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Exam 15: Capital Structure

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Question 41

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Companies HD and LD have identical tax rates, total assets, total investor-supplied capital, and returns on investors' capital However, Company HD has a higher debt ratio and thus more interest expense than Company LD. Which of the following statements is CORRECT?

A) Company HD has a higher net income than Company LD.
B) Company HD has a lower ROA than Company LD.
C) Company HD has a lower ROE than Company LD.
D) The two companies have the same ROA.
E) The two companies have the same ROE.

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

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Question 42

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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.

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

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Question 43

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Monroe Inc. is an all-equity firm with 500,000 shares outstanding. It has $2,000,000 of EBIT, and EBIT 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) , and its tax rate is 40%. The company is considering issuing $5,000,000 of 9.00% bonds and using the proceeds to repurchase stock. The risk-free rate is 4.5%, the market risk premium is 5.0%, and the firm's beta is currently 0.90. However, the CFO believes the beta would rise to 1.10 if the recapitalization occurs. Assuming the shares could be repurchased at the price that existed prior to the recapitalization, what would the price per share be following the recapitalization? (Hint: P0 = EPS/rs because EPS = DPS.)

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).

Assume that you and your brother plan to open a business that will make and sell a newly designed type of sandal. Two robotic machines are available to make the sandals, Machine A and Machine B. The price per pair will be $20.00 regardless of which machine is used. The fixed and variable costs associated with the two machines are shown below. What is the difference between the break-even points for Machines A and B? (Hint: Find BEB - BEA)

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

Southeast U's campus book store sells course packs for $15.00 each, the variable cost per pack is $11.00, fixed costs for this operation are $300,000, and annual sales are 100,000 packs. The unit variable cost consists of a $4.00 royalty payment, VR, per pack to professors plus other variable costs of VO = $7.00. The royalty payment is negotiable. The book store's directors believe that the store should earn a profit margin of 10% on sales, and they want the store's managers to pay a royalty rate that will produce that profit margin. What royalty per pack would permit the store to earn a 10% profit margin on course packs, other things held constant?

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.

Financial risk refers to the extra risk borne by stockholders as a result of a firm's use of debt as compared with their risk if the firm had used no debt.

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.

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 break-even point, i.e., at what unit sales volume would income equal costs?

Firms U and L each have the same amount of assets, investor-supplied capital, and both have a return on investors' capital (ROIC) of 12%. 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 an after-tax cost of 8%. Both firms have positive net income and a 35% tax rate. Which of the following statements is CORRECT?

Which of the following statements best describes the optimal capital structure?

Southwest U's campus book store sells course packs for $16 each. The variable cost per pack is $10, and at current annual sales of 50,000 packs, the store earns $75,000 before taxes on course packs. How much are the fixed costs of producing the course packs?

You plan to invest in one of two home delivery pizza companies, High and Low, that were recently founded and are about to commence operations. They are identical except for their use of debt (wd) and the interest rates on their debt--High uses more debt and thus must pay a higher interest rate. Based on the data given below, how much higher or lower will High's expected EPS be versus that of Low, i.e., what is EPSHigh - EPSLow?

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.

According to Modigliani and Miller (MM), in a world with corporate income taxes the optimal capital structure calls for approximately 100% debt financing.

Which of the following statements is CORRECT?

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?

Modigliani and Miller's first article led to the conclusion that capital structure is "irrelevant" because it has no effect on a firm's value. However, that article was criticized because it assumed that no taxes existed. MM then revised their original article to include corporate taxes, and this model led to the conclusion that a firm's value would be maximized if it used (almost) 100% debt.