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Exam 14: Capital Structure and Leverage

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Question 1

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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.

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Question 2

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If a firm utilizes debt financing,a 10% decline in earnings before interest and taxes (EBIT)will result in a decline in earnings per share that is larger than 10%,and the higher the debt ratio,the larger this difference will be.

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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.

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.

Your firm's debt ratio is only 5.00%,but the new CFO thinks that more debt should be employed.She wants to sell bonds and use the proceeds to buy back and retire common shares so the percentage of common equity in the capital structure (w_c) = 1 - w_d.Other things held constant,and based on the data below,if the firm increases the percentage of debt in its capital structure (w_d) to 60.0%,by how much would the ROE change,i.e. ,what is ROE_New - ROE_Old? Do not round your intermediate calculations. ​

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 is CORRECT?

Southeast U's campus book store sells course packs for $15.00 each,the variable cost per pack is $12.00,fixed costs for this operation are $300,000,and annual sales are 110,000 packs.The unit variable cost consists of a $3.00 royalty payment,V_R ,per pack to professors plus other variable costs of V_O = $9.00.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? Do not round your intermediate calculations.

Gator Fabrics Inc.currently has zero debt .It is a zero growth company,and additional firm data are shown below.Now the company is considering using some debt,moving to the new capital structure indicated below.The money raised would be used to repurchase stock at the current price.It is estimated that the increase in risk resulting from the additional leverage would cause the required rate of return on equity to rise somewhat,as indicated below.If this plan were carried out,by how much would the WACC change,i.e. ,what is WACC_Old - WACC_New? Do not round your intermediate calculations. ​

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 $25.50 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? Do not round your intermediate calculations.(Hint: Find BE_B - BE_A) ​

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.

A major contribution of the Miller model is that it demonstrates,other things held constant,that

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.

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

Senate Inc.is considering two alternative methods for producing playing cards.Method 1 involves using a machine with a fixed cost (mainly depreciation) of $12,500 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) ?

The Miller model begins with the Modigliani and Miller (MM)model with corporate taxes and then adds personal taxes.

Companies HD and LD have identical amounts of assets,investor-supplied capital,operating income (EBIT) ,tax rates,and business risk.Company HD,however,has a higher debt ratio than LD.Company HD's return on investors' capital (ROIC) exceeds its after-tax cost of debt,r_d(1 - T) .Which of the following statements is CORRECT?

Firms HD and LD are identical except for their use of debt and the interest rates they pay--HD has more debt and thus must pay a higher interest rate.Both companies are small,so they are not subject to the interest deduction limitation.Based on the data given below,how much higher or lower will HD's ROE be versus that of LD,i.e. ,what is ROE_HD - ROE_LD? Do not round your intermediate calculations. ​

Which of the following statements is CORRECT?

You work for the CEO of a new company that plans to manufacture and sell a new type of laptop computer.The issue now is how to finance the company,with only equity or with a mix of debt and equity.Expected operating income is $620,000.Other data for the firm are shown below.How much higher or lower will the firm's expected EPS be if it uses some debt rather than only equity,i.e. ,what is EPS_L - EPS_U? ​