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Cartwright Communications is considering making a change to its capital structure to reduce its cost of capital and increase firm value.Right now, Cartwright 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 company's cost of equity, which is based on the CAPM, is 12% and its tax rate is 25%.What would be Cartwright's estimated cost of equity if it were to change its capital structure to 50% debt and 50% equity?


A) 13.00%
B) 13.65%
C) 14.84%
D) 15.58%
E) 16.00%

F) B) and E)
G) A) and B)

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A venture capital investment group received a proposal from Wireless Solutions to produce a new smart phone.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) 4,513
B) 4,750
C) 5,000
D) 5,250
E) 5,513

F) All of the above
G) D) and E)

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Laramie Trucking's CEO is considering a change to the company's 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 firm's tax rate is 25%.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) 11.50%
B) 12.50%
C) 13.58%
D) 14.77%
E) 16.05%

F) A) and D)
G) D) and E)

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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) True
B) False

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Which of the following statements is CORRECT?


A) A change in the personal tax rate should not affect firms' capital structure decisions.
B) "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.
C) 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.
D) If changes in the bankruptcy code make bankruptcy less costly to corporations, then this would likely reduce the debt ratio of the average corporation.
E) If corporate tax rates were decreased while other things were held constant, and if the Modigliani-Miller tax-adjusted tradeoff theory of capital structure were correct, this would tend to cause corporations to decrease their use of debt.

F) B) and D)
G) C) and E)

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The MM model with corporate taxes is the same as the Miller model, but with zero personal taxes.

A) True
B) False

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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) True
B) False

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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) True
B) False

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A new company to produce state-of-the-art car stereo systems is being considered by Jagger Enterprises.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) 86,640
B) 91,200
C) 96,000
D) 100,800
E) 105,840

F) B) and C)
G) C) and E)

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Which of the following statements is CORRECT?


A) The factors that affect a firm's business risk are affected by industry characteristics and economic conditions.Unfortunately, these factors are generally beyond the control of the firm's management.
B) One of the benefits to a firm of being at or near its target capital structure is that this eliminates any risk of bankruptcy.
C) A firm's financial risk can be minimized by diversification.
D) The amount of debt in its capital structure can under no circumstances affect a company's business risk.
E) A firm's business risk is determined solely by the financial characteristics of its industry.

F) B) and D)
G) B) and C)

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The Miller model begins with the MM model with corporate taxes and then adds personal taxes.

A) True
B) False

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Other things held constant, an increase in financial leverage will increase a firm's market (or systematic) risk as measured by its beta coefficient.

A) True
B) False

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The trade-off theory states that the capital structure decision involves a tradeoff between the costs and benefits of debt financing.

A) True
B) False

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Based on the information below for Benson Corporation, what is the optimal capital structure?


A) Debt = 50%; Equity = 50%; EPS = $3.05; Stock price = $28.90.
B) Debt = 60%; Equity = 40%; EPS = $3.18; Stock price = $31.20.
C) Debt = 80%; Equity = 20%; EPS = $3.42; Stock price = $30.40.
D) Debt = 70%; Equity = 30%; EPS = $3.31; Stock price = $30.00.
E) Debt = 40%; Equity = 60%; EPS = $2.95; Stock price = $26.50.

F) B) and C)
G) All of the above

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Which of the following is NOT associated with (or does not contribute to) business risk? Recall that business risk is affected by a firm's operations.


A) Sales price variability.
B) The extent to which operating costs are fixed.
C) The extent to which interest rates on the firm's debt fluctuate.
D) Input price variability.
E) Demand variability.

F) B) and E)
G) None of the above

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Which of the following statements is CORRECT?


A) Since debt financing is cheaper than equity financing, raising a company's debt ratio will always reduce its WACC.
B) Increasing a company's debt ratio will typically reduce the marginal cost of both debt and equity financing.However, this action still may raise the company's WACC.
C) Increasing a company's debt ratio will typically increase the marginal cost of both debt and equity financing.However, this action still may lower the company's WACC.
D) Since a firm's beta coefficient it not affected by its use of financial leverage, leverage does not affect the cost of equity.
E) Since debt financing raises the firm's financial risk, increasing a company's debt ratio will always increase its WACC.

F) C) and D)
G) A) and D)

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The major contribution of the Miller model is that it demonstrates that


A) personal taxes decrease the value of using corporate debt.
B) financial distress and agency costs reduce the value of using corporate debt.
C) equity costs increase with financial leverage.
D) debt costs increase with financial leverage.
E) personal taxes increase the value of using corporate debt.

F) A) and D)
G) A) and C)

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A firm's capital structure does not affect its calculated free cash flows, because FCF reflects only operating cash flows.

A) True
B) False

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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) True
B) False

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Which of the following statements is CORRECT, holding other things constant?


A) An increase in the personal tax rate is likely to increase the debt ratio of the average corporation.
B) If changes in the bankruptcy code make bankruptcy less costly to corporations, then this would likely reduce the debt ratio of the average corporation.
C) An increase in the company's degree of operating leverage is likely to encourage a company to use more debt in its capital structure.
D) An increase in the corporate tax rate is likely to encourage a company to use more debt in its capital structure.
E) Firms whose assets are relatively liquid tend to have relatively low bankruptcy costs, hence they tend to use relatively little debt.

F) A) and E)
G) A) and B)

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