Professional Documents
Culture Documents
Financial risk.
Total risk.
Business risk.
Market risk.
None of the above is correct.
above.)
Business risk
Diff: E
Business risk is concerned with the operations of the firm. Which of the
following is not associated with (or not a part of) business risk?
a.
b.
c.
d.
e.
Demand variability.
Sales price variability.
The extent to which operating costs are fixed.
Changes in required returns due to financing decisions.
The ability to change prices as costs change.
Business risk
3.
Diff: E
2.
Answer: c
Answer: d
Diff: E
Answer: d
Diff: E
Answer: e
Diff: E
Answer: c
From the information below, select the optimal capital structure for Minnow
Entertainment Company.
a.
b.
c.
d.
e.
Debt
Debt
Debt
Debt
Debt
=
=
=
=
=
40%;
50%;
60%;
80%;
70%;
Equity
Equity
Equity
Equity
Equity
=
=
=
=
=
60%;
50%;
40%;
20%;
30%;
EPS
EPS
EPS
EPS
EPS
=
=
=
=
=
$2.95;
$3.05;
$3.18;
$3.42;
$3.31;
Stock
Stock
Stock
Stock
Stock
price
price
price
price
price
Diff: E
Which of the
structure?
following
=
=
=
=
=
$26.50.
$28.90.
$31.20.
$30.40.
$30.00.
Answer: e
statements
best
describes
the
optimal
Diff: E
capital
a. The optimal capital structure is the mix of debt, equity, and preferred
stock that maximizes the companys earnings per share (EPS).
b. The optimal capital structure is the mix of debt, equity, and preferred
stock that maximizes the companys stock price.
c. The optimal capital structure is the mix of debt, equity, and preferred
stock that minimizes the companys weighted average cost of capital
(WACC).
d. Statements a and b are correct.
e. Statements b and c are correct.
Chapter 13 - Page 2
The firms
following?
a.
b.
c.
d.
e.
Maximum
Minimum
Minimum
Minimum
Minimum
target
Answer: e
capital
structure
is
consistent
of
the
Answer: d
Diff: E
which
with
Diff: E
Answer: e
Diff: E
Diff: E
Answer: e
Answer: a
Diff: E
Diff: E
Answer: c
Diff: E
The
The
The
The
The
companys
companys
companys
companys
companys
Answer: a
15.
Diff: E
Which of the following would increase the likelihood that a company would
increase its debt ratio in its capital structure?
a.
b.
c.
d.
e.
14.
Answer: e
Answer: e
Diff: E
Chapter 13 - Page 4
Answer: c
Diff: E
Answer: e
Diff: E
Diff: E
Answer: d
Answer: a
Diff: E
Answer: d
Diff: E
Answer: c
Diff: E
Answer: a
Diff: E
Chapter 13 - Page 6
Answer: c
Diff: E
Answer: d
Company A and Company B have the same tax rate, the same total assets, and
the same basic earning power. Both companies have a basic earning power
that exceeds their before-tax costs of debt, kd. However, Company A has a
higher debt ratio and higher interest expense than Company B. Which of the
following statements is most correct?
a.
b.
c.
d.
e.
Diff: E
Answer: b
Diff: E
Firm U and Firm L each have the same total assets. Both firms also have a
basic earning power of 20 percent. Firm U is 100 percent equity financed,
while Firm L is financed with 50 percent debt and 50 percent equity. Firm
Ls debt has a before-tax cost of 8 percent. Both firms have positive net
income. Which of the following statements is most correct?
a.
b.
c.
d.
e.
Medium:
Optimal capital structure
27.
Answer: d
Diff: M
Answer: e
Diff: M
Answer: c
Diff: M
Company A and Company B have the same total assets, operating income
(EBIT), tax rate, and business risk. Company A, however, has a much higher
debt ratio than Company B. Company As basic earning power (BEP) exceeds
its cost of debt financing (kd). Which of the following statements is most
correct?
a. Company A has a higher return on assets (ROA) than Company B.
b. Company A has a higher times interest earned (TIE) ratio than Company B.
c. Company A has a higher return on equity (ROE) than Company B, and its
risk, as measured by the standard deviation of ROE, is also higher than
Company Bs.
d. Statements b and c are correct.
e. All of the statements above are correct.
Limits of leverage
30.
Answer: d
Diff: M
Chapter 13 - Page 8
Signaling theory
31.
Answer: b
Diff: M
If you know that your firm is facing relatively poor prospects but needs
new capital, and you know that investors do not have this information,
signaling theory would predict that you would
a. Issue debt to maintain the returns of equity holders.
b. Issue equity to share the burden of decreased equity returns between
old and new shareholders.
c. Be indifferent between issuing debt and equity.
d. Postpone going into capital markets until your firms prospects
improve.
e. Convey your inside information to investors using the media to
eliminate the information asymmetry.
Answer: d
Diff: M
Answer: b
Diff: M
Answer: a
Diff: M
Answer: c
Diff: M
Tough:
Variations in capital structures
36.
Answer: d
Diff: T
Chapter 13 - Page 10
Diff: E
The Price Company will produce 55,000 widgets next year. Variable costs
will equal 40 percent of sales, while fixed costs will total $110,000. At
what price must each widget be sold for the company to achieve an EBIT of
$95,000?
a.
b.
c.
d.
e.
$2.00
$4.45
$5.00
$5.37
$6.21
Breakeven price
38.
Answer: e
Answer: a
Diff: E
Texas Products Inc. has a division that makes burlap bags for the citrus
industry.
The division has fixed costs of $10,000 per month, and it
expects to sell 42,000 bags per month. If the variable cost per bag is
$2.00, what price must the division charge in order to break even?
a.
b.
c.
d.
e.
$2.24
$2.47
$2.82
$3.15
$2.00
Medium:
New financing
39.
Answer: a
Diff: M
The Altman Company has a debt ratio of 33.33 percent, and it needs to raise
$100,000 to expand. Management feels that an optimal debt ratio would be
16.67 percent. Sales are currently $750,000, and the total assets turnover
is 7.5. How should the expansion be financed so as to produce the desired
debt ratio?
a.
b.
c.
d.
e.
100% equity
100% debt
20 percent debt, 80 percent equity
40 percent debt, 60 percent equity
50 percent debt, 50 percent equity
Diff: M
The Congress Company has identified two methods for producing playing
cards.
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?
a.
b.
c.
d.
e.
5,000
10,000
15,000
20,000
25,000
decks
decks
decks
decks
decks
Answer: b
Answer: b
Diff: M
Answer: c
Diff: M
$ 183,333
$ 456,500
$ 805,556
$ 910,667
$1,200,000
Chapter 13 - Page 12
Breakeven
43.
Answer: d
Elephant Books sells paperback books 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?
a.
b.
c.
d.
e.
$600,000
$466,667
$333,333
$200,000
$175,225
Operating decision
44.
Answer: d
Diff: M
Musgrave Corporation has fixed costs of $46,000 and variable costs that are
30 percent of the current sales price of $2.15.
At a price of $2.15,
Musgrave sells 40,000 units. Musgrave can increase sales by 10,000 units
by cutting its unit price from $2.15 to $1.95, but variable cost per unit
wont change. Should it cut its price?
a.
b.
c.
d.
e.
Diff: M
Answer: c
Diff: M
$300,000
$100,000
$ 10,000
40%
Shares outstanding
EPS
Stock price
120,000
$1.45
$17.40
$15.30
$17.75
$18.00
$19.03
$20.48
A consultant
Publishing:
has
collected
Total assets
$3,000
Operating income (EBIT) $800
Interest expense
$0
Net income
$480
Share price
Answer: e
the
following
million
million
million
million
$32.00
information
Diff: M
regarding
Tax rate
Debt ratio
WACC
M/B ratio
EPS = DPS
Young
40%
0%
10%
1.00
$3.20
The company has no growth opportunities (g = 0), so the company pays out
all of its earnings as dividends (EPS = DPS). Youngs stock price can be
calculated by simply dividing earnings per share by the required return on
equity capital, which currently equals the WACC because the company has no
debt.
The consultant believes that the company would be much better off if it
were to change its capital structure to 40 percent debt and 60 percent
equity.
After meeting with investment bankers, the consultant concludes
that the company could issue $1,200 million of debt at a before-tax cost of
7 percent, leaving the company with interest expense of $84 million. The
$1,200 million raised from the debt issue would be used to repurchase stock
at $32 per share. The repurchase will have no effect on the firms EBIT;
however, after the repurchase, the cost of equity will increase to 11
percent.
If the firm follows the consultants advice, what will be its
estimated stock price after the capital structure change?
a.
b.
c.
d.
e.
$32.00
$33.48
$31.29
$32.59
$34.72
Tough:
Hamada equation and cost of equity
47.
Answer: a
Diff: T
14.35%
30.00%
14.72%
15.60%
13.64%
Chapter 13 - Page 14
Answer: d
Diff: T
0.10
0.20
0.30
0.40
0.50
Debt-to-equity
ratio (D/E)
0.90
0.80
0.70
0.60
0.50
0.10/0.90
0.20/0.80
0.30/0.70
0.40/0.60
0.50/0.50
=
=
=
=
=
0.11
0.25
0.43
0.67
1.00
Bond
rating
Before-tax
cost of debt
AA
A
A
BB
B
7.0%
7.2
8.0
8.8
9.6
wc
wc
wc
wc
wc
=
=
=
=
=
0.9;
0.8;
0.7;
0.6;
0.5;
wd
wd
wd
wd
wd
=
=
=
=
=
0.1;
0.2;
0.3;
0.4;
0.5;
WACC
WACC
WACC
WACC
WACC
=
=
=
=
=
14.96%
10.96%
7.83%
10.15%
10.18%
Answer: d
Diff: T
Zippy Pasta Corporation (ZPC) has a constant growth rate of 7 percent. The
company retains 30 percent of its earnings to fund future growth. ZPCs
expected EPS (EPS1) and ks for various capital structures are given below.
What is the optimal capital structure for ZPC?
Debt/Total Assets
20%
30
40
50
70
a.
b.
c.
d.
e.
Debt/Total
Debt/Total
Debt/Total
Debt/Total
Debt/Total
Assets
Assets
Assets
Assets
Assets
=
=
=
=
=
Expected EPS
$2.50
3.00
3.25
3.75
4.00
ks
15.0%
15.5
16.0
17.0
18.0
20%
30%
40%
50%
70%
Diff: T
Given the following choices, what is the optimal capital structure for Chip
Co.? (Assume that the companys growth rate is 2 percent.)
Debt Ratio
0%
25
40
50
75
a.
b.
c.
d.
e.
0% debt; 100%
25% debt; 75%
40% debt; 60%
50% debt; 50%
75% debt; 25%
Dividends
Per Share
$5.50
6.00
6.50
7.00
7.50
Cost of
Equity (ks)
11.5%
12.0
13.0
14.0
15.0
equity
equity
equity
equity
equity
Answer: b
Answer: a
Diff: T
$51.14
$53.85
$56.02
$68.97
$76.03
Chapter 13 - Page 16
Answer: a
Diff: T
Etchabarren Electronics has made the following forecast for the upcoming
year based on the companys current capitalization:
Interest expense
Operating income (EBIT)
Earnings per share
$2,000,000
$20,000,000
$3.60
The company has $20 million worth of debt outstanding and all of its debt
yields 10 percent. The companys tax rate is 40 percent. The companys
price earnings (P/E) ratio has traditionally been 12, so the company
forecasts that under the current capitalization its stock price will be
$43.20 at year end.
The companys investment bankers have suggested that the company
recapitalize. Their suggestion is to issue enough new bonds at a yield of
10 percent to repurchase 1 million shares of common stock. Assume that the
stock can be repurchased at todays $40 stock price.
Assume that the repurchase will have no effect on the companys operating
income; however, the repurchase will increase the companys dollar interest
expense. Also, assume that as a result of the increased financial risk the
companys price earnings (P/E) ratio will be 11.5 after the repurchase.
Given these assumptions, what would be the expected year-end stock price if
the company proceeded with the recapitalization?
a.
b.
c.
d.
e.
$48.30
$42.56
$44.76
$40.34
$46.90
Answer: d
Diff: T
$106.67
$102.63
$ 77.14
$ 74.67
$ 70.40
Answer: d
Buchanan Brothers anticipates that its net income at the end of the year
will be $3.6 million (before any recapitalization). The company currently
has 900,000 shares of common stock outstanding and has no debt.
The
companys stock trades at $40 a share.
The company is considering a
recapitalization, where it will issue $10 million worth of debt at a yield
to maturity of 10 percent and use the proceeds to repurchase common stock.
Assume the stock price remains unchanged by the transaction, and the
companys tax rate is 34 percent. What will be the companys earnings per
share, if it proceeds with the recapitalization?
a.
b.
c.
d.
e.
$2.23
$2.45
$3.26
$4.52
$5.54
Diff: T
Answer: a
Diff: T
A
0.3
10%
B
0.7
14%
The firm will have total assets of $500,000, a tax rate of 40 percent, and
a book value per share of $10, regardless of the capital structure. EBIT is
expected to be $200,000 for the coming year. What is the difference in
earnings per share (EPS) between the two alternatives?
a.
b.
c.
d.
e.
$2.87
$7.62
$4.78
$3.03
$1.19
Answer: d
Diff: T
Chapter 13 - Page 18
Multiple Part:
(The following information applies to the next four problems.)
Copybold Corporation is a start-up firm considering two alternative capital
structures, one is conservative and the other aggressive. The conservative
capital structure calls for a D/A ratio = 0.25, while the aggressive strategy
calls for D/A = 0.75. Once the firm selects its target capital structure, it
envisions two possible scenarios for its operations: Feast or Famine. The Feast
scenario has a 60 percent probability of occurring and forecasted EBIT in this
state is $60,000. The Famine state has a 40 percent chance of occurring and
expected EBIT is $20,000. Further, if the firm selects the conservative capital
structure its cost of debt will be 10 percent, while with the aggressive capital
structure its debt cost will be 12 percent. The firm will have $400,000 in total
assets, it will face a 40 percent marginal tax rate, and the book value of equity
per share under either scenario is $10.00 per share.
Capital structure and EPS
57.
$
0
$1.48
$0.62
$0.98
$2.40
Answer: b
Diff: M
What is the difference between the EPS forecasts for Feast and Famine under
the conservative capital structure?
a.
b.
c.
d.
e.
$1.00
$0.80
$2.20
$0.44
$
0
Diff: M
What is the difference between the EPS forecasts for Feast and Famine under
the aggressive capital structure?
a.
b.
c.
d.
e.
58.
Answer: e
Answer: c
Diff: M
1.00
1.18
2.45
2.88
3.76
Answer: a
Diff: M
0.58
0.39
0.15
0.23
1.00
(The following information applies to the next three problems.)
$5 billion
Total assets
$5 billion
Debt
Common equity
Total debt & common equity
$1 billion
4 billion
$5 billion
The book value of the company (both debt and common equity) equals its market
value (both debt and common equity). Furthermore, the company has determined the
following information:
The
The
The
The
The
Answer: c
Diff: E
What is Fotopoulos
recapitalization)?
a.
b.
c.
d.
e.
0.6213
0.8962
0.9565
1.0041
1.2700
Chapter 13 - Page 20
current
Answer: c
unlevered
beta
(before
the
Diff: E
proposed
Answer: e
Diff: M
What will be the companys new cost of common equity if it proceeds with
the recapitalization? (Hint: Be sure that the beta you use is carried
out to 4 decimal places.)
a.
b.
c.
d.
e.
10.74%
11.62%
12.27%
12.62%
13.03%
(The following information applies to the next two problems.)
An analyst has
Corporation:
collected
the
following
information
regarding
the
Milbrett
Currently, the company has no debt or preferred stock and its interest expense
and preferred dividends equal zero. The book value and market value of common
equity equals $100 million.
The company has 5 million outstanding shares of
common stock, and its stock price is $20 a share.
Milbrett is considering a recapitalization, where they will issue $20 million of
debt and use the proceeds to buy back common stock at the current price of $20 a
share.
As a result of the recapitalization, the size of the firm will not
change.
Assume that the newly-issued debt will have a before-tax cost of
8 percent. Assume that the recapitalization will have no effect on the companys
basic earning power.
Capital structure, financial leverage, and ratios
64.
Diff: E
Answer: d
Answer: c
Diff: T
Assume that after the recapitalization the companys times-interestearned ratio will be 12.5.
What is Milbretts expected earnings per
share following the recapitalization?
a.
b.
c.
d.
e.
$2.44
$2.62
$2.76
$2.80
$2.88
Diff: E
Answer: c
Diff: M
0.43
0.93
1.00
1.06
1.44
Answer: c
What would be the companys new cost of common equity (using the CAPM) if
it were to change its capital structure to 40 percent debt and 60 percent
common equity?
(Note:
Here we are asking for the new cost of common
equity, not the WACC!)
a.
b.
c.
d.
e.
11.36%
12.62%
13.40%
14.30%
16.40%
(The following information applies to the next four problems.)
Chapter 13 - Page 22
Answer: c
Diff: E
Answer: b
Diff: M
Answer: d
Diff: M
0.4107
0.9583
1.0000
1.0147
1.3800
11.23%
11.71%
12.25%
12.67%
13.00%
Answer: c
Diff: M
$0.75
$2.46
$3.43
$4.04
$6.86
Answer: c
Diff: E
Medium:
Financial leverage
13A-2.
Diff: M
The use of financial leverage by the firm has a potential impact on which
of the following?
(1)
(2)
(3)
(4)
(5)
a.
b.
c.
d.
e.
The
The
The
The
The
1,
1,
2,
2,
1,
3,
2,
3,
3,
2,
Financial leverage
13A-3.
Answer: e
Answer: d
Diff: M
If a firm uses debt financing (Debt ratio = 0.40) and sales change from
the current level, which of the following statements is most correct?
a. The percentage change in net operating income (EBIT) resulting from
the change in sales will exceed the percentage change in net income
(NI).
b. The percentage change in EBIT will equal the percentage change in net
income.
c. The percentage change in net income relative to the percentage change
in sales (and in EBIT) will not depend on the interest rate paid on
the debt.
d. The percentage change in net operating income will be less than the
percentage change in net income.
e. Since debt is used, the degree of operating leverage must be greater
than 1.
Chapter 13 - Page 24
Financial risk
13A-4.
Answer: b
Diff: M
Answer: a
Diff: M
Answer: e
Diff: M
DOL
13A-7.
Answer: c
The degree of
characteristics?
operating
leverage
has
which
of
the
Diff: M
following
Answer: a
Diff: M
Degree of leverage
13A-9.
Answer: a
Diff: M
Chapter 13 - Page 26
of
the
Answer: a
Diff: E
13A-10. Maxvill Motors has annual sales of $15,000. Its variable costs equal 60
percent of its sales, and its fixed costs equal $1,000. If the companys
sales increase 10 percent, what will be the percentage increase in the
companys earnings before interest and taxes (EBIT)?
a.
b.
c.
d.
e.
12%
14%
16%
18%
20%
Answer: d
Diff: E
13A-11. Quick Launch Rocket Company, a satellite launching firm, expects its
sales to increase by 50 percent in the coming year as a result of NASA's
recent problems with the space shuttle. The firm's current EPS is $3.25.
Its degree of operating leverage is 1.6, while its degree of financial
leverage is 2.1. What is the firm's projected EPS for the coming year
using the DTL approach?
a.
b.
c.
d.
e.
$ 3.25
$ 5.46
$10.92
$ 8.71
$19.63
Change in EPS
Answer: b
Diff: E
13A-12. Your firm's EPS last year was $1.00. You expect sales to increase by 15
percent during the coming year. If your firm has a degree of operating
leverage equal to 1.25 and a degree of financial leverage equal to 3.50,
then what is its expected EPS?
a.
b.
c.
d.
e.
$1.3481
$1.6563
$1.9813
$2.2427
$2.5843
Medium:
DOL change
Answer: a
Diff: M
3.75
4.20
3.50
4.67
3.33
DOL
Answer: d
Diff: M
13A-14. The "degree of leverage" concept is designed to show how changes in sales
will affect EBIT and EPS. If a 10 percent increase in sales causes EPS
to increase from $1.00 to $1.50, and if the firm uses no debt, then what
is its degree of operating leverage?
a.
b.
c.
d.
e.
3.6
4.2
4.7
5.0
5.5
Answer: c
Diff: M
1.0
2.2
3.5
4.0
5.0
Chapter 13 - Page 28
Answer: c
Diff: M
1.15
1.00
1.22
1.12
2.68
Answer: d
Diff: M
13A-17. Coats Corp. generates $10,000,000 in sales. Its variable costs equal 85
percent of sales and its fixed costs are $500,000.
Therefore, the
companys operating income (EBIT) equals $1,000,000.
The company
estimates that if its sales were to increase 10 percent, its net income
and EPS would increase 17.5 percent.
What is the companys interest
expense? (Assume that the change in sales would have no effect on the
companys tax rate.)
a.
b.
c.
d.
e.
$100,000
$105,874
$111,584
$142,857
$857,142
DTL
Answer: e
Diff: M
1.714
3.100
3.250
3.500
6.000
Answer: e
Diff: M
13A-19. Bell Brothers has $3,000,000 in sales. Its fixed costs are estimated to
be $100,000, and its variable costs are equal to fifty cents for every
dollar of sales.
The company has $1,000,000 in debt outstanding at a
before-tax cost of 10 percent. If Bell Brothers' sales were to increase
by 20 percent, how much of a percentage increase would you expect in the
company's net income?
a.
b.
c.
d.
e.
15.66%
18.33%
19.24%
21.50%
23.08%
Expected EBIT
Answer: c
Diff: M
13A-20. Assume that a firm currently has EBIT of $2,000,000, a degree of total
leverage of 7.5, and a degree of financial leverage of 1.875. If sales
decline by 20 percent next year, then what will be the firm's expected
EBIT in one year?
a.
b.
c.
d.
e.
$2,400,000
$1,600,000
$ 400,000
$3,600,000
$1,350,000
Expected EBIT
Answer: d
Diff: M
13A-21. Assume that a firm has a degree of financial leverage of 1.25. If sales
increase by 20 percent, the firm will experience a 60 percent increase in
EPS, and it will have an EBIT of $100,000. What will be the EBIT for
this firm if sales do not increase?
a.
b.
c.
d.
e.
$113,412
$100,000
$ 84,375
$ 67,568
$ 42,115
Expected EBIT
Answer: e
Diff: M
$ 60,000
$175,000
$100,000
$ 90,000
$114,000
Chapter 13 - Page 30
Answer: d
Diff: M
13A-23. A company currently sells 75,000 units annually. At this sales level,
its EBIT is $4 million, and its degree of total leverage is 2.0. The
firm's debt consists of $15 million in bonds with a 9.5 percent coupon.
The company is considering a new production method which will entail an
increase in fixed costs but a decrease in variable costs, and will result
in a degree of operating leverage of 1.6.
The president, who is
concerned about the stand-alone risk of the firm, wants to keep the
degree of total leverage at 2.0.
If EBIT remains at $4 million, what
amount of bonds must be retired to accomplish this?
a.
b.
c.
d.
e.
$8.42
$9.19
$7.63
$6.58
$4.44
million
million
million
million
million
Tough:
Financial leverage, DOL, and DTL
Answer: a
Diff: T
13A-24. A company has an EBIT of $4 million, and its degree of total leverage is
2.4. The firms debt consists of $20 million in bonds with a 10 percent
yield to maturity. The company is considering a new production process
that will require an increase in fixed costs but a decrease in variable
costs. If adopted, the new process will result in a degree of operating
leverage of 1.4.
The president wants to keep the degree of total
leverage at 2.4.
If EBIT remains at $4 million, what amount of bonds
must be outstanding to accomplish this (assuming the yield to maturity
remains at 10 percent)?
a.
b.
c.
d.
e.
$16.7
$18.5
$19.2
$19.8
$20.1
million
million
million
million
million
Answer: c
Diff: T
13A-25. Lincoln Lodging Inc. estimates that if its sales increase 10 percent then
its net income will increase 18 percent. The companys EBIT equals $2.4
million, and its interest expense is $400,000. The companys operating
costs include fixed and variable costs.
What is the level of the
companys fixed operating costs?
a.
b.
c.
d.
e.
$ 450,000
$ 666,667
$1,200,000
$2,000,000
$2,125,000
CHAPTER 13
ANSWERS AND SOLUTIONS
1.
Business risk
Answer: c
Diff: E
2.
Business risk
Answer: d
Diff: E
3.
Business risk
Answer: d
Diff: E
Answer: d
Diff: E
5.
Answer: e
Diff: E
maximizes
the
firms
stock
price
and
6.
Answer: c
Diff: E
7.
Answer: e
Diff: E
8.
Answer: e
Diff: E
9.
Answer: d
Diff: E
Both an increase in the corporate tax rate and a decrease in the companys
degree of operating leverage will encourage the firm to use more debt in
its capital structure. Therefore, the correct choice is statement d.
10.
Answer: e
Diff: E
Statement e is the correct choice. Lowering the corporate tax rate reduces
the tax advantages of debt leading firms to use less debt financing. If
the personal tax rate were to increase, individuals would now find interest
received on corporate debt less attractive, causing firms to utilize less
debt financing. An increase in the costs of bankruptcy would lead firms to
use less debt in order to reduce the probability of having to incur these
higher costs.
11.
Answer: e
Diff: E
Statement e is correct. Less stable sales would lead a firm to reduce its
debt ratio. A lower corporate tax rate reduces the tax advantage of the
deductibility of interest expense.
This reduction in the tax shield
provided by debt would encourage less use of debt. If management believes
the firms stock is overvalued, then it would want to issue equity rather
than debt, thereby increasing the firms equity ratio.
Chapter 13 - Page 32
12.
Answer: a
Diff: E
Statement a is correct; all the other statements are false. Since interest
is tax deductible, it would make sense to increase debt if the corporate
tax rate rises.
Interest received by individual investors is not tax
exempt, so an increase in the personal tax rate would not encourage a firm
to increase its debt level in the capital structure. Increasing operating
leverage would discourage a company from increasing debt. If a companys
assets become less liquid, it would hurt the companys financial position,
making it less likely that the firm could make interest payments when
necessary. An increase in expected bankruptcy costs would encourage a
company to use less debt.
13.
Answer: e
Diff: E
If the costs incurred when filing for bankruptcy increased, firms would be
penalized more if they filed for bankruptcy and would be less willing to
take that risk.
Therefore, they would reduce debt levels to help avoid
bankruptcy risk, so statement a is false. An increase in the corporate tax
rate would mean that firms would get larger tax breaks for interest
payments.
Therefore, firms have an incentive to increase interest
payments, in order to reduce taxes. Therefore, they will increase their
debt ratios, so statement b is true. An increase in the personal tax rate
decreases the after-tax return that investors will receive.
Firms will
have to issue debt at higher interest rates in order to provide investors
with the same after-tax returns they used to receive.
This will raise
firms costs of debt, which will increase their WACCs, so firms will not
increase their debt ratios. Therefore, statement c is false. If a firms
business risk decreases, then this will tend to increase its debt ratio.
Therefore, statement d is true. Since both statements b and d are true, the
correct choice is statement e.
14.
Answer: a
Diff: E
15.
Answer: c
Diff: E
Answer: e
Diff: E
Answer: c
Diff: E
k
WACC
D/A ratio
Statement a is false. The WACC does not necessarily increase. Remember,
you are replacing high cost equity with low cost debt. When there is very
little debt in the capital structure, the WACC will actually decrease.
(See the diagram above.) The capital structure that maximizes stock price
is not necessarily the capital structure that maximizes EPS, so statement b
is false.
If the corporate tax rate increases, companies will obtain a
bigger tax advantage for their interest payments. Thus, they may increase
their debt levels to take advantage of this situation, and this would raise
debt ratios. Therefore, the correct answer is statement c.
Chapter 13 - Page 34
18.
Answer: e
Diff: E
Statement a is false; if you are to the left of the firms optimal capital
structure on the WACC curve, increasing a companys debt ratio will
actually decrease the firms WACC. Statement b is false; if you are to the
right of the firms optimal capital structure on the WACC curve, increasing
a companys debt ratio will actually increase the firms WACC. Statement c
is false; as you increase the firms debt ratio the cost of debt will
increase because youre using more debt. Because youre using more debt the
cost of equity also increases because the firms financial risk has
increased. From statements a and b you can see that whether the WACC is
increased depends on where you are on the WACC curve relative to the firms
optimal capital structure. Therefore, the correct answer is statement e.
19.
Answer: d
Diff: E
Answer: a
Diff: E
Answer: d
Diff: E
Answer: c
Diff: E
23.
Answer: a
Diff: E
Statement a is true; a higher EPS does not always mean that the stock price
will increase. Statement b is false; a lower WACC will mean a higher stock
price.
Statement c is false; EPS can increase just because shares
outstanding decline.
(The firms net income will decline because its
interest expense increases.)
24.
Answer: c
Diff: E
Answer: d
Diff: E
BEP = EBIT/TA. Since they both have the same total assets and the same
BEP, then EBIT must be the same for both companies. If A has a higher debt
ratio and higher interest expense than B, and they both have the same EBIT
and tax rate, then A must have a lower NI than B. Therefore, statement a
is true. If A has a lower NI than B but both have the same total assets,
then As ROA (NI/TA) must be lower than Bs ROA. Therefore, statement b is
true. If both companies have the same total assets but As debt ratio is
higher than Bs, then As equity must be lower (since Total assets = Total
debt + Total equity). If A has less equity, and a lower NI than B, it is
not possible to judge which companys ROE (NI/EQ) is higher.
26.
Answer: b
Diff: E
BEP = EBIT/TA.
If both firms have the same BEP ratio and same total
assets, then they must have the same EBIT. Since Firm U has no debt in its
capital structure, Firm U will have higher net income than Firm L because U
has no interest expense and L does. The TIE ratio is EBIT/Int. If the two
companies have the same EBIT, the one with the lower interest expense (Firm
U), will have a higher TIE. Therefore, statement a is false. Firms L and
U have the same EBIT, but Firm L has a higher interest expense, so its net
income will be lower than Firm U. Since ROA is equal to NI/TA, and the two
firms have the same total assets, Firm L will have a lower ROA than Firm U.
Therefore, statement b is true. Leverage will increase ROE if BEP > kd.
Since BEP is 20 percent and kd is 8 percent, leverage will increase Firm
Ls ROE. Therefore, statement c is false.
27.
Answer: d
Diff: M
28.
Answer: e
Diff: M
29.
Answer: c
Diff: M
30.
Limits of leverage
Answer: d
Diff: M
31.
Signaling theory
Answer: b
Diff: M
32.
Answer: d
Diff: M
Answer: b
Diff: M
Answer: a
Diff: M
Statement a is true; the other statements are false. If the personal tax
rate were increased, investors would prefer to receive less of their income
as interest--implying firms would substitute equity for debt. High business
risk is associated with high operating leverage; therefore, firms with high
business risk would use less debt.
35.
Answer: c
Diff: M
If corporate tax rates were decreased while other things were held
constant, and if the MM tax-adjusted tradeoff theory of capital structure
were correct, corporations would decrease their use of debt because the tax
shelter benefit would not be as great as when tax rates are high. Business
risk is the riskiness of the firms operations if it uses no debt. The
optimal capital structure does not maximize EPS, and the degree of total
leverage shows how a given change in sales will affect earnings per share.
36.
Answer: d
Diff: T
37.
Answer: e
Diff: E
Answer: a
Diff: E
EBIT
$95,000
$205,000
$205,000
P
38.
=
=
=
=
=
PQ - VQ - FC
P(55,000) - (0.4)P(55,000) - $110,000
(0.6)(55,000)P
33,000P
$6.21.
Breakeven price
Total costs = $10,000 + $2(42,000) = $94,000.
Price = $94,000/42,000 = $2.24.
39.
New financing
Answer: a
Diff: M
41.
1
2
Answer: b
Diff: M
Answer: b
Diff: M
= $1.00(Q) + $10,000.
= $1.50(Q) + $5,000.
solve for Q:
$1.50(Q) + $5,000
$0.5(Q)
Q.
Calculate the old and new breakeven volumes using the old data and new
projections:
Old QBE = $120,000/($1.20 - $0.60) = $120,000/$0.60 = 200,000 units.
New QBE = $240,000/($1.05 - $0.41) = $240,000/$0.64 = 375,000 units.
Change in breakeven volume = 375,000 - 200,000 = 175,000 units.
42.
Chapter 13 - Page 38
Answer: c
Diff: M
43.
Breakeven
Answer: d
Diff: M
$7(200,000) - $5(200,000) - F = 0
F = $400,000.
$7(200,000) - $4(200,000) - F = 0
F = $600,000.
$600,000 - $400,000 = $200,000.
44.
Operating decision
Answer:
Diff: M
Answer: c
Before recap.
$300,000
-10,000
$290,000
116,000
$174,000
120,000
$174,000/120,000 = $1.45.
$17.40/1.45 = 12.
before
and
Diff: M
after
the
After recap.
$300,000
-50,000
$250,000
100,000
$150,000
100,000*
$150,000/100,000 = $1.50.
46.
47.
Answer: e
Diff: M
Step 1:
Step 2:
Step 3:
Step 4:
Answer: a
Diff: T
Step 1:
Step 2:
Find the
b =
1.2 =
1.2 =
1.0435 =
Step 3:
Find the new levered beta given the new capital structure using
the Hamada equation:
b = bU[1 + (1 - T)(D/E)]
b = 1.0435[1 + (0.6)(1)]
b = 1.6696.
Step 4:
Find
ks =
ks =
ks =
Chapter 13 - Page 40
the firms new cost of equity given its new beta and the CAPM:
kRF + RPM(b)
6% + 5%(1.6696)
14.35%.
48.
Answer: d
Diff: T
kRF = 5%; kM - kRF = 6%; ks = kRF + (kM - kRF)b; WACC = wdkd(1 - T) + wcks.
You need to use the D/E ratio given for each capital structure to find the
levered beta using the Hamada equation. Then, use each of these betas with
the CAPM to find the ks for that capital structure. Use this ks and kd for
each capital structure to find the WACC. The optimal capital structure is
the one that minimizes the WACC.
(D/E)
b = bU[1 + (1 - T)(D/E)]
0.11
0.25
0.43
0.67
1.00
1.0667
1.1500
1.2571
1.4000
1.6000
wc
kd
0.9
0.8
0.7
0.6
0.5
7.0%
7.2
8.0
8.8
9.6
wd
WACC
0.1
0.2
0.3
0.4
0.5
10.68%
10.38
10.22
10.15
10.18
Answer: d
Diff: T
The optimal capital structure maximizes the firms stock price. When the
debt ratio is 20%, expected EPS is $2.50.
Given the firms policy of
retaining 30% of earnings, the expected dividend per share D1 is $2.50
0.70 = $1.75. The stock price P0 is $1.75/(15% - 7%) or $21.88. When the
debt ratio is 30%, expected EPS is $3.00 and expected D1 is $3.00 0.70 =
$2.10. The stock price P0 is $2.10/(15.5% - 7%) = $24.71. Similarly, when
the debt ratio is 40%, D1 = $2.275 and P0 = $25.28. When the debt ratio is
50%, D1 = $2.625 and P0 = $26.25. When the debt ratio is 70%, D1 = $2.80
and P0 = $25.45. The stock price is highest when the debt ratio is 50%.
50.
Answer: b
Diff: T
First, calculate the stock price for each debt level using the dividend
growth model, P0 = D1/(kS - g):
Debt
0%
25
40
50
75
Div/share
$5.50
6.00
6.50
7.00
7.50
kS
11.5%
12.0
13.0
14.0
15.0
P0
$5.50/(0.115 - 0.02)
$6.00/(0.12 - 0.02)
$6.50/(0.13 - 0.02)
$7.00/(0.14 - 0.02)
$7.50/(0.15 - 0.02)
=
=
=
=
=
$57.89.
$60.00.
$59.09.
$58.33.
$57.69.
Clearly, $60.00 is the highest price, so 25% debt and 75% equity is the
optimal capital structure.
Chapter 13- Page 41
51.
Answer: a
Diff: T
First, find the companys current cost of capital, dividends per share, and
stock price:
ks = 0.066 + (0.06)0.9 = 12%. To find the stock price, you still need the
dividends per share or DPS = ($2,000,000(1 - 0.4))/200,000 = $6.00. Thus,
the stock price is P0 = $6.00/0.12 = $50.00. Thus, by issuing $2,000,000
in new debt the company can repurchase $2,000,000/$50.00 = 40,000 shares.
Now after recapitalization, the new cost of capital, DPS, and stock price
can be found:
ks = 0.066 + (0.06)1.1 = 13.20%. DPS for the remaining (200,000 - 40,000) =
160,000 shares are thus [($2,000,000 - ($2,000,000 0.10))(1 - 0.4)]/
160,000 = $6.75. And, finally, P0 = $6.75/0.132 = $51.14.
52.
Answer: a
Diff: T
$20,000,000
6,000,000
$14,000,000
5,600,000
$ 8,400,000
P/E = 11.5.
P0 = ($4.20)(11.5) = $48.30.
Answer: d
Diff: T
The bonds used in the repurchase will create a new interest expense for the
company. This will change net income. Dividends per share will change
because net income changes and the number of shares outstanding changes.
New interest expense: $800,000 8% = $64,000.
New net income: ($2,000,000 - $64,000)(1 - 0.3) = $1,355,200.
Shares repurchased: $800,000/80 = 10,000 shares.
New shares outstanding: 175,000 - 10,000 = 165,000 shares.
New dividends per share: $1,355,200/165,000 = $8.2133.
We must also calculate a new cost of equity: 5% + (5%)1.2 = 11%.
New stock price: $8.21/11% = $74.67.
Chapter 13 - Page 42
54.
Answer: d
Diff: T
Answer: a
Diff: T
Answer: d
Diff: T
You need to find the beta with no debt and the new ks with the new capital
structure before you can calculate the firms WACC.
Step 1:
Step 2:
Calculate the firms new beta with the new capital structure:
bL = bU[1 + (1 - T)(D/E)]
bL = 0.954545[1 + (0.6)($5/$5)]
bL = 1.5273.
Step 3:
Calculate the firms new cost of equity with the new capital
structure:
ks = kRF + (RP)b
ks = 6% + 7%(1.5273)
ks = 16.6909%.
Step 4:
57.
Answer: e
Diff: M
Debt = 75% = $300,000; Equity = 25% = $100,000; BVPS = $10; Total assets =
$400,000.
Probability
EBIT
Less: Interest
EBT
Less: Taxes (40%)
NI
# shares
EPS
Feast
0.6
$60,000
36,000
$24,000
9,600
$14,400
10,000
$1.44
Famine
0.4
$20,000
36,000
($16,000)
(6,400)
($ 9,600)
10,000
-$0.96
Answer: b
Diff: M
Debt = 25% = $100,000; Equity = 75% = $300,000; BVPS = $10; Total assets =
$400,000.
Probability
EBIT
Less: Interest
EBT
Less: Taxes (40%)
NI
# shares
EPS
Feast
0.6
$60,000
10,000
$50,000
20,000
$30,000
30,000
$1.00
Famine
0.4
$20,000
10,000
$10,000
4,000
$ 6,000
30,000
$0.20
Answer: c
Diff: M
Chapter 13 - Page 44
60.
Answer: a
Diff: M
Answer: c
Diff: E
First, we will calculate the cost of common equity and then use that to
solve for the WACC.
ks = kRF + (kM - kRF)b
ks = 5% + (6%)1.1
ks = 11.6%.
WACC = wdkd(1 - T) + wcks
WACC = (0.2)(7.5%)(1 - 0.4) + (0.8)(11.6%)
WACC = 10.18%.
62.
Answer: c
Diff: E
To unlever the beta, we must use the Hamada equation, substituting the
known values.
bL
1.1
1.1
bU
63.
=
=
=
=
bU[1 + (1 - T)(D/E)]
bU[1 + (1 - 0.4)(1/4)]
bU[1.15]
0.9565.
Answer: e
Diff: M
First, we must find the levered beta after the recapitalization, using
the unlevered beta calculated in the previous problem.
bL
bL
bL
bL
=
=
=
=
bU[1 + (1 - T)(D/E)]
0.9565[1 + (1 - 0.4)(2/3)]
0.9565[1.4]
1.3391.
64.
Answer: d
Diff: E
Answer: c
Diff: T
66.
Step 1:
Step 2:
Determine the firms interest expense, given the TIE and EBIT:
EBIT
TIE =
Interest
$20,000,000
12.5 =
Interest
12.5Interest = $20,000,000
$1,600,000 = Interest.
Step 3:
Step 4:
Step 5:
net income:
$20,000,000
1,600,000
$18,400,000
7,360,000
$11,040,000
bU[1 + (1 - T)(D/E)]
bU[1 + (0.60)(0.25/0.75)]
bU[1.2]
1.00.
Chapter 13 - Page 46
Answer: c
Diff: E
67.
Answer: c
Diff: M
68.
Step 1:
Calculate the new levered beta using the Hamada equation and the
unlevered beta calculated previously:
bL = bU[1 + (1 - T)(D/E)]
bL = 1.00[1 + (0.60)(0.40/0.60)]
bL = 1.40.
Step 2:
Calculate the new cost of equity using the CAPM equation and the
new levered beta:
ks = 5% + (6%)1.40 = 13.40%.
Answer: c
Diff: E
Answer: b
Diff: M
Answer: d
Diff: M
=
=
=
=
bU[1 + (1 - T)(D/E)]
bU[1 + (0.6)(0.25/0.75)]
bU[1.2]
bU.
Calculate the new levered beta for the firm, using the new
capital structure:
bU = 0.9583; New D = 50%; New E = 50%; T = 40%.
bL = bU[1 + (1 - T)(D/E)]
= 0.9583[1 + (0.60)(0.50/0.50)]
= 1.5333.
Step 2:
71.
Diff: M
Step 2:
Answer: c
$300,000
200,000
$100,000
40,000
$ 60,000
(given)
(given)
Chapter 13 - Page 48
Answer: c
Diff: E
13A-2.
Financial leverage
Answer: e
Diff: M
13A-3.
Financial leverage
Answer: d
Diff: M
13A-4.
Financial risk
Answer: b
Diff: M
13A-5.
Answer: a
Diff: M
13-6.
Answer: e
Diff: M
13-7.
DOL
Answer: c
Diff: M
13-8.
Answer: a
Diff: M
Statement a is correct; the other statements are false. After the sales
increase, the percentage increase in EBIT will be the same for both
companies. Company E's net income will rise by exactly 10%.
13-9.
Degree of leverage
Answer: a
Diff: M
Answer: a
Diff: E
Answer: d
Diff: E
Answer: b
Diff: E
EPS1 = ?
= EPS0[1.0 + (DTL)(%Sales)]
= $1.00[1.0 + (4.375)(0.15)]
= $1.00(1.6563) = $1.6563.
Chapter 13- Page 49
Answer: a
Diff: M
Calculate DOL using new sales, new variable cost percentage, and new
fixed costs:
S0 = $75,000,000; FC0 = $40,000,000; VC = 0.30(S0) = $22,500,000.
S1 = $100,000,000; FC1 = $55,000,000; VC = 0.25(S1) = $25,000,000.
DOL (In millions):
DOLS =
100 - 25
75
=
= 3.75.
100 - 25 - 55
20
13-14. DOL
Answer: d
Diff: M
Answer: c
Diff: M
Use the information provided and the formula for DOL in sales dollars:
DOLS =
150,000($4) - 0.3(150,000)($4)
150,000($4) - 0.3(150,000)($4) - 0.5(150,000)($4)
$600,000 $180,000
$600,000 $180,000 $300,000
$420,000
DOLS =
= 3.5.
$120,000
DOLS =
Alternate method:
Express P as 1.0 or 100% of price and V and FC as a percent of price:
Q(P V)
150,000(1.0 - 0.3)
0.7
DOLQ =
=
=
= 3.50.
150,000[(1.0 - 0.3) - 0.5]
0.2
Q(P V) FC
13-16. DOL, DFL, and DTL
Answer: c
Diff: M
Chapter 13 - Page 50
Answer: d
Diff: M
Answer: e
Diff: M
Answer: e
Diff: M
S VC
S VC FC I
$10,000,000 $8,500,000
$10,000,000 $8,500,000 $500,000 I
$1,500,000
$1,000,000 I
$1,750,000 - 1.75I
$142,857.14 $142,857.
13-18. DTL
DTL = (S - VC)/(EBIT - I)
= ($3,000,000 - $1,800,000)/($700,000 - $500,000)
= 6.
13-19. DTL and change in NI
Step 1:
$3,000,000 - 0.5($3,000,000)
$3,000,000 - 0.5($3,000,000) - $100,000 - 0.1($1,000,000)
$1,500,000
$1,300,000
= 1.1538.
=
Step 2:
Answer: c
Diff: M
DOL = DTL/DFL
= 7.5/1.875 = 4.0.
EBIT = (-0.20)(4.0)($2,000,000) = -$1,600,000.
EBIT = $2,000,000 - $1,600,000 = $400,000.
Answer: d
Diff: M
Answer: e
Diff: M
Answer: d
DTL = (DOL)(DFL)
2.0 = 1.6(DFL)
1.25 = DFL.
1.25 =
$4,000,000
$4,000,000 - I
$800,000
= $8,421,053.
0.095
Chapter 13 - Page 52
Diff: M
Answer: a
Diff: T
Answer: c
Diff: T
% Sales
% EBIT
% EPS
% Sales
18%
=
10%
DTL = 1.8.
DFL = $2,400,000/($2,400,000 - $400,000)
= 1.2.
Given DTL = DFL DOL, we can calculate DOL = 1.5. Recognizing S - VC - FC
= EBIT, 1.5 = (S - VC)/$2,400,000 or S - VC = $3,600,000. The difference
between (S - VC) and EBIT must represent fixed operating costs. Thus, FC =
$3,600,000 - $2,400,000 = $1,200,000.