Question 1

Eccles Inc., a zero growth firm, has an expected EBIT of $100,000 and a corporate tax rate of 30%. 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 Inc.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?

Accepted Answer

A)   16.4%
B)   18.2%
C)   20.2%
D)   22.5%
E)   25.0%F) A) and B)
G) B) and E)

Question 2

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?

Accepted Answer

A)   6.04%
B)   6.36%
C)   6.70%
D)   7.05%
E)   7.42%F) B) and E)
G) None of the above

Question 3

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

Accepted Answer

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) A) and D)
G) B) and D)

Question 4

Serendipity Inc. is re-evaluating its debt level. Its current capital structure consists of 80% debt and 20% common equity, its beta is 1.60, and its tax rate is 35%. However, the CFO thinks the company has too much debt, and he is considering moving to a capital structure with 40% debt and 60% equity. The risk-free rate is 5.0% and the market risk premium is 6.0%. By how much would the capital structure shift change the firm's cost of equity?

Accepted Answer

A)   $5.20%
B)  $5.78%
C)   $6.36%
D)   $6.99%
E)   $7.69%F) B) and D)
G) All of the above

Question 5

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.

Accepted Answer

A) True 
 B)False

Question 6

Morales Publishing's tax rate is 40%, its beta is 1.10, and it uses no debt. However, the CFO is considering moving to a capital structure with 30% debt and 70% equity. If the risk-free rate is 5.0% and the market risk premium is 6.0%, by how much would the capital structure shift change the firm's cost of equity?

Accepted Answer

A)   1.53%
B)   1.70%
C)   1.87%
D)   2.05%
E)   2.26%F) None of the above
G) A) and E)

Question 7

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 value (in millions)  of Wilson Dover's debt if its equity is viewed as an option?

Accepted Answer

A)   $167.57
B)   $186.19
C)   $204.81
D)   $225.29
E)   $247.82F) C) and D)
G) B) and E)

Question 8

The Anson Jackson Court Company (AJC)  currently has $200,000 market value (and book value)  of perpetual debt outstanding carrying a coupon rate of 6%. Its earnings before interest and taxes (EBIT)  are $100,000, and it is a zero growth company. AJC's current cost of equity is 8.8%, and its tax rate is 40%. The firm has 10,000 shares of common stock outstanding selling at a price per share of $60.00.
-Refer to the data for the Anson Jackson Court Company (AJC) . What is AJC's current total market value and weighted average cost of capital?

Accepted Answer

A)   $600,000; 7.5%
B)   $600,000; 8.0%
C)   $800,000; 7.0%
D)   $800,000; 7.5%
E)   $800,000; 8.0%F) B) and E)
G) A) and E)

Question 9

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.

Accepted Answer

A) True 
 B)False

Question 10

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.

Accepted Answer

A) True 
 B)False

Question 11

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.

Accepted Answer

A) True 
 B)False

Question 12

After an intensive research and development effort, two methods for producing playing cards have been identified by the Turner Company. One method involves using a machine having a fixed cost of $10,000 and variable costs of $1.00 per deck of cards. The other method would use a less expensive machine (fixed cost = $5,000) , but it would require greater variable costs ($1.50 per deck of cards) . If the selling price per deck of cards will be the same under each method, at what level of output will the two methods produce the same net operating income (EBIT) ?

Accepted Answer

A)   5,000 decks
B)   10,000 decks
C)   15,000 decks
D)   20,000 decks
E)   25,000 decksF) None of the above
G) A) and B)

Question 13

The world-famous discounter, Fernwood Booksellers, specializes in selling paperbacks for $7 each. The variable cost per book is $5. At current annual sales of 200,000 books, the publisher is just breaking even. It is estimated that if the authors' royalties are reduced, the variable cost per book will drop by $1. Assume authors' royalties are reduced and sales remain constant; how much more money can the publisher put into advertising (a fixed cost)  and still break even?

Accepted Answer

A)   $600,000
B)   $466,667
C)   $333,333
D)   $200,000
E)   none of the aboveF) D) and E)
G) A) and D)

Question 14

Pennewell Publishing Inc. (PP)  is a zero growth company. It currently has zero debt and its earnings before interest and taxes (EBIT)  are $80,000. PP's current cost of equity is 10%, and its tax rate is 40%. The firm has 10,000 shares of common stock outstanding selling at a price per share of $48.00.
-Refer to the data for Pennewell Publishing Inc. (PP) . Assume that PP is considering changing from its original capital structure to a new capital structure with 35% debt and 65% equity. This results in a weighted average cost of capital equal to 9.4% and a new value of operations of $510,638. Assume PP raises $178,723 in new debt and purchases T-bills to hold until it makes the stock repurchase. What is the stock price per share immediately after issuing the debt but prior to the repurchase?

Accepted Answer

A)   $45.90
B)   $48.12
C)   $51.06
D)   $53.33
E)   $58.75F) B) and D)
G) A) and E)

Question 15

Which of the following statements is CORRECT?

Accepted Answer

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 basic earning power ratio. (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 basic earning power (bep) .F) B) and E)
G) A) and E)

Question 16

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 (wd)  Percent financed  with equity (wC)  Debt-to-equity  ratio (D/S)  Bond  Rating  Before-tax  cost of debt 0.100.900.10/0.90=0.11AAA7.0%0.200.800.20/0.80=0.25AA7.20.300.700.30/0.70=0.43 A8.00.400.600.40/0.60=0.67BBB8.80.500.500.50/0.50=1.00BB9.6\begin{array}{ccccc}\begin{array}{c}	ext { Percent financed } \	ext { with debt }\left(\mathrm{w}_{\mathrm{d}}ight) \end{array} & \begin{array}{c}	ext { Percent financed } \	ext { with equity }\left(\mathrm{w}_{\mathrm{C}}ight) \end{array} & \begin{array}{c}	ext { Debt-to-equity } \	ext { ratio }(\mathrm{D} / \mathrm{S}) \end{array} & \begin{array}{c}	ext { Bond } \	ext { Rating }\end{array} & \begin{array}{c}	ext { Before-tax } \	ext { cost of debt }\end{array} \\hline 0.10 & 0.90 & 0.10 / 0.90=0.11 & \mathrm{AAA} & 7.0 \% \0.20 & 0.80 & 0.20 / 0.80=0.25 & \mathrm{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} Percent financed  with debt (wd​) ​0.100.200.300.400.50​ Percent financed  with equity (wC​) ​0.900.800.700.600.50​ Debt-to-equity  ratio (D/S) ​0.10/0.90=0.110.20/0.80=0.250.30/0.70=0.430.40/0.60=0.670.50/0.50=1.00​ Bond  Rating ​AAAAA ABBBBB​ Before-tax  cost of debt ​7.0%7.28.08.89.6​​ 
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 40%.σσOn 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?

Accepted Answer

A)   wc = 0.9; wd = 0.1; wacc = 14.96%
B)   wc = 0.8; wd = 0.2; wacc = 10.96%
C)   wc = 0.7; wd = 0.3; wacc = 7.83%
D)   wc = 0.6; wd = 0.4; wacc = 10.15%
E)   wc = 0.5; wd = 0.5; wacc = 10.18% F) C) and E)
G) A) and C)

Question 17

Blueline Publishers is considering a recapitalization plan. It is currently 100% equity financed but under the plan it would issue long-term debt with a yield of 9% and use the proceeds to repurchase common stock. The recapitalization would not change the company's total assets, nor would it affect the firm's basic earning power, which is currently 15%. The CFO believes that this recapitalization would reduce the WACC and increase stock price. Which of the following would also be likely to occur if the company goes ahead with the recapitalization plan?

Accepted Answer

A)   the company's earnings per share would decline.
B)   the company's cost of equity would increase.
C)   the company's roa would increase.
D)   the company's roe would decline.
E)   the company's net income would increase.F) B) and E)
G) A) and D)

Question 18

Which of the following statements is CORRECT?

Accepted Answer

A)   the optimal capital structure simultaneously maximizes eps and minimizes the wacc.
B)   the optimal capital structure minimizes the cost of equity, which is a necessary condition for maximizing the stock price.
C)   the optimal capital structure simultaneously minimizes the cost of debt, the cost of equity, and the wacc.
D)   the optimal capital structure simultaneously maximizes stock price and minimizes the wacc.
E)   as a rule, the optimal capital structure is found by determining the debt-equity mix that maximizes expected eps.F) A) and D)
G) A) and B)

Question 19

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?

Accepted Answer

A)   4,513
B)   4,750
C)   5,000
D)   5,250
E)   5,513F) C) and D)
G) A) and B)

Question 20

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?

Accepted Answer

A)   391,667
B)   411,250
C)   431,813
D)   453,403
E)   476,073F) A) and B)
G) A) and C)

Exam 16: Capital Structure Decisions

Correct Answer
verified

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.

Correct Answer
verified

Which of the following statements is CORRECT?

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

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

Correct Answer
verified

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.

Correct Answer
verified

Correct Answer
verified

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.

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

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?

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Which of the following statements is CORRECT?

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

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.

Correct Answer
verified

Exam 16: Capital Structure Decisions

Correct AnswerverifiedShow Answer

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.

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

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

Correct AnswerverifiedShow Answer

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.

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

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.

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

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?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

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.

Correct AnswerverifiedShow Answer

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified