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Exam 14: Capital Structure and Leverage

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Question 31

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Which of the following events is likely to encourage a company to raise its target debt ratio,other things held constant?

A) An increase in the corporate tax rate.
B) An increase in the personal tax rate.
C) An increase in the company's operating leverage.
D) The Federal Reserve tightens interest rates in an effort to fight inflation.
E) The company's stock price hits a new high.

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Question 32

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Companies HD and LD have identical tax rates,total assets,total investor-supplied capital,and returns on investors' capital (ROIC) ,and their ROICs exceed their after-tax costs of debt,r_d(1 - T) .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.

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Question 33

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Other things held constant,an increase in financial leverage will increase a firm's market (or systematic)risk as measured by its beta coefficient.

Which of the following statements is CORRECT?

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.

Your girlfriend plans to start a new company to make a new type of cat litter.Her father will finance the operation,but she will have to pay him back.You are helping her,and the issue now is how to finance the company,with equity only or with a mix of debt and equity.The price per unit will be $10.00 regardless of how the firm is financed.The expected fixed and variable operating costs,along with other information,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? Do not round your intermediate calculations. $\begin{array}{lrr}&0 \% \text { Debt, U }&60 \% \text { Debt, L }\\\hline\text { Expected unit sales } & 290,000 & 290,000 \\\text { Price per unit } & \$ 10.00 & \$ 10.00 \\\text { Fixed costs } & \$ 1,000,000 & \$ 1,000,000 \\\text { Variable cost/unit } & \$ 3.50 & \$ 3.50 \\\text { Required investment } & \$ 2,500,000 & \$ 2,500,000 \\\text { Shares issued at } \$ 10 / \text { share } & 250,000 & 100,000 \\\% \text { Debt } & 0.00 \% & 60.00 \% \\\text { Debt, } \$ & \$ 0 & \$ 1,500,000 \\\text { Equity, } \$ & \$ 2,500,000 & \$ 1,000,000 \\\text { Interest rate } & \mathrm{NA} & 10.00 \% \\\text { Tax rate } & 35.00 \% & 35.00 \%\end{array}$ ?

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.

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

Southwest U's campus book store sells course packs for $19 each.The variable cost per pack is $12,and at current annual sales of 43,000 packs,the store earns $75,000 before taxes on course packs.How much are the fixed costs of producing the course packs?

Which of the following statements is CORRECT?

If a firm borrows money,it is using financial leverage.

Some people--including the former chairman of the Federal Reserve Board of Governors (Ben Bernanke)--have argued that one advantage of corporate debt from the stockholders' standpoint is that the existence of debt forces managers to focus on cash flow and to refrain from spending too much of the firm's money on private plane and other "perks." This is one of the factors that led to the rise of LBOs and private equity firms.

As a consultant to First Responder Inc. ,you have obtained the following data (dollars in millions) .The company plans to pay out all of its earnings as dividends,hence g = 0.Also,no net new investment in operating capital is needed because growth is zero.The CFO believes that a move from zero debt to 80.0% debt would cause the cost of equity to increase from 10.0% to 12.0%,and the interest rate on the new debt would be 9.0%.What would the firm's total market value be if it makes this change? Hints: Find the FCF,which is equal to NOPAT = EBIT(1 - T) because no new operating capital is needed,and then divide by (WACC - g) .Do not round your intermediate calculations. $\begin{array}{lrlr}\text { Oper income (EBIT) } & \$ 800 & \text { Tax rate } & 40.0 \% \\\text { New cost of equity }\left(\mathrm{r}_{\mathrm{s}}\right) & 12.00 \% & \text { New wd } & 80.0 \% \\\text { Interest rate }\left(\mathrm{r}_{\mathrm{d}}\right) & 9.00 \% & &\end{array}$ ?

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.

Which of the following statements is CORRECT?

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 (w_d) 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 EPS_High - EPS_Low? Do not round your intermediate calculations. $\begin{array}{lclclc}\text { Applicable to Both Firms }&&\text { Firm High's Data }&&\text { Firm Low's Data }\\\text { Capital } & \$ 3,000,000 & \mathrm{w}_{\mathrm{d}} & 70 \% & \mathrm{w}_{\mathrm{d}} & 20 \% \\\text { EBIT } & \$ 565,000 & \text { Shares } & 90,000 & \text { Shares } & 240,000 \\\text { Tax rate } & 35 \% & \text { Int. rate } & 12 \% & \text { Int. rate } & 10 \%\end{array}$ ?

Your uncle is considering investing in a new company that will produce high quality stereo speakers.The sales price would be set at 1.70 times the variable cost per unit;the variable cost per unit is estimated to be $75.00;and fixed costs are estimated at $1,170,000.What sales volume would be required to break even,i.e. ,to have EBIT = zero?

In a world with no taxes,Modigliani and Miller (MM)show that a firm's capital structure does not affect its value.However,when taxes are considered,MM show a positive relationship between debt and value,i.e. ,the firm's value rises as it uses more and more debt,other things held constant.

A firm's capital structure does not affect its free cash flows as discussed in the text,because FCF reflects only operating cash flows,which are available to service debt,to pay dividends to stockholders,and for other purposes.

Which of the following statements is CORRECT?