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Exam 16: Capital Structure Decisions

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Question 1

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Companies HD and LD have identical tax rates,total assets,and basic earning power ratios,and their basic earning power exceeds their before-tax cost of debt,r_d.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 lower ROA than Company LD.
B) Company HD has a lower ROE than Company LD.
C) The two companies have the same ROA.
D) The two companies have the same ROE.
E) Company HD has a higher net income than Company LD.

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Question 2

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Which of the following statements is CORRECT?

A) A change in the personal tax rate should not affect firms' capital structure decisions.
B) "Business risk" is differentiated from "financial risk" by the fact that financial risk reflects only the use of debt, while business risk reflects both the use of debt and such factors as sales variability, cost variability, and operating leverage.
C) The optimal capital structure is the one that simultaneously (1) maximizes the price of the firm's stock, (2) minimizes its WACC, and (3) maximizes its EPS.
D) If changes in the bankruptcy code make bankruptcy less costly to corporations, then this would likely reduce the debt ratio of the average corporation.
E) If corporate tax rates were decreased while other things were held constant, and if the Modigliani-Miller tax-adjusted tradeoff theory of capital structure were correct, this would tend to cause corporations to decrease their use of debt.

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Question 3

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Exhibit 16.3 Best Bagels, Inc. (BB) currently has zero debt. Its earnings before interest and taxes (EBIT) are $100,000, and it is a zero growth company. BB's current cost of equity is 13%, and its tax rate is 40%. The firm has 20,000 shares of common stock outstanding selling at a price per share of $23.08. -Refer to Exhibit 16.3.Now assume that BB is considering changing from its original capital structure to a new capital structure with 45% debt and 55% equity.This results in a weighted average cost of capital equal to 10.4% and a new value of operations of $576,923.Assume BB raises $259,615 in new debt and purchases T-bills to hold until it makes the stock repurchase.What is the stock price per share immediately after issuing the debt but prior to the repurchase?

Which of the following statements is CORRECT?

Exhibit 16.1 Pennewell Publishing Inc. (PP) is a zero growth company. It currently has zero debt and its earnings before interest and taxes (EBIT) are $80,000. PP's current cost of equity is 10%, and its tax rate is 40%. The firm has 10,000 shares of common stock outstanding selling at a price per share of $48.00. -Refer to Exhibit 16.1.Assume that PP is considering changing from its original capital structure to a new capital structure with 35% debt and 65% equity.This results in a weighted average cost of capital equal to 9.4% and a new value of operations of $510,638.Assume PP raises $178,723 in new debt and purchases T-bills to hold until it makes the stock repurchase.What is the stock price per share immediately after issuing the debt but prior to the repurchase?

It is possible that two firms could have identical financial and operating leverage,yet have different degrees of risk as measured by the variability of EPS.

Which of the following would increase the likelihood that a company would increase its debt ratio,other things held constant?

Based on the information below for Benson Corporation,what is the optimal capital structure?

Which of the following statements is CORRECT?

Different borrowers have different risks of bankruptcy,and bankruptcy is costly to lenders.Therefore,lenders charge higher rates to borrowers judged to be more at risk of going bankrupt.

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

Exhibit 16.4 The Anson Jackson Court Company (AJC) currently has $200,000 market value (and book value) of perpetual debt outstanding carrying a coupon rate of 6%. Its earnings before interest and taxes (EBIT) are $100,000, and it is a zero growth company. AJC's current cost of equity is 8.8%, and its tax rate is 40%. The firm has 10,000 shares of common stock outstanding selling at a price per share of $60.00. -Refer to Exhibit 16.4.Now assume that AJC is considering changing from its original capital structure to a new capital structure that results in a stock price of $64 per share.The resulting capital structure would have a $336,000 total market value of equity and a $504,000 market value of debt.How many shares would AJC repurchase in the recapitalization?

Exhibit 16.4 The Anson Jackson Court Company (AJC) currently has $200,000 market value (and book value) of perpetual debt outstanding carrying a coupon rate of 6%. Its earnings before interest and taxes (EBIT) are $100,000, and it is a zero growth company. AJC's current cost of equity is 8.8%, and its tax rate is 40%. The firm has 10,000 shares of common stock outstanding selling at a price per share of $60.00. -Refer to Exhibit 16.4.The firm is considering moving to a capital structure that is comprised of 40% debt and 60% equity,based on market values.The new funds would be used to replace the old debt and to repurchase stock.It is estimated that the increase in risk resulting from the additional leverage would cause the required rate of return on debt to rise to 7%,while the required rate of return on equity would rise to 9.5%.If this plan were carried out,what would be AJC's new WACC and total value?

Financial risk refers to the extra risk stockholders bear as a result of using debt as compared with the risk they would bear if no debt were used.

The firm's target capital structure should be consistent with which of the following statements?

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

Which of the following statements is CORRECT?

Two operationally similar companies,HD and LD,have the same total assets,operating income (EBIT) ,tax rate,and business risk.Company HD,however,has a much higher debt ratio than LD.Also HD's basic earning power (BEP) exceeds its cost of debt (r_d) .Which of the following statements is CORRECT?

After an intensive research and development effort,two methods for producing playing cards have been identified by the Turner Company.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 (EBIT) ?

Barette Consulting currently has no debt in its capital structure,has $500 million of total assets,and its basic earning power is 15%.The CFO is contemplating a recapitalization where it will issue debt at a cost of 10% and use the proceeds to buy back shares of the company's common stock,paying book value.If the company proceeds with the recapitalization,its operating income,total assets,and tax rate will remain unchanged.Which of the following is most likely to occur as a result of the recapitalization?