Financial Management (Chapter 15: Capital Structure Policy)

15.1   A Glance at Capital Structure Choices in Practice

1) The firm's optimal capital structure is the mix of financing sources that

A) minimizes the risk of financial distress.

B) maximizes after-tax earnings.

C) maximizes the total value of the firm's debt and equity.

D) maximizes favorable leverage.

2) Suppose we calculate a times interest earned ratio of 29 for Colgate-Palmolive. We can conclude

A) Colgate-Palmolive may experience some difficulty meeting its interest payments.

B) Colgate-Palmolive is very unlikely to have difficulty meeting its interest payments.

C) Colgate-Palmolive has $29 of operating cash flow for every dollar of interest expense.

D) Colgate-Palmolive's EBITDA is 29 times larger than its interest expense.

3) A firm's capital structure consists of which of the following?

A) The amount of debt that a firm uses

B) The amount of debt and preferred stock that a firm uses

C) The amount of debt, preferred stock, and common stock that a firm uses

D) The mix of long and short-term debt used by the firm

4) The enterprise value of the firm is defined as

A) (Market Value of Interest Bearing Debt-Excess Cash) + Market Value of Equity

B) (Book Value of Interest Bearing Debt-Excess Cash) + Market Value of Equity

C) (Book Value of Interest Bearing Debt-Excess Cash) + Book Value of Equity

D) Market Value of Interest Bearing Debt + Market Value of Equity

5) Which of the following is NOT a component of a firm's capital structure?

A) Preferred stock

B) Bonds

C) Common stock

D) Accounts payable

E) Retained earnings

6) Merrimac Brewing company's total assets equal $18 million. The book value of Merrimac's equity is $6 million.  Excess cash is $200,000.  The market value of Merrimac's equity is $10 million. Its Debt to Enterprise Value ratio is .5.  What is the book value of Merrimac's interest- bearing debt?

A) $5.25 million

B) $10.2 million

C) $15 million

D) $20.4 million

7) Merrimac Brewing company's total assets equal $18 million. The book value of Merrimac's equity is $6 million. Excess cash is $200,000.  The market value of Merrimac's equity is $10 million. Its Debt to Enterprise Value ratio is .5. What is Merrimac's Debt Ratio?

A) .75

B) .67

C) .33

D) .25

8) Cornucopia's liabilities and equity are shown below:

Accounts Payable	$500,000
Accrued Expenses	250,000
Short-term Note at 5%	300,000
Long-Term Debt	1,250,000
Common Equity, Book Value	2,500,000
Common Equity, Market Value	6,000,000

What is Cornucopia's debt ratio?

A) .48

B) .32

C) .21

D) .30

9) Cornucopia's liabilities and equity are shown below:

Accounts Payable	$500,000
Accrued Expenses	250,000
Short-term Note at 5%	300,000
Long-Term Debt	1,250,000
Common Equity, Book Value	2,500,000
Common Equity, Market Value	6,000,000

 What is Cornucopia's debt to value ratio?

A) .48

B) .32

C) .21

D) .30

10) Fibonacci Property Management's balance sheet shows total liabilities of $5 million and total assets of $13 million. Interest bearing liabilities total $3 million (book value). The market value of Fibonnacci's equity is $21 million. What is Fibonacci's debt ratio?

A) .38

B) .23

C) .125

D) .24

11) Fibonacci Property Management's balance sheet shows total liabilities of $5 million and total assets of $13 million. Interest bearing liabilities total $3 million (book value).  Excess cash $500,000.  The market value of Fibonnacci's equity is $21 million. What is Fibonacci's Debt to Enterprise Value ratio?

A) .38

B) .23

C) .125

D) .106

12) Tremont Inc.'s Total Assets =$25 million. The balance sheet shows Accounts payable and accruals totaling $7 million, common stock and retained earnings total $10 million. There is no preferred stock. What is the book value of interest bearing debt?

A) $15 million

B) $7 million

C) $18 million

D) $8 million

13) Which of the following should be excluded from a firm's capital structure?

A) Common equity

B) Non-interest bearing debt

C) Long-term debt

D) Short-term bank notes

14) A company that earns a rate of return on its investments lower than the interest rate on its debt is said to have

A) unfavorable financial leverage.

B) a sub-optimal capital structure.

C) favorable financial leverage.

D) negative financial leverage.

15) A company whose rate of return on investments is higher than the interest rate on its debt is said to have

A) unfavorable financial leverage.

B) a sub-optimal capital structure.

C) favorable financial leverage.

D) negative financial leverage.

16) How does the text distinguish between firm's financial structure and its capital structure?

A) Financial structure includes only interest bearing debt.

B) Capital structure includes only non-interest bearing debt.

C) Financial structure uses market values of equity.

D) Capital structure includes only interest bearing debt.

17) Financial structure includes long-term and short-term sources of funds.

Answer:  TRUE

18) A firm's financial structure is defined by the Debt Ratio, while its capital structure is defined by the Debt to Value ratio.

Answer:  TRUE

19) The Times Interest Earned Ratio measures a firm's ability to meet both interest payments and scheduled principal repayments.

Answer:  FALSE

20) The debt ratio is usually computed using book values for both debt and equity.

Answer:  TRUE

21) Debt ratios and debt to enterprise value ratios differ widely from one industry to another.

Answer:  TRUE

22) What is meant by the terms "favorable" and "unfavorable" leverage?

Answer:  If a firm can earn a higher rate of return on its investments than it pays in interest on borrowed funds, the difference goes to the firm's owners, its shareholders. The additional money earned will cause Return on Equity to be higher than Return on Assets. In essence, the firm is using "other people's money" to make money for its owners. 

Leverage can also work in reverse. Interest is a fixed cost. It must be paid whether or not the firm has sufficient earnings. When the rate of return on investments is lower that the interest rate on borrowed, leverage is said to be "unfavorable" and return on owner's equity will be reduced by the difference.

23) Why is the Debt to Assets Ratio always higher than the Debt to Value ratio?

Answer:  First, the debt to assets ratio uses book values. Book values for debt in the numerator are usually close to market values, but the asset values used in the denominator are often distorted by inflation and, in any case, do not represent the true value of the firm. The Debt to Value ratio has a smaller numerator, because non-interest bearing debt is excluded, and a larger denominator because for a healthy firm, the market value of the equity will be considerably greater than the book value.

24) Bipolar Beverages total assets equal $360 million. The book value of Bipolar's equity is $180 million. The market value of Bipolar's equity is $ 250 million. The book value of the company's interest bearing debt is $120 million. Compute Bipolar's Debt Ratio and Debt to Value Ratio.

Answer: 

Debt Ratio = 180,000,000/360,000,000 = .50

Debt to value ratio = $120,000,000/($120,000,000 + 250,000,000) = .324

15.2   Capital Structure Theory

1) In its original form, the Modigliani and Miller Capital Structure Theorem

A) uses unrealistic assumptions.

B) provided important insights into capital structure policy.

C) concludes that how a firm is financed is not important.

D) all of the above.

2) The inclusion of bankruptcy risk in firm valuation

A) acknowledges that a firm has an upper limit to debt financing.

B) causes cost of capital curve to be linear.

C) causes the cost of capital curve to be downward sloping regardless of capital structure.

D) has no consequences for practical management of capital structure policy.

3) Which of the following is the most important factor that affects a firm's financing mix?

A) The amount of EPS

B) The amount of operating income

C) The number of shares that are outstanding

D) The predictability of cash flows

4) When the impact of taxes is considered, as the firm takes on more debt

A) there will be no change in total cash flows.

B) both taxes and total cash flow to stockholders and bondholders will decrease.

C) cash flows will increase because taxes will decrease.

D) the weighted average cost of capital will increase.

5) The original form of the Modigliani and Miller Capital Structure Theorem

A) ignores the effect of taxes.

B) ignores the relationship between firm value and cost of capital.

C) ignores transaction costs.

D) both A and C are true.

6) Optimal capital structure is

A) the funding mix that will maximize the company's common stock price.

B) the mix of all items that appear on the right-hand side of the company's balance sheet.

C) the mix of funds that will minimize the firm's beta.

D) the mix of securities that will maximize EPS.

7) An optimal capital structure is achieved

A) when a firm's expected profits are maximized.

B) when a firm's expected EPS are maximized.

C) when a firm's break-even point is achieved.

D) when a firm's weighted average cost of capital is minimized.

8) From the information below, select the optimal capital structure for Mountain High Corp.

A) Debt = 40%; Equity = 60%; EPS = $2.95; Stock price = $26.50

B) Debt = 50%; Equity = 50%; EPS = $3.05; Stock price = $28.90

C) Debt = 60%; Equity = 40%; EPS = $3.18; Stock price = $31.20

D) Debt = 80%; Equity = 20%; EPS = $3.42; Stock price = $30.40

E) Debt = 70%; Equity = 30%; EPS = $3.31; Stock price = $30.00

9) An optimal capital structure is achieved

A) when a firm's expected profits are maximized.

B) when a firm's expected EPS are maximized.

C) when a firm's expected stock price is maximized.

D) when a firm's break-even point is achieved.

10) Using the original Modigliani and Miller assumptions if a firm's cost of capital is 12% when it is all equity financed and it's cost of debt is 8%, the cost of equity will be ________% when the firm is financed with equal amount of debt and equity.

A) 12%

B) 24%

C) 16%

D) cannot be determined with the information given.

11) The tradeoff theory of capital structure management assumes

A) no corporate income taxes.

B) cost of equity remains constant with an increase in financial leverage.

C) firms might fail.

D) none of the above.

12) Which of the following is consistent with the Tradeoff theory of capital structure?

A) The cost of capital continuously decreases as the firm's debt ratio increases.

B) The cost of capital remains constant as the firm's debt ratio increases.

C) There are no costs associated with bankruptcy.

D) There is an optimal level of debt financing.

13) Which of the following is a reasonable conclusion from the Tradeoff theory of capital structure?

A) A high debt ratio will result in a maximum price of a firm's common stock.

B) A firm's common stock price will not be affected by the amount of debt a firm uses.

C) A low debt ratio will result in a maximum price for a firm's common stock.

D) Modest levels of debt have a more favorable impact on a firm's average cost of capital and stock price than no debt.

14) Which of the following is consistent with the original formulation of the Modigliani and Miller Capital Structure Theorem?

A) A firm's composite cost of capital decreases as financial leverage is used.

B) A firm's common stock price falls as financial leverage is used.

C) A firm's composite cost of capital and common stock price are unaffected by the amount of financial leverage used by the firm.

D) A firm's composite cost of capital increases as operating leverage is used.

15) Which of the following will happen if the original Modigliani and Miller Theorem is relaxed to include taxes, but not bankruptcy costs?

A) Increased usage of financial leverage will increase a firm's composite cost of capital indefinitely.

B) Increased usage of financial leverage will lower a firm's composite cost of capital indefinitely.

C) Increased usage of financial leverage will not affect a firm's composite cost of capital.

D) Increased usage of operating leverage will increase a firm's composite cost of capital indefinitely.

16) The Tradeoff theory of capital structure suggests that if a firm moves from zero debt in its capital structure to moderate usage of debt, the result is an increase in a firm's

A) stock price.

B) cost of equity.

C) dividend payout.

D) both A and C.

17) If interest expense lowers taxes, why does the WACC not decrease indefinitely with the addition of more debt?

A) The tax shield effect of debt will result in a lower cost of equity.

B) Increasing debt too much can result in a greater likelihood of firm failure (financial distress).

C) A firm's common stock price will not be affected by the amount of debt a firm uses.

D) Too much common equity increases the probability of bankruptcy.

18) Capital structure theory suggests that companies may put the interests of ________ ahead of the interests of ________.

A) Potential stockholders, existing stockholders

B) Stockholders, bondholders

C) Existing shareholders, IRS

D) There are no potential conflicts arising from the way a firm manages its capital structure.

19) The inclusion of bankruptcy costs and taxes in firm valuation

A) causes the cost of capital curve to be umbrella shaped.

B) is consistent with a saucer-shaped cost of capital curve.

C) is consistent with a cost of capital curve that slopes downward.

D) causes the cost of capital to rise in a linear fashion as more debt is added to the capital structure.

20) The theory that managers may prefer internal sources of funds to the lowest cost source of funds is known as

A) the Modigliani and Miller Proposition.

B) tradeoff theory.

C) financial stress avoidance theory.

D) pecking order theory.

21) The Tradeoff Theory of capital structure theory indicates that

A) the tax shield on debt positively affects firm value, indicating that there is some benefit to financial leverage as opposed to an all-equity capitalization.

B) the higher the firm's financial leverage, the higher the probability the firm will be unable to meet the financial obligations included in its debt contracts, which could ultimately lead to firm failure.

C) there is a range of capital structures, rather than a single capital structure, that is optimal.

D) all of the above.

22) The Tradeoff Theory view of capital structure management says that the cost of capital curve is

A) a straight line.

B) v-shaped.

C) s-shaped.

D) saucer-shaped.

23) Assume that the tax rate is 40% and bankruptcy costs are negligible until a firm's debt to equity ratio is greater than one.  If Madison Co. increases debt from 10% of its capital structure to 40%, cash flows to investors will

A) decrease.

B) remain the same.

C) increase.

D) A firm's cash flows are independent of its capital structure.

24) The pecking order theory of capital structure is derived from

A) expectations theory.

B) the Modigliani-Miller theory.

C) liquidity preference theory.

D) agency theory.

25) With taxes, but in the absence of financial distress costs, the optimal capital structure would be

A) 100% equity.

B) 50% debt, 50% equity.

C) 100% debt.

D) completely insensitive to the mix of debt and equity.

26) Chelsea Corporation's cost of equity is 16% and it is 100% equity financed. If it can borrow enough money at 10% to buy back half of its stock, what would would happen to the cost of equity be under the original assumptions of the Modigliani and Miller Capital Structure Theorem.

A) It would remain at 16%.

B) It would rise to 22%.

C) It would fall to 11%.

D) It would fall to 13%.

27) Lowell Corporation and Lawrence Corporation each have EBIT of $4 million. Lowell has no debt and no interest expense; Lawrence has $2 million in debt at a before-tax rate of 8%. The tax rate is 40%. How much cash does each firm return to its investors.

A) Lowell $2,400,000, Lawrence $2,144,000

B) Lowell $2,400,000, Lawrence $2,240,000

C) Lowell $2,400,000, Lawrence $2,464,000

D) Lowell $2,400,000, Lawrence $2,304,000

28) The most acceptable view of capital structure, according to the text, is that the weighted average cost of capital

A) first falls with moderate levels of leverage and then increases as a firm's leverage becomes high.

B) does not change with leverage.

C) increases proportionately with increases in leverage.

D) increases with moderate amounts of leverage and then falls.

29) Newbury Inc. has retained $2 million in earnings this year. It can borrow up to $1.5 million at a rate of 8% and sell the same amount of new stock at a cost of 17%.  Newbury's cost of common equity without selling any new stock is 16%. If Newbury's capital budget is $2.5 million, pecking order theory says management will use

A) $1.5 million in debt and $1 million in retained earnings.

B) $2 million in retained earnings and $0.5 million in debt.

C) $833,333 each from retained earnings, new debt and new stock.

D) $1.5 million in debt and $1 million in new stock.

30) Which of the following is part of a firm's financial structure but NOT a component of its capital structure?

A) Retained earnings

B) Mortgage bonds

C) Accounts payable

D) Both A and C

31) Investors require a higher return on common stock investments if a firm uses less leverage.

Answer:  FALSE

32) Other things the same, the use of debt financing reduces the firm's total tax bill, resulting in a higher total market value.

Answer:  TRUE

33) Given the existence of taxes and bankruptcy costs, the optimal capital structure is 100% debt.

Answer:  FALSE

34) The Modigliani and Miller Capital Structure Theorem suggests that the cost of equity decreases as financial leverage increases.

Answer:  FALSE

35) The objective of capital structure management is to maximize the market value of the firm's equity.

Answer:  TRUE

36) Agency costs occur when managers choose the easiest form of financing over the value maximizing capital structure.

Answer:  TRUE

37) The pecking order theory of capital structure indicates that firms prefer to finance investment opportunities with least expensive forms of financing first and the most expensive last.

Answer:  FALSE

38) The trade-off theory of capital structure recognizes the tax-shield benefit of debt financing, but also recognizes that the benefit is offset by costs associated with debt financing.

Answer:  TRUE

39) The tax shield on interest is calculated by multiplying the interest rate paid on debt by the principal amount of the debt and the firm's marginal tax rate.

Answer:  TRUE

40) In the original version of the Modigliani and Miller capital structure theorem, as a firm increases the amount of debt in its capital structure, the cost of equity will rise but the cost of capital will remain the same.

Answer:  TRUE

41) Adams Inc. expects EBIT of $50 million if there is a recession, $100 million if the economy is normal, and $150 million if the economy expands. Bellingham Inc. also expects EBIT of $50 million if there is a recession, $100 million if the economy is normal, and $150 million if the economy expands. 

Adams is financed entirely with equity while Bellingham is financed 50% with debt at 10%. Adams has $200 million in equity; Bellingham is financed with $100 million of debt and $100 million of equity. The tax rate is 30%. Both firms pay out all available earnings as dividends. If there is a recession, compare dividends and total distributions to investors for each company.

Answer:  Adams Inc. EBIT $50 million - Interest $0 = Earnings before tax $50 million.

	Adams	Bellingham
EBIT	$50 million	$50 million
Interest Exp	0.00	10 million
EBT	50 million	40 million
Taxes @.30	15 million	12 million
Net Income	$35 million	$28 million
Dividends	$35 million	$28 million
Total distributions	$35 million	$28 million +$10 million = $38 million

42) Cheshire Corporation is now financed 100% with equity. The cost of equity is 15%. Cheshire is considering a proposal to borrow enough money at 7% to buy back half of its common stock. It would then be financed 50% with debt and 50% with equity. 

Assume that this does not affect the cost of equity. Cheshire's tax rate is 40%. What is Cheshire's cost of capital without and with the stock repurchase?

Answer:  Cheshire's cost of capital is now 15%. After the stock repurchase, it would be

7%(1 - .4)(.5) + 15%(.5) = 9.6%

43) Under what conditions are shareholders likely to incur agency costs when managers make capital budgeting decisions?

Answer:  When managers are not major shareholders of the company, their self-interest may not coincide with the interests of shareholders. Managers may avoid risky but potentially rewarding proposals and the additional effort and scrutiny that come with raising outside capital.

44) Briefly explain what the empirical evidence suggests about financial managers' actions as they relate to the capital structure theory.

Answer:  Capital structure theory predicts that managers will add debt to the capital structure when current leverage is below the firm's optimal range of leverage use at the base of the overall cost of capital curve. Survey research indicates that in practice managers only go to the debt markets after after internal funds have been exhausted. This is surprising as the cost of internal equity is greater than that of the cost of debt. 

There are two reasons why this is happening. The most obvious reason for this behavior is that using internal funds minimizes the inconvenience to managers and constraints on their behavior that might come with issuing debt. The other possibility is that managers do not actually try to minimize the WACC.

15.3   Why Do Capital Structures Differ across Industries?

1) Which of the following factors favors the use of more debt in a company's financial structure?

A) High levels of taxable income

B) Low levels of taxable income

C) The business is basically risky with unpredictable cash flows.

D) Risk of bankruptcy would make customers reluctant to buy the company's products.

2) Which industry would you expect to have the highest Debt to Asset ratios?

A) Business oriented software

B) Electric utilities

C) Communications equipment

D) Retail clothing

3) In which countries would you expect companies to have the lowest leverage ratios?

A) Countries with very high tax rates

B) Countries that tend to subsidize key industries and protect them from failure

C) Countries where creditors have very strong legal protection

D) Countries where the market value of companies is high compared to their book values

4) Which of the following is a good reason for a company to have higher than average debt ratios.

A) The company's cash flows are difficult to predict.

B) The company generates little taxable income.

C) Customer support is an important aspect of the company's business.

D) The company faces high marginal tax rates.

5) At the beginning of the financial crisis of 2008, excessive debt caused serious problems in the ________ industry.

A) computer

B) pharmaceuticals

C) utilities

D) financial

6) U. S. companies differ very little in their capital structures.

Answer:  FALSE

7) Companies faced with higher tax burdens are likely to use more debt.

Answer:  TRUE

8) Conservative balance sheets may be advantageous for companies that have long-term relationships with their customers.

Answer:  TRUE

9) Top management's desire to avoid the scrutiny that comes with higher levels of debt may influence the capital structures of some firms.

Answer:  TRUE

10) List and briefly explain at least two important reasons why capital structures tend to differ between industries and even companies within the same industry.

Answer:  There are several reasons why firms use more or less debt in their capital structure. Firms facing high tax burdens may find the tax shield from interest especially valuable. Firms with relatively safe businesses (i.e. low bankruptcy costs) and a low rate of return on assets such as electric or gas utilities may use leverage to boost return on equity. Other businesses may have an especially strong need to reassure their customers that they will not go out of business (high bankruptcy costs.)

15.4   Making Financing Decisions

1)

	Waltham Watch	Comparable Firms
Debt ratio	33%	42%
Interest -bearing debt ratio	19%	23
Times interest earned ratio	25	20
EBITDA coverage ratio	6	4

From the table above we can conclude

A) Waltham has a conservative capital structure policies.

B) Waltham has too much debt.

C) Waltham uses more leverage than the typical firm in its industry.

D) Waltham's EPS would be more sensitive than a typical firm's to changes in EBIT.

2) Which two ratios would be most helpful in managing a firm's capital structure?

A) Book Debt to Equity, Current Ratio

B) Debt to Value Ratio and Times Interest Earned

C) Debt to Assets, Profit Margin

D) Payables Turnover, Return on Assets

3) When benchmarking a firm's capital structure, management should compare it to

A) firms in S&P 500.

B) firms in the same geographic region.

C) firms recognized for the quality of their management.

D) firms in similar lines of business.

4) If a firm chose to increase its debt ratio from 20% to 40%, what is the potential risk?

A) The average cost of capital would most likely rise.

B) The price of the firm's common stock would definitely decline.

C) If economic forces cause a reduction of sales, the firm's EPS might decline.

D) The firm's WACC might decline.

5) When using an EPS-EBIT chart to evaluate a pure debt financing and pure equity financing plan, the debt financing plan line will have

A) a steeper slope than the equity financing plan line.

B) a slower rate of change as EBIT increases.

C) a downward slope.

D) the same slope as the equity plan, but a higher intercept.

6) Basic tools of capital structure management include

A) EBIT-EPS analysis.

B) comparative profitability ratios.

C) capital budgeting techniques.

D) economic value added analysis.

7) An increase in the ________ is likely to encourage a corporation to increase its debt ratio.

A) corporate tax rate

B) personal tax rate

C) company's degree of operating leverage

D) expected cost of bankruptcy

8) The EBIT-EPS indifference point

A) identifies the EBIT level at which the EPS will be the same regardless of the financing plan.

B) identifies the point at which the analysis can use EBIT and EPS interchangeably.

C) identifies the level of earnings at which the management is indifferent about the payments of dividends.

D) none of the above.

9) As a general rule, the optimal capital structure

A) maximizes expected EPS and also maximizes the price per share of common stock.

B) minimizes the interest rate on debt and also maximizes the expected EPS.

C) minimizes the required rate on equity and also maximizes the stock price.

D) maximizes the price per share of common stock and also minimizes the weighted average cost of capital.

10) The capital structure that minimizes the weighted average cost of capital will also

A) maximize EPS for any given level of EBIT.

B) minimize the value of the firm.

C) minimize bankruptcy costs.

D) maximize the price per share of common stock.

Use the following information to answer the following question(s).

Your firm is trying to determine whether it should finance a project requiring $800,000 with new common stock or with debt. The firm is faced with the following financing alternatives:

        I:      Issue new common stock. Sale price of the common stock is expected to be $40 per share.

        II:    Issue new bonds with a coupon rate of 12%.

The firm has a marginal tax rate of 34%, the company currently has 40,000 shares of common stock outstanding, and $90,000 face value of 10% debt outstanding.

11) Total shares outstanding will be

A) 20,000 under alternative I and zero under alternative II.

B) 40,000 under alternative I and 60,000 under alternative II.

C) 60,000 under alternative I and 40,000 under alternative II.

D) 60,000 under both alternative I and alternative II.

12) The total interest obligation will be

A) $105,000 under alternative I and $9,000 under alternative II.

B) $9,000 under alternative I and $105,000 under alternative II.

C) zero under alternative I and $96,000 under alternative II.

D) $105,000 under both alternative I and alternative II.

13) Weaknesses of the EBIT-EPS analysis include

A) that it disregards the implicit costs of debt financing.

B) that it ignores the effect of the specific financing decision on the firm's cost of common equity capital.

C) that it considers only the level of the earnings stream and ignores the variability inherent in it.

D) all of the above.

14) Farar, Inc. projects operating income of $4 million next year. The firm's income tax rate is 40%. Farar presently has 750,000 shares of common stock, no preferred stock, and no debt. The firm is considering the issuance of $6 million of 10% bonds to finance a new product that is not expected to generate an increase in income for two years. If Farar issues the bonds this year, what will projected EPS be next year?

A) $1.53

B) $1.98

C) $2.72

D) $4.53

15) Zybeck Corp. projects operating income of $4 million next year. The firm's income tax rate is 40%. Zybeck presently has 750,000 shares of common stock which have a market value of $10 per share, no preferred stock, and no debt. The firm is considering two alternatives to finance a new product: (a) the issuance of $6 million of 10% bonds, or (b) the issuance of 60,000 new shares of common stock. There are no issuance costs for either the bonds or the stock. If Zybeck issues common stock this year, what will projected EPS be next year?

A) $2.10

B) $2.96

C) $2.33

D) $1.67

16) Zybeck Corp. projects operating income of $4 million next year. The firm's income tax rate is 40%. Zybeck presently has 750,000 shares of common stock which have a market value of $10 per share, no preferred stock, and no debt. The firm is considering two alternatives to finance a new product: (a) the issuance of $6 million of 10% bonds, or (b) the issuance of 60,000 new shares of common stock at $10 per share. If Zybeck issues common stock this year, what will the firm's return on equity be next year?

A) 16.7%

B) 18.2%

C) 22.1%

D) 26.4%

E) 29.6%

17) Abbot Corp has a debt ratio (debt to assets) of 20%. Management is wondering if its current capital structure is too conservative. Abbot Corp's present EBIT is $4.5 million, and profits available to common shareholders are $2,910,600, with 600,000 shares of common stock outstanding. If the firm were to instead have a debt ratio of 40%, additional interest expense would cause profits available to stockholders to decline to $2,851,200, but only 480,000 common shares would be outstanding. What is the difference in EPS at a debt ratio of 40% versus 20%?

A) $4.85

B) $6.34

C) $1.09

D) $-0.10

18) Babbit Corp has a debt ratio (debt to assets) of 40%. Management is wondering if its current capital structure is too conservative. Babbit Corp's present EBIT is $4.5 million, and profits available to common shareholders are $2,851,200, with 480,000 shares of common stock outstanding. If the firm were to instead have a debt ratio of 60%, additional interest expense would cause profits available to stockholders to decline to $2,791,800, but only 384,000 common shares would be outstanding. What is the difference in EPS at a debt ratio of 60% versus 40%?

A) $5.94

B) $1.33

C) $1.09

D) $-0.12

19) Cabot Corp has a debt ratio (debt to assets) of 60%. Management is wondering if its current capital structure is too conservative. Cabot Corp's present EBIT is $4.5 million, and profits available to common shareholders are $2,791,800, with 384,000 shares of common stock outstanding. 

If the firm were to instead have a debt ratio of 80%, additional interest expense would cause profits available to stockholders to decline to $2,732,400, but only 307,200 common shares would be outstanding. What is the difference in EPS at a debt ratio of 80% versus 60%?

A) $$1.62

B) $1.33

C) $7.27

D) $-0.15

Use the following information to answer the following question(s).

Your firm is trying to determine whether it should finance a project requiring $800,000 with new common stock or with debt. The firm is faced with the following financing alternatives:

        I:      Issue new common stock. Sale price of the common stock is expected to be $40 per share.

        II:    Issue new bonds with a coupon rate of 12%.

The firm has a marginal tax rate of 34%, the company currently has 40,000 shares of common stock outstanding, and $90,000 face value of 10% debt outstanding.

20) The indifference level of EBIT is

A) $99,000.

B) $66,600.

C) $333,000.

D) $297,000.

21) EPS at the indifference level of EBIT is

A) $3.17.

B) $4.80.

C) $5.27.

D) $5.90.

22) A firm is analyzing two different capital structures for financing a new asset that will cost $100,000. The effects of the two structures on the firm's balance sheet are described below.

Plan A: finance with 50% debt

New asset       $100,000        Debt                                $50,000

                                                    Common equity          $50,000

                                                    Total                             $100,000

Plan B: finance with 70% debt

New asset       $100,000        Debt                                $70,000

                                                    Common equity          $30,000

                                                    Total                            $100,000

Based on the information provided, we can conclude that

A) if the firm chooses Plan A, then any changes in the firm's EBIT will lead to larger fluctuations in the firm's EPS than if the firm chooses Plan B.

B) if the firm chooses Plan B, then any changes in the firm's EBIT will lead to larger fluctuations in the firm's EPS than if the firm chooses Plan A.

C) if the firm chooses Plan A, then any changes in the firm's EBIT will lead to the same fluctuations in the firm's EPS as will occur if the firm chooses Plan B.

D) if the firm chooses Plan B, then any changes in the firm's EBIT will lead to smaller fluctuations in the firm's EPS than if the firm chooses Plan A.

23) The level of EBIT that will equate EPS between two different financing plans is called the

A) indifference point.

B) optimal capital plan.

C) pivot point.

D) tradeoff point

24) Useful ratios for bench-marking a firm's capital structure include

A) the Debt ratio.

B) Times Interest Earned ratio.

C) EBITDA coverage ratio.

D) all of the above.

25) Which of the following factors was most often cited by CFOs as an important influence on debt use?

A) Keeping the confidence of customers and suppliers

B) Minimizing bankruptcy costs

C) Maintaining financial flexibility

D) Benchmarking against similar firms

26) The EBIT-EPS indifference point, sometimes called the break-even point, identifies the optimal range of financial leverage regardless of the financing plan chosen by the financial manager.

Answer:  FALSE

27) Comparative leverage ratio analysis does not involve the use of industry norms.

Answer:  FALSE

28) High coverage ratios, compared with a standard, imply unused debt capacity.

Answer:  TRUE

29) Benchmarking the company's capital structure is popular because it is impossible to know exactly what the company's optimal capital structure should be.

Answer:  TRUE

30) Rising bankruptcy costs should cause most firms to use less debt and more equity.

Answer:  TRUE

31) Roberts, Inc. is trying to decide how best to finance a proposed $10 million capital investment. Under Plan I, the project will be financed entirely with long-term 9% bonds. The firm currently has no debt or preferred stock. Under Plan II, common stock will be sold to net the firm $20 a share; presently, 1 million shares are outstanding. The corporate tax rate for Roberts is 40%.

a.    Calculate the indifference level of EBIT associated with the two financing plans.

b.    Which financing plan would you expect to cause the greatest change in EPS relative to a change in EBIT? Why?

c.     If EBIT is expected to be $3.1 million, which plan will result in a higher EPS?

Answer: 
a.    (EBIT)(1 - 0.4)/1,500,000 =

       (EBIT - $900,000)(1 - 0.4)/1,000,000

       EBIT = $2,700,000

b.    The bond plan will magnify changes in EPS since adding debt increases financial leverage.

c.    Since $3.1 million EBIT is above the indifference point of $2.7 million, the bond plan will give a higher EPS.

32) Young Enterprises is financed entirely with 3 million shares of common stock selling for $20 a share. Capital of $4 million is needed for this year's capital budget. Additional funds can be raised with new stock (ignore dilution) or with 13% 10-year bonds. Young's tax rate is 40%.

a.    Calculate the financing plan's EBIT indifference point.

b.    Does the "indifference point" calculated in question (a) above truly represent a point where stockholders are indifferent between stock and debt financing? Explain your answer.

Answer: 
a.    (EBIT - 0)(1 - 0.4)/3,200,000 =

       (EBIT - 520,000)(1 - 0.4)/3,000,000

       EBIT = $8,320,000.

b.    No. Financial risk is ignored.

33) The MAX Corporation is planning a $4 million expansion this year. The expansion can be financed by issuing either common stock or bonds. The new common stock can be sold for $60 per share. The bonds can be issued with a 12% coupon rate. The firm's existing shares of preferred stock pay dividends of $2.00 per share. The company's combined state and federal corporate income tax rate is 46%. The company's balance sheet prior to expansion is as follows:

                                               MAX Corporation

        Current assets                                                       $ 2,000,000

        Fixed assets                                                               8,000,000

        Total assets                                                           $10,000,000

        Current liabilities                                                 $ 1,500,000

        Bonds:

        (8%, $1,000 par value)                                           1,000,000

        (10%, $1,000 par value)                                         4,000,000

        Preferred stock:

        ($100 par value)                                                          500,000

        Common stock:

        ($2 par value)                                                               700,000

        Retained earnings                                                   2,300,000

        Total liabilities and equity                               $10,000,000

a.    Calculate the indifference level of EBIT between the two plans.

b.    If EBIT is expected to be $3 million, which plan will result in higher EPS?

Answer: 
a.

EPS: Stock Plan [(EBIT - $480,000)(1 - .46) - $10,000]/[(350,000 + 66,667)]

[(EBIT)(.54) - $259,200 - $10,000]/(416,667)

EPS: Bond Plan

[(EBIT - $960,000)(1 - .46) - $10,000]/(350,000)

[(EBIT)(.54) - $518,400 - $10,000]/(350,000)

(350,000)[EBIT(.54) - $269,200] =

(416,667)[EBIT(.54) - $528,400]

(189,000)EBIT - $94,220,000,000 =

(225,000)EBIT - $220,000,000,000

(36,000)EBIT = $125,780,000,000

EBIT = $3,493,889

b.

EPS: Stock Plan

[($3,000,000 - $480,000)(1 - .46) - $10,000]/(350,000 + 66,667) = $1,350,800/416,667 = $3.24

EPS: Bond Plan

[($3,000,000 - $960,000)(1 - .46) - $10,000]/350,000 =

$1,091,600/350,000 = $3.12

Stock plan has higher EPS.

34) Sunshine Candy Company's capital structure for the past year of operation is shown below.

        First mortgage bonds at 12%                            $2,000,000

        Debentures at 15%                                                 1,500,000

        Common stock (1 million shares)                     5,000,000

        Retained earnings                                                     500,000

        Total                                                                         $9,000,000

The federal tax rate is 50%. Sunshine Candy Company, home-based in Orlando, wants to raise an additional $1 million to open new facilities in Tampa and Miami. The firm can accomplish this via two alternatives: (1) it can sell a new issue of 20-year debentures with 16% interest; or (2) 20,000 new shares of common stock can be sold to the public to net the candy company $50 per share. 

A recent study, performed by an outside consulting organization, projected Sunshine Candy Company's long-term EBIT level at approximately $6.8 million. Find the indifference level of EBIT (with regard to EPS) between the suggested financing plans.

Answer: 

[(EBIT - 465,000)(0.5)]/1,020,000 =

[(EBIT - 625,000)(0.5)]/1,000,000

(0.5 EBIT - 232,500)/102 =

<0 -="" .5="" 312="" ebit="">/100

50 EBIT - 23,250,000 = 51 EBIT - 31,875,000

EBIT = $8,625,000 indifference level

35) Allston-Brighton Corp. has total assets of $10 million, total liabilities of $4 million, of which $1 million are non-interest bearing. Interest expense was $180,000. Earnings before interest and taxes were $2.5 million. Depreciation was $1.5 million. Compute the following ratios: Debt ratio, Interest-bearing debt ratio, Times interest earned ratio, and EBITDA coverage ratio.

Answer: 

Debt ratio = $4,000,000/$10,000,000 = .40.

Interest bearing debt ratio = (4,000,000 - 1,000,000)/10,000,000 = .30

Times Interest earned ratio = 2,500,000/180,000 = 13.89

EBITDA coverage ratio = (2,500,000 + 1,500,000)/180,000 = 22.22