15
CAPITAL CHAPTER STRUCTURE DECISIONS
Please see the preface for information on the AACSB letter indicators (F, M,
etc.) on the subject lines.
True/False
Easy:
1
.
(15.1) Bankruptcy
Answer: a
EASY
costs
FQ
Different borrowers have different risks of bankruptcy, and
bankruptcy is costly to lenders. Therefore, lenders charge higher
rates to borrowers judged to be more at risk of going bankrupt.
a.
b.
2
.
(15.2
Answe
EASY
)
r: b
Busin
ess
risk
FQ
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.
a.
b.
3
.
True
False
True
False
(15.2
Answe
EASY
)
r: a
Finan
cial
risk
FQ
Financial risk refers to the extra risk stockholders bear as a result
of using debt as compared with the risk they would bear if no debt
were used.
a.
b.
True
False
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part.
Chapter 15: Cap Structure
True/False
Page 1
.
4
.
Financial risk refers to the extra risk stockholders bear as a result
of using debt as compared with the risk they would bear if no debt
were used.
(15.2
Answe
EASY
)
r: b
Finan
cial
risk
FQ
As the text indicates, a firm's financial risk has identifiable
market risk and diversifiable risk components.
a.
b.
5
.
(15.2
Answe
EASY
)
r: a
Finan
cial
risk
FQ
A firms capital structure does not affect its calculated free cash
flows, because FCF reflects only operating cash flows.
a.
b.
6
.
True
False
True
False
(15.2
Answe
)
r: a
Finan
cial
lever
age
FQ
Whenever a firm borrows money, it is using financial leverage.
a.
b.
(15.2
) Use
of
finan
cial
lever
age
FQ
True
False
Answe
r: b
EASY
EASY
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part.
Page 2 True/False
Chapter 15: Cap Structure
7
.
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.
a.
b.
8
.
(15.2
Answe
EASY
)
r: b
Opera
ting
and
finan
cial
lever
age
FQ
Provided a firm does not use an extreme amount of debt, financial
leverage typically affects both EPS and EBIT, while operating
leverage only affects EBIT.
a.
b.
9
.
True
False
True
False
(15.3
Answe
EASY
)
r: a
Trade
-off
theor
y
FQ
The trade-off theory states that the capital structure decision
involves a tradeoff between the costs and benefits of debt
financing.
a.
b.
True
False
Medium:
10
.
(15.2) Use of
Answer: a
MEDIUM
debt in financing
FQ
If a firm utilizes debt financing, an X% decline in earnings before
interest and taxes (EBIT) will result in a decline in earnings per
share that is larger than X.
a.
b.
True
False
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part.
Chapter 15: Cap Structure
True/False
Page 3
.
11
If a firm utilizes debt financing, an X% decline in earnings before
interest and taxes (EBIT) will result in a decline in earnings per
share that is larger than X.
.
(15.2
Answe
MEDIUM
)
r: b
Finan
cial
lever
age
FQ
Firm A has a higher degree of business risk than Firm B. Firm A can
offset this by using less financial leverage. Therefore, the
variability of both firms' expected EBITs could actually be
identical.
a.
b.
12
.
(15.2
Answe
MEDIUM
)
r: b
Busin
ess
risk
FQ
Two firms, although they operate in different industries, have the
same expected earnings per share and the same standard deviation of
expected EPS. Thus, the two firms must have the same business risk.
a.
b.
13
.
True
False
True
False
(15.2) Operating
Answer: a
MEDIUM
and financial
leverage
FQ
It is possible that two firms could have identical financial and
operating leverage, yet have different degrees of risk as measured
by the variability of EPS.
a.
b.
True
False
(15.3
)
Bankr
Answe
r: a
MEDIUM
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part.
Page 4 True/False
Chapter 15: Cap Structure
.
14
.
It is possible that two firms could have identical financial and
operating leverage, yet have different degrees of risk as measured
by the variability of EPS.
uptcy
costs
FQ
If Miller and Modigliani had incorporated the costs of bankruptcy
into their model, it is unlikely that they would have concluded that
100% debt financing is optimal.
a.
b.
True
False
Multiple Choice: Conceptual
Easy:
15
.
(15.2) Business
Answer: a
EASY
risk
CQ
An increase in the debt ratio will generally have no effect on which
of these items?
a.
b.
c.
d.
e.
16
.
Business risk.
Total risk.
Financial risk.
Market risk.
The firm's beta.
(15.2
Answe
EASY
)
r: d
Busin
ess
risk
CQ
Business risk is affected by a firm's operations. Which of the
following is NOT associated with (or does not contribute to) business
risk?
a.
b.
c.
d.
e.
(15.3
)
Targe
t
Demand variability.
Sales price variability.
The extent to which operating costs are fixed.
The extent to which interest rates on the firm's debt
fluctuate.
Input price variability.
Answe
r: a
EASY
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part.
Chapter 15: Cap Structure
True/False
Page 5
.
17
.
Business risk is affected by a firm's operations. Which of the
following is NOT associated with (or does not contribute to) business
risk?
debt
ratio
CQ
Which of the following events is likely to encourage a company to
raise its target debt ratio, other things held constant?
a.
b.
c.
d.
e.
18
.
(15.3
Answe
EASY
)
r: b
Lever
age
and
capit
al
struc
ture
CQ
Which of the following would increase the likelihood that a company
would increase its debt ratio, other things held constant?
a.
b.
c.
d.
e.
19
.
An increase in the corporate tax rate.
An increase in the personal tax rate.
An increase in the companys operating leverage.
The Federal Reserve tightens interest rates in an effort to
fight inflation.
The company's stock price hits a new high.
An increase in costs incurred when filing for bankruptcy.
An increase in the corporate tax rate.
An increase in the personal tax rate.
The Federal Reserve tightens interest rates in an effort to
fight inflation.
The company's stock price hits a new low.
(15.5
Answe
)
r: d
Capit
al
struc
ture
and
WACC
CQ
Which of the following statements is CORRECT?
a.
b.
c.
EASY
Since debt financing raises the firm's financial risk,
increasing a companys debt ratio will always increase its
WACC.
Since debt financing is cheaper than equity financing,
raising a companys debt ratio will always reduce its WACC.
Increasing a companys debt ratio will typically reduce the
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part.
Page 6 True/False
Chapter 15: Cap Structure
.
20
Which of the following statements is CORRECT?
marginal cost of both debt and equity financing. However,
this action still may raise the companys WACC.
d.
Increasing a companys debt ratio will typically increase
the marginal cost of both debt and equity financing.
However, this action still may lower the companys WACC.
e.
Since a firm's beta coefficient it not affected by its use
of financial leverage, leverage does not affect the cost of
equity.
.
(15.6
Answe
)
r: d
Optim
al
capit
al
struc
ture
CQ
Which of the following statements is CORRECT?
a.
b.
c.
d.
e.
21
.
EASY
The capital structure that maximizes expected EPS also
maximizes the price per share of common stock.
The capital structure that minimizes the interest rate on
debt also maximizes the expected EPS.
The capital structure that minimizes the required return on
equity also maximizes the stock price.
The capital structure that minimizes the WACC also maximizes
the price per share of common stock.
The capital structure that gives the firm the best credit
rating also maximizes the stock price.
(15.5
Answe
EASY
)
r: c
Optim
al
capit
al
struc
ture
CQ
Based on the information below, what is Ezzel Enterprises' optimal
capital structure?
a.
b.
c.
d.
e.
Debt
Debt
Debt
Debt
Debt
=
=
=
=
=
40%;
50%;
60%;
80%;
70%;
Equity
Equity
Equity
Equity
Equity
=
=
=
=
=
60%;
50%;
40%;
20%;
30%;
EPS
EPS
EPS
EPS
EPS
=
=
=
=
=
$2.95;
$3.05;
$3.18;
$3.42;
$3.31;
Stock
Stock
Stock
Stock
Stock
price
price
price
price
price
=
=
=
=
=
$26.50.
$28.90.
$31.20.
$30.40.
$30.00.
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part.
Chapter 15: Cap Structure
True/False
Page 7
.
22
Based on the information below, what is Ezzel Enterprises' optimal
capital structure?
.
(15.5) Optimal
Answer: b
EASY
capital structure
CQ
Which of the following statements best describes the optimal capital
structure?
a.
b.
c.
d.
e.
23
.
The optimal capital structure is the mix of debt, equity, and
preferred stock that maximizes the companys earnings per
share (EPS).
The optimal capital structure is the mix of debt, equity,
and preferred stock that maximizes the companys stock
price.
The optimal capital structure is the mix of debt, equity,
and preferred stock that minimizes the companys cost of
equity.
The optimal capital structure is the mix of debt, equity,
and preferred stock that minimizes the companys cost of
debt.
The optimal capital structure is the mix of debt, equity, and
preferred stock that minimizes the companys cost of preferred
stock.
(15.6
Answe
EASY
)
r: a
Finan
cial
lever
age
and
EPS
CQ
Volga Publishing is considering a proposed increase in its debt
ratio, which would also increase the companys interest expense.
The plan would involve issuing new bonds and using the proceeds to
buy back shares of its common stock. The companys CFO thinks the
plan will not change total assets or operating income, but that it
will increase earnings per share (EPS). Assuming the CFOs
estimates are correct, which of the following statements is CORRECT?
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part.
Page 8 True/False
Chapter 15: Cap Structure
.
Volga Publishing is considering a proposed increase in its debt
ratio, which would also increase the companys interest expense.
The plan would involve issuing new bonds and using the proceeds to
buy back shares of its common stock. The companys CFO thinks the
plan will not change total assets or operating income, but that it
will increase earnings per share (EPS). Assuming the CFOs
estimates are correct, which of the following statements is CORRECT?
a.
Since the proposed plan increases Volgas financial risk,
the companys stock price still might fall even if EPS
increases.
b.
If the plan reduces the WACC, the stock price is also likely
to decline.
c.
Since the plan is expected to increase EPS, this implies
that net income is also expected to increase.
d.
If the plan does increase the EPS, the stock price will
automatically increase at the same rate.
e.
Under the plan there will be more bonds outstanding, and
that will increase their liquidity and thus lower the
interest rate on the currently outstanding bonds.
Easy/Medium:
24
.
(15.6) Optimal
Answer: e
capital structure
CQ
Which of the following statements is CORRECT?
a.
b.
c.
d.
e.
25
.
EASY/MEDIUM
As a rule, the optimal capital structure is found by
determining the debt-equity mix that maximizes expected EPS.
The optimal capital structure simultaneously maximizes EPS
and minimizes the WACC.
The optimal capital structure minimizes the cost of equity,
which is a necessary condition for maximizing the stock
price.
The optimal capital structure simultaneously minimizes the
cost of debt, the cost of equity, and the WACC.
The optimal capital structure simultaneously maximizes stock
price and minimizes the WACC.
(15.5) Target
Answer: e
EASY/MEDIUM
capital structure
CQ
The firms target capital structure should be consistent with which
of the following statements?
a.
b.
c.
d.
e.
Maximize the earnings per share (EPS).
Minimize the cost of debt (rd).
Obtain the highest possible bond rating.
Minimize the cost of equity (rs).
Minimize the weighted average cost of capital (WACC).
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part.
Chapter 15: Cap Structure
True/False
Page 9
.
26
The firms target capital structure should be consistent with which
of the following statements?
.
(Comp: Answe
15.2,1 r: b
5.5)
Busine
ss &
fin.
risk &
cap.
struc.
CQ
Which of the following statements is CORRECT?
a.
b.
c.
d.
e.
EASY/MEDIUM
A firms business risk is determined solely by the financial
characteristics of its industry.
The factors that affect a firms business risk are affected
by industry characteristics and economic conditions.
Unfortunately, these factors are generally beyond the
control of the firm's management.
One of the benefits to a firm of being at or near its target
capital structure is that this eliminates any risk of
bankruptcy.
A firms financial risk can be minimized by diversification.
The amount of debt in its capital structure can under no
circumstances affect a companys business risk.
Medium:
27
.
(15.2) Operating
Answer: e
MEDIUM
leverage
CQ
Which of the following statements is CORRECT? As a firm increases
the operating leverage used to produce a given quantity of output,
this will
a.
b.
c.
d.
e.
(15.2
) Use
of
normally
ratio.
normally
normally
expected
normally
expected
normally
ratio.
lead to an increase in its fixed assets turnover
lead to
lead to
EBIT.
lead to
EPS.
lead to
a decrease in its business risk.
a decrease in the standard deviation of its
a decrease in the variability of its
a reduction in its fixed assets turnover
Answe
r: d
MEDIUM
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part.
Page 10
True/False
Chapter 15: Cap Structure
.
28
.
Which of the following statements is CORRECT? As a firm increases
the operating leverage used to produce a given quantity of output,
this will
finan
cial
lever
age
CQ
If debt financing is used, which of the following is CORRECT?
a.
b.
c.
d.
e.
29
.
The percentage change in net operating income will be
greater than a given percentage change in net income.
The percentage change in net operating income will be equal
to a given percentage change in net income.
The percentage change in net income relative to the
percentage change in net operating income will depend on the
interest rate charged on debt.
The percentage change in net income will be greater than the
percentage change in net operating income.
The percentage change in sales will be greater than the
percentage change in EBIT, which in turn will be greater
than the percentage change in net income.
(15.2
Answe
MEDIUM
)
r: e
Lever
age
and
capit
al
struc
ture
CQ
Which of the following statements is CORRECT, holding other things
constant?
a.
b.
c.
Firms whose assets are relatively liquid tend to have
relatively low bankruptcy costs, hence they tend to use
relatively little debt.
An increase in the personal tax rate is likely to increase
the debt ratio of the average corporation.
If changes in the bankruptcy code make bankruptcy less
costly to corporations, then this would likely reduce the
debt ratio of the average corporation.
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part.
Chapter 15: Cap Structure
True/False
Page 11
.
30
Which of the following statements is CORRECT, holding other things
constant?
d.
An increase in the companys degree of operating leverage is
likely to encourage a company to use more debt in its
capital structure.
e.
An increase in the corporate tax rate is likely to encourage
a company to use more debt in its capital structure.
.
(15.2
Answe
MEDIUM
)
r: e
Lever
age
and
capit
al
struc
ture
CQ
Other things held constant, which of the following events is most
likely to encourage a firm to increase the amount of debt in its
capital structure?
a.
b.
c.
d.
e.
31
.
Its sales become less stable over time.
The costs that would be incurred in the event of bankruptcy
increase.
Management believes that the firms stock has become
overvalued.
Its degree of operating leverage increases.
The corporate tax rate increases.
(15.2
Answe
MEDIUM
)
r: c
Lever
age
and
capit
al
struc
ture
CQ
Reynolds Resorts is currently 100% equity financed. The CFO is
considering a recapitalization plan under which the firm would issue
long-term debt with a yield of 9% and use the proceeds to repurchase
common stock. The recapitalization would not change the companys
total assets, nor would it affect the firms basic earning power,
which is currently 15%. The CFO believes that this recapitalization
would reduce the WACC and increase stock price. Which of the
following would also be likely to occur if the company goes ahead
with the recapitalization plan?
a.
b.
c.
The companys net income would increase.
The companys earnings per share would decline.
The companys cost of equity would increase.
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part.
Page 12
True/False
Chapter 15: Cap Structure
.
32
Reynolds Resorts is currently 100% equity financed. The CFO is
considering a recapitalization plan under which the firm would issue
long-term debt with a yield of 9% and use the proceeds to repurchase
common stock. The recapitalization would not change the companys
total assets, nor would it affect the firms basic earning power,
which is currently 15%. The CFO believes that this recapitalization
would reduce the WACC and increase stock price. Which of the
following would also be likely to occur if the company goes ahead
with the recapitalization plan?
d.
The companys ROA would increase.
e.
The companys ROE would decline.
.
(15.2) Capital
Answer: e
MEDIUM
structure, ROA,
and ROE
CQ
Blemker Corporation has $500 million of total assets, its basic
earning power is 15%, and it currently has no debt in its capital
structure. The CFO is contemplating a recapitalization where it
will issue debt at a cost of 10% and use the proceeds to buy back
shares of the companys common stock, paying book value. If the
company proceeds with the recapitalization, its operating income,
total assets, and tax rate will remain unchanged. Which of the
following is most likely to occur as a result of the
recapitalization?
a.
b.
c.
d.
e.
33
.
The
The
The
The
The
ROA would increase.
ROA would remain unchanged.
basic earning power ratio would decline.
basic earning power ratio would increase.
ROE would increase.
(15.6
Answe
)
r: c
Finan
cial
lever
age
and
EPS
CQ
Which of the following statements is CORRECT?
MEDIUM
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part.
Chapter 15: Cap Structure
True/False
Page 13
.
34
Which of the following statements is CORRECT?
a.
Increasing financial leverage is one way to increase a
firms basic earning power (BEP).
b.
If a firm lowered its fixed costs while increasing its
variable costs, holding total costs at the present level of
sales constant, this would decrease its operating leverage.
c.
The debt ratio that maximizes EPS generally exceeds the debt
ratio that maximizes share price.
d.
If a company were to issue debt and use the money to
repurchase common stock, this action would have no impact on
its basic earning power ratio. (Assume that the repurchase
has no impact on the companys operating income.)
e.
If changes in the bankruptcy code made bankruptcy less
costly to corporations, this would likely reduce the average
corporation's debt ratio.
.
(15.5
Answe
MEDIUM
)
r: b
Finan
cial
lever
age
and
ratio
s
CQ
Companies HD and LD have identical tax rates, total assets, and
basic earning power ratios, and their basic earning power exceeds
their before-tax cost of debt, rd. However, Company HD has a higher
debt ratio and thus more interest expense than Company LD. Which of
the following statements is CORRECT?
a.
b.
c.
d.
e.
Company
Company
Company
The two
The two
HD has a higher net income than Company LD.
HD has a lower ROA than Company LD.
HD has a lower ROE than Company LD.
companies have the same ROA.
companies have the same ROE.
(15.5) Financial
leverage and
ratios
CQ
Answer: b
MEDIUM
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part.
Page 14
True/False
Chapter 15: Cap Structure
35
.
Firms U and L each have the same amount of assets, and both have a
basic earning power ratio of 20%. Firm U is unleveraged, i.e., it
is 100% equity financed, while Firm L is financed with 50% debt and
50% equity. Firm Ls debt has a before-tax cost of 8%. Both firms
have positive net income. Which of the following statements is
CORRECT?
a.
b.
c.
d.
e.
36
.
(15.5
Answe
MEDIUM
)
r: c
Finan
cial
lever
age
and
ratio
s
CQ
Companies HD and LD have the same total assets, operating income
(EBIT), tax rate, and business risk. Company HD, however, has a
much higher debt ratio than LD. Also HDs basic earning power (BEP)
exceeds its cost of debt (rd). Which of the following statements is
CORRECT?
a.
b.
c.
d.
e.
37
.
The two companies have the same times interest earned (TIE)
ratio.
Firm L has a lower ROA than Firm U.
Firm L has a lower ROE than Firm U.
Firm L has the higher times interest earned (TIE) ratio.
Firm L has a higher EBIT than Firm U.
HD should have a higher return on assets (ROA) than LD.
HD should have a higher times interest earned (TIE) ratio
than LD.
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.
Given that BEP > rd, HD's stock price must exceed that of LD.
Given that BEP > rd, LD's stock price must exceed that of HD.
(Comp
Answe
:
r: b
15.2,
15.3)
Capit
al
struc
ture
and
WACC
CQ
Which of the following statements is CORRECT?
MEDIUM
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part.
Chapter 15: Cap Structure
True/False
Page 15
.
38
Which of the following statements is CORRECT?
a.
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.
b.
The capital structure that minimizes a firms weighted
average cost of capital is also the capital structure that
maximizes its stock price.
c.
The capital structure that minimizes the firms weighted
average cost of capital is also the capital structure that
maximizes its earnings per share.
d.
If a firm finds that the cost of debt is less than the cost
of equity, increasing its debt ratio must reduce its WACC.
e.
Other things held constant, if corporate tax rates declined,
then the Modigliani-Miller tax-adjusted tradeoff theory
would suggest that firms should increase their use of debt.
.
(Comp: 15.2,15.5,
Answer: a
15.6) Capital
structure, WACC,
TIE, and EPS CQ
Which of the following statements is CORRECT?
a.
b.
c.
d.
e.
MEDIUM
The capital structure that maximizes the stock price is also
the capital structure that minimizes the weighted average
cost of capital (WACC).
The capital structure that maximizes the stock price is also
the capital structure that maximizes earnings per share.
The capital structure that maximizes the stock price is also
the capital structure that maximizes the firms times
interest earned (TIE) ratio.
Increasing a companys debt ratio will typically reduce the
marginal costs of both debt and equity financing; however,
this still may raise the companys WACC.
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.
Medium/Hard:
(15.2)
Miscellaneous
capital structure
concepts CQ
Answer: a
MEDIUM/HARD
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part.
Page 16
True/False
Chapter 15: Cap Structure
39
.
Which of the following statements is CORRECT?
a.
b.
c.
d.
e.
40
.
In general, a firm with low operating leverage also has a
small proportion of its total costs in the form of fixed
costs.
There is no reason to think that changes in the personal tax
rate would affect firms capital structure decisions.
A firm with high business risk is more likely to increase
its use of financial leverage than a firm with low business
risk, assuming all else equal.
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.
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 financing.
(15.2)
Answer: a
Miscellaneous
capital structure
concepts CQ
Which of the following statements is CORRECT?
a.
b.
MEDIUM/HARD
If corporate tax rates were decreased while other things
were held constant, and if the Modigliani-Miller taxadjusted tradeoff theory of capital structure were correct,
this would tend to cause corporations to decrease their use
of debt.
A change in the personal tax rate should not affect firms
capital structure decisions.
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part.
Chapter 15: Cap Structure
True/False
Page 17
.
41
Which of the following statements is CORRECT?
c.
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.
d.
The optimal capital structure is the one that simultaneously
(1) maximizes the price of the firms stock, (2) minimizes
its WACC, and (3) maximizes its EPS.
e.
If changes in the bankruptcy code make bankruptcy less
costly to corporations, then this would likely reduce the
debt ratio of the average corporation.
.
(15.5
Answe
)
r: c
Lever
age
and
capit
al
struc
ture
CQ
Which of the following statements is CORRECT?
a.
b.
c.
d.
e.
(15.5
)
MEDIUM/HARD
When a company increases its debt ratio, the costs of equity
and debt both increase. Therefore, the WACC must also
increase.
The capital structure that maximizes the stock price is
generally the capital structure that also maximizes earnings
per share.
All else equal, an increase in the corporate tax rate would
tend to encourage a company to increase its debt ratio.
Since debt financing raises the firms financial risk,
increasing a companys debt ratio will always increase its
WACC.
Since debt is cheaper than equity, increasing a companys
debt ratio will always reduce its WACC.
Answe
r: c
MEDIUM/HARD
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part.
Page 18
True/False
Chapter 15: Cap Structure
.
42
.
Which of the following statements is CORRECT?
Finan
cial
lever
age
and
ratio
s
CQ
Companies HD and LD have identical amounts of assets, operating
income (EBIT), tax rates, and business risk. Company HD, however,
has a much higher debt ratio than LD. Company HDs basic earning
power ratio (BEP) exceeds its cost of debt (rd). Which of the
following statements is CORRECT?
a.
b.
c.
d.
e.
Company HD has a higher return on assets (ROA) than Company
LD.
Company HD has a higher times interest earned (TIE) ratio
than Company LD.
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 LDs.
The two companies have the same ROE.
Company HDs ROE would be higher if it had no debt.
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part.
Chapter 15: Cap Structure
True/False
Page 19
Hard:
43
.
(15.4) Variations
Answer: d
in capital
structures
CQ
Which of the following statements is CORRECT?
a.
b.
c.
d.
e.
HARD
Generally, debt-to-total-assets ratios do not vary much
among different industries, although they do vary among
firms within a given industry.
Electric utilities generally have very high common equity
ratios because their revenues are more volatile than those
of firms in most other industries.
Drug companies (prescription, not illegal!) generally have
high debt-to-equity ratios because their earnings are very
stable and, thus, they can cover the high interest costs
associated with high debt levels.
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.
Since most stocks sell at or very close to their book
values, book value capital structures are almost always
adequate for use in estimating firms' costs of capital.
Multiple Choice: Problems
Easy:
44
.
(15.2) Breakeven
Answer: d
EASY
point
nonalgorithmic
CQ
Elephant Books sells paperback books for $7 each. The variable
cost per book is $5. At current annual sales of 200,000 books,
the publisher is just breaking even. It is estimated that if the
authors' royalties are reduced, the variable cost per book will
drop by $1. Assume authors' royalties are reduced and sales
remain constant; how much more money can the publisher put into
advertising (a fixed cost) and still break even?
a.
b.
c.
d.
e.
$600,00
0
$466,66
7
$333,33
3
$200,00
0
None of
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part.
Page 20
Problems
Chapter 15: Cap Structure
.
Elephant Books sells paperback books for $7 each. The variable
cost per book is $5. At current annual sales of 200,000 books,
the publisher is just breaking even. It is estimated that if the
authors' royalties are reduced, the variable cost per book will
drop by $1. Assume authors' royalties are reduced and sales
remain constant; how much more money can the publisher put into
advertising (a fixed cost) and still break even?
the
above
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part.
Chapter 15: Cap Structure
Problems
Page 21
Easy/Medium:
45
.
(15.2) Breakeven
Answer: a
EASY/MEDIUM
analysis
CQ
DeLong Inc. has fixed operating costs of $470,000, variable costs
of $2.80 per unit produced, and its products sell for $4.00 per
unit. What is the company's breakeven point, i.e., at what unit
sales volume would income equal costs?
a.
b.
c.
d.
e.
46
.
391,667
411,250
431,813
453,403
476,073
(15.2)
Answer:
EASY/MEDIUM
Breakev
c
en
analysi
s
CQ
Senbet Ventures is considering starting a new company to
produce stereos. The sales price would be set at 1.5 times the
variable cost per unit; the VC/unit is estimated to be $2.50;
and fixed costs are estimated at $120,000. What sales volume
would be required in order to break even, i.e., to have an EBIT
of zero for the stereo business?
a.
b.
c.
d.
e.
86,640
91,200
96,000
100,800
105,840
Medium:
47
.
(15.2) Debt's
Answer: a
MEDIUM
effect on ROE
CQ
Vu Enterprises expects to have the following data during the
coming year. What is Vu's expected ROE?
Assets
D/A
EBIT
a.
b.
c.
d.
$200,000
65%
$25,000
Interest
rate
Tax rate
8%
40%
12.51%
13.14%
13.80%
14.49%
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part.
Page 22
Problems
Chapter 15: Cap Structure
.
48
Vu Enterprises expects to have the following data during the
coming year. What is Vu's expected ROE?
e.
15.21%
.
(15.2) Net
Answer: b
MEDIUM
operating income
nonalgorithmic
CQ
The Congress Company has identified two methods for producing
playing cards. One method involves using a machine having a
fixed cost of $10,000 and variable costs of $1.00 per deck of
cards. The other method would use a less expensive machine
(fixed cost = $5,000), but it would require greater variable
costs ($1.50 per deck of cards). If the selling price per deck
of cards will be the same under each method, at what level of
output will the two methods produce the same net operating
income (EBIT)?
a.
b.
c.
d.
e.
49
.
5,000 decks
10,000 decks
15,000 decks
20,000 decks
25,000 decks
(15.5)
Answer: e
MEDIUM
Calculating
the
unlevered
beta
CQ
Ang Enterprises has a levered beta of 1.10, its capital
structure consists of 40% debt and 60% equity, and its tax rate
is 40%. What would Ang's beta be if it used no debt, i.e., what
is its unlevered beta?
a.
b.
c.
d.
e.
0.64
0.67
0.71
0.75
0.79
(15.5)
Capital
Answer: e
MEDIUM
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part.
Chapter 15: Cap Structure
Problems
Page 23
.
50
.
Ang Enterprises has a levered beta of 1.10, its capital
structure consists of 40% debt and 60% equity, and its tax rate
is 40%. What would Ang's beta be if it used no debt, i.e., what
is its unlevered beta?
structure
and value
nonalgorith
mic CQ
A consultant has collected the following information regarding
Young Publishing:
Total
assets
Operati
ng
income
(EBIT)
Interes
t
expense
Net
income
Share
price
$3,000
million
$800
million
Tax
rate
Debt
ratio
40%
$0
million
WACC
10%
$480
million
$32.00
M/B
ratio
EPS =
DPS
0%
1.00
$3.20
The company has no growth opportunities (g = 0), so the company
pays out all of its earnings as dividends (EPS = DPS). The
consultant believes that if the company moves to a capital
structure with financed 20% debt and 80% equity (based on market
values) that the cost of equity will increase to 11% and that the
pre-tax cost of debt will be 10%. If the company makes this
change, what would be the total market value (in millions) of the
firm?
a.
b.
c.
d.
e.
$3,200
$3,600
$4,000
$4,200
$4,800
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part.
Page 24
Problems
Chapter 15: Cap Structure
Medium/Hard:
51
.
(15.2) EBIT and
Answer: c
MEDIUM/HARD
setting the price
CQ
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, fixed costs are estimated
at $750,000, and 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 this profit
goal?
a.
b.
c.
d.
e.
52
.
4,513
4,750
5,000
5,250
5,513
(15.2)
Answer:
MEDIUM/HARD
Differe
c
nces in
ROE
CQ
Firms HD and LD are identical except for their level of debt and
the interest rates they pay on debt--HD has more debt and pays a
higher interest rate on that debt. Based on the data given below,
what is the difference between the two firms' ROEs?
Applic
able
to
Both
Firms
Assets
Firm
HD's
Data
$200
EBIT
$40
Tax
rate
35%
a.
b.
c.
d.
e.
Firm LD's Data
2.18%
2.29%
2.41%
2.54%
2.66%
Debt
ratio
Intere
st
rate
50%
12%
Debt
ratio
Intere
st
rate
30%
10%
Hard:
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part.
Chapter 15: Cap Structure
Problems
Page 25
53
.
(15.5)
Answer: b
HARD
Calculating
levered beta and
cost of equity
CQ
Lauterbach Corporation uses no debt, its beta is 1.10, and its
tax rate is 40%. However, the CFO is considering moving to a
capital structure with 30% debt and 70% equity. If the riskfree rate is 5.0% and the market risk premium is 6.0%, by how
much would the capital structure shift change the firm's cost
of equity?
a.
b.
c.
d.
e.
54
.
1.53%
1.70%
1.87%
2.05%
2.26%
(15.5)
Answer: b
HARD
Calculating
levered beta and
cost of equity
CQ
Vafeas Inc.'s capital structure consists of 80% debt and 20%
common equity, its beta is 1.60, and its tax rate is 35%.
However, the CFO thinks the company has too much debt, and he
is considering moving to a capital structure with 40% debt and
60% equity. The risk-free rate is 5.0% and the market risk
premium is 6.0%. By how much would the capital structure shift
change the firm's cost of equity?
a.
b.
c.
d.
e.
-5.20%
-5.78%
-6.36%
-6.99%
-7.69%
(15.5) Cost
of equity-unlevering
and
relevering
betas CQ
Answer: e
HARD
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part.
Page 26
Problems
Chapter 15: Cap Structure
55
.
Stephens Electronics is considering a change in its target
capital structure, which currently consists of 25% debt and 75%
equity. The CFO believes the firm should use more debt, but
the CEO is reluctant to increase the debt ratio. The risk-free
rate, rRF, is 5.0%, the market risk premium, RPM, is 6.0%, and
the firms tax rate is 40%. Currently, the cost of equity, rs,
is 11.5% as determined by the CAPM. What would be the
estimated cost of equity if the firm used 60% debt? (Hint: You
must first find the current beta and then the unlevered beta to
solve the problem.)
a.
b.
c.
d.
e.
10.95%
11.91%
12.94%
14.07%
15.29%
(15.5)
Recapitaliz
ation
CQ
Answer: b
HARD
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part.
Chapter 15: Cap Structure
Problems
Page 27
56
.
Michaely Inc. is an all-equity firm with 200,000 shares
outstanding. It has $2,000,000 of EBIT, which 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). Its tax rate is 40%.
The company is considering issuing $5,000,000 of 10.0% bonds
and using the proceeds to repurchase stock. The risk-free rate
is 6.5%, the market risk premium is 5.0%, and the beta is
currently 0.90, but the CFO believes beta would rise to 1.10 if
the recapitalization occurs.
Assuming that the shares can be repurchased at the price that
existed prior to the recapitalization, what would the price be
following the recapitalization?
a.
b.
c.
d.
e.
57
.
$65.77
$69.23
$72.69
$76.33
$80.14
(15.6) Capital
Answer: b
HARD
structure and P0
nonalgorithmic
CQ
Dabney Electronics currently has no debt. Its operating income
is $20 million and its tax rate is 40%. It pays out all of its
net income as dividends and has a zero growth rate. The
current stock price is $40 per share, and it has 2.5 million
shares of stock outstanding. If it moves to a capital
structure that has 40% debt and 60% equity (based on market
values), its investment bankers believe its weighted average
cost of capital would be 10%. What would its stock price be if
it changes to the new capital structure?
a.
b.
c.
d.
e.
$40
$48
$52
$54
$60
(15.5)
Hamada
equation
and rs
nonalgorith
mic
CQ
Answer: c
HARD
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part.
Page 28
Problems
Chapter 15: Cap Structure
58
.
Simon Software Co. is trying to estimate its optimal capital
structure. Right now, Simon has a capital structure that
consists of 20% debt and 80% equity, based on market values.
(Its D/S ratio is 0.25.) The risk-free rate is 6% and the
market risk premium, rM rRF, is 5%. Currently the companys
cost of equity, which is based on the CAPM, is 12% and its tax
rate is 40%. What would be Simons estimated cost of equity if
it were to change its capital structure to 50% debt and 50%
equity?
a.
b.
c.
d.
e.
59
.
13.00%
13.64%
14.35%
14.72%
15.60%
(15.5) Opt cap
Answer: d
HARD
struc, Hamada
equation
nonalgorithmic CQ
Aaron Athletics is trying to determine its optimal capital
structure. The companys capital structure consists of debt and
common stock. In order to estimate the cost of debt, the
company has produced the following table:
Percent
financed with
debt (wd)
Percent
financed with
equity (wc)
Debt-toequity ratio
(D/S)
Bond
rating
0.10
0.90
0.10/0.90 =
0.11
AAA
Before-tax
cost of debt
7.0%
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part.
Chapter 15: Cap Structure
Problems
Page 29
0.20
0.80
0.30
0.70
0.40
0.60
0.50
0.20/0.80
0.25
0.30/0.70
0.43
0.40/0.60
0.67
0.50/0.50
1.00
0.50
=
AA
7.2
=
A
8.0
=
BBB
8.8
=
BB
9.6
The company uses the CAPM to estimate its cost of common equity,
rs. The risk-free rate is 5% and the market risk premium is 6%.
Aaron estimates that if it had no debt its beta would be 1.0.
(Its unlevered beta, bU, equals 1.0.) The companys tax rate,
T, is 40%.
On the basis of this information, what is the companys optimal
capital structure, and what is the firms cost of capital at
this optimal capital structure?
a.
b.
c.
d.
e.
wc
wc
wc
wc
wc
=
=
=
=
=
0.9;
0.8;
0.7;
0.6;
0.5;
wd
wd
wd
wd
wd
=
=
=
=
=
0.1;
0.2;
0.3;
0.4;
0.5;
WACC
WACC
WACC
WACC
WACC
=
=
=
=
=
14.96%
10.96%
7.83%
10.15%
10.18%
Multi-part:
(The following data apply to Problems 60, 61, and 62. The problems MUST be
kept together, and they cannot be changed algorithmically.)
Powell Plastics, Inc. (PP) currently has zero debt. Its earnings before
interest and taxes (EBIT) are $80,000, and it is a zero growth company.
PPs current cost of equity is 10%, and its tax rate is 40%. The firm has
10,000 shares of common stock outstanding selling at a price per share of
$48.00.
60
.
(15.5) WACC
Answer: b
MEDIUM
and
recapitaliza
tion
nonalgorithm
ic
CQ
PP is considering moving to a capital structure that is
comprised of 30% debt and 70% equity, based on market values.
The debt would have an interest rate of 8%. The new funds
would be used to repurchase stock. It is estimated that the
increase in risk resulting from the added leverage would cause
the required rate of return on equity to rise to 12%. If this
plan were carried out, what would be PP's new value of
operations?
a.
b.
$484,359
$487,805
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part.
Page 30
Problems
Chapter 15: Cap Structure
.
61
PP is considering moving to a capital structure that is
comprised of 30% debt and 70% equity, based on market values.
The debt would have an interest rate of 8%. The new funds
would be used to repurchase stock. It is estimated that the
increase in risk resulting from the added leverage would cause
the required rate of return on equity to rise to 12%. If this
plan were carried out, what would be PP's new value of
operations?
c.
$521,173
d.
$560,748
e.
$584,653
.
(15.6) Stock
Answer: c
MEDIUM
price,
recapitalizati
on
nonalgorithmic
CQ
Now assume that PP is considering changing from its original
capital structure to a new capital structure with 35% debt and
65% equity. This results in a weighted average cost of capital
equal to 9.4% and a new value of operations of $510,638.
Assume PP raises $178,723 in new debt and purchases T-bills to
hold until it makes the stock repurchase. What is the stock
price per share immediately after issuing the debt but prior to
the repurchase?
a.
b.
c.
d.
e.
$45.90
$48.12
$51.06
$53.33
$58.75
(15.6) Stock
price,
recapitaliza
tion
nonalgorithm
ic
CQ
Answer: c
MEDIUM
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part.
Chapter 15: Cap Structure
Problems
Page 31
62
.
Assume that PP is considering changing from its
original capital structure to a new capital
structure with 35% debt and 65% equity. This
results in a weighted average cost of capital
equal to 9.4% and a new value of operations of
$510,638. Assume PP raises $178,723 in new debt
and purchases T-bills to hold until it makes the
stock repurchase. PP then sells the T-bills and
uses the proceeds to repurchase stock. How many
shares remain after the repurchase, and what is
the stock price per share immediately after the
repurchase?
a.
b.
c.
d.
e.
7,500;
7,000;
6,500;
6,649;
6,959;
$71.49
$59.57
$51.06
$53.33
$58.78
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part.
Page 32
Problems
Chapter 15: Cap Structure
(The following data apply to Problems 63, 64, and 65.
kept together.)
The problems MUST be
Volunteer Fabricators, Inc. (VF) currently has zero debt. It is a zero
growth company, and it has the data shown below. Now the company is
considering using some debt, moving to the market value capital structure
indicated below. The money raised would be used to repurchase stock. 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.
EBIT =
Growth =
Orig cost
of
equity,
rs =
$80,000
0%
10.0%
N
e
w
D
e
b
t
/
V
a
l
u
e
=
N
e
w
E
q
u
i
t
y
/
V
a
l
u
e
=
N
o
.
o
f
s
h
a
r
20%
80%
10,000
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part.
Chapter 15: Cap Structure
Problems
Page 33
(The following data apply to Problems 63, 64, and 65.
kept together.)
e
s
=
New cost
11.0% P
of equity
r
= rs =
i
c
e
p
e
r
s
h
a
r
e
=
Tax rate
40% I
=
n
t
e
r
e
s
t
r
a
t
e
=
r
The problems MUST be
$48.00
7.0%
d
=
(15.5) WACC and recapitalization
63
.
CQ
MEDIUM
If this plan were carried out, what would be VF's new WACC and
its new value of operations?
a.
b.
c.
d.
e.
(15.6)
Stock
price,
recapital
ization
WACC
9.64%
9.83%
10.03%
10.23%
10.74%
Value
$497,925
$507,884
$518,041
$528,402
$538,970
Answer: b
MEDIUM
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part.
Page 34
Problems
Chapter 15: Cap Structure
.
64
If this plan were carried out, what would be VF's new WACC and
its new value of operations?
CQ
.
Now assume that VF is considering changing from its original zero
debt capital structure to a new capital structure with even more
debt. This results in changes in the cost of debt and equity,
and thus to a new WACC and a new value of operations. Assume VF
raises the amount of new debt indicated below and uses the funds
to purchase and hold T-bills until it makes the stock repurchase.
What is the stock price per share immediately after issuing the
debt but prior to the repurchase?
Debt/Valu
e=
40%
Equity/Va
lue=
60%
a.
b.
c.
d.
e.
65
.
Value of
new debt
=
New WACC
=
$213,333
9.0%
$50.67
$53.33
$56.00
$58.80
$61.74
(15.6) Stock
Answer: d
MEDIUM
price,
recapitalization
CQ
Based on the data in the previous two problems, what would the
stock price be if VF issued the new debt and immediately used
the proceeds to repurchase stock?
a.
b.
c.
d.
e.
$49.43
$50.70
$52.00
$53.33
$56.00
(The following data apply to Problems 66, 67, and 68. The problems MUST be
kept together, and they cannot be changed algorithmically.)
Barnes Baskets, Inc. (BB) currently has zero debt. Its earnings before
interest and taxes (EBIT) are $100,000, and it is a zero growth company.
BBs current cost of equity is 13%, and its tax rate is 40%. The firm has
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part.
Chapter 15: Cap Structure
Problems
Page 35
.
Based on the data in the previous two problems, what would the
stock price be if VF issued the new debt and immediately used
the proceeds to repurchase stock?
20,000 shares of common stock outstanding selling at a price per share of
$23.08.
66
.
(15.5) WACC
Answer: a
MEDIUM
and
recapitaliza
tion
nonalgorithm
ic
CQ
BB is considering moving to a capital structure that is
comprised of 20% debt and 80% equity, based on market values.
The debt would have an interest rate of 7%. The new funds
would be used to repurchase stock. It is estimated that the
increase in risk resulting from the additional leverage would
cause the required rate of return on equity to rise to 14%. If
this plan were carried out, what would BB's new value of
operations be?
a.
b.
c.
d.
e.
67
.
$498,339
$512,188
$525,237
$540,239
$590,718
(15.6)
Answer: d
MEDIUM
Stock
price,
recapitaliz
ation
nonalgorith
mic
CQ
Now assume that BB is considering changing from its original
capital structure to a new capital structure with 45% debt and
55% equity. This results in a weighted average cost of capital
equal to 10.4% and a new value of operations of $576,923.
Assume BB raises $259,615 in new debt and purchases T-bills to
hold until it makes the stock repurchase. What is the stock
price per share immediately after issuing the debt but prior to
the repurchase?
a.
b.
c.
d.
e.
$14.42
$19.36
$23.91
$28.85
$35.62
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part.
Page 36
Problems
Chapter 15: Cap Structure
68
.
(15.6) Stock price, Answer: a
MEDIUM
recapitalization
nonalgorithmic
CQ
Now assume that BB is considering changing from its original
capital structure to a new capital structure with 45% debt and
55% equity. This results in a weighted average cost of capital
equal to 10.4% and a new value of operations of $576,923.
Assume BB raises $259,615 in new debt and purchases T-bills to
hold until it makes the stock repurchase. BB then sells the Tbills and uses the proceeds to repurchase stock. How many
shares remain after the repurchase, and what is the stock price
per share immediately after the repurchase?
a.
b.
c.
d.
e.
11,001;
12,711;
13,901;
15,220;
17,105;
$28.85
$35.62
$42.57
$54.31
$89.67
(The following data apply to Problems 69, 70, 71, and 72. The problems MUST
be kept together, and they cannot be changed algorithmically.)
The A. J. Croft Company (AJC) currently has $200,000 market value (and book
value) of perpetual debt outstanding carrying a coupon rate of 6%. Its
earnings before interest and taxes (EBIT) are $100,000, and it is a zero
growth company. AJC's current cost of equity is 8.8%, and its tax rate is
40%. The firm has 10,000 shares of common stock outstanding selling at a
price per share of $60.00.
69
.
(15.5)
Answer: d
MEDIUM
Market
value and
WACC
nonalgorith
mic
CQ
What is AJC's current total market value and weighted average
cost of capital?
a.
b.
c.
d.
e.
$600,000;
7.5%
$600,000;
8.0%
$800,000;
7.0%
$800,000;
7.5%
$800,000;
8.0%
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part.
Chapter 15: Cap Structure
Problems
Page 37
.
70
What is AJC's current total market value and weighted average
cost of capital?
.
(15.5) WACC
Answer: b
HARD
and
recapitaliza
tion
nonalgorithm
ic
CQ
The firm is considering moving to a capital structure that is
comprised of 40% debt and 60% equity, based on market values.
The new funds would be used to replace the old debt and to
repurchase stock. It is estimated that the increase in risk
resulting from the additional leverage would cause the required
rate of return on debt to rise to 7%, while the required rate
of return on equity would rise to 9.5%. If this plan were
carried out, what would be AJC's new WACC and total value?
a.
b.
c.
d.
e.
71
.
7.38%;
$800,008
7.38%;
$813,008
7.50%;
$813,008
7.50%;
$790,008
7.80%;
$790,008
(15.6) Stock price, Answer: e
HARD
recapitalization
nonalgorithmic
CQ
Now assume that AJC is considering changing from its original
capital structure to a new capital structure with 50% debt and
50% equity. If it makes this change, its resulting market
value would be $820,000. What would be its new stock price per
share?
a.
b.
c.
$58
$59
$60
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part.
Page 38
Problems
Chapter 15: Cap Structure
.
72
Now assume that AJC is considering changing from its original
capital structure to a new capital structure with 50% debt and
50% equity. If it makes this change, its resulting market
value would be $820,000. What would be its new stock price per
share?
d.
$61
e.
$62
.
(15.6) No.
Answer: c
HARD
shares
repurchased
nonalgorith
mic
CQ
Now assume that AJC is considering changing from its original
capital structure to a new capital structure that results in a
stock price of $64 per share. The resulting capital structure
would have a $336,000 total market value of equity and a
$504,000 market value of debt. How many shares would AJC
repurchase in the recapitalization?
a.
b.
c.
d.
e.
4,250
4,500
4,750
5,000
5,250
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part.
Chapter 15: Cap Structure
Problems
Page 39
CHAPTER 15
ANSWERS AND SOLUTIONS
2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part.
Page 40
Answers
Chapter 15: Cap Structure
1.
(15.1) Bankruptcy costs
FQ
Answer: a
EASY
2.
(15.2) Business risk
FQ
Answer: b
EASY
3.
(15.2) Financial risk
FQ
Answer: a
EASY
4.
(15.2) Financial risk
FQ
Answer: b
EASY
5.
(15.2) Financial risk
FQ
Answer: a
EASY
6.
(15.2) Financial leverage
FQ
Answer: a
EASY
7.
(15.2) Use of financial leverage
FQ
Answer: b
EASY
8.
(15.2) Operating and financial leverage
Answer: b
EASY
9.
(15.3) Trade-off theory
FQ
Answer: a
EASY
1
10.
(15.2) Use of debt in financing
FQ
Answer: a
MEDIUM
1
11.
(15.2) Financial leverage
FQ
Answer: b
MEDIUM
1
12.
(15.2) Business risk
FQ
Answer: b
MEDIUM
1
13.
(15.2) Operating and financial leverage
Answer: a
MEDIUM
FQ
FQ
If one firm's sales and earnings were more volatile than those of the other, it could have greater EPS variability in
spite of identical financial and operating leverage.
1
14.
(15.3) Bankruptcy costs
FQ
1
15.
(15.2) Business risk
CQ
Answer: a
EASY
1
16.
(15.2) Business risk
CQ
Answer: d
EASY
1
17.
(15.3) Target debt ratio
CQ`
Answer: a
EASY
1
18.
(15.3) Leverage and capital structure
Answer: b
EASY
1
19.
(15.5) Capital structure and WACC
Answer: d
EASY
CQ
Answer: a
CQ
MEDIUM
20.
(15.5) Optimal capital structure
CQ
Answer: d
EASY
2
21.
(15.5) Optimal capital structure
CQ
Answer: c
EASY
2
22.
(15.5) Optimal capital structure
CQ
Answer: b
EASY
2
23.
(15.6) Financial leverage and EPS
CQ
Answer: a
EASY
2
24.
(15.5) Optimal capital structure
CQ
2
25.
(15.5) Target capital structure
2
26.
(Comp: 15.2,15.5) Business & fin. risk & cap. struc. CQAnswer: b
2
27.
(15.2) Operating leverage
Answer: e
Answer: e
CQ
CQ
EASY/MEDIUM
EASY/MEDIUM
EASY/MEDIUM
Answer: e
MEDIUM
More operating leverage generally means a greater use of automation, which means more fixed assets. If fixed
assets increase, but sales do not, then the fixed asset turnover (S/FA) will decline.
2
28.
(15.2) Use of financial leverage
2
29.
(15.2) Leverage and capital structure
3
30.
(15.2) Leverage and capital structure
3
31.
CQ
Answer: d
MEDIUM
Answer: e
MEDIUM
CQ
Answer: e
MEDIUM
(15.2) Leverage and capital structure
CQ
Answer: c
MEDIUM
3
32.
(15.2) Capital structure, ROA, and ROE
CQ
Answer: e
MEDIUM
3
33.
(15.5) Financial leverage and EPS
CQ
Answer: c
MEDIUM
3
34.
(15.5) Financial leverage and ratios
CQ
Answer: b
MEDIUM
3
35.
(15.5) Financial leverage and ratios
CQ
Answer: b
MEDIUM
3
36.
(15.5) Financial leverage and ratios
CQ
Answer: c
MEDIUM
3
37.
(Comp: 15.2,15.3) Capital structure and WACC
Answer: b
MEDIUM
3
38.
(Comp: 15.2,15.5) Capital structure, WACC, TIE, and EPS CQ Answer: a
CQ
CQ
MEDIUM
39.
(15.2) Miscellaneous capital structure concepts CQ Answer: a
MEDIUM/HARD
4
40.
(15.2) Miscellaneous capital structure concepts CQ Answer: a
MEDIUM/HARD
4
41.
(15.5) Leverage and capital structure
CQ
Answer: c
MEDIUM/HARD
4
42.
(15.5) Financial leverage and ratios
CQ
Answer: c
MEDIUM/HARD
4
43.
(15.4) Variations in capital structures
CQ
Answer: d
HARD
4
44.
(15.2) Breakeven pointnonalgorithmic
CQ
Answer: d
EASY
$7(200,000) $5(200,000) F = 0; F = $400,000.
$7(200,000) $4(200,000) F = 0; F = $600,000.
$600,000 $400,000 = $200,000.
4
45.
(15.2) Breakeven analysis
CQ
Answer: a
EASY/MEDIUM
Answer: c
EASY/MEDIUM
Fixed operating costs
$470,000
Variable costs per unit
$2.80
Sales price per unit
$4.00
Breakeven volume (units) = FC/(P VC) = 391,667
4
46.
(15.2) Breakeven analysis
CQ
VC/unit
$2.50
Price multiple over VC
1.50
Price
$3.75
Fixed costs
$120,000
Breakeven volume (units) = FC/(P VC) = 96,000
4
47.
(15.2) Debt's effect on ROE
Assets
D/A
EBIT
Interest rate
Tax rate
EBIT
Interest
EBT
Tax
NI
$200,000
65%
$25,000
8%
40%
$25,000
10,400
$14,600
5,840
$ 8,760
ROE = NI avail to common/Common equity
ROE = 12.51%
CQ
Answer: a
MEDIUM
48.
(15.2) Net operating incomenonalgorithmic
CQ
Answer: b
MEDIUM
CQ
Answer: e
MEDIUM
Answer: e
MEDIUM
Total cost Method 1 = $1.00Q + $10,000.
Total cost Method 2 = $1.50Q + $5,000.
Set equal and solve for Q:
Q + $10,000 = $1.50Q + $5,000; $5,000 = $0.5Q; 10,000 = Q.
4
49.
(15.5) Calculating the unlevered beta
bL
D/A
Tax rate
D/E = (D/A) / (1-D/A)
bU = bL/(1 + (D/E) (1 T))
5
50.
1.10
0.40
40%
0.67
0.79
(15.5) Capital structure and valuenonalgorithmic CQ
Step 1: Find the new WACC:
WACC = wcrs + wd(1 T)rd = (0.8(0.11)) + (0.2(1 0.4)0.10) = 0.10.
Step 2: Find the free cash flow: Because there is no growth, there is no investment in capital, hence FCF is equal
to NOPAT:
FCF = NOPAT Investment in capital = EBIT(1 T) 0 = $800(1 0.4) = $480 million.
Step 3: Find the new value of the firm:
V = FCF/(WACC g) = $480/0.10 = $4,800 million.
5
51.
(15.2) EBIT and setting the price
CQ
Answer: c
MEDIUM/HARD
Answer: c
MEDIUM/HARD
VC/unit
$250
Price multiple over VC
2
Price
$500
Fixed costs
$750,000
Profit target
$500,000
Volume (units) to meet profit goal = (FC + Profit)/(P VC) =
5,000
Check: Op profit = (P VC) Units FC =
$500,000
5
52.
(15.2) Differences in ROE
Applicable to Both Firms
Assets
$200
EBIT
$40
Tax rate 35%
Debt =
Interest = I =
Taxable income = EBIT I =
NI = (Taxable Income)(1 T) =
CQ
Firm HD's Data
Debt ratio 50%
Interest rate 12%
Firm LD's Data
Debt ratio 30%
Interest rate 10%
$100.0
$12.0
$28.0
$18.2
$60.0
$6.0
$34.0
$22.1
Equity = A Debt =
ROE = NI/Equity =
Difference in ROEs = 2.41%
5
53.
$140.0
15.79%
(15.5) Calculating levered beta and cost of equity
bU =
Target % Debt =
Target D/E =
T=
bL = bU (1+ (D/E) (1 T))
rRF =
RPM =
rsU = rRF + bU(RPM) =
rsL = rRF + bL(RPM) =
Change in equity cost =
5
54.
$100.0
18.20%
CQ
Answer: b
HARD
CQ
Answer: b
HARD
1.10
30%
0.43
40%
1.38
5.00%
6.00%
11.60%
13.30%
1.70%
(15.5) Calculating levered beta and cost of equity
bL =
1.60
Current Debt%
80%
Target Debt%
40%
Current D/E = D%/(1 D%)
4.00
Target D/E = D%/(1 D%)
0.67
Tax rate =
35%
bU = bL/(1 + (D/E)(1 T))
0.4444
new bL = bU (1 + (D/E) (1 T)) 0.6370
rRF =
5.00%
RPM
6.00%
rs 80% D = rRF + b80% D(RPM) =
14.60%
rs 40% D = rRF + b40% D (RPM) =
8.82%
Change in equity cost
-5.78%
5
55.
(15.5) Cost of equity--unlevering and relevering betas CQ Answer: e
Original rs
Current D/A
rRF
RPM
Tax rate
Target D/A
11.5%
25%
5%
6%
40%
60%
Original b:
rs = rRF + bL(RPM); b = (rs rRF)/RPM =
Original D/E:
D/A/(1 D/A) =
Unlevered beta:
bU = bL/(1 + (D/E)(1 T))
Target D/E =
1.50
New beta:
bL = bU (1+ (D/E)(1 T))
rs New = rRF + bL New (RPM) =
5
56.
HARD
(15.5) Recapitalization
Shares outstanding
EBIT
Dividend payout ratio
1.083
0.3333
0.90
1.7153
15.29%
CQ
200,000
$2,000,000
100%
Interest rate
Risk-free rate
Market risk premium
Answer: b
HARD
10%
6.5%
5.0%
Tax rate
Bonds issued = stock repurchased
40%
$5,000,000
Beta - before recap
Beta - after recap
Before the recapitalization
rs = rRF + bold(RPM)
DPS = EPS = (EBIT)(1 T)/Shares
P0 = DPS/rs
Shares repurchased = Bonds issued/P0
5
57.
11.00%
$6.00
$54.55
91,667
After the recapitalization
rs = rRF + bnew(RPM)
DPS = EPS = (EBIT rd Bonds)(1 T)/Shares
P0 = DPS/rs
0.90
1.10
12.00%
$8.31
$69.23
(15.6) Capital structure and P0nonalgorithmic
CQ
Answer: b
HARD
Step 1: Find the new value of the firm after the recapitalization. Because growth is zero, free cash flow is equal
to NOPAT:
V = FCF/WACC = NOPAT/WACC = EBIT(1 T)/WACC = $20(1 0.4)/0.1 = $120 million.
Step 2: Find the new value of equity and debt after the recapitalization:
S = wcV = 0.6($120) = $72 million.
D = wdV = 0.4($120) = $48 million.
Step 3: Find the new price per share after the recapitalization:
P = [S + (D D0)]/n0 = [$72 + ($48 0)]/2.5 = $48.
5
58.
(15.5) Hamada equation and rsnonalgorithmic
CQ
Answer: c
Facts given: rs = 12%; D/E = 0.25; rRF = 6%; RPM = 5%; T = 40%.
Step 1: Find the firms current levered beta using the CAPM:
rs = rRF + RPM(b)
12% = 6% + 5%(b)
b = 1.2.
Step 2: Find the firms unlevered beta using the Hamada equation:
b = bU[1 + (1 T)(D/E)]
1.2 = bU[1 + (0.6)(0.25)]
1.2 = 1.15bU
1.0435 = bU.
Step 3: Find the new levered beta given the new capital structure using the Hamada equation:
b = bU[1 + (1 T)(D/E)]
= 1.0435[1 + (0.6)(1)]
= 1.6696.
Step 4: Find the firms new cost of equity given its new beta and the CAPM:
rs = rRF + RPM(b)
HARD
= 6% + 5%(1.6696)
= 14.35%.
5
59.
(15.5) Opt cap struc, Hamada equationnonalgorithmic CQ
Answer: d
HARD
rRF = 5%; rM rRF = 6%. rs = rRF + (rM rRF)b. WACC = rd wd (1 T) + rs wc.
You need to use the D/E ratio given for each capital structure to find the levered beta using the Hamada equation. Then,
use each of these betas with the CAPM to find the rs for that capital structure. Use this rs and rd for each capital structure
to find the WACC. The optimal capital structure is the one that minimizes the WACC.
(D/E)
0.11
0.25
0.43
0.67
1.00
b = bU[1 + (1T)(D/E)]
1.0667
1.1500
1.2571
1.4000
1.6000
rs = rRF + (rM rRF)b
11.4005%
11.9000
12.5429
13.4000
14.6000
wc
0.9
0.8
0.7
0.6
0.5
rd
7.0%
7.2
8.0
8.8
9.6
wd
0.1
0.2
0.3
0.4
0.5
WACC
10.68%
10.38
10.22
10.15
10.18
For example, if the D/E is 0.11: b = 1.0[1 + (1 T)(D/E)] = 1.0[1 + (1 0.4)(0.1111)] = 1.0667.
rs = rRF + (rM rRF)b = 5% + 6%(1.0667) = 11.40%.
The weights are given at 0.9 and 0.1 for equity and debt, respectively, and the rd for that capital structure is given as 7%.
WACC = rd wd (1 T) + rs wc
= 7% 0.1 (1 0.4) + 11.40% 0.9 = 10.68%.
Do the same calculation for each of the capital structures and find each WACC. The optimal capital structure is
the one that minimizes the WACC, which is 10.15%. Therefore, the optimal capital structure is 40% debt and 60%
equity.
6
60.
(15.5) WACC and recapitalizationnonalgorithmic
CQ
Answer: b
MEDIUM
(15.6) Stock price, recapitalizationnonalgorithmic CQ Answer: c
MEDIUM
WACC = wcrs + wd(1 T)rd
= (0.7)(0.12) + (0.3) (10.4)(0.08) = 0.0984 = 9.84%.
V = FCF/WACC. Since g = 0, FCF = NOPAT = EBIT(1 T).
V = $80,000(1 0.4)/0.0984 = $487,804.878 $487,805.
6
61.
Value of operations
+ value of T-bills
Total value
value of debt
Value of equity
Divide by # shares
Price per share
$510,638
178,723
$689,361
178,723
$510,638
10,000
$51.06
62.
(15.6) Stock price, recapitalizationnonalgorithmic CQ Answer: c
MEDIUM
First, find the stock price after issuing debt but prior to repurchase:
Value of operations
+ value of T-bills
Total value
value of debt
Value of equity
Divide by # shares
Price per share
$510,638
178,723
$689,361
178,723
$510,638
10,000
$51.06
The price per share does not change in the repurchase, so the number of shares repurchased is equal to the amount
used to repurchase shares divided by the price per share:
Number shares repurchased = $178,723/$51.06 = 3,500.
Number shares remaining = 10,000 3,500 = 6,500.
As a check, the price per share after repurchase is:
Value of operations
+ value of T-bills
Total value
repurchase
Value of equity
Divide by # shares
Price per share
6
63.
$510,638
0
$510,638
178,723
$331,915
6,500
$51.06
(15.5) WACC and recapitalization
Debt/Value =
Equity/Value=
20%
80%
CQ
Answer: a
Interest rate = rd =
New cost of equity = rs =
WACC = wd(1T)rd + wcrs = 0.84% + 8.80% = 9.64%
V = FCF/WACC. Since g = 0, FCF = NOPAT = EBIT(1 T).
V = NOPAT/WACC
V = $48,000/9.64% = $497,925
MEDIUM
7.0%
11.0%
64.
(15.6) Stock price, recapitalization
Value of operations = EBIT(1T) / WACC
+ value of T-bills
Total value
value of debt
Value of equity
Divide by # shares
Price per share
6
65.
CQ
Answer: b
MEDIUM
CQ
Answer: d
MEDIUM
$533,333
213,333
$746,666
-213,333
$533,333
10,000
$53.33
(15.6) Stock price, recapitalization
The price per share does not change in the repurchase, so share price would be the same as in the preceding
answer.
As a check, consider the following data:
Value of operations = EBIT(1 T)/WACC
+ value of T-bills
Total value
repurchase
Value of equity
New shares = old Debt/Price =
Stock price = Equity divided by # shares
6
66.
$533,333
0
$533,333
-213,333
$320,000
6,000
$53.33
(15.5) WACC and recapitalizationnonalgorithmic
CQ
Answer: a
MEDIUM
Answer: d
MEDIUM
WACC = wcrs + wd(1 T)rd
= (0.8)(0.14) + (0.2)(0.07)(1 0.4) = 0.1204 = 12.04%.
V = FCF/WACC. Since g = 0, FCF = NOPAT = EBIT(1 T).
V = $100,000(1 0.4)/0.1204 = $498,338.87 $498,339.
6
67.
(15.6) Stock price, recapitalizationnonalgorithmic
Value of operations
+ value of T-bills
Total value
value of debt
Value of equity
Divide by # shares
Price per share
$576,923
259,615
$836,538
259,615
$576,923
20,000
$28.85
CQ
68.
(15.6) Stock price, recapitalizationnonalgorithmic CQ Answer: a
MEDIUM
First, find the stock price after issuing debt but prior to repurchase:
Value of operations
+ value of T-bills
Total value
value of debt
Value of equity
Divide by # shares
Price per share
$576,923
259,615
$836,538
259,615
$576,923
20,000
$28.85
The price per share does not change in the repurchase, so the number of shares repurchased is equal to the amount
used to repurchase shares divided by the price per share:
Number shares repurchased = $259,615/$28.85 = 8,999.
Number shares remaining = 20,000 8,999 = 11,001.
As a check, the price per share after repurchase is:
Value of operations
+ value of T-bills
Total value
repurchase
Value of equity
Divide by # shares
Price per share
6
69.
$576,923
0
$576,923
259,615
$317,308
11,001
$28.84
(15.5) Market value and WACCnonalgorithmic
CQ
Answer: d
MEDIUM
V = Debt + Equity = $200,000 + $60(10,000) = $200,000 + $600,000
= $800,000.
WACC = wcrs + wd(1 T)rd
= (($600,000/$800,000)(0.088)) + ($200,000/$800,000)(1 0.4)(0.06)
= (0.75)(0.088) + (0.25)(0.036) = 0.075 = 7.5%.
As a check, V = FCF/WACC. Since g = 0, FCF = NOPAT = EBIT(1 T).
V = $100,000(1 0.4)/0.075 = $800,000.
7
70.
(15.5) WACC and recapitalizationnonalgorithmic
WACC = wcrs + wd(1 T)rd
= (0.6)(0.095) + (0.4)(1 0.4)(0.07) = 0.0738 = 7.38%.
V = FCF/WACC. Since g = 0, FCF = NOPAT = EBIT(1 T).
CQ
Answer: b
HARD
V = $100,000(1 0.4)/0.0738 = $813,008.
7
71.
(15.6) Stock price, recapitalizationnonalgorithmic
CQ
Answer: e
HARD
Answer: c
HARD
Step 1. Find the new value of equity and debt after the recapitalization:
S = wcV = 0.5($820,000) = $410,000.
D = wdV = 0.5($820,000) = $410,000.
Step 2. Find the new price per share after the recapitalization:
P = [S+ (DD0)]/n0 = [$410,000 + ($410,000 $200,000)]/10,000
= $62.
7
72.
(15.6) No. shares repurchasednonalgorithmic
CQ
First, find the number of shares remaining:
n = S/P = $336,000/$64 = 5,250.
The number of repurchased shares is the original number of shares minus the resulting number of shares:
# repurchased = 10,000 5,250 = 4,750.
Alternatively, number of shares repurchased is equal to the debt used to repurchase stock divided by the price per
share:
# repurchased = ($504,000 $200,000)/$64 = 4,750.