a. Demand variability.
b. Sales price variability.
c. The extent to which operating costs are fixed.
d. The extent to which interest rates on the firm's debt fluctuate.
e. Input price variability.
____ 2. Which of the following statements is CORRECT?
a. Since debt financing raises the firm's financial risk, increasing the target debt ratio will
always increase the WACC.
b. Since debt financing is cheaper than equity financing, raising a company's debt ratio will
always reduce its WACC.
c. 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.
d. 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.
e. Since a firm's beta coefficient is not affected by its use of financial leverage, leverage does
not affect the cost of equity.
____ 3. Which of the following statements is CORRECT?
a. The capital structure that maximizes expected EPS also maximizes the price per share of common stock.
b. The capital structure that minimizes the interest rate on debt also maximizes the expected
c. The capital structure that minimizes the required return on equity also maximizes the stock price.
d. The capital structure that minimizes the WACC also maximizes the price per share of common stock.
e. The capital structure that gives the firm the best bond rating also maximizes the stock price.
____ 4. Based on the information below, what is the firm's optimal capital structure?
a. Debt = 40%; Equity = 60%; EPS = $2.95; Stock price = $26.50.
b. Debt = 50%; Equity = 50%; EPS = $3.05; Stock price = $28.90.
c. Debt = 60%; Equity = 40%; EPS = $3.18; Stock price = $31.20.
d. Debt = 80%; Equity = 20%; EPS = $3.42; Stock price = $30.40.
e. Debt = 70%; Equity = 30%; EPS = $3.31; Stock price = $30.00.
____ 5. Which of the following events is likely to encourage a company to raise its target debt ratio, other things held constant?
a. A decrease in costs incurred when filing for bankruptcy.
b. An increase in the personal tax rate.
c. An increase in the company's operating leverage.
d. The Federal Reserve tightens interest rates in an effort to fight inflation.
e. Statements a and b are correct.
____ 6. Which of the following statements is CORRECT?
a. A firm's business risk is determined solely by the financial characteristics of its industry.
b. 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.
c. 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.
d. A firm's financial risk can be minimized by diversification.
e. The amount of debt in its capital structure can under no circumstances affect a company's
EBIT and business risk.
____ 7. Which of the following statements is CORRECT? As a firm increases the operating leverage used to produce a given quantity of output, this
a. normally leads to an increase in its fixed assets turnover ratio.
b. normally leads to a decrease in its business risk.
c. normally leads to a decrease in the standard deviation of its expected EBIT.
d. normally leads to a decrease in the variability of its expected EPS.
e. normally leads to a reduction in its fixed assets turnover ratio.
____ 8. 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?
a. Since the proposed plan increases the firm's financial risk, the stock price might fall even if
b. If the plan reduces the WACC, the stock price is likely to decline.
c. Since the plan is expected to increase EPS, this implies that net income is also expected to
d. If the plan does increase the EPS, the stock price will automatically increase at the same
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.
____ 9. Your firm 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 some of its common stock. The recapitalization would not change the company's total assets, nor would it affect the firm's basic earning power, 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?
a. The company's net income would increase.
b. The company's earnings per share would decline.
c. The company's cost of equity would increase.
d. The company's ROA would increase.
e. The company's ROE would decline.
____ 10. 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 L's debt has a before-tax cost of 8%. Both firms have positive net income. Which of the following statements is CORRECT?
a. The two companies have the same times interest earned (TIE) ratio.
b. Firm L has a lower ROA than Firm U.
c. Firm L has a lower ROE than Firm U.
d. Firm L has the higher times interest earned (TIE) ratio.
e. Firm L has a higher EBIT than Firm U.
____ 11. A major contribution of the Miller model is that it demonstrates, other things held constant, that
a. personal taxes increase the value of using corporate debt.
b. personal taxes lower the value of using corporate debt.
c. personal taxes have no effect on the value of using corporate debt.
d. financial distress and agency costs reduce the value of using corporate debt.
e. debt costs increase with financial leverage.
____ 12. Which of the following statements is CORRECT, holding other things constant?
a. Firms whose assets are relatively liquid tend to have relatively low bankruptcy costs, hence they tend to use relatively little debt.
b. An increase in the personal tax rate is likely to increase the debt ratio of the average corporation.
c. If changes in the bankruptcy code make bankruptcy less costly to corporations, then this would likely lead to lower debt ratios for corporations.
d. 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.
e. An increase in the corporate tax rate would in theory encourage companies to use more debt in their capital structures.
____ 13. 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?
a. Its sales are projected to become less stable in the future.
b. The bankruptcy laws are changed in a way that would make bankruptcy more costly to the firm and its stockholders.
c. Management believes that the firm's stock is currently overvalued.
d. The firm decides to automate its factory with specialized equipment and thus increase its use of operating leverage.
e. The corporate tax rate is increased.
____ 14. Which of the following statements is CORRECT?
a. When a company increases its debt ratio, the costs of equity and debt both increase.
Therefore, the WACC must also increase.
b. The capital structure that maximizes the stock price is generally the capital structure that also maximizes earnings per share.
c. All else equal, an increase in the corporate tax rate would tend to encourage companies to increase their debt ratios.
d. Since debt financing raises the firm's financial risk, increasing a company's debt ratio will always increase its WACC.
e. Since the cost of debt is generally fixed, increasing the debt ratio tends to stabilize net income.
____ 15. 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 breakeven point, i.e., at what unit sales volume would income equal costs?
____ 16. Southwest U's campus bookstore 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 49,000 packs. What are the pre-tax profits from sales of course packs?
____ 17. You work for the CEO of a new company that plans to manufacture and sell a new product, a watch that has an embedded TV set and a magnifying glass crystal. The issue now is how to finance the company, with only equity or with a mix of debt and equity. Expected operating income is $240,000. 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 ? Note: This question is worth 2 points 0% Debt, U 60% Debt, L Oper income (EBIT) $240,000 $240,000 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%
____ 18. Dabney Electronics currently has no debt. Its operating income is $20 million and its tax rate is 40 percent. 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 percent debt and 60 percent equity (based on market values), its investment bankers believe its weighted average cost of capital would be 10 percent. What would its stock price be if it changes to the new capital structure? Note: This question is worth 2 points.
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