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Exam 12: Capital Structure

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Question 1

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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) 3.6
B) 4.2
C) 4.7
D) 5.0
E) 5.5

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Question 2

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The optimal capital structure is the one that maximizes __________,and this will always be lower than the debt/equity ratio that maximizes __________.

A) expected EPS; the firm's stock price
B) net income, expected EPS
C) book value of the firm; net income
D) expected EPS; book value of the firm
E) the firm's stock price; expected EPS

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Question 3

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If a firm uses no debt,the uncertainty inherent in projections of future returns on equity can be described as business risk.

Calculate the current price per share (P0) for Olson Corporation,given the following information.The data all pertain to the year just ended.

The firm's target capital structure is consistent with which of the following?

Generally speaking,companies in Italy and Japan use less debt in their capital structure than companies in the United States or Canada.

As a general rule,the capital structure that

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.

Allyson,who is the CFO of Mundane Minerals & Mining (MMM) ,is trying to decide whether to issue debt or common stock to finance the capital budgeting projects she has evaluated as acceptable (that is,the projects have positive net present values,NPV) .Because MMM is a relatively small company,Allyson believes that the type of capital she uses to finance the projects will send a signal to investors.As a result,which of the following actions would you recommend Allyson take?

As the percentage of debt in a firm's capital structure increases,its financial risk increases.Once the firm increases its debt beyond the optimal level,rising interest charges result in an immediate decrease in EPS.

The degree of financial risk is the single most important determinant of a firm's capital structure.

Although the exact relationship between a firm's degree of financial leverage and its beta is difficult to estimate,it has been shown both theoretically and empirically that a firm's beta increases with its degree of financial leverage.

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?

The probability of incurring bankruptcy increase as the firm increases as the debt/equity ratio decreases.

Which of the following factors affects business risk?

The central result from the work of Miller and Modigliani (MM)and subsequent researchers,is that it is now possible to precisely identify a firm's optimal capital structure.

The combination of debt and equity that maximizes a firm's value is known as the

Which of the following is correct?

The weighted average cost of capital (WACC)declines as more of the lowest cost component is added.What limits a firm from using nearly all debt is that as the debt ratio rises,the absolute interest expense gets very large.The large interest expense reduces income and results in a debt ratio limit even though the WACC continues to decline.

According to the signaling theory of capital structure,the issuance of equity for a firm with various financing alternatives signals that the firm has very favorable prospects which it wants to share with new shareholders.