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Exam 14: Capital Structure and Leverage

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Question 31

True/False

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If two firms have the same expected earnings per share (EPS)and the same standard deviation of expected EPS,then they must have the same amount of business risk.

A) True
B) False

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Question 32

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Firm A is very aggressive in its use of debt to leverage up its earnings for common stockholders,whereas Firm NA is not aggressive and uses no debt.The two firms' operations are identical⎯they have the same total investor-supplied capital,sales,operating costs,and EBIT.Thus,they differ only in their use of financial leverage (w_d) .Based on the following data,how much higher or lower is A's ROE than that of NA,i.e.,what is ROE_A − ROE_NA?

A) 8.60%
B) 9.06%
C) 9.53%
D) 10.01%
E) 10.51%

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

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Question 33

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It is possible for Firms A and B to have identical financial and operating leverage,yet for Firm A to have more risk as measured by the variability of EPS.This would occur if Firm A has more business risk than Firm B.

Senate Inc.is considering two alternative methods for producing playing cards.Method 1 involves using a machine with a fixed cost (mainly depreciation) of $12,000 and variable costs of $1.00 per deck of cards.Method 2 would use a less expensive machine with a fixed cost of only $5,000,but it would require a variable cost of $1.50 per deck.The sales price per deck would be the same under each method.At what unit output level would the two methods provide the same operating income (EBIT) ?

Which of the following statements is CORRECT?

Dyson Inc.currently finances with 20.0% debt (i.e.,w_d = 20%) ,but its new CFO is considering changing the capital structure so w_d = 60.0% by issuing additional bonds and using the proceeds to repurchase and retire common shares so the percentage of common equity in the capital structure (w_c) = 1 − w_d.Given the data shown below,by how much would this recapitalization change the firm's cost of equity? (Hint: You must unlever the current beta and then use the unlevered beta to solve the problem.)

The Miller model begins with the Modigliani and Miller (MM)model without corporate taxes and then adds personal taxes.

Your firm is currently 100% equity financed.The CFO is considering a recapitalization plan under which the firm would issue long-term debt with an after-tax yield of 9% and use the proceeds to repurchase some of its common stock.The recapitalization would not change the company's total investor-supplied capital,the size of the firm (i.e.,total assets) ,and it would not affect the firm's return on investors' capital (ROIC) ,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?

The firm's target capital structure should do which of the following?

Which of the following statements is CORRECT?

Other things held constant,firms that use assets that can be sold easily (like trucks)tend to use more debt than firms whose assets are harder to sell (like those engaged in research and development).

Modigliani and Miller (MM)won Nobel Prizes for their work on capital structure theory.

Which of the following statements is CORRECT?

Confu Inc.expects to have the following data during the coming year.What is the firm's expected ROE? ​ ​

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?

Your uncle is considering investing in a new company that will produce high quality stereo speakers.The sales price would be set at 1.5 times the variable cost per unit; the variable cost per unit is estimated to be $75.00; and fixed costs are estimated at $1,200,000.What sales volume would be required to break even,i.e.,to have EBIT = zero?

A firm's capital structure does not affect its free cash flows as discussed in the text,because FCF reflects only operating cash flows,which are available to service debt,to pay dividends to stockholders,and for other purposes.

Southwest U's campus book store 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 50,000 packs.What are the pre-tax profits from sales of course packs?

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?

Different borrowers have different risks of bankruptcy,and if a borrower goes bankrupt,its lenders will probably not get back the full amount of funds that they loaned.Therefore,lenders charge higher rates to borrowers judged to be more likely to go bankrupt.