Sample Quiz 2 Fall 2010 FIN 351
1. A firm issues 100,000 equity shares with a total market value of $5,000,000. The firm's market value of debt is
also of equal amount, i.e. $5,000,000. The firm is expected to generate $1.5 million in operating income and pay
$250,000 in interest. Ignoring taxes, this will generate $12.50 earnings per share. What will happen to EPS if the
firm's borrowing and interest expense increases by 50% and the number of shares in circulation is cut by 50%
(assuming that the share price remains unchanged with this change in capital structure)?
A. EPS decrease to $10.00.
B. EPS decrease to $11.67.
C. EPS increase to $15.00.
D. EPS increase to $22.50.
2. What is the proportion of debt financing for a firm that expects a 24% return on equity, a 16% return on assets,
and a 12% return on debt? Ignore taxes.
3. Global Auto has sold 20 cars at the price of $20,000 per car. The variable cost is $15,000 per car. The interest
expense is $10,000 and fixed costs are $25,000. The tax rate is 30%. What is the Degree of operating leverage of
4. According to MM II, as a firm's debt-to-equity ratio decreases:
A. its financial risk increases.
B. its operating risk increases.
C. the required rate of return on equity increases.
D. the required rate of return on equity decreases.
5. A firm’s degree of total leverage is 2. What does this mean?
A. A 1% increase in units sold results in a 2% increase in net income.
B. A 1% increase in units sold results in a 2% increase in operating income.
C. A 1% increase in operating income results in a 2% increase in net income.
D. A 1% increase in fixed costs results in a 2% increase in net income.
6. A firm all equity financed is valued at $1 million. The firm then issues $1 million in permanent debt at a 10%
interest rate, and a 35% tax rate. What is the value of the firm if MM I is modified to recognize corporate taxes?