
o 6.22%
o 6.52%
o 6.83%
Expected unit sales 28,500 28,500
Price per phone $250.00 $250.00
Fixed operating costs $1,000,000 $1,000,000
Variable operating cost/unit $200.00 $200.00
% Debt 0.00% 60.00%
Debt, $ $0 $1,500,000
Equity, $ $2,500,000 $1,000,000
Tax rate 35.00% 35.00%
Sales revenues $7,125,000 $7,125,000

Fixed costs 1,000,000 1,000,000
Variable costs 5,700,000 5,700,000
Operating income $ 425,000 $ 425,000
Interest 0 150,000
Taxable income $ 425,000 $ 275,000
Taxes 148,750 96,250
Net income $ 276,250 $ 178,750
ROE 11.05% 17.88%
ANSWER:
RATIONALE:

Chapter 13: Capital Structure and Leverage

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Chapter 13: Capital Structure and Leverage

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Chapter 13: Capital Structure and Leverage

o A firm's business risk is largely determined by the financial

o Financial risk refers to the extra risk borne by stockholders as a result of

o Other things held constant, an increase in financial leverage will increase

o Provided a firm does not use an extreme amount of debt, operating

o The trade-off theory states that capital structure decisions involve a

o Different borrowers have different risks of bankruptcy, and if a borrower

o It is possible for Firms A and B to have identical financial and operating

o According to Modigliani and Miller (MM), in a world without taxes the

o According to Modigliani and Miller (MM), in a world with corporate

o According to Modigliani and Miller (MM), in a world without corporate

o Modigliani and Miller's second article, which assumed the existence of

o The Modigliani and Miller (MM) articles implicitly assumed that

o Modigliani and Miller (MM), in their second article, took account of

o Some peopleincluding the former chairman of the Federal Reserve

o According to the signaling theory of capital structure, firms first use

o A firm's treasurer likes to be in a position to raise funds to support

o An increase in the debt ratio will generally have no effect on which of

o The firm's beta.

o Business risk is affected by a firm's operations. Which of the following

o Sales price variability.

o The extent to which operating costs are fixed.

o Input price variability.

o Which of the following statements is CORRECT?

o Since debt financing is cheaper than equity financing, raising a

o Increasing a company's debt ratio will typically reduce the

o Increasing a company's debt ratio will typically increase the

o Since a firm's beta coefficient is not affected by its use of financial

o Which of the following statements is CORRECT?

o The capital structure that maximizes expected EPS also maximizes

o The capital structure that minimizes the required return on equity

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

o Debt = 40%; Equity = 60%; EPS = $2.95; Stock price = $26.50.

o Debt = 50%; Equity = 50%; EPS = $3.05; Stock price = $28.90.

o Debt = 60%; Equity = 40%; EPS = $3.18; Stock price = $31.20.

o Debt = 80%; Equity = 20%; EPS = $3.42; Stock price = $30.40.

o Debt = 70%; Equity = 30%; EPS = $3.31; Stock price = $30.00.

o Which of the following statements best describes the optimal capital

o The optimal capital structure is the mix of debt, equity, and

o The optimal capital structure is the mix of debt, equity, and

o The optimal capital structure is the mix of debt, equity, and

o The optimal capital structure is the mix of debt, equity, and

o Which of the following events is likely to encourage a company to raise

o An increase in the corporate tax rate.

o An increase in the personal tax rate.

o An increase in the company's operating leverage.

o The Federal Reserve tightens interest rates in an effort to fight

o The company's stock price hits a new high.

o The costs associated with filing for bankruptcy increase.

o The corporate tax rate is increased.

o The personal tax rate is increased.

o The company's stock price hits a new low.

o Which of the following statements is CORRECT?

o As a rule, the optimal capital structure is found by determining the

o The optimal capital structure simultaneously maximizes EPS and

o The optimal capital structure minimizes the cost of equity, which

o The optimal capital structure simultaneously minimizes the cost of

o The optimal capital structure simultaneously maximizes the stock

o The firm's target capital structure should do which of the following?

o Maximize the earnings per share (EPS).

o Minimize the cost of debt (rd).

o Obtain the highest possible bond rating.