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Whenever a firm borrows money, it is using financial leverage.

A) True
B) False

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VanMannen Foundations, Inc.(VF) VanMannen Foundations, Inc.(VF) is a zero-growth company that currently has zero debt, and it has the data shown below.  EBIT =$80,000 Growth =0% Orig cost of equity, rs=10.0% No. of shares =10,000 Price per share =$60.00 Tax rate =25%\begin{array}{lr}\text { EBIT }= & \$ 80,000 \\\text { Growth }= & 0 \% \\\text { Orig cost of equity, } r_{s}= & 10.0 \%\\\text { No. of shares }= & 10,000 \\\text { Price per share }= & \$ 60.00 \\\text { Tax rate }= & 25 \%\end{array} ​ -Refer to the data for VanMannen Foundations, Inc.(VF).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.If this plan were carried out, what would be VF's new WACC and its new value of operations? ? ?  New interest rate =rd=6.00% New cost of equity =rs=10.75% New Debt / Value =wd=20% New Equity / Value =ws=80%\begin{array} { l l } \text { New interest rate } = \mathrm { r } _ { \mathrm { d } } = & 6.00 \% \\ \text { New cost of equity } = \mathrm { r } _ { \mathrm { s } } = & 10.75 \% \\ \text { New Debt } / \text { Value } = \mathrm { w } _ { \mathrm { d } } = & 20 \% \\ \text { New Equity } / \text { Value } = \mathrm { w } _ { \mathrm { s } } = & 80 \% \end{array}  WACC ‾ Value ‾\underline{ \text { WACC } } \quad \underline { \text { Value } } a. 9.50%$631,5799.50 \% \quad\$ 631,579 b. 9.80%$644,2119.80 \% \quad \$ 644,211 c. 10.10%$657,09510.10 \% \quad \$ 657,095 d. 10.40%$670,23710.40 \% \quad \$ 670,237 e. 10.70%$683,64110.70 \% \quad \$ 683,641

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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) None of the above

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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) A) and E)

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Merriwether Building has operating income of $20 million, a tax rate of 25%, and no debt.It pays out all of its net income as dividends and has a zero growth rate.The current stock price is $27 per share, and it has 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) $28
B) $30
C) $33
D) $35
E) $40

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

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Eccles Inccorporated Eccles Incorporated, a zero growth firm, has an expected EBIT of $100,000 and a corporate tax rate of 25%.Eccles uses $500,000 of 12.0% debt, and the cost of equity to an unlevered firm in the same risk class is 16.0%. -Refer to the data for Eccles Incorporated.Assume that the firm's gain from leverage according to the Miller model is $126,667.If the effective personal tax rate on stock income is TS = 20%, what is the implied personal tax rate on debt income?


A) 12.8%
B) 14.2%
C) 15.8%
D) 17.6%
E) 19.6%

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

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LeCompte Learning Solutions is considering making a change to its capital structure in hopes of increasing its value.The company's 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 (wdd)  Percent financed  with equity (wS)  Debt-to-equity  ratio =wd/wS=(D/S)  B ond  Rating  Before-tax  cost of debt 0.100.900.10/0.90=0.11 AAA 7.0%0.200.800.20/0.80=0.25 AA 7.20.300.700.30/0.70=0.43 A8.00.400.600.40/0.60=0.67BBB8.80.500.500.50/0.50=1.00BB9.6\begin{array} { c c c c c } \begin{array} { c } \text { Percent financed } \\\text { with debt } \left( \mathrm { wd } _ { \mathrm { d } } \right) \end{array} & \begin{array} { c } \text { Percent financed } \\\text { with equity } \left( \mathrm { w } _ { \mathrm { S } } \right) \end{array} & \begin{array} { c } \text { Debt-to-equity } \\\text { ratio } = \mathrm { w } _ { \mathrm { d } } / \mathrm { w } _ { \mathrm { S } } = ( \mathrm { D } / \mathrm { S } ) \end{array} & \begin{array} { c } \text { B ond } \\\text { Rating }\end{array} & \begin{array} { c } \text { Before-tax } \\\text { cost of debt }\end{array} \\\hline 0.10 & 0.90 & 0.10 / 0.90 = 0.11 & \text { AAA } & 7.0 \% \\0.20 & 0.80 & 0.20 / 0.80 = 0.25 & \text { AA } & 7.2 \\0.30 & 0.70 & 0.30 / 0.70 = 0.43 & \mathrm {~A} & 8.0 \\0.40 & 0.60 & 0.40 / 0.60 = 0.67 & \mathrm { BBB } & 8.8 \\0.50 & 0.50 & 0.50 / 0.50 = 1.00 & \mathrm { BB } & 9.6\end{array} 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%.LeCompte estimates that if it had no debt its beta would be 1.0.(Its "unlevered beta," bU, equals 1.0.) The company's tax rate, T, is 25%. On the basis of this information, what is LeCompte's optimal capital structure, and what is the firm's cost of capital at this optimal capital structure?


A) ws = 0.9; wd = 0.1; WACC = 11.73%
B) ws = 0.8; wd = 0.2; WACC = 10.78%
C) ws = 0.7; wd = 0.3; WACC = 9.11%
D) ws = 0.6; wd = 0.4; WACC = 9.50%
E) ws = 0.5; wd = 0.5; WACC = 11.37%

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

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The firm's target capital structure should be consistent with which of the following statements?


A) Minimize the cost of debt (rd) .
B) Obtain the highest possible bond rating.
C) Minimize the cost of equity (rs) .
D) Minimize the weighted average cost of capital (WACC) .
E) Maximize the earnings per share (EPS) .

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

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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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Which of the following statements is CORRECT?


A) The capital structure that maximizes the stock price is generally the capital structure that also maximizes earnings per share.
B) All else equal, an increase in the corporate tax rate would tend to encourage a company to increase its debt ratio.
C) Since debt financing raises the firm's financial risk, increasing a company's debt ratio will always increase its WACC.
D) Since debt is cheaper than equity, increasing a company's debt ratio will always reduce its WACC.
E) When a company increases its debt ratio, the costs of equity and debt both increase.Therefore, the WACC must also increase.

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

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B

Anson Jackson Court Company (AJC) The Anson Jackson Court (AJC) currently has $150,000 market value (and book value) of perpetual debt outstanding carrying a coupon rate of 6%.Its earnings before interest and taxes (EBIT) are $89,000, and it is a zero growth company.AJC's current cost of equity is 10%, and its tax rate is 25%.The firm has 10,000 shares of common stock outstanding selling at a price per share of $60.00. -Daylight Solutions is considering a recapitalization that would increase its debt ratio and increase its interest expense.The company would issue new bonds and use the proceeds to buy back shares of its common stock.The company's CFO thinks the plan will not change total assets or operating income, but that it will increase earnings per share (EPS) .Assuming the CFO's estimates are correct, which of the following statements is CORRECT?


A) If the plan reduces the WACC, the stock price is also likely to decline.
B) Since the plan is expected to increase EPS, this implies that net income is also expected to increase.
C) If the plan does increase the EPS, the stock price will automatically increase at the same rate.
D) 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.
E) Since the proposed plan increases Daylight's financial risk, the company's stock price still might fall even if EPS increases.

F) A) and C)
G) A) and B)

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Which of the following statements is CORRECT?


A) There is no reason to think that changes in the personal tax rate would affect firms' capital structure decisions.
B) 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.
C) 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.
D) 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.
E) In general, a firm with low operating leverage also has a small proportion of its total costs in the form of fixed costs.

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

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Which of these items will not generally be affected by an increase in the debt ratio?


A) Total risk.
B) Financial risk.
C) Market risk.
D) The firm's beta.
E) Business risk.

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

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Which of the following would increase the likelihood that a company would increase its debt ratio, other things held constant?


A) An increase in the corporate tax rate.
B) An increase in the personal tax rate.
C) The Federal Reserve tightens interest rates in an effort to fight inflation.
D) The company's stock price hits a new low.
E) An increase in costs incurred when filing for bankruptcy.

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

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Which of the following statements is CORRECT?


A) 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.
B) The debt ratio that maximizes EPS generally exceeds the debt ratio that maximizes share price.
C) If a company were to issue debt and use the money to repurchase common stock, this action would have no impact on its return on invested capital.(Assume that the repurchase has no impact on the company's operating income.)
D) If changes in the bankruptcy code made bankruptcy less costly to corporations, this would likely reduce the average corporation's debt ratio.
E) Increasing financial leverage is one way to increase a firm's return on invested capital.

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

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Larsen Films' is analyzing its cost structure.Its fixed operating costs are $470,000, its 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) 391,667
B) 411,250
C) 431,813
D) 453,403
E) 476,073

F) A) and B)
G) A) and C)

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A

Wilson Dover Inc. The total value (debt plus equity) of Wilson Dover Inc.is $500 million and the face value of its 1-year coupon debt is $200 million.The volatility (σ) of Wilson Dover's total value is 0.60, and the risk-free rate is 5%.Assume that N(d1) = 0.9720 and N(d2) = 0.9050. ​ -Refer to the data for Wilson Dover Inc.What is the yield on Wilson Dover's debt?


A) 6.04%
B) 6.36%
C) 6.70%
D) 7.05%
E) 7.42%

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

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E

NorthWest Water (NWW) Five years ago, NorthWest Water (NWW) issued $50,000,000 face value of 30-year bonds carrying a 14% (annual payment) coupon.NWW is now considering refunding these bonds.It has been amortizing $3 million of flotation costs on these bonds over their 30-year life.The company could sell a new issue of 25-year bonds at an annual interest rate of 11.67% in today's market.A call premium of 14% would be required to retire the old bonds, and flotation costs on the new issue would amount to $3 million.NWW's marginal tax rate is 40%.The new bonds would be issued when the old bonds are called. -Refer to the data for NorthWest Water (NWW) .What is the required after-tax refunding investment outlay, i.e., the cash outlay at the time of the refunding?


A) $5,049,939
B) $5,315,725
C) $5,595,500
D) $5,890,000
E) $6,200,000

F) A) and D)
G) None of the above

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An all-equity firm with 200,000 shares outstanding, Antwerther Inc., 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 25%. ​ 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) $70.31
B) $74.01
C) $77.71
D) $81.60
E) $85.68

F) A) and E)
G) C) and E)

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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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