Capital Structure and Leverage: Multiple Choice: Conceptual

CAP#TA$ %T CHAPTE &CT& E A'D !
" $E(E A)E

(Difficulty: E = Easy, M = Medium, and T = Tough)
Multiple Choice: Conceptual Easy:

Business risk
1
Answer: c
Diff: E
A decrease in the debt ratio will generally have no effect on . a. b. c. d. e. Financial risk. Total risk. Business risk. Market risk. None of the above is correct. above.!
(It will affect each ty e of risk Answer: d Diff: E
Business risk
"
Business risk is concerned with the o erations of the fir#. $hich of the following is not associated with (or not a art of! business risk% a. b. c. d. e. &e#and variability. 'ales rice variability. The e(tent to which o erating costs are fi(ed. )hanges in re*uired returns due to financing decisions. The ability to change rices as costs change. Answer: d Diff: E N
Business risk
+
$hich of the following factors would affect a co# any,s business risk% a. b. c. d. e. The level of uncertainty regarding the de#and for its The degree of o erating leverage. The a#ount of debt in its ca ital structure. 'tate#ents a and b are correct. All of the state#ents above are correct. roduct.
Chapter 13- Page 1
Business and financial risk

-
Answer: d
Diff: E
$hich of the following state#ents is #ost correct% a. A fir#,s business risk is solely deter#ined by the financial characteristics of its industry. b. The factors that affect a fir#,s business risk are deter#ined artly by industry characteristics and artly by econo#ic conditions. .nfortunately/ these and other factors that affect a fir#,s business risk are not sub0ect to any degree of #anagerial control. c. 1ne of the benefits to a fir# of being at or near its target ca ital structure is that financial fle(ibility beco#es #uch less i# ortant. d. The fir#,s financial risk #ay have both #arket risk and diversifiable risk co# onents. e. None of the state#ents above is correct.
Optimal capital structure

2
Answer: e
Diff: E
$hich of the following state#ents is #ost correct% a. As a rule/ the o ti#al ca ital structure is found by deter#ining the debt3e*uity #i( that #a(i#i4es e( ected 56'. b. The o ti#al ca ital structure si#ultaneously #a(i#i4es 56' and #ini#i4es the $A)). c. The o ti#al ca ital structure #ini#i4es the cost of e*uity/ which is a necessary condition for #a(i#i4ing the stock rice. d. The o ti#al ca ital structure si#ultaneously #ini#i4es the cost of debt/ the cost of e*uity/ and the $A)). e. None of the state#ents above is correct.

7
Answer: c
Diff: E
Fro# the infor#ation below/ select the o ti#al ca ital structure for Minnow 5ntertain#ent )o# any. a. b. c. d. e. &ebt &ebt &ebt &ebt &ebt 8 8 8 8 8 -9:; 29:; 79:; >9:; ?9:; 5*uity 5*uity 5*uity 5*uity 5*uity 8 8 8 8 8 79:; 29:; -9:; "9:; +9:; 56' 56' 56' 56' 56' 8 8 8 8 8 <".=2; <+.92; <+.1>; <+.-"; <+.+1; 'tock 'tock 'tock 'tock 'tock rice rice rice rice rice 8 8 8 8 8 <"7.29. <">.=9. <+1."9. <+9.-9. <+9.99. Answer: e Diff: E

?
$hich of the following state#ents best describes the o ti#al ca ital structure% a. The o ti#al ca ital structure is the #i( of debt/ e*uity/ and referred stock that #a(i#i4es the co# any,s earnings er share (56'!. b. The o ti#al ca ital structure is the #i( of debt/ e*uity/ and referred stock that #a(i#i4es the co# any,s stock rice. c. The o ti#al ca ital structure is the #i( of debt/ e*uity/ and referred stock that #ini#i4es the co# any,s weighted average cost of ca ital ($A))!. d. 'tate#ents a and b are correct. e. 'tate#ents b and c are correct.
Chapter 13 - Page 2
Target capital structure

>
Answer: e
Diff: E
The fir#,s target ca ital structure is consistent with which of the following% a. b. c. d. e. Ma(i#u# Mini#u# Mini#u# Mini#u# Mini#u# earnings er share (56'!. cost of debt (kd!. risk. cost of e*uity (ks!. weighted average cost of ca ital ($A))!. Answer: d Diff: E
Leverage and capital structure

=
$hich of the following is likely to encourage a co# any to use #ore debt in its ca ital structure% a. b. c. d. e. An increase in the cor orate ta( rate. An increase in the ersonal ta( rate. A decrease in the co# any,s degree of o erating leverage. 'tate#ents a and c are correct. All of the state#ents above are correct. Answer: e Diff: E

19
$hich of the following state#ents is #ost correct% a. A reduction in the cor orate ta( rate is likely to increase the debt ratio of the average cor oration. b. An increase in the ersonal ta( rate is likely to increase the debt ratio of the average cor oration. c. If changes in the bankru tcy code #ake bankru tcy less costly to cor orations/ then this would likely reduce the debt ratio of the average cor oration. d. All of the state#ents above are correct. e. None of the state#ents above is correct.

11
Answer: e
Diff: E to
$hich of the following state#ents is likely to encourage increase its debt ratio in its ca ital structure% a. b. c. d. e. Its sales beco#e less stable over ti#e. Its cor orate ta( rate declines. Manage#ent believes that the fir#,s stock is overvalued. 'tate#ents a and b are correct. None of the state#ents above is correct.
a fir#

1"
Answer: a
Diff: E
$hich of the following factors is likely to encourage a cor oration to increase the ro ortion of debt in its ca ital structure% a. b. c. d. An increase in the cor orate ta( rate. An increase in the ersonal ta( rate. An increase in the co# any,s degree of o erating leverage. The co# any,s assets beco#e less li*uid. Chapter 13- Page 3
e. An increase in e( ected bankru tcy costs. Leverage and capital structure

1+
Answer: e
Diff: E
$hich of the following would increase the likelihood that a co# any would increase its debt ratio in its ca ital structure% a. b. c. d. e. An increase in costs incurred when filing for bankru tcy. An increase in the cor orate ta( rate. An increase in the ersonal ta( rate. A decrease in the fir#,s business risk. 'tate#ents b and d are correct. Answer: a is likely to encourage Diff: E N to

1-
$hich of the following factors increase its debt ratio% a. b. c. d. e.
a co# any
An increase in the cor orate ta( rate. An increase in the ersonal ta( rate. Its assets beco#e less li*uid. Both state#ents a and c are correct. All of the state#ents above are correct. Answer: c Diff: E N

12
@ones )o. currently is 199 ercent e*uity financed. The co# any is considering changing its ca ital structure. More s ecifically/ @ones, )F1 is considering a reca itali4ation lan in which the fir# would issue long3 ter# debt with a yield of = ercent and use the roceeds to re urchase co##on stock. The reca itali4ation would not change the co# any,s total assets nor would it affect the co# any,s basic earning ower/ which is currently 12 ercent. The )F1 esti#ates that the reca itali4ation will reduce the co# any,s $A)) and increase its stock rice. $hich of the following is also likely to occur if the co# any goes ahead with the lanned reca itali4ation% a. b. c. d. e. The The The The The co# co# co# co# co# any,s any,s any,s any,s any,s net inco#e will increase. earnings er share will decrease. cost of e*uity will increase. A1A will increase. A15 will decrease. Answer: e Diff: E N

17
$hich of the following state#ents is #ost correct% a. $hen a co# any increases its debt ratio/ the costs of both e*uity and debt ca ital increase. Therefore/ the weighted average cost of ca ital ($A))! #ust also increase. b. The ca ital structure that #a(i#i4es stock rice is generally the ca ital structure that also #a(i#i4es earnings er share. c. 'ince debt financing is chea er than e*uity financing/ increasing a co# any,s debt ratio will always reduce the co# any,s $A)). d. The ca ital structure that #a(i#i4es stock rice is generally the ca ital structure that also #a(i#i4es the co# any,s $A)).
Chapter 13 - Page 4
e. None of the state#ents above is correct. Leverage and capital structure

1?
Answer: c
Diff: E
$hich of the following state#ents is #ost correct% a. $hen a co# any increases its debt ratio/ the costs of e*uity and debt ca ital both increase. Therefore/ the weighted average cost of ca ital ($A))! #ust also increase. b. The ca ital structure that #a(i#i4es stock rice is generally the ca ital structure that also #a(i#i4es earnings er share. c. All else e*ual/ an increase in the cor orate ta( rate would tend to encourage a co# any to increase its debt ratio. d. 'tate#ents a and b are correct. e. 'tate#ents a and c are correct.
Capital structure and WACC

1>
Answer: e
Diff: E
$hich of the following state#ents is #ost correct% a. 'ince debt financing raises the fir#,s financial risk/ increasing a co# any,s debt ratio will always increase the co# any,s $A)). b. 'ince debt financing is chea er than e*uity financing/ increasing a co# any,s debt ratio will always reduce the co# any,s $A)). c. Increasing a co# any,s debt ratio will ty ically reduce the #arginal costs of both debt and e*uity financing; however/ it still #ay raise the co# any,s $A)). d. 'tate#ents a and c are correct. e. None of the state#ents above is correct.
Capital structure,
1=
OA, and
OE
Answer: d
Diff: E
Aidgefield 5nter rises has total assets of <+99 #illion. The co# any currently has no debt in its ca ital structure. The co# any,s basic earning ower is 12 ercent. The co# any is conte# lating a reca itali4ation where it will issue debt at 19 ercent and use the roceeds to buy back shares of the co# any,s co##on stock. If the co# any roceeds with the reca itali34ation its o erating inco#e/ total assets/ and ta( rate will re#ain the sa#e. $hich of the following will occur as a result of the reca itali4ation% a. b. c. d. e. The co# any,s A1A will decline. The co# any,s A15 will increase. The co# any,s basic earning ower will decline. 'tate#ents a and b are correct. All of the state#ents above are correct. Answer: a Diff: E
Capital structure, WACC, T!E, and E"#

"9
$hich of the following state#ents is #ost correct% a. The ca ital structure that #a(i#i4es structure that #ini#i4es the weighted b. The ca ital structure that #a(i#i4es structure that #a(i#i4es earnings er c. The ca ital structure that #a(i#i4es stock average stock share. stock rice is also the ca ital cost of ca ital ($A))!. rice is also the ca ital rice is also the ca ital Chapter 13- Page 5
structure that #a(i#i4es the fir#,s ti#es interest earned (TI5! ratio. d. 'tate#ents a and b are correct. e. 'tate#ents b and c are correct. Capital structure t$e%r& Answer: d Diff: E
"1
$hich of the following state#ents about ca ital structure theory is #ost correct% a. 'ignaling theory suggests fir#s should in nor#al ti#es #aintain reserve borrowing ca acity that can be used if an es ecially good invest#ent o ortunity co#es along. b. In general/ an increase in the cor orate ta( rate would cause fir#s to use less debt in their ca ital structures. c. According to the Btrade3off theory/C an increase in the costs of bankru tcy would lead fir#s to reduce the a#ount of debt in their ca ital structures. d. 'tate#ents a and c are correct. e. All of the state#ents above are correct.
'iscellane%us capital structure c%ncepts

""
Answer: c
Diff: E
$hich of the following state#ents is #ost correct% a. If )ongress were to ass legislation that increases the ersonal ta( rate/ but decreases the cor orate ta( rate/ this would encourage co# anies to increase their debt ratios. b. If a co# any were to issue debt and use the #oney to re urchase co##on stock/ this action would have no i# act on the co# any,s return on assets. (Assu#e that the re urchase has no i# act on the co# any,s o erating inco#e.! c. If a co# any were to issue debt and use the #oney to increase assets/ this action would increase the co# any,s return on e*uity. (Assu#e that the co# any,s return on assets re#ains unchanged.! d. 'tate#ents a and b are correct. e. 'tate#ents b and c are correct.
(inancial leverage and E"#

"+
Answer: a
Diff: E
Dolga 6ublishing is considering a ro osed increase in its debt ratio/ which will also increase the co# any,s interest e( ense. The lan would involve the co# any issuing new bonds and using the roceeds to buy back shares of its co##on stock. The co# any,s )F1 e( ects that the lan will not change the co# any,s total assets or o erating inco#e. Eow3ever/ the co# any,s )F1 does esti#ate that it will increase the co# any,s earnings er share (56'!. Assu#ing the )F1,s esti#ates are correct/ which of the following state#ents is #ost correct% a. 'ince the ro osed lan increases Dolga,s financial risk/ the co# any,s stock rice still #ight fall even though its 56' is e( ected to increase. b. If the lan reduces the co# any,s $A))/ the co# any,s stock rice is also likely to decline. c. 'ince the lan is e( ected to increase 56'/ this i# lies that net inco#e is also e( ected to increase.
Chapter 13 - Page 6
d. 'tate#ents a and b are correct. e. 'tate#ents a and c are correct.
Chapter 13- Page 7
(inancial leverage and E"#

"-
Answer: c
Diff: E
$hich of the following state#ents is #ost correct% a. Increasing financial leverage is one way to increase a fir#,s basic earning ower (B56!. b. Fir#s with lower fi(ed costs tend to have greater o erating leverage. c. The debt ratio that #a(i#i4es 56' generally e(ceeds the debt ratio that #a(i#i4es share rice. d. 'tate#ents a and b are correct. e. 'tate#ents a and c are correct.
(inancial leverage and rati%s

"2
Answer: d
Diff: E
)o# any A and )o# any B have the sa#e ta( rate/ the sa#e total assets/ and the sa#e basic earning ower. Both co# anies have a basic earning ower that e(ceeds their before3ta( costs of debt/ kd. Eowever/ )o# any A has a higher debt ratio and higher interest e( ense than )o# any B. $hich of the following state#ents is #ost correct% a. b. c. d. e. )o# any A has a lower net inco#e than B. )o# any A has a lower A1A than B. )o# any A has a lower A15 than B. 'tate#ents a and b are correct. None of the state#ents above is correct. Answer: ) Diff: E

"7
. Fir# . and Fir# F each have the sa#e total assets. Both fir#s also have a basic earning ower of "9 ercent. Fir# . is 199 ercent e*uity financed/ while Fir# F is financed with 29 ercent debt and 29 ercent e*uity. Fir# F,s debt has a before3ta( cost of > ercent. Both fir#s have ositive net inco#e. $hich of the following state#ents is #ost correct% a. b. c. d. e. The two co# anies have Fir# F has a lower A1A Fir# F has a lower A15 'tate#ents a and b are 'tate#ents b and c are the sa#e ti#es interest earned (TI5! ratio. than Fir# .. than Fir# .. correct. correct.
Medium:
"?
Answer: d
Diff: '
As a general rule/ the ca ital structure that a. Ma(i#i4es e( ected 56' also #a(i#i4es the rice er share of co##on stock. b. Mini#i4es the interest rate on debt also #a(i#i4es the e( ected 56'. c. Mini#i4es the re*uired rate on e*uity also #a(i#i4es the stock rice. d. Ma(i#i4es the rice er share of co##on stock also #ini#i4es the weighted average cost of ca ital. e. None of the state#ents above is correct.
Chapter 13 - Page 8
Operating and financial leverage

">
Answer: e
Diff: '
$hich of the following state#ents is #ost correct% a. Fir#s whose sales are very sensitive to changes in the business cycle are #ore likely to rely on debt financing. b. Fir#s with large ta( loss carry forwards are #ore likely to rely on debt financing. c. Fir#s with a high o erating leverage are #ore likely to rely on debt financing. d. 'tate#ents a and c are correct. e. None of the state#ents above is correct.

"=
Answer: c
Diff: '
)o# any A and )o# any B have the sa#e total assets/ o erating inco#e (5BIT!/ ta( rate/ and business risk. )o# any A/ however/ has a #uch higher debt ratio than )o# any B. )o# any A,s basic earning ower (B56! e(ceeds its cost of debt financing (kd!. $hich of the following state#ents is #ost correct% a. )o# any A has a higher return on assets (A1A! than )o# any B. b. )o# any A has a higher ti#es interest earned (TI5! ratio than )o# any B. c. )o# any A has a higher return on e*uity (A15! than )o# any B/ and its risk/ as #easured by the standard deviation of A15/ is also higher than )o# any B,s. d. 'tate#ents b and c are correct. e. All of the state#ents above are correct.
Limits %f leverage
+9
Answer: d
Diff: '
$hich of the following are ractical difficulties associated with ca ital structure and degree of leverage analyses% a. It is nearly i# ossible to deter#ine e(actly how 6G5 ratios or e*uity ca itali4ation rates (ks values! are affected by different degrees of financial leverage. b. Managers, attitudes toward risk differ and so#e #anagers #ay set a target ca ital structure other than the one that would #a(i#i4e stock rice. c. Managers often have a res onsibility to rovide continuous service; they #ust reserve the long3run viability of the enter rise. Thus/ the goal of e# loying leverage to #a(i#i4e short3run stock rice and #ini#i4e ca ital cost #ay conflict with long3run viability. d. All of the state#ents above are correct. e. None of the state#ents above re resents a serious i# edi#ent to the ractical a lication of leverage analysis in ca ital structure deter#ination.
Chapter 13- Page 9
#ignaling t$e%r&
+1
Answer: )
Diff: '
If you know that your fir# is facing relatively oor ros ects but needs new ca ital/ and you know that investors do not have this infor#ation/ signaling theory would redict that you would a. Issue debt to #aintain the returns of e*uity holders. b. Issue e*uity to share the burden of decreased e*uity returns between old and new shareholders. c. Be indifferent between issuing debt and e*uity. d. 6ost one going into ca ital #arkets until your fir#,s ros ects i# rove. e. )onvey your inside infor#ation to investors using the #edia to eli#inate the infor#ation asy##etry.

+"
Answer: d
Diff: '
$hich of the following state#ents is #ost correct% a. The o ti#al ca ital structure #ini#i4es the $A)). b. If the after3ta( cost of e*uity financing e(ceeds the after3ta( cost of debt financing/ fir#s are always able to reduce their $A)) by increasing the a#ount of debt in their ca ital structure. c. Increasing the a#ount of debt in a fir#,s ca ital structure is likely to increase the costs of both debt and e*uity financing. d. 'tate#ents a and c are correct. e. 'tate#ents b and c are correct.

++
Answer: )
Diff: '
$hich of the following state#ents is #ost correct% a. A fir# can use retained earnings without aying a flotation cost. Therefore/ while the cost of retained earnings is not 4ero/ the cost of retained earnings is generally lower than the after3ta( cost of debt financing. b. The ca ital structure that #ini#i4es the fir#,s weighted average cost of ca ital is also the ca ital structure that #a(i#i4es the fir#,s stock rice. c. The ca ital structure that #ini#i4es the fir#,s weighted average cost of ca ital is also the ca ital structure that #a(i#i4es the fir#,s earnings er share. d. If a fir# finds that the cost of debt financing is currently less than the cost of e*uity financing/ an increase in its debt ratio will always reduce its weighted average cost of ca ital. e. 'tate#ents a and b are correct.
Chapter 13 - Page 10

+-
Answer: a
Diff: '
$hich of the following state#ents is #ost correct% a. In general/ a fir# with low o erating leverage has a s#all ro ortion of its total costs in the for# of fi(ed costs. b. An increase in the ersonal ta( rate would not affect fir#s, ca ital structure decisions. c. A fir# with high business risk is #ore likely to increase its use of financial leverage than a fir# with low business risk/ assu#ing all else e*ual. d. 'tate#ents a and b are correct. e. All of the state#ents above are correct.

+2
Answer: c
Diff: '
$hich of the following state#ents is correct% a. BBusiness riskC is differentiated fro# Bfinancial riskC 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 o erating leverage. b. If cor orate ta( rates were decreased while other things were held constant/ and if the Modigliani3Miller ta(3ad0usted tradeoff theory of ca ital structure were correct/ this would tend to cause cor orations to increase their use of debt. c. If cor orate ta( rates were decreased while other things were held constant/ and if the Modigliani3Miller ta(3ad0usted tradeoff theory of ca ital structure were correct/ this would tend to cause cor orations to decrease their use of debt. d. The o ti#al ca ital structure is the one that si#ultaneously (1! #a(i#i4es the rice of the fir#,s stock/ ("! #ini#i4es its $A))/ and (+! #a(i#i4es its 56'. e. None of the state#ents above is correct.
Tough:
*ariati%ns in capital structures
+7
Answer: d
Diff: T
$hich of the following is correct% a. Henerally/ debt to total assets ratios do not vary #uch a#ong different industries although they do vary for fir#s within a articular industry. b. .tilities generally have very high co##on e*uity ratios due to their need for vast a#ounts of e*uity3su orted ca ital. c. The drug industry has a high debt to co##on e*uity ratio because their earnings are very stable and thus/ can su ort the large interest costs associated with higher debt levels. d. $ide variations in ca ital structures e(ist between industries and also between individual fir#s within industries and are influenced by uni*ue fir# factors including #anagerial attitudes. e. 'ince #ost stocks sell at or around their book values/ using accounting values rovides an accurate icture of a fir#,s ca ital structure.
Chapter 13- Page 11
Multiple Choice: P*o+lems Easy:

Determining price fr%m EB!T
+?
Answer: e
Diff: E
The 6rice )o# any will roduce 22/999 widgets ne(t year. Dariable costs will e*ual -9 ercent of sales/ while fi(ed costs will total <119/999. At what rice #ust each widget be sold for the co# any to achieve an 5BIT of <=2/999% a. b. c. d. e. <".99 <-.-2 <2.99 <2.+? <7."1 Answer: a Diff: E
Breakeven price
+>
Te(as 6roducts Inc. has a division that #akes burla bags for the citrus industry. The division has fi(ed costs of <19/999 er #onth/ and it e( ects to sell -"/999 bags er #onth. If the variable cost er bag is <".99/ what rice #ust the division charge in order to break even% a. b. c. d. e. <"."<".-? <".>" <+.12 <".99
Medium:
New financing
+=
Answer: a
Diff: '
The Alt#an )o# any has a debt ratio of ++.++ ercent/ and it needs to raise <199/999 to e( and. Manage#ent feels that an o ti#al debt ratio would be 17.7? ercent. 'ales are currently <?29/999/ and the total assets turnover is ?.2. Eow should the e( ansion be financed so as to roduce the desired debt ratio% a. b. c. d. e. 199: e*uity 199: debt "9 ercent debt/ >9 -9 ercent debt/ 79 29 ercent debt/ 29
ercent e*uity ercent e*uity ercent e*uity
Chapter 13- Page 13
Net %perating inc%me

-9
Answer: )
Diff: '
The )ongress )o# any has identified two #ethods for roducing laying cards. 1ne #ethod involves using a #achine having a fi(ed cost of <19/999 and variable costs of <1.99 er deck of cards. The other #ethod would use a less e( ensive #achine (fi(ed cost 8 <2/999!/ but it would re*uire greater variable costs (<1.29 er deck of cards!. If the selling rice er deck of cards will be the sa#e under each #ethod/ at what level of out ut will the two #ethods roduce the sa#e net o erating inco#e% a. b. c. d. e. 2/999 19/999 12/999 "9/999 "2/999 decks decks decks decks decks Answer: ) Diff: '
C$ange in )reakeven v%lume

-1
Eensley )or oration uses breakeven analysis to study the effects of e( ansion ro0ects it considers. )urrently/ the fir#,s lastic bag business seg#ent has fi(ed costs of <1"9/999/ while its unit rice er carton is <1."9 and its variable unit cost is <9.79. The fir# is considering a new bag #achine and an auto#atic carton folder as #odifications to its e(isting roduction lines. $ith the e( ansion/ fi(ed costs would rise to <"-9/999/ but variable cost would dro to <9.-1 er unit. 1ne key benefit is that Eensley can lower its wholesale rice to its distributors to <1.92 er carton (that is/ its selling rice!/ and this would likely #ore than double its #arket share/ as it will beco#e the lowest cost roducer. $hat is the change in the breakeven volu#e with the ro osed ro0ect% a. 199/999 units b. 1?2/999 units c. ?2/999 units d. "99/999 units e. 9 units
Breakeven and e+pansi%n

-"
Answer: c
Diff: '
Martin )or oration currently sells 1>9/999 units er year at a rice of <?.99 er unit; its variable cost is <-."9 er unit; and fi(ed costs are <-99/999. Martin is considering e( anding into two additional states/ which would increase its fi(ed costs to <729/999 and would increase its variable unit cost to an average of <-.-> er unit. If Martin e( ands/ it e( ects to sell "?9/999 units at <?.99 er unit. By how #uch will Martin,s breakeven sales dollar level change% a. b. c. d. e. < 1>+/+++ < -27/299 < >92/227 < =19/77? <1/"99/999
Breakeven
-+
Answer: d
Diff: '
5le hant Books sells a erback books for <? each. The variable cost er book is <2. At current annual sales of "99/999 books/ the ublisher is 0ust breaking even. It is esti#ated that if the authors, royalties are reduced/ the variable cost er book will dro by <1. Assu#e authors, royalties are reduced and sales re#ain constant; how #uch #ore #oney can the ublisher ut into advertising (a fi(ed cost! and still break even% a. b. c. d. e. <799/999 <-77/77? <+++/+++ <"99/999 <1?2/""2 Answer: d Diff: '
Operating decisi%n
--
Musgrave )or oration has fi(ed costs of <-7/999 and variable costs that are +9 ercent of the current sales rice of <".12. At a rice of <".12/ Musgrave sells -9/999 units. Musgrave can increase sales by 19/999 units by cutting its unit rice fro# <".12 to <1.=2/ but variable cost er unit won,t change. 'hould it cut its rice% a. b. c. d. e. No/ 5BIT decreases by <7/999. No/ 5BIT decreases by <"29. Ies/ 5BIT increases by <11/299. Ies/ 5BIT increases by <>/929. Ies/ 5BIT increases by <2/929. Answer: c lies to Fott 5nter risesJ <+99/999 <199/999 < 19/999 -9: 'hares outstanding 56' 'tock rice 1"9/999 <1.-2 <1?.-9 Diff: '
Capital structure and st%ck price

-2
The following infor#ation a 1 erating inco#e (5BIT! &ebt Interest e( ense Ta( rate
The co# any is considering a reca itali4ation where it would issue <+->/999 worth of new debt and use the roceeds to buy back <+->/999 worth of co##on stock. The buyback will be undertaken at the re3 reca itali4ation share rice (<1?.-9!. The reca itali4ation is not e( ected to have an effect on o erating inco#e or the ta( rate. After the reca itali4ation/ the co# any,s interest e( ense will be <29/999. Assu#e that the reca itali4ation has no effect on the co# any,s rice earnings (6G5! ratio. $hat is the e( ected rice of the co# any,s stock following the reca itali4ation% a. b. c. d. e. <12.+9 <1?.?2 <1>.99 <1=.9+ <"9.->
Chapter 13- Page 15

-7
Answer: e the following infor#ation
Diff: ' Ioung -9: 9: 19: 1.99K <+."9
A consultant 6ublishingJ
has
collected
regarding
Total assets <+/999 1 erating inco#e (5BIT! <>99 Interest e( ense <9 Net inco#e <->9 'hare rice
#illion #illion #illion #illion <+".99
Ta( rate &ebt ratio $A)) MGB ratio 56' 8 &6'
The co# any has no growth o ortunities (g 8 9!/ so the co# any ays out all of its earnings as dividends (56' 8 &6'!. Ioung,s stock rice can be calculated by si# ly dividing earnings er share by the re*uired return on e*uity ca ital/ which currently e*uals the $A)) because the co# any has no debt. The consultant believes that the co# any would be #uch better off if it were to change its ca ital structure to -9 ercent debt and 79 ercent e*uity. After #eeting with invest#ent bankers/ the consultant concludes that the co# any could issue <1/"99 #illion of debt at a before3ta( cost of ? ercent/ leaving the co# any with interest e( ense of <>- #illion. The <1/"99 #illion raised fro# the debt issue would be used to re urchase stock at <+" er share. The re urchase will have no effect on the fir#,s 5BIT; however/ after the re urchase/ the cost of e*uity will increase to 11 ercent. If the fir# follows the consultant,s advice/ what will be its esti#ated stock rice after the ca ital structure change% a. b. c. d. e. <+".99 <++.-> <+1."= <+".2= <+-.?"
Tough:
,amada e-uati%n and c%st %f e-uit&
-?
Answer: a
Diff: T
. 'i#on 'oftware )o. is trying to esti#ate its o ti#al ca ital structure. Aight now/ 'i#on has a ca ital structure that consists of "9 ercent debt and >9 ercent e*uity. (Its &G5 ratio is 9."2.! The risk3 free rate is 7 ercent and the #arket risk re#iu#/ kM L kAF/ is 2 ercent. )urrently the co# any,s cost of e*uity/ which is based on the )A6M/ is 1" ercent and its ta( rate is -9 ercent. $hat would be 'i#on,s esti#ated cost of e*uity if it were to change its ca ital structure to 29 ercent debt and 29 ercent e*uity% a. b. c. d. e. 1-.+2: +9.99: 1-.?": 12.79: 1+.7-:
Optimal capital structure and ,amada e-uati%n

->
Answer: d
Diff: T
Aaron Athletics is trying to deter#ine its o ti#al ca ital structure. The co# any,s ca ital structure consists of debt and co##on stock. In order to esti#ate the cost of debt/ the co# any has roduced the following tableJ
&ebt3to3total3 assets ratio (wd! 9.19 9."9 9.+9 9.-9 9.29 5*uity3to3total3 assets ratio (wc! 9.=9 9.>9 9.?9 9.79 9.29 &ebt3to3e*uity ratio (&G5! 9.19G9.=9 9."9G9.>9 9.+9G9.?9 9.-9G9.79 9.29G9.29 8 8 8 8 8 9.11 9."2 9.-+ 9.7? 1.99 Bond rating AA A A BB B Before3ta( cost of debt ?.9: ?." >.9 >.> =.7
The co# any,s ta( rate/ T/ is -9
ercent.
The co# any uses the )A6M to esti#ate its cost of co##on e*uity/ ks. The risk3free rate is 2 ercent and the #arket risk re#iu# is 7 ercent. Aaron esti#ates that if it had no debt its beta would be 1.9. (Its Bunlevered beta/C b./ e*uals 1.9.! 1n the basis of this infor#ation/ what is the co# any,s o ti#al ca ital structure/ and what is the fir#,s weighted average cost of ca ital ($A))! at this o ti#al ca ital structure% a. b. c. d. e. wc wc wc wc wc 8 8 8 8 8 9.=; 9.>; 9.?; 9.7; 9.2; wd wd wd wd wd 8 8 8 8 8 9.1; 9."; 9.+; 9.-; 9.2; $A)) $A)) $A)) $A)) $A)) 8 8 8 8 8 1-.=7: 19.=7: ?.>+: 19.12: 19.1>: Answer: d Diff: T

-=
Mi y 6asta )or oration (M6)! has a constant growth rate of ? ercent. The co# any retains +9 ercent of its earnings to fund future growth. M6),s e( ected 56' (56'1! and ks for various ca ital structures are given below. $hat is the o ti#al ca ital structure for M6)% &ebtGTotal Assets "9: +9 -9 29 ?9 a. b. c. d. e. &ebtGTotal &ebtGTotal &ebtGTotal &ebtGTotal &ebtGTotal Assets Assets Assets Assets Assets 8 8 8 8 8 "9: +9: -9: 29: ?9: 5( ected 56' <".29 +.99 +."2 +.?2 -.99 ks 12.9: 12.2 17.9 1?.9 1>.9
Chapter 13- Page 17

29
Answer: )
Diff: T
Hiven the following choices/ what is the o ti#al ca ital structure for )hi )o.% (Assu#e that the co# any,s growth rate is " ercent.! &ebt Aatio 9: "2 -9 29 ?2 a. b. c. d. e. 9: debt; 199: "2: debt; ?2: -9: debt; 79: 29: debt; 29: ?2: debt; "2: e*uity e*uity e*uity e*uity e*uity Answer: a Diff: T &ividends 6er 'hare <2.29 7.99 7.29 ?.99 ?.29 )ost of 5*uity (ks! 11.2: 1".9 1+.9 1-.9 12.9

21
Flood Motors is an all3e*uity fir# with "99/999 shares outstanding. The co# any,s 5BIT is <"/999/999/ and 5BIT is e( ected to re#ain constant over ti#e. The co# any ays out all of its earnings each year/ so its earnings er share e*uals its dividends er share. The co# any,s ta( rate is -9 ercent. The co# any is considering issuing <" #illion worth of bonds (at ar! and using the roceeds for a stock re urchase. If issued/ the bonds would have an esti#ated yield to #aturity of 19 ercent. The risk3free rate in the econo#y is 7.7 ercent/ and the #arket risk re#iu# is 7 ercent. The co# any,s beta is currently 9.=/ but its invest#ent bankers esti#ate that the co# any,s beta would rise to 1.1 if it roceeds with the reca itali4ation. Assu#e that the shares are re urchased at a rice e*ual to the stock #arket rice rior to the reca itali4ation. $hat would be the co# any,s stock rice following the reca itali4ation% a. b. c. d. e. <21.1<2+.>2 <27.9" <7>.=? <?7.9+

2"
Answer: a
Diff: T
5tchabarren 5lectronics has #ade the following forecast for the u co#ing year based on the co# any,s current ca itali4ationJ Interest e( ense 1 erating inco#e (5BIT! 5arnings er share <"/999/999 <"9/999/999 <+.79
The co# any has <"9 #illion worth of debt outstanding and all of its debt yields 19 ercent. The co# any,s ta( rate is -9 ercent. The co# any,s rice earnings (6G5! ratio has traditionally been 1"/ so the co# any forecasts that under the current ca itali4ation its stock rice will be <-+."9 at year end. The co# any,s invest#ent bankers have reca itali4e. Their suggestion is to issue 19 ercent to re urchase 1 #illion shares the stock can be re urchased at today,s <-9 suggested that the co# any enough new bonds at a yield of of co##on stock. Assu#e that stock rice.
Assu#e that the re urchase will have no effect on the co# any,s o erating inco#e; however/ the re urchase will increase the co# any,s dollar interest e( ense. Also/ assu#e that as a result of the increased financial risk the co# any,s rice earnings (6G5! ratio will be 11.2 after the re urchase. Hiven these assu# tions/ what would be the e( ected year3 end stock rice if the co# any roceeded with the reca itali4ation% a. b. c. d. e. <->.+9 <-".27 <--.?7 <-9.+<-7.=9 Answer: d Diff: T

2+
Fascheid 5nter rises is an all3e*uity fir# with 1?2/999 shares outstanding. The co# any,s stock rice is currently <>9 a share. The co# any,s 5BIT is <"/999/999/ and 5BIT is e( ected to re#ain constant over ti#e. The co# any ays out all of its earnings each year/ so its earnings er share e*uals its dividends er share. The fir#,s ta( rate is +9 ercent. The co# any is considering issuing <>99/999 worth of bonds and using the roceeds for a stock re urchase. If issued/ the bonds would have an esti#ated yield to #aturity of > ercent. The risk3free rate is 2 ercent and the #arket risk re#iu# is also 2 ercent. The co# any,s beta is currently 1.9/ but its invest#ent bankers esti#ate that the co# any,s beta would rise to 1." if it roceeded with the reca itali4ation. $hat would be the co# any,s stock rice following the re urchase transaction% a. b. c. d. <197.7? <19".7+ < ??.1< ?-.7? Chapter 13- Page 19
e. < ?9.-9 Capital structure and E"#

2-
Answer: d
Diff: T
Buchanan Brothers antici ates that its net inco#e at the end of the year will be <+.7 #illion (before any reca itali4ation!. The co# any currently has =99/999 shares of co##on stock outstanding and has no debt. The co# any,s stock trades at <-9 a share. The co# any is considering a reca itali4ation/ where it will issue <19 #illion worth of debt at a yield to #aturity of 19 ercent and use the roceeds to re urchase co##on stock. Assu#e the stock rice re#ains unchanged by the transaction/ and the co# any,s ta( rate is +- ercent. $hat will be the co# any,s earnings er share/ if it roceeds with the reca itali4ation% a. b. c. d. e. <"."+ <".-2 <+."7 <-.2" <2.2Answer: a Diff: T
Capital structure and E"#

22
T)E )or oration is considering two alternative ca ital structures with the following characteristics. &ebtGAssets ratio kd A 9.+ 19: B 9.? 1-:
The fir# will have total assets of <299/999/ a ta( rate of -9 ercent/ and a book value er share of <19/ regardless of the ca ital structure. 5BIT is e( ected to be <"99/999 for the co#ing year. $hat is the difference in earnings er share (56'! between the two alternatives% a. b. c. d. e. <".>? <?.7" <-.?> <+.9+ <1.1= Answer: d Diff: T N
Capital structure, leverage, and WACC

27
6ennington Airlines currently has a beta of 1.". The co# any,s ca ital structure consists of <? #illion of e*uity and <+ #illion of debt. The co# any is considering changing its ca ital structure. .nder the ro osed lan the co# any would increase its debt by <" #illion and use the roceeds to re urchase co##on stock. ('o/ after the lan is co# leted/ the co# any will have <2 #illion of debt and <2 #illion of e*uity.! The co# any esti#ates that if it goes ahead with the lan/ its bonds will have a no#inal yield to #aturity of >.2 ercent. The co# any,s ta( rate is -9 ercent. The risk3free rate is 7 ercent and the #arket risk re#iu# is ? ercent. $hat is the co# any,s esti#ated $A)) if it goes ahead with the lan% a. >.+2:
b. =.?2: c. 1"."?: d. 19.=9: e. 11.-2:
Chapter 13- Page 21
Multiple Part:
(The following information applies to the next four problems.) )o ybold )or oration is a start3u fir# considering two alternative ca ital structures/ one is conservative and the other aggressive. The conservative ca ital structure calls for a &GA ratio 8 9."2/ while the aggressive strategy calls for &GA 8 9.?2. 1nce the fir# selects its target ca ital structure/ it envisions two ossible scenarios for its o erationsJ Feast or Fa#ine. The Feast scenario has a 79 ercent robability of occurring and forecasted 5BIT in this state is <79/999. The Fa#ine state has a -9 ercent chance of occurring and e( ected 5BIT is <"9/999. Further/ if the fir# selects the conservative ca ital structure its cost of debt will be 19 ercent/ while with the aggressive ca ital structure its debt cost will be 1" ercent. The fir# will have <-99/999 in total assets/ it will face a -9 ercent #arginal ta( rate/ and the book value of e*uity er share under either scenario is <19.99 er share. Capital structure and E"#
2?
Answer: e
Diff: '
$hat is the difference between the 56' forecasts for Feast and Fa#ine under the aggressive ca ital structure% a. b. c. d. e. < 9 <1.-> <9.7" <9.=> <".-9 Answer: ) Diff: '

2>
$hat is the difference between the 56' forecasts for Feast and Fa#ine under the conservative ca ital structure% a. b. c. d. e. <1.99 <9.>9 <"."9 <9.-< 9 Answer: c Diff: '
Capital structure and C* %f E"#

2=
$hat is the coefficient of variation of e( ected 56' under the aggressive ca ital structure% a. b. c. d. e. 1.99 1.1> ".-2 ".>> +.?7
Capital structure and C* %f E"#

79
Answer: a variation of e( ected 56'
Diff: ' the
$hat is the coefficient of conservative ca ital structure% a. b. c. d. e. 9.2> 9.+= 9.12 9."+ 1.99
under
(The following information applies to the next three problems.) )urrently/ the Foto oulos )or oration,s balance sheet is as followsJ Assets Total assets <2 billion <2 billion &ebt )o##on e*uity Total debt N co##on e*uity <1 billion - billion <2 billion
The book value of the co# any (both debt and co##on e*uity! e*uals its #arket value (both debt and co##on e*uity!. Further#ore/ the co# any has deter#ined the following infor#ationJ The The The The The co# any esti#ates that its before3ta( cost of debt is ?.2 co# any esti#ates that its levered beta is 1.1. risk3free rate is 2 ercent. #arket risk re#iu#/ kM L kAF/ is 7 ercent. co# any,s ta( rate is -9 ercent. ercent.
In addition/ the Foto oulos )or The ro osed lan is to issue <1 to re urchase <1 billion worth reca itali4ation/ the fir#,s si4e Capital structure and WACC
71
oration is considering a reca itali4ation. billion worth of debt and to use the #oney of co##on stock. As a result of this will not change. Answer: c Diff: E N
$hat is Foto oulos, current $A)) (before the a. 2.=": b. =.>>: c. 19.1>: d. 19.?>: e. 11.+>:
ro osed reca itali4ation!%
,amada e-uati%n and unlevered )eta

7"
Answer: c unlevered beta (before the
Diff: E
$hat is Foto oulos, reca itali4ation!% a. b. c. d. e. 9.7"1+ 9.>=7" 9.=272 1.99-1 1."?99
current
ro osed
Chapter 13- Page 23
,amada e-uati%n and c%st %f c%mm%n e-uit&

7+
Answer: e
Diff: '
$hat will be the co# any,s new cost of co##on e*uity if it roceeds with the reca itali4ation% (EintJ Be sure that the beta you use is carried out to - deci#al laces.! a. b. c. d. e. 19.?-: 11.7": 1"."?: 1".7": 1+.9+: (The following information applies to the next two problems.)
An analyst has )or orationJ
collected
the
following
infor#ation
regarding
the
Milbrett
Total assets 8 <199 #illion. Basic earning ower (B56! 8 "9:. Ta( rate 8 -9:.
)urrently/ the co# any has no debt or referred stock and its interest e( ense and referred dividends e*ual 4ero. The book value and #arket value of co##on e*uity e*uals <199 #illion. The co# any has 2 #illion outstanding shares of co##on stock/ and its stock rice is <"9 a share. Milbrett is considering a reca itali4ation/ where they will issue <"9 #illion of debt and use the roceeds to buy back co##on stock at the current rice of <"9 a share. As a result of the reca itali4ation/ the si4e of the fir# will not change. Assu#e that the newly3issued debt will have a before3ta( cost of > ercent. Assu#e that the reca itali4ation will have no effect on the co# any,s basic earning ower. Capital structure, financial leverage, and rati%s
7-
Answer: d
Diff: E
$hich of the following is likely to occur following the reca itali4ation% a. b. c. d. e. The co# The co# The co# The co# None of any,s net inco#e will increase. any,s A1A will increase. any,s o erating inco#e will decrease. any,s A15 will increase. the state#ents above is correct. Answer: c Diff: T N

72
Assu#e that after the reca itali4ation the co# any,s ti#es3interest3 earned ratio will be 1".2. $hat is Milbrett,s e( ected earnings er share following the reca itali4ation% a. b. c. d. e. <".-<".7" <".?7 <".>9 <".>>
(The following information applies to the next two problems.) Financial analysts for Naulls Industries have revealed the following infor#ation about the co# anyJ Naulls Industries currently has a ca ital structure that consists of ?2 ercent co##on e*uity and "2 ercent debt. The risk3free rate/ kAF/ is 2 ercent. The #arket risk re#iu# / kM 3 kAF/ is 7 ercent. Naulls,s co##on stock has a beta of 1.". Naulls has "93year bonds outstanding with an annual cou on rate of 1" ercent and a face value of <1/999. The bonds sell today for <1/"99. The co# any,s ta( rate is -9 ercent. Answer: c Diff: E N

77
$hat is the co# any,s unlevered beta% a. b. c. d. e. 9.-+ 9.=+ 1.99 1.97 1.-Answer: c Diff: ' N

7?
$hat would be the co# any,s new cost of co##on e*uity (using the )A6M! if it were to change its ca ital structure to -9 ercent debt and 79 ercent co##on e*uity% (NoteJ Eere we are asking for the new cost of co##on e*uity/ not the $A))O! a. b. c. d. e. 11.+7: 1".7": 1+.-9: 1-.+9: 17.-9: (The following information applies to the next four problems.)
'tewart Inc. has <-/999/999 in total assets. The co# any,s current ca ital structure consists of "2 ercent debt and ?2 ercent co##on e*uity. )urrently/ the co# any,s before3ta( cost of debt is > ercent. The risk3free rate (k AF! is 2 ercent and the #arket risk re#iu# (kM L kAF! is also 2 ercent. At the fir#,s current ca ital structure/ the co# any,s beta is 1.12 (i.e./ its current cost of co##on e*uity is 19.?2 ercent!. 'tewart,s o erating inco#e (5BIT! is <+99/999/ its interest e( ense is <>9/999/ and its ta( rate is -9 ercent. The co# any has >9/999 outstanding shares of co##on stock. The co# any,s net inco#e is currently <1+"/999/ and its earnings er share (56'! is <1.72. The co# any ays out all of its earnings as dividends (56' 8 &6'!/ and hence its growth rate is 4ero. Thus/ its stock rice is si# ly 56'Gks; where ks is the cost of co##on e*uity. It follows that the co# any,s stock rice is currently <12.+->> (<1.72G9.19?2!.
Chapter 13- Page 25
Capital structure, leverage, and WACC

7>
Answer: c
Diff: E
$hat is the co# any,s $A))% a. 7."=: b. >.>7: c. =."7: d. 19.97: e. 19.?9:

7=
Answer: )
Diff: '
$hat is the co# any,s unlevered beta% a. b. c. d. e. 9.-19? 9.=2>+ 1.9999 1.91-? 1.+>99 Answer: d Diff: ' N

?9
The co# any is considering changing its ca ital structure. ' ecifically/ the fir# is considering a ca ital structure that consists of 29 ercent debt and 29 ercent co##on e*uity. In order to #ake this change/ the co# any would issue additional debt and use the roceeds to re urchase co##on stock. Assu#e that if the fir# ado ts this change/ its total interest e( ense would now be <"99/999. Assu#e that the ca ital structure change would have no effect on the co# any,s total assets/ o erating inco#e/ or ta( rate. Assu#e that all co##on shares will be re urchased at <17 a share/ which is slightly above the current stock rice of <12.+->>. $hat would be the co# any,s new cost of co##on e*uity if it ado ts a ca ital structure that consists of 29 ercent debt and 29 ercent co##on e*uity% a. b. c. d. e. 11."+: 11.?1: 1"."2: 1".7?: 1+.99: Answer: c Diff: ' N
Capital structure, leverage, and E"#

?1
$hat would be the co# any,s earnings er share/ if it ado ts a ca ital structure with 29 ercent debt and 29 ercent co##on e*uity% a. b. c. d. e. <9.?2 <".-7 <+.-+ <-.9<7.>7
,e+ Appendi- !"A

Multiple Choice: Conceptual Easy:
DOL, D(L, and DTL 1+A3?". $hich of the following state#ents is #ost correct% a. An increase in fi(ed costs/ (holding sales and variable costs constant! will reduce the co# any,s degree of o erating leverage. b. An increase in interest e( ense will reduce the co# any,s degree of financial leverage. c. If the co# any has no debt outstanding/ then its degree of total leverage e*uals its degree of o erating leverage. d. Answers a and b are correct. e. Answers b and c are correct. Answer: c Diff: E
Medium:
(inancial leverage 1+A3 . The use of financial leverage by the fir# has a which of the following% (1! ("! (+! (-! (2! a. b. c. d. e. The The The The The 1/ 1/ "/ "/ 1/ +/ "/ +/ +/ "/ risk associated with the fir#. return e( erienced by the shareholder. variability of net inco#e. degree of o erating leverage. degree of financial leverage. 2 2 2 -/ 2 +/ 2 Answer: d Diff: '
?+
Answer: e
Diff: '
otential i# act on
(inancial leverage
1+A3?-. If a fir# uses debt financing (&ebt ratio 8 9.-9! and sales change fro# the current level/ which of the following state#ents is #ost correct% a. The ercentage change in net o erating inco#e (5BIT! resulting fro# the change in sales will e(ceed the ercentage change in net inco#e (NI!. b. The ercentage change in 5BIT will e*ual the ercentage change in net inco#e. c. The ercentage change in net inco#e relative to the ercentage change in sales (and in 5BIT! will not de end on the interest rate aid on the debt. d. The ercentage change in net o erating inco#e will be less than the ercentage change in net inco#e. e. 'ince debt is used/ the degree of o erating leverage #ust be greater Chapter 13- Page 27
than 1.
(inancial risk 1+A3 . $hich of the following state#ents is #ost correct%

?2
Answer: )
Diff: '
a. 'u ose )o# any APs 56' is e( ected to e( erience a larger ercentage change in res onse to a given ercentage change in sales than )o# any BPs 56'. 1ther things held constant/ )o# any A would a ear to have #ore business risk than )o# any B. b. 'tate#ent a would be correct if the ter# B5BITC were substituted for B56'.C c. 'tate#ent a would be correct if the ter# B5BITC were substituted for Bsales.C d. 'tate#ent a would be correct if the words Bfinancial riskC were substituted for Bbusiness risk.C e. The state#ents above are false. Operating and financial leverage 1+A3?7. $hich of the following state#ents is #ost correct% a. The degree of o erating leverage (&1F! de ends on a co# anyPs fi(ed costs/ variable costs/ and sales. The &1F for#ula assu#es (1! that fi(ed costs are constant and ("! that variable costs are a constant ro ortion of sales. b. The degree of total leverage (&TF! is e*ual to the &1F lus the degree of financial leverage (&FF!. c. Arith#etically/ financial leverage and o erating leverage offset one another so as to kee the degree of total leverage constant. Therefore/ the for#ula shows that the greater the degree of financial leverage/ the s#aller the degree of o erating leverage. d. The state#ents above are true. e. The state#ents above are false. Operating and financial leverage 1+A3??. $hich of the following state#ents is #ost correct% a. All else being e*ual/ an increase in a fir#Ps fi(ed costs will increase its degree of o erating leverage. b. Fir#s that have large fi(ed costs and low variable costs have a higher degree of financial leverage than do fir#s with low fi(ed costs and high variable costs. c. If a fir#Ps net inco#e rises 19 ercent every ti#e its 5BIT rises 19 ercent/ this i# lies the fir# has no debt outstanding. d. None of the state#ents above is correct. e. Answers a and c are correct. Answer: e Diff: ' Answer: a Diff: '
Chapter 13- Page 29
DOL 1+A3 . The degree of characteristics%

?>
Answer: c o erating leverage has which of the
Diff: '
following
a. The closer the fir# is o erating to breakeven *uantity/ the s#aller the &1F. b. A change in *uantity de#anded will roduce the sa#e ercentage change in 5BIT as an identical change in rice er unit of out ut/ other things held constant. c. The &1F is not a fi(ed nu#ber for a given fir#/ but will de end u on the ti#e 4ero values of the econo#ic variables Q (Quantity!/ 6 (6rice!/ and D (Dolu#e!. d. The &1F relates the change in net inco#e to the change in net o erating inco#e. e. If the fir# has no debt/ the &1F will e*ual 1. De)t rati% and DOL Answer: a Diff: '
1+A3?=. )o# any & has a 29 ercent debt ratio/ whereas )o# any 5 has no debt financing. The two co# anies have the sa#e level of sales/ and the sa#e degree of o erating leverage. $hich of the following state#ents is #ost correct% a. If sales increase 19 ercent for both co# anies/ then )o# any & will have a larger ercentage increase in its net inco#e. b. If sales increase 19 ercent for both co# anies/ then )o# any & will have a larger ercentage increase in its o erating inco#e (5BIT!. c. If 5BIT increases 19 ercent for both co# anies/ then )o# any &,s net inco#e will rise by #ore than 19 ercent/ while )o# any 5,s net inco#e will rise by less than 19 ercent. d. Answers a and c are correct. e. None of the answers above is correct. Degree %f leverage Answer: a Diff: '
1+A3>9. $hich of the following is a key benefit of using the degree of leverage conce t in financial analysis% a. It allows decision #akers a relatively clear assess#ent conse*uences of alternative actions. b. It establishes the o ti#al ca ital structure for the fir#. c. It shows how a given change in leverage will affect sales. d. All of the state#ents above. e. 1nly state#ents a and c above are correct. of the
Multiple Choice: P*o+lems Easy:

DOL and c$anges in EB!T Answer: a Diff: E 1+A3>1. Ma(vill Motors has annual sales of <12/999. Its variable costs e*ual 79 ercent of its sales/ and its fi(ed costs e*ual <1/999. If the co# any,s sales increase 19 ercent/ what will be the ercentage increase in the co# any,s earnings before interest and ta(es (5BIT!% a. b. c. d. e. 1": 1-: 17: 1>: "9: Answer: d Diff: E
DTL and f%recast E"#
1+A3>". Quick Faunch Aocket )o# any/ a satellite launching fir#/ e( ects its sales to increase by 29 ercent in the co#ing year as a result of NA'APs recent roble#s with the s ace shuttle. The fir#Ps current 56' is <+."2. Its degree of o erating leverage is 1.7/ while its degree of financial leverage is ".1. $hat is the fir#Ps ro0ected 56' for the co#ing year using the &TF a roach% a. b. c. d. e. < +."2 < 2.-7 <19.=" < >.?1 <1=.7+ Answer: ) Diff: E
C$ange in E"#
1+A3>+. Iour fir#Ps 56' last year was <1.99. Iou e( ect sales to increase by 12 ercent during the co#ing year. If your fir# has a degree of o erating leverage e*ual to 1."2 and a degree of financial leverage e*ual to +.29/ then what is its e( ected 56'% a. b. c. d. e. <1.+->1 <1.727+ <1.=>1+ <"."-"? <".2>-+
Chapter 13- Page 31
Medium:
DOL c$ange Answer: a Diff: ' 1+A3>-. 'tro#burg )or oration #akes surveillance e*ui #ent for intelligence organi4ations. Its sales are <?2/999/999. Fi(ed costs/ including research and develo #ent/ are <-9/999/999/ while variable costs a#ount to +9 ercent of sales. 'tro#burg lans an e( ansion which will generate additional fi(ed costs of <12/999/999/ decrease variable costs to "2 ercent of sales/ and also er#it sales to increase to <199/999/999. $hat is 'tro#burgPs degree of o erating leverage at the new ro0ected sales level% a. b. c. d. e. DOL +.?2 -."9 +.29 -.7? +.++ Answer: d Diff: '
1+A3>2. The Rdegree of leverageR conce t is designed to show how changes in sales will affect 5BIT and 56'. If a 19 ercent increase in sales causes 56' to increase fro# <1.99 to <1.29/ and if the fir# uses no debt/ then what is its degree of o erating leverage% a. b. c. d. e. +.7 -." -.? 2.9 2.2 Answer: c Diff: '
DOL in sales d%llars
1+A3>7. Marcus )or oration currently sells 129/999 units a year at a rice of <-.99 a unit. Its variable costs are a ro(i#ately +9 ercent of sales/ and its fi(ed costs a#ount to 29 ercent of revenues at its current out ut level. Although fi(ed costs are based on revenues at the current out ut level/ the cost level is fi(ed. $hat is MarcusPs degree of o erating leverage in sales dollars% a. b. c. d. e. 1.9 "." +.2 -.9 2.9
DOL, D(L, and DTL

>?
Answer: c
Diff: '
1+A3 . 6QA Manufacturing )or oration has <1/299/999 in debt outstanding. The co# anyPs before3ta( cost of debt is 19 ercent. 'ales for the year totaled <+/299/999 and variable costs were 79 ercent of sales. Net inco#e was e*ual to <799/999 and the co# anyPs ta( rate was -9 ercent. If 6QAPs degree of total leverage is e*ual to 1.-9/ what is its degree of o erating leverage% a. b. c. d. e. 1.12 1.99 1."" 1.1" ".7> Answer: d Diff: '
DTL and interest e+pense
1+A3>>. )oats )or . generates <19/999/999 in sales. Its variable costs e*ual >2 ercent of sales and its fi(ed costs are <299/999. Therefore/ the co# any,s o erating inco#e (5BIT! e*uals <1/999/999. The co# any esti#ates that if its sales were to increase 19 ercent/ its net inco#e and 56' would increase 1?.2 ercent. $hat is the co# any,s interest e( ense% (Assu#e that the change in sales would have no effect on the co# any,s ta( rate.! a. b. c. d. e. DTL 1+A3>=. Alvare4 Technologies o erating costs total of sales/ so the co# co# any,s interest e( total leverage (&TF!% a. b. c. d. e. 1.?1+.199 +."29 +.299 7.999 <199/999 <192/>?<111/2><1-"/>2? <>2?/1-" Answer: e Diff: '
has sales of <+/999/999. The co# any,s fi(ed <299/999 and its variable costs e*ual 79 ercent any,s current o erating inco#e is <?99/999. The ense is <299/999. $hat is the co# any,s degree of
Chapter 13- Page 33
DTL and c$ange in N!

=9
Answer: e
Diff: '
1+A3 . Bell Brothers has <+/999/999 in sales. Its fi(ed costs are esti#ated to be <199/999/ and its variable costs are e*ual to fifty cents for every dollar of sales. The co# any has <1/999/999 in debt outstanding at a before3ta( cost of 19 ercent. If Bell BrothersP sales were to increase by "9 ercent/ how #uch of a ercentage increase would you e( ect in the co# anyPs net inco#e% a. b. c. d. e. 12.77: 1>.++: 1=."-: "1.29: "+.9>: Answer: c Diff: '
E+pected EB!T
1+A3=1. Assu#e that a fir# currently has 5BIT of <"/999/999/ a degree of total leverage of ?.2/ and a degree of financial leverage of 1.>?2. If sales decline by "9 ercent ne(t year/ then what will be the fir#Ps e( ected 5BIT in one year% a. b. c. d. e. <"/-99/999 <1/799/999 < -99/999 <+/799/999 <1/+29/999 Answer: d Diff: '
E+pected EB!T
="
1+A3 . Assu#e that a fir# has a degree of financial leverage of 1."2. If sales increase by "9 ercent/ the fir# will e( erience a 79 ercent increase in 56'/ and it will have an 5BIT of <199/999. $hat will be the 5BIT for this fir# if sales do not increase% a. b. c. d. e. <11+/-1" <199/999 < >-/+?2 < 7?/27> < -"/112 Answer: e Diff: '
E+pected EB!T
1+A3=+. Sulwicki )or oration wants to deter#ine the effect of an e( ansion of its sales on its o erating inco#e (5BIT!. The fir#Ps current degree of o erating leverage is ".2. It ro0ects new unit sales to be 1?9/999/ an increase of -2/999 over last yearPs level of 1"2/999 units. Fast yearPs 5BIT was <79/999. Based on a degree of o erating leverage of ".2/ what is this yearPs e( ected 5BIT with the increase in sales% a. b. c. d. e. < 79/999 <1?2/999 <199/999 < =9/999 <11-/999
Degree %f financial leverage

=-
Answer: d
Diff: '
1+A3 . A co# any currently sells ?2/999 units annually. At this sales level/ its 5BIT is <- #illion/ and its degree of total leverage is ".9. The fir#Ps debt consists of <12 #illion in bonds with a =.2 ercent cou on. The co# any is considering a new roduction #ethod which will entail an increase in fi(ed costs but a decrease in variable costs/ and will result in a degree of o erating leverage of 1.7. The resident/ who is concerned about the stand3alone risk of the fir#/ wants to kee the degree of total leverage at ".9. If 5BIT re#ains at <- #illion/ what a#ount of bonds #ust be retired to acco# lish this% a. b. c. d. e. <>.-" <=.1= <?.7+ <7.2> <-.-#illion #illion #illion #illion #illion
Tough:
(inancial leverage, DOL, and DTL Answer: a Diff: T 1+A3=2. A co# any has an 5BIT of <- #illion/ and its degree of total leverage is ".-. The fir#,s debt consists of <"9 #illion in bonds with a 19 ercent yield to #aturity. The co# any is considering a new roduction rocess that will re*uire an increase in fi(ed costs but a decrease in variable costs. If ado ted/ the new rocess will result in a degree of o erating leverage of 1.-. The resident wants to kee the degree of total leverage at ".-. If 5BIT re#ains at <- #illion/ what a#ount of bonds #ust be outstanding to acco# lish this (assu#ing the yield to #aturity re#ains at 19 ercent!% a. b. c. d. e. <17.? <1>.2 <1=." <1=.> <"9.1 #illion #illion #illion #illion #illion Answer: c Diff: T
DOL, D(L, and fi+ed %perating c%sts
1+A3=7. Fincoln Fodging Inc. esti#ates that if its sales increase 19 ercent then its net inco#e will increase 1> ercent. The co# any,s 5BIT e*uals <".- #illion/ and its interest e( ense is <-99/999. The co# any,s o erating costs include fi(ed and variable costs. $hat is the level of the co# any,s fi(ed o erating costs% a. b. c. d. e. < -29/999 < 777/77? <1/"99/999 <"/999/999 <"/1"2/999
Chapter 13- Page 35
A'%,E CHAPTE % A'D %.$&T#.'% !"
1. ". +.
Business risk Business risk Business risk
Answer: c Answer: d Answer: d
Diff: E Diff: E N
Diff: E
The correct answer is state#ent d. 'tate#ents a and b are correct. Both relate directly to the business side of the fir#. 'tate#ent c/ on the other hand/ is related to the financial risk of the fir#. 'ince state#ents a and b are correct/ state#ent d is the correct choice. -. 2. Business and financial risk Optimal capital structure Answer: d Answer: e Diff: E Diff: E
7 . ?. >. =.
The o ti#al ca ital structure #a(i#i4es the fir#,s stock the fir#,s $A)). Optimal capital structure Optimal capital structure Target capital structure Leverage and capital structure
rice and #ini#i4es Diff: E Diff: E Diff: E Diff: E
Answer: c Answer: e Answer: e Answer: d
19Both an increase in the cor orate ta( rate and a decrease in the co# any,s degree of o erating leverage will encourage the fir# to use #ore debt in its ca ital structure. Therefore/ the correct choice is state#ent d. . Leverage and capital structure Answer: e Diff: E
'tate#ent e is the correct choice. Fowering the cor orate ta( rate reduces the ta( advantages of debt leading fir#s to use less debt financing. If the ersonal ta( rate were to increase/ individuals would now find interest received on cor orate debt less attractive/ causing fir#s to utili4e less debt financing. An increase in the costs of bankru tcy would lead fir#s to use less debt in order to reduce the robability of having to incur these higher costs. 11. Leverage and capital structure Answer: e Diff: E
1".
'tate#ent e is correct. Fess stable sales would lead a fir# to reduce its debt ratio. A lower cor orate ta( rate reduces the ta( advantage of the deductibility of interest e( ense. This reduction in the ta( shield rovided by debt would encourage less use of debt. If #anage#ent believes the fir#,s stock is overvalued/ then it would want to issue e*uity rather than debt/ thereby increasing the fir#,s e*uity ratio. Leverage and capital structure Answer: a Diff: E 'tate#ent a is correct; all the other state#ents are false. 'ince interest is ta( deductible/ it would #ake sense to increase debt if the cor orate ta( rate rises. Interest received by individual investors is not ta( e(e# t/ so an increase in the ersonal ta( rate would not encourage a fir# to increase its debt level in the ca ital structure. Increasing o erating leverage would discourage a co# any fro# increasing debt. If a co# any,s assets beco#e less li*uid/ it would hurt the co# any,s financial osition/ #aking it less likely that the fir# could #ake interest ay#ents when necessary. An increase in
e( ected bankru tcy costs would encourage a co# any to use less debt. 1+. Leverage and capital structure Answer: e Diff: E
If the costs incurred when filing for bankru tcy increased/ fir#s would be enali4ed #ore if they filed for bankru tcy and would be less willing to take that risk. Therefore/ they would reduce debt levels to hel avoid bankru tcy risk/ so state#ent a is false. An increase in the cor orate ta( rate would #ean that fir#s would get larger ta( breaks for interest ay#ents. Therefore/ fir#s have an incentive to increase interest ay#ents/ in order to reduce ta(es. Therefore/ they will increase their debt ratios/ so state#ent b is true. An increase in the ersonal ta( rate decreases the after3ta( return that investors will receive. Fir#s will have to issue debt at higher interest rates in order to rovide investors with the sa#e after3ta( returns they used to receive. This will raise fir#s, costs of debt/ which will increase their $A))s/ so fir#s will not increase their debt ratios. Therefore/ state#ent c is false. If a fir#,s business risk decreases/ then this will tend to increase its debt ratio. Therefore/ state#ent d is true. 'ince both state#ents b and d are true/ the correct choice is state#ent e. 1-. Leverage and capital structure Answer: a Diff: E N
The correct answer is state#ent a. If cor orate ta( rates increase/ then co# anies get a larger ta( advantage fro# debt in their ca ital structure/ so they will increase their debt ratios. If ersonal ta(es increase/ bondholders will ay #ore ta(es and will de#and a higher rate of return fro# co# anies to co# ensate the#. Therefore/ co# anies will need to ay higher interest rates/ which #akes debt #ore e( ensive. Therefore/ an increase in the ersonal ta( rate will not encourage cor orations to increase their debt ratios. If their assets beco#e less li*uid/ co# anies will have to ay a higher interest rate on their bonds. (Ae#e#ber/ k 8 kT U I6 U &A6 U MA6 U F6. If assets are less li*uid/ F6 increases.! This #akes the debt #ore e( ensive and #akes co# anies less likely to increase their debt ratios.
12.
Answer: c
Diff: E
The correct answer is state#ent c. The co# any will have higher debt interest ay#ents/ so net inco#e will decline. Thus/ state#ent a is false. The effect on 56' is a#biguous. 5arnings decline (NI!/ but so will the nu#ber of shares. Therefore/ state#ent b is false. The fir#,s reca itali4ation will not change total assets. Eowever/ since net inco#e declines/ A1A will decrease; so state#ent d is false. As long as the B56 ratio is greater than the cost of debt/ A15 will increase. Eowever/ you don,t have enough infor#ation to deter#ine the cost of debt/ so you can #ake no deter#ination about A15. Thus/ state#ent e is false. The increase in debt will increase the risk to shareholders/ so the cost of e*uity will increase. Therefore/ state#ent c is correct. 17. Leverage and capital structure Answer: e Diff: E N
The correct answer is state#ent e. 'tate#ent a is incorrect. Ty ically/ the cost of debt rises slower than the cost of e*uity. Also/ the fir# is substituting chea er debt for #ore e( ensive e*uity. At so#e oint/ increasing
debt will likely lead to an increase in the $A)). But this is not true across all levels of debt. VThink of a fir# with no debtJ increasing the debt ratio to 0ust 19: will robably lower the $A))W. This also e( lains why state#ent c is incorrect. A fir# with a high debt ratio (i.e./ =9:! will likely increase its $A)) by further increasing its debt. 'tate#ent b is incorrect. Although 56' is #a(i#i4ed/ the total value of the co# any #ay be co# ro#ised. This contrasts with state#ent d. The ca ital structure that #a(i#i4es stock rice should #ini#i4e the $A)). 'o/ state#ent d is also incorrect. 1?. Leverage and capital structure k $A)) Answer: c Diff: E
&GA ratio 'tate#ent a is false. The $A)) does not necessarily increase. Ae#e#ber/ you are re lacing high cost e*uity with low cost debt. $hen there is very little debt in the ca ital structure/ the $A)) will actually decrease. ('ee the diagra# above.! The ca ital structure that #a(i#i4es stock rice is not necessarily the ca ital structure that #a(i#i4es 56'/ so state#ent b is false. If the cor orate ta( rate increases/ co# anies will obtain a bigger ta( advantage for their interest ay#ents. Thus/ they #ay increase their debt levels to take advantage of this situation/ and this would raise debt ratios. Therefore/ the correct answer is state#ent c. Capital structure and WACC Answer: e Diff: E 'tate#ent a is false; if you are to the left of the fir#,s o ti#al ca ital structure on the $A)) curve/ increasing a co# any,s debt ratio will actually decrease the fir#,s $A)). 'tate#ent b is false; if you are to the right of the fir#,s o ti#al ca ital structure on the $A)) curve/ increasing a co# any,s debt ratio will actually increase the fir#,s $A)). 'tate#ent c is false; as you increase the fir#,s debt ratio the cost of debt will increase because you,re using #ore debt. Because you,re using #ore debt the cost of e*uity also increases because the fir#,s financial risk has increased. Fro# state#ents a and b you can see that whether the $A)) is increased de ends on where you are on the $A)) curve relative to the fir#,s o ti#al ca ital structure. Therefore/ the correct answer is state#ent e. 1=. Capital structure, OA, and OE Answer: d Diff: E
1>.
"9 .
'tate#ents a and b are correct; therefore/ state#ent d is the a ro riate choice. A1A 8 NIGTA. If total assets re#ain the sa#e/ but NI decreases (because of the new interest ay#ent!/ A1A will decrease. NI will fall/ but not as #uch in co# arison to the a#ount that co##on e*uity will fall because B56 X kd/ thus A15 8 NIG)5 will rise. B56 will re#ain the sa#e. B56 8 5BITGTA/ where TA and 5BIT re#ain the sa#e (which was given in the roble#!. Capital structure, WACC, T!E, and E"# Answer: a Diff: E
'tate#ent a is correct; the other state#ents are false. The ca ital structure that #a(i#i4es the fir#,s stock rice generally calls for a debt ratio that is lower than the one that #a(i#i4es 56'. The fir# could #a(i#i4e its TI5 by having no debt (that is 4ero interest ay#ents!. But/ this ca ital structure would robably not #a(i#i4e the fir#,s stock rice. "1. Capital structure t$e%r& Answer: d Diff: E
'tate#ents a and c are correct; therefore/ state#ent d is the correct choice. An increase in the cor orate ta( rate reduces the after3ta( cost of debt #aking it #ore attractive relative to e*uity. Thus/ fir#s #ight be e( ected to use #ore debt in their ca ital structure rather than less debt. "". 'iscellane%us capital structure c%ncepts Answer: c Diff: E N
The correct answer is state#ent c. 'tate#ent a is not correct. @ust the o osite is true33we would e( ect co# anies to use less debt. 'tate#ent b is not correct. The additional debt would result in an increase in interest e( ense and a decrease in net inco#e. 'ince assets are unchanged/ the co# anyPs A1A #ust decrease. 'tate#ent c is correct. The additional debt would be used to urchase additional assets. $e are told that the A1A stays the sa#e. Therefore/ if assets increase/ it #ust #ean that net inco#e also increases. There is no change in e*uity/ so the A15 of the fir# #ust increase. "+ . (inancial leverage and Answer: a Diff: E E"#
'tate#ent a is true; a higher 56' does not always #ean that the stock rice will increase. 'tate#ent b is false; a lower $A)) will #ean a higher stock rice. 'tate#ent c is false; 56' can increase 0ust because shares outstanding decline. (The fir#,s net inco#e will decline because its interest e( ense increases.! "-. (inancial leverage and E"# Answer: c Diff: E
'tate#ent a is false because B56 8 5BITGTotal assets. The e(tent to which the fir# uses debt financing does not affect 5BIT or total assets. 'tate#ent b is false because fir#s with a high ercentage of fi(ed costs have a high degree of o erating leverage by definition. "2. (inancial leverage and rati%s Answer: d Diff: E
B56 8 5BITGTA. 'ince they both have the sa#e total assets and the sa#e B56/ then 5BIT #ust be the sa#e for both co# anies. If A has a higher debt ratio and higher interest e( ense than B/ and they both have the sa#e 5BIT and ta( rate/ then A #ust have a lower NI than B. Therefore/ state#ent a is true. If A has a lower NI than B but both have the sa#e total assets/ then A,s A1A (NIGTA! #ust be lower than B,s A1A. Therefore/ state#ent b is true. If both co# anies have the sa#e total assets but A,s debt ratio is higher than B,s/ then A,s e*uity #ust be lower (since Total assets 8 Total debt U Total e*uity!. If A has less e*uity/ and a lower NI than B/ it is not ossible to 0udge which co# any,s A15 (NIG5Q! is higher. "7. (inancial leverage and rati%s Answer: ) Diff: E
B56 8 5BITGTA. If both fir#s have the sa#e B56 ratio and sa#e total assets/ then they #ust have the sa#e 5BIT. 'ince Fir# . has no debt in its ca ital structure/ Fir# . will have higher net inco#e than Fir# F because . has no
interest e( ense and F does. The TI5 ratio is 5BITGInt. If the two co# anies have the sa#e 5BIT/ the one with the lower interest e( ense (Fir# .!/ will have a higher TI5. Therefore/ state#ent a is false. Fir#s F and . have the sa#e 5BIT/ but Fir# F has a higher interest e( ense/ so its net inco#e will be lower than Fir# .. 'ince A1A is e*ual to NIGTA/ and the two fir#s have the sa#e total assets/ Fir# F will have a lower A1A than Fir# .. Therefore/ state#ent b is true. Feverage will increase A15 if B56 X kd. 'ince B56 is "9 ercent and kd is > ercent/ leverage will increase Fir# F,s A15. Therefore/ state#ent c is false. "?. ">. "=. Optimal capital structure Operating and financial leverage (inancial leverage and rati%s Answer: d Answer: e Answer: c Diff: ' Diff: ' Diff: '
+9. +1. +".
'tate#ent a is false; A,s net inco#e is lower than B,s due to higher interest e( ense/ but its assets are e*ual to B,s/ so A,s A1A #ust be lower than B,s A1A. 'tate#ent b is false; A has the sa#e 5BIT as B/ but higher interest ay#ents than B; therefore/ A,s TI5 is lower than B,s. 'tate#ent c is correct. Limits %f leverage Answer: d Diff: ' #ignaling t$e%r& Capital structure and WACC 'tate#ent b is false because it is not always true. Answer: ) Answer: d Diff: ' Diff: '
++.
Answer: )
Diff: '
'tate#ent b is true; the other state#ents are false. The cost of retained earnings should be higher than debt financing. 56' is #a(i#i4ed at a higher ca ital structure than the one that #ini#i4es the fir#,s weighted average cost of ca ital. Increasing debt increases the risk of bankru tcy/ which can increase the costs of both debt and e*uity. +-. 'iscellane%us capital structure c%ncepts Answer: a Diff: '
+2 .
'tate#ent a is true; the other state#ents are false. If the ersonal ta( rate were increased/ investors would refer to receive less of their inco#e as interest33i# lying fir#s would substitute e*uity for debt. Eigh business risk is associated with high o erating leverage; therefore/ fir#s with high business risk would use less debt. 'iscellane%us capital structure c%ncepts Answer: c Diff: '
+7 . +?.
If cor orate ta( rates were decreased while other things were held constant/ and if the MM ta(3ad0usted tradeoff theory of ca ital structure were correct/ cor orations would decrease their use of debt because the ta( shelter benefit would not be as great as when ta( rates are high. Business risk is the riskiness of the fir#,s o erations if it uses no debt. The o ti#al ca ital structure does not #a(i#i4e 56'/ and the degree of total leverage shows how a given change in sales will affect earnings er share. *ariati%ns in capital structures Determining price fr%m EB!T Answer: d Answer: e Diff: T Diff: E
+> .
5BIT <=2/999 <"92/999 <"92/999 6
8 8 8 8 8
6Q 3 DQ 3 F) 6(22/999! 3 (9.-!6(22/999! 3 <119/999 (9.7!(22/999!6 ++/9996 <7."1. Answer: a Diff: E
Breakeven price Total costs 8 <19/999 U <"(-"/999! 8 <=-/999. 6rice 8 <=-/999G-"/999 8 <"."-.
+=
New financing 1ld debt ratio 8 9.++++; New debt ratio 8 9.177?.
Answer: a
Diff: '
'ales 8 ?.2. TA <?29/999 TA 8 8 <199/999. ?.2

&ebt 8 9.++++(<199/999! 8 <++/+++. New TA 8 <199/999 U <199/999 8 <"99/999. New &ebt 8 <"99/999(9.177?! 8 <++/+++. Alt#an,s current debt of <++/+++ re resents a ro(i#ately 17.7?: of total assets following the e( ansion/ thus the fir# should finance with 199 ercent e*uity. Net %perating inc%me Total costMethod 1 8 <1.99(Q! U <19/999. Total costMethod " 8 <1.29(Q! U <2/999. 'et e*ual and Q U <19/999 8 <2/999 8 19/999 8 solve for QJ <1.29(Q! U <2/999 <9.2(Q! Q. Answer: ) Diff: ' and new Answer: ) Diff: '
-9 .
-1 .
C$ange in )reakeven v%lume
)alculate the old and new breakeven volu#es using the old data ro0ectionsJ 1ld QB5 8 <1"9/999G(<1."9 3 <9.79! 8 <1"9/999G<9.79 8 "99/999 units. New QB5 8 <"-9/999G(<1.92 3 <9.-1! 8 <"-9/999G<9.7- 8 +?2/999 units. )hange in breakeven volu#e 8 +?2/999 3 "99/999 8 1?2/999 units. -". Breakeven and e+pansi%n )alculate the initial breakeven volu#e in dollarsJ 1ld 'B5 8 Answer: c
Diff: '
F) <-99/999 F) D)Gunit 8 <-."9 D) 8 13 13 13 <?.99 6riceGunit 'ales
<-99/999 8 <1/999/999. 1 3 9.79
)alculate the new breakeven volu#e in sales dollarsJ New 'B5
<729/999 <729/999 <-.-> 8 8 8 <1/>92/227. 13 1 3 9.7<?.99
The increase in 'B 8 <1/>92/227 3 <1/999/999 8 <>92/227. -+. Breakeven <?("99/999! 3 <2("99/999! 3 F 8 9 F 8 <-99/999. <?("99/999! 3 <-("99/999! 3 F 8 9 F 8 <799/999. <799/999 3 <-99/999 8 <"99/999. -. Operating decisi%n )alculate 5BIT1 at -9/999 units using the current sales 5BIT1 8 ' 3 D) 3 F) 8 -9/999(<".12! 3 9.+9(-9/999!(<".12! 3 <-7/999 8 <>7/999 3 <"2/>99 3 <-7/999 8 <1-/"99. Answer: riceJ d Diff: ' Answer: d Diff: '
)alculate 5BIT" at 29/999 units using the lower rice of <1.=2J 5BIT" 8 29/999(<1.=2! 3 9.+9(29/999!(<1.=2! 3 <-7/999 8 <=?/299 3 <"=/"29 3 <-7/999 8 <""/"29. The change in 5BIT 8 <""/"29 3 <1-/"99 8 U<>/929. rice/ 5BIT increases by <>/929. Capital structure and st%ck price Ies/ Musgrave should cut its Answer: c Diff: '
-2 .
$e can do this roble# by using the 6G5 before and after the reca itali4ation. Aecall that 6G5 8 6riceG56'. 5BIT Interest 5BT Ta( (-9:! NI 'hares 56' 6G5 Before reca . <+99/999 319/999 <"=9/999 117/999 <1?-/999 1"9/999 <1?-/999G1"9/999 8 <1.-2. <1?.-9G1.-2 8 1". After reca . <+99/999 329/999 <"29/999 199/999 <129/999 199/999T <129/999G199/999 8 <1.29.
T1"9/999 3 (<+->/999G<1?.-9! 8 199/999 shares. As 6G5 8 1" after the reca itali4ation (recall the *uestion states that it does not change!/ we know 1" 8 6riceG<1.29; 6rice 8 1" <1.29 8 <1>.99.
-7.
Capital structure and st%ck price 'te 'te 'te 1J "J +J
Answer: e
Diff: '
Find the current nu#ber of shares outstandingJ 'hares 8 NIG56' 8 <->9 #illionG<+."9 8 129 #illion shares. Find the nu#ber of shares after the re urchaseJ New shares 8 129 L <1/"99G<+" 8 129 L +?.2 8 11".2 #illion shares. Find the new 56' after the re urchaseJ 56' 8 V(5BIT L INT!(1 3 T!WGNew shares 8 V(<>99 L <>-! 9.7WG11".2 8 <+.>1>77?. Find the new stock riceJ 'tock rice 8 56'GNew $A)) 8 <+.>1>77?G9.11 8 <+-.?". Answer: a Diff: T
'te
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-?.
,amada e-uati%n and c%st %f e-uit& Facts givenJ 'te 1J
ks 8 1":; &G5 8 9."2; kAF 8 7:; A6M 8 2:; T 8 -9:.
Find the fir#,s current levered beta using the )A6MJ ks 8 kAF U A6M(b! 1": 8 7: U 2:(b! b 8 1.". Find the b 8 1." 8 1." 8 1.9-+2 8 fir#,s unlevered beta using the Ea#ada e*uationJ b.V1 U (1 3 T!(&G5!W b.V1 U (9.7!(9."2!W 1.12b. b..
'te
"J
'te
+J
Find the new levered beta given the new ca ital structure using the Ea#ada e*uationJ b 8 b.V1 U (1 3 T!(&G5!W b 8 1.9-+2V1 U (9.7!(1!W b 8 1.77=7. Find ks 8 ks 8 ks 8 the fir#,s new cost of e*uity given its new beta and the )A6MJ kAF U A6M(b! 7: U 2:(1.77=7! 1-.+2:.
'te
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->.
Optimal capital structure and ,amada e-uati%n
Answer: d
Diff: T
kAF 8 2:; kM 3 kAF 8 7:; ks 8 kAF U (kM 3 kAF!b; $A)) 8 wdkd(1 3 T! U wcks. Iou need to use the &G5 ratio given for each ca ital structure to find the levered beta using the Ea#ada e*uation. Then/ use each of these betas with the )A6M to find the ks for that ca ital structure. .se this k s and kd for each ca ital structure to find the $A)). The o ti#al ca ital structure is the one that #ini#i4es the $A)).
(&G5! b 8 b.V1 U (1 3 T!(&G5!W 9.11 9."2 9.-+ /.01 1.99 1.977? 1.1299 1."2?1 2.3/// 1.7999 ks 8 kAF U (kM 3 kAF!b 11.-999: 11.=999 1".2-"= 24.3/// 1-.7999 wc 9.= 9.> 9.? /.0 9.2 kd ?.9: ?." >.9 5.5 =.7 wd 9.1 9." 9.+ /.3 9.2 $A)) 19.7>: 19.+> 19."" 2/.26 19.1>
For e(a# le/ if the &G5 is 9.11J b 8 1.9V1 U (1 3 T!(&G5!W 8 1.9V1 U (1 3 9.-!(9.1111!W 8 1.977?. ks 8 kAF U (kM 3 kAF!b 8 2: U 7:(1.977?! 8 11.-9:. The weights are given at 9.= and 9.1 for e*uity and debt/ res ectively/ and the kd for that ca ital structure is given as ? ercent. $A)) 8 wdkd(1 3 T! U wcks 8 (9.1!(?:!(1 3 9.-! U (9.=!(11.-9:! 8 19.7>:. &o the sa#e calculation for each of the ca ital structures and find each $A)). The o ti#al ca ital structure is the one that #ini#i4es the $A))/ which is 19.12:. Therefore/ the o ti#al ca ital structure is -9: debt and 79: e*uity. -=. Capital structure and st%ck price Answer: d Diff: T
29 .
The o ti#al ca ital structure #a(i#i4es the fir#,s stock rice. $hen the debt ratio is "9:/ e( ected 56' is <".29. Hiven the fir#,s olicy of retaining +9: of earnings/ the e( ected dividend er share &1 is <".29 9.?9 8 <1.?2. The stock rice 69 is <1.?2G(12: 3 ?:! or <"1.>>. $hen the debt ratio is +9:/ e( ected 56' is <+.99 and e( ected &1 is <+.99 9.?9 8 <".19. The stock rice 69 is <".19G(12.2: 3 ?:! 8 <"-.?1. 'i#ilarly/ when the debt ratio is -9:/ & 1 8 <"."?2 and 69 8 <"2.">. $hen the debt ratio is 29:/ & 1 8 <".7"2 and 69 8 <"7."2. $hen the debt ratio is ?9:/ & 1 8 <".>9 and 69 8 <"2.-2. The stock rice is highest when the debt ratio is 29:. Capital structure and st%ck price First/ calculate the stock #odel/ 69 8 &1G(k' 3 g!J &ebt 9: 76 -9 29 ?2 &ivGshare <2.29 0.// 7.29 ?.99 ?.29 k' 11.2: 27./ 1+.9 1-.9 12.9 Answer: ) Diff: T
rice for each debt level using the dividend growth 69 <2.29G(9.112 3 9.9"! 80.//9:/.27 ; /./7< <7.29G(9.1+ 3 9.9"! <?.99G(9.1- 3 9.9"! <?.29G(9.12 3 9.9"!
8 = 8 8 8
<2?.>=. 80/.//. <2=.9=. <2>.++. <2?.7=.
21.
)learly/ <79.99 is the highest rice/ so "2: debt and ?2: e*uity is the o ti#al ca ital structure. Capital structure and st%ck price Answer: a Diff: T
First/ find the co# any,s current cost of ca ital/ dividends er share/ stock riceJ ks 8 9.977 U (9.97!9.= 8 1":. To find the stock rice/ you still need dividends er share or &6' 8 (<"/999/999(1 3 9.-!!G"99/999 8 <7.99. Thus/ stock rice is 69 8 <7.99G9.1" 8 <29.99. Thus/ by issuing <"/999/999 in debt the co# any can re urchase <"/999/999G<29.99 8 -9/999 shares.
and the the new
Now after reca itali4ation/ the new cost of ca ital/ &6'/ and stock rice can be foundJ ks 8 9.977 U (9.97!1.1 8 1+."9:. &6' for the re#aining ("99/999 3 -9/999! 8 179/999 shares are thus V(<"/999/999 3 (<"/999/999 9.19!!(1 3 9.-!WG 179/999 8 <7.?2. And/ finally/ 69 8 <7.?2G9.1+" 8 <21.1-. 2". Capital structure and st%ck price Answer: a Diff: T
To answer this we need to deter#ine the followingJ 1. Eow #any shares are currently outstanding% ". $hat are the interest e( ense and net inco#e/ before and after the change% Before reca itali4ationJ 5BIT <"9/999/999 Interest "/999/999 5BT <1>/999/999 Ta(es (-9:! ?/"99/999 NI <19/>99/999 56' 8 <+.79. 'hares outstanding 8 <19/>99/999G<+.79 8 +/999/999 shares. After reca itali4ationJ New shares 8 + #illion 3 1 #illion 8 " #illion shares. Total debt 8 <"9/999/999 U (<1/999/999!(<-9! 8 <79/999/999. Interest ay#ent 8 (<79/999/999!(9.1! 8 <7/999/999. Net inco#eJ 5BIT Interest 5BT Ta(es (-9:! NI 2+ . <"9/999/999 7/999/999 <1-/999/999 2/799/999 < >/-99/999 6G5 8 11.2. 69 8 (<-."9!(11.2! 8 <->.+9. Answer: d Diff: T
56' 8 <>/-99/999G"/999/999 8 <-."9. Capital structure and st%ck price
The bonds used in the re urchase will create a new interest e( ense for the co# any. This will change net inco#e. &ividends er share will change because net inco#e changes and the nu#ber of shares outstanding changes. New interest e( enseJ <>99/999 >: 8 <7-/999. New net inco#eJ (<"/999/999 3 <7-/999!(1 3 9.+! 8 <1/+22/"99. 'hares re urchasedJ <>99/999G>9 8 19/999 shares. New shares outstandingJ 1?2/999 3 19/999 8 172/999 shares. New dividends er shareJ <1/+22/"99G172/999 8 <>."1++. $e #ust also calculate a new cost of e*uityJ 2: U (2:!1." 8 11:. New stock riceJ <>."1G11: 8 <?-.7?. Capital structure and E"# Answer: d
2-.
Diff: T
After issuing the debt/ the co# any can re urchase <19/999/999G<-9 8 "29/999 shares leaving 729/999 shares outstanding. $e still need to find the e( ected NI after issuing the debt. $e,re given the antici ated NI is <+.7 #illion.
Thus/ the 5BIT (before the debt issue! can be found as followsJ <+/799/999 8 5BIT(1 3 9.+-! or 5BIT 8 <2/-2-/2-2.-2. The co# any will ay <1/999/999 in interest after issuing the debt so the new 5BT will be <2/-2-/2-2.-2 3 <1/999/999 8 <-/-2-/2-2.-2. The new NI figure will be <-/-2-/2-2.-2(1 3 9.+-! 8 <"/=-9/999. Finally/ 56' 8 <"/=-9/999G729/999 8 <-.2" after the reca itali4ation. 22. Capital structure and E"# Answer: a Diff: T
)a ital structure AJ The fir# will have debt of <299/999(9.+! 8 <129/999 and e*uity of <+29/999. $e,re told the shares have a book value of <19 so the nu#ber of shares outstanding is <+29/999G<19 8 +2/999. Interest e( ense will be <129/999(19:! 8 <12/999. $e can co# ute 5BT as 5BIT 3 I or <"99/999 3 <12/999 8 <1>2/999. Also/ we can co# ute NI as 5BT(1 3 T! or <1>2/999(1 3 9.-! 8 <111/999. Finally/ 56' 8 <111/999G+2/999 8 <+.1?. )a ital structure BJ The fir# will have debt of <299/999(9.?! 8 <+29/999 and e*uity of <129/999. The nu#ber of shares outstanding is <129/999G<19 8 12/999. Interest e( ense will be <+29/999(1-:! 8 <-=/999. $e can co# ute 5BT as <"99/999 3 <-=/999 8 <121/999. Also/ we can co# ute NI as <121/999(1 3 9.-! 8 <=9/799. Finally/ 56' 8 <=9/799G12/999 8 <7.9-. The difference in 56' between ca ital structure A and ca ital structure B is <7.9- 3 <+.1? 8 <".>?. 27. Capital structure, leverage, and WACC Answer: d Diff: T N
Iou need to find the beta with no debt and the new k s with the new ca ital structure before you can calculate the fir#,s $A)). 'te 1J )alculate the fir#,s unlevered beta using the Ea#ada e*uationJ bF 8 b.V1 U (1 3 T!(&G5!W 1." 8 b.V1 U (9.7!(<+G<?!W 1." 8 1."2?1b. b. 8 9.=2-2-2. )alculate the fir#,s new beta with the new ca ital structureJ bF 8 b.V1 U (1 3 T!(&G5!W bF 8 9.=2-2-2V1 U (9.7!(<2G<2!W bF 8 1.2"?+. )alculate the fir#,s structureJ ks 8 kAF U (A6!b ks 8 7: U ?:(1.2"?+! ks 8 17.7=9=:. new cost of e*uity with the new ca ital
'te
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'te
+J
'te
2?.
)alculate the fir#,s new $A))J $A)) 8 wdkd(1 3 T! U wcks $A)) 8 9.2(>.2:!(9.7! U 9.2(17.7=9=:! $A)) 8 19.>=22: 19.=9:. Capital structure and E"#
-J
Answer: e
Diff: '
&ebt 8 ?2: 8 <+99/999; 5*uity 8 "2: 8 <199/999; BD6' 8 <19; Total assets 8 <-99/999. 6robability 5BIT FessJ Interest 5BT Feast 9.7 <79/999 +7/999 <"-/999 Fa#ine 9.<"9/999 +7/999 (<17/999!
FessJ Ta(es (-9:! NI Y shares 56'
=/799 <1-/-99 19/999 <1.--
(7/-99! (< =/799! 19/999 3<9.=7
2> .
&ifference in 56' for aggressive ca ital structureJ 56'Feast 3 56'Fa#ine 8 <1.-- 3 (<9.=7! 8 <".-9. Capital structure and E"# Answer: ) Diff: '
&ebt 8 "2: 8 <199/999; 5*uity 8 ?2: 8 <+99/999; BD6' 8 <19; Total assets 8 <-99/999. 6robability 5BIT FessJ Interest 5BT FessJ Ta(es (-9:! NI Y shares 56' Feast 9.7 <79/999 19/999 <29/999 "9/999 <+9/999 +9/999 <1.99 Fa#ine 9.<"9/999 19/999 <19/999 -/999 < 7/999 +9/999 <9."9
2= .
&ifference in 56' for conservative ca ital structureJ 56'Feast 3 56'Fa#ine 8 <1.99 3 <9."9 8 <9.>9. Capital structure and C* %f E"# Answer: c Diff: '
)alculate coefficient of variation. 5( ected 56'AggressiveJ 5(56'! 8 9.7 56'Feast U 9.- 56'Fa#ine 8 (9.7!(<1.--! U 9.-(3<9.=7! 8 <9.->. 'tandard deviationJ '&56'3aggressive 8 V9.7(<1.-- 3 <9.->!" U 9.-(3<9.=7 3 <9.->!"WZ 8 V9.22+9 U 9.>"=-W1G" 8 1.1?7. )DAggressive 8 1.1?7G9.-> ".-2. 79
Capital structure and C* %f E"# )alculate coefficient of variation. 5( ected 56' conservativeJ 5(56'! 8 9.7(<1.99! U 9.-(<9."9! 8 <9.7>.
Answer: a
Diff: '
'tandard deviationJ '&56'3)onservative 8 V9.7(<1.99 3 <9.7>!" U 9.-(<9."9 3 <9.7>!"WZ 8 V9.971- U 9.9=""W1G" 8 9.+=1=. )D)onservative 8 9.+=1=G9.7> 8 9.2?7 9.2>. 71. Capital structure and WACC Answer: c Diff: E N
First/ we will calculate the cost of co##on e*uity and then use that to solve for the $A)). ks 8 kAF U (kM 3 kAF!b ks 8 2: U (7:!1.1 ks 8 11.7:. $A)) 8 wdkd(1 3 T! U wcks $A)) 8 (9."!(?.2:!(1 3 9.-! U (9.>!(11.7:! $A)) 8 19.1>:. 7". ,amada e-uati%n and unlevered )eta Answer: c Diff: E N
To unlever the beta/ we #ust use the Ea#ada e*uation/ substituting the known values. bF 1.1 1.1 b. 7+. 8 8 8 8 b.V1 U (1 3 T!(&G5!W b.V1 U (1 3 9.-!(1G-!W b.V1.12W 9.=272. Answer: e Diff: ' N
First/ we #ust find the levered beta after the reca itali4ation/ using the unlevered beta calculated in the revious roble#. bF bF bF bF 8 8 8 8 b.V1 U (1 3 T!(&G5!W 9.=272V1 U (1 3 9.-!("G+!W 9.=272V1.-W 1.++=1.
ks 8 kAF U (kM L kAF!bF ks 8 2: U (7:!1.++=1 ks 8 1+.9+:.
7-.
Capital structure, financial leverage, and rati%s
Answer: d
Diff: E
The correct answer is state#ent d. 'tate#ent a is incorrect; since o erating inco#e is unchanged and interest e( ense goes u / net inco#e #ust decrease. 'tate#ent b is incorrect; if net inco#e decreases and assets re#ain the sa#e/ A1A #ust decrease. 'tate#ent c is incorrect; we are told the fir#,s basic earning ower (B56! and assets do not change/ so o erating inco#e #ust also re#ain the sa#e. 'tate#ent d is correct; since B56 X k d/ the use of debt to buy back stock will increase A15. 72. Capital structure and E"# Answer: c Diff: T N
Total assets 8 <199/999/999; B56 8 "9:; TI5 8 1".2; T 8 -9:. 'te 1J &eter#ine the fir#,s o erating inco#eJ B56 8 5BITGTA 9."9 8 5BITG<199/999/999 5BIT 8 <"9/999/999.
'te
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&eter#ine the fir#,s interest e( ense/ given the TI5 and 5BITJ
5BIT Interest <"9 / 999 / 999 1".2 8 Interest 1".2Interest 8 <"9/999/999 <1/799/999 8 Interest.
TI5 8 'te +J &eter#ine the fir#,s 1 erating inco#e Interest e( ense 5BT Ta(es (-9:! Net inco#e net inco#eJ <"9/999/999 1/799/999 <1>/-99/999 ?/+79/999 <11/9-9/999
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&eter#ine the nu#ber of shares outstanding after reca itali4ationJ If the fir# re urchased <"9 #illion worth of stock and the stock rice is <"9/ then the fir# bought 1 #illion shares. 'hares outstanding now 8 2/999/999 L 1/999/999 8 -/999/999. &eter#ine the fir#,s 56' after reca itali4ationJ 56' 8 NIGY of shares 56' 8 <11/9-9/999G-/999/999 56' 8 <".?7. ,amada e-uati%n and unlevered Diff: E N )eta
'te
2J
77
Answer: c bF 8 1."8 1."8 b. 8 b.V1 U (1 3 T!(&G5!W b.V1 U (9.79!(9."2G9.?2!W b.V1."W 1.99.
7?
,amada
e-uati%n
and
c%st
%f
c%mm%n Diff: '
e-uit& N
Answer: c b. 8 1.99 was calculated 'te 1J reviously in the roble# above.
)alculate the new levered beta using the Ea#ada e*uation and the unlevered beta calculated reviouslyJ bF 8 b.V1 U (1 3 T!(&G5!W bF 8 1.99V1 U (9.79!(9.-9G9.79!W bF 8 1.-9. )alculate the new cost of e*uity using the )A6M e*uation and the new levered betaJ ks 8 2: U (7:!1.-9 8 1+.-9:. Answer: c Diff: E N
'te
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7>.
Capital structure, leverage, and WACC wd 8 "2:; ws 8 ?2:; kd 8 >:; ks 8 19.?2:; T 8 -9:.
The after3ta( cost of debt is >.9: (1 3 9.-9! 8 -.>:. Its cost of co##on e*uity is (given as! 19.?2:. 'o/ the $A)) 8 9."2(-.>:! U 9.?2(19.?2:! 8
=."7"2: =."7:. 7=. ,amada e-uati%n and unlevered )eta bF 8 1.12; T 8 -9:; & 8 "2:; 5 8 ?2:. bF 1.12 1.12 9.=2>+ ?9. 8 8 8 8 b.V1 U (1 3 T!(&G5!W b.V1 U (9.7!(9."2G9.?2!W b.V1."W b.. Answer: d Diff: ' N Answer: ) Diff: ' N
,amada e-uati%n and c%st %f c%mm%n e-uit& 'te 1J
)alculate the new levered beta for the fir#/ using the new ca ital structureJ b. 8 9.=2>+; New & 8 29:; New 5 8 29:; T 8 -9:. bF 8 b.V1 U (1 3 T!(&G5!W 8 9.=2>+V1 U (9.79!(9.29G9.29!W 8 1.2+++.
'te
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)alculate the fir#,s new cost of co##on e*uityJ kAF 8 2:; kM L kAF 8 2:; bF 8 1.2+++. k' 8 2: U (2:!1.2+++ 8 1".777: 1".7?:.
?1.
Capital structure, leverage, and E"# 'te 1J )alculate followsJ net inco#e under the fir#,s
Answer: c new
Diff: '
N as
ca ital
structure
5BIT Interest 5BT Ta(es (-9:! NI 'te "J
<+99/999 "99/999 <199/999 -9/999 < 79/999
(given! (given!
)alculate 56' under the fir#,s new ca ital structureJ The fir# has assets of <- #illion. 1riginally/ <+ #illion was in co##on e*uity and <1 #illion was in debt. Now/ that a#ount is s lit evenly/ <" #illion in co##on e*uity and <" #illion in debt. The fir# will borrow <1 #illion and use the roceeds to re urchase <1 #illion worth of co##on e*uity. At the re urchase rice of <17Gshare/ the fir# will buy back <1/999/999G<17 8 7"/299 shares/ leaving >9/999 L 7"/299 8 1?/299 shares outstanding. 56' 8 NIGY shares 8 <79/999G1?/299 8 <+.-">7 <+.-+.
,E/ APPE'D#0 !"A %.$&T#.'%

?"24A;. DOL, D(L, and DTL ?+24A;. (inancial leverage ?-24A;. (inancial leverage ?224A;. (inancial risk ?724A;. Operating and financial leverage ??24;. Operating and financial leverage ?>24;. DOL ?=24;. De)t rati% and DOL Answer: c Answer: e Answer: d Answer: ) Answer: a Answer: e Answer: c Answer: a Diff: E Diff: ' Diff: ' Diff: ' Diff: ' Diff: ' Diff: ' Diff: '
'tate#ent a is correct; the other state#ents are false. After the sales increase/ the ercentage increase in 5BIT will be the sa#e for both co# anies. )o# any 5Ps net inco#e will rise by e(actly 19:. >924;. Degree %f leverage >124;. DOL and c$anges in EB!T First/ find 5BIT before sales increaseJ 5BIT 8 'ales 3 ('ales D):! 3 F) 8 <12/999 3 (<12/999 9.79! 3 <1/999 Answer: a Answer: a Diff: ' Diff: E
8 <2/999. Now/ assu#ing sales increase by 19: or to <12/999 1.19 8 <17/299/ calculate the new 5BIT. 5BIT 8 <17/299 3 (<17/299 9.79! 3 <1/999 8 <2/799. 'o/ the ercentage increase is V(<2/799 3 <2/999!G<2/999W 199 8 1":. Answer: d Diff: E
>"24;. DTL and f%recast E"# 56'1 8 8 8 8 56'9 U 56'9V&TF ( ercent change in sales!W <+."2V1 U (1.7!(".1!(9.2!W <+."2(".7>! <>.?1.
>+24;. C$ange in E"# 56'9 8 <1.99. &1F 8 1."2. :' 8 12:. &FF 8 +.29. 56'1 8 %
Answer: )
Diff: E
&TF 8 &1F(&FF! 8 1."2(+.29! 8 -.+?2. 8 56'9V1.9 U (&TF!(:'ales!W 8 <1.99V1.9 U (-.+?2!(9.12!W 8 <1.99(1.727+! 8 <1.727+. >-24;. DOL c$ange 56'1
Answer: a
Diff: '
)alculate &1F using new sales/ new variable cost ercentage/ and new fi(ed costsJ '9 8 <?2/999/999; F)9 8 <-9/999/999; D) 8 9.+9('9! 8 <""/299/999. '1 8 <199/999/999; F)1 8 <22/999/999; D) 8 9."2('1! 8 <"2/999/999. &1F (In #illions!J &1F' 8 >224;. DOL These two e*uations could be usedJ &TF 8 (&1F!(&FF!. 56'1 8 56'9V1 U (&TF!(:'ales!W. Note that 56' rises by 29 increase in sales/ so 1.29 8 1.99V1 U (&TF!(9.1!W 1.29 8 1 U 9.1 &TF 9.1 &TF 8 9.29 &TF 8 2.99. ercent/ fro# <1.99 to <1.29/ on a 19 ercent
199 3 "2 ?2 8 8 +.?2. 199 3 "2 3 22 "9
Answer: d
Diff: '
Now &TF 8 2 8 (&1F!(&FF! But if &ebt 8 9/ then &FF 8 1/ so &1F 8 &TF 8 2.9. >724;. DOL in sales d%llars .se the infor#ation &1F' Answer: c Diff: '
rovided and the for#ula for &1F in sales dollarsJ
129/999(<-! 3 9.+(129/999!(<-! 8 129/999(<-! 3 9.+(129/999!(<-! 3 9.2(129/999!(<-!
&1F' 8
<799 / 999 <1>9 / 999 <799 / 999 <1>9 / 999 <+99 / 999
&1F' 8
<-"9 / 999 8 +.2. <1"9 / 999
Alternate #ethodJ 5( ress 6 as 1.9 or 199: of
Q (6 D! 129/999(1.9 3 9.+! 9.? &1FQ 8 8 8 8 +.29. 129/999V(1.9 3 9.+! 3 9.2W 9." Q (6 D! F)

>?24;. DOL, D(L, and DTL
rice and D and F) as a
ercent of
riceJ
Answer: c
Diff: '
First/ calculate 6QAPs &FF as 5BITG(5BIT 3 I!. Interest e( ense (I! on the debt is <1/299/999(19:! 8 <129/999. $e can work backwards fro# NI to find 5BIT as followsJ 5BT 8 NIG(1 3 T! or <799/999G9.7 8 <1/999/999. 5BIT 8 5BT U I or <1/999/999 U <129/999 8 <1/129/999. &FF is thus <1/129/999G(<1/129/999 3 <129/999! 8 1.12. Aecogni4ing &TF 8 &FF &1F/ we can solve 1.-9 8 1.12 &1F for &1F 8 1."". >>24;. DTL and interest e+pense Aecall that &TF 8 : change in NIG: change in sales 8 9.1?2G9.19 8 1.?2. &TF 8 1.?2 8 1.?2 8 <1/299/999 8 I 8 >=24;. DTL &TF 8 (' 3 D)!G(5BIT 3 I! 8 (<+/999/999 3 <1/>99/999!G(<?99/999 3 <299/999! 8 7. =924;. DTL and c$ange in N! 'te 1J Find &egree of total leverage (&TF! &TF 8 8 8 Answer: e Diff: ' Answer: d Diff: '
' D) ' D) F) I <19 / 999 / 999 <> / 299 / 999 <19 / 999 / 999 <> / 299 / 999 <299 / 999 I <1 / 299 / 999 <1 / 999 / 999 I <1/?29/999 3 1.?2I <1-"/>2?.1- [ <1-"/>2?.
Answer: e Diff: '
' D ' D F I
<+/999/999 3 9.2(<+/999/999! <+/999/999 3 9.2(<+/999/999! 3 <199/999 3 9.1(<1/999/999!
<1 / 299 / 999 <1 / +99 / 999 8 1.12+>.

'te "J Find ercentage increase in net inco#eJ :NI 8 (9."9!(&TF! 8 (9."9!(1.12+>! 8 9."+9> 8 "+.9>:. Answer: c Diff: '
=124;. E+pected EB!T
&1F 8 &TFG&FF 8 ?.2G1.>?2 8 -.9. 5BIT 8 (39."9!(-.9!(<"/999/999! 8 3<1/799/999. 5BIT 8 <"/999/999 3 <1/799/999 8 <-99/999.
="24;. E+pected EB!T
Answer: d
Diff: '
&TF 8 :56'G:'ales 8 79:G"9: 8 +.9. &1F 8 &TFG&FF 8 +.9G1."2 8 ".-9. 1ld 5BIT 8 <199/999GV1 U (9."9!(".-9!W 8 <199/999G1.-> 8 <7?/27>. Alternate solutionJ .se &FF e( ression to calculate change in 5BIT and &FF 8 1."2 8 :56'G:5BIT 1."2 8 9.79GV5BITG(<199/999 3 5BIT!W 1."2 8 V9.79(<199/999! 3 9.79(5BIT!WG5BIT 1."25BIT 8 <79/999 3 9.79(5BIT! 1.>25BIT 8 <79/999 5BIT 8 <+"/-+". 1ld 5BIT 8 <199/999 3 <+"/-+" 8 <7?/27>. =+24;. E+pected EB!T Answer: e Diff: ' revious 5BITJ
'et u the &1F e*uation/ letting \ be the unknown new 5BITJ Fet \ 8 New 5BIT.
\ 79/999 \ 79/999 79/999 &1FQ 8 ".2 8 8 79/999 1?9/999 3 1"2/999 9.+7 1"2/999
".2(9.+7! 8
\ 79/999 79/999 \ 79/999 9.=9 8 79/999 <2-/999 8 \ 3 <79/999 \ 8 <11-/999.
New 5BIT 8 <11-/999. =-24;. Degree %f financial leverage &TF 8 (&1F!(&FF! ".9 8 1.7(&FF! 1."2 8 &FF. Answer: d Diff: '
1."2 8
<-/999/999 <-/999/999 3 I
<2/999/999 3 1."2(I! 8 <-/999/999 I 8 <>99/999. &ebt 8

<>99/999 8 <>/-"1/92+. 9.9=2
Must retire 8 <12/999/999 3 <>/-"1/92+ 8 <7.2> #illion of debt. =224;. (inancial leverage, DOL, and DTL First/ find the new &FFJ &TF 8 (&1F!(&FF! ".- 8 (1.-!(&FF! &FF 8 1.?1-+. Then/ find the new interest ay#ents in a yearJ &FF 8 (5BIT!G(5BIT 3 I! 1.?1-+ 8 (<-/999/999!G(<-/999/999 3 I! I 8 <1/777/7>7.11. Finally/ solve re#ains at 19:J &ebt value(ITM! &ebt(9.19! &ebt for the new debt level/ knowing that the yield to #aturity 8 Interest ay#ent 8 <1/777/7>7.11 8 <17/777/>71.11 <17.? #illion. Answer: c Diff: T Answer: a Diff: T
=724;. DOL, D(L, and fi+ed %perating c%sts
$ePre given enough infor#ation to find both &FF and &TF. &TF 8 &1F &FF 8 8
: 5BIT : 56' : 'ales : 5BIT
: 56' : 'ales 1>: 8 19:
&TF 8 1.>. &FF 8 <"/-99/999G(<"/-99/999 3 <-99/999! 8 1.". Hiven &TF 8 &FF &1F/ we can calculate &1F 8 1.2. Aecogni4ing ' 3 D) 3 F) 8 5BIT/ 1.2 8 (' 3 D)!G<"/-99/999 or ' 3 D) 8 <+/799/999. The difference between (' 3 D)! and 5BIT #ust re resent fi(ed o erating costs. Thus/ F) 8 <+/799/999 3 <"/-99/999 8 <1/"99/999.

Capital Structure and Leverage: Multiple Choice: Conceptual

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Capital Structure and Leverage: Multiple Choice: Conceptual

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CAP#TA$ %T CHAPTE &CT& E A'D !

" $E(E A)E

Multiple Choice: Conceptual Easy:

(It will affect each ty e of risk Answer: d Diff: E

Chapter 13- Page 1

Business and financial risk

Optimal capital structure

Optimal capital structure

Optimal capital structure

Target capital structure

Leverage and capital structure

Leverage and capital structure

Leverage and capital structure

Leverage and capital structure

e. An increase in e( ected bankru tcy costs. Leverage and capital structure

Leverage and capital structure

$hich of the following factors increase its debt ratio% a. b. c. d. e.

Leverage and capital structure

Leverage and capital structure

e. None of the state#ents above is correct. Leverage and capital structure

Capital structure and WACC

Capital structure, WACC, T!E, and E"#

'iscellane%us capital structure c%ncepts

(inancial leverage and E"#

d. 'tate#ents a and b are correct. e. 'tate#ents a and c are correct.

Chapter 13- Page 7

(inancial leverage and E"#

(inancial leverage and rati%s

(inancial leverage and rati%s

Operating and financial leverage

(inancial leverage and rati%s

Chapter 13- Page 9

Capital structure and WACC

Capital structure and WACC

'iscellane%us capital structure c%ncepts

'iscellane%us capital structure c%ncepts

Chapter 13- Page 11

Multiple Choice: P*o+lems Easy:

ercent e*uity ercent e*uity ercent e*uity

Chapter 13- Page 13

Net %perating inc%me

C$ange in )reakeven v%lume

Breakeven and e+pansi%n

Capital structure and st%ck price

Chapter 13- Page 15

Capital structure and st%ck price

Answer: e the following infor#ation

Diff: ' Ioung -9: 9: 19: 1.99K <+."9

#illion #illion #illion #illion <+".99

Ta( rate &ebt ratio $A)) MGB ratio 56' 8 &6'

Optimal capital structure and ,amada e-uati%n

The co# any,s ta( rate/ T/ is -9

Capital structure and st%ck price

Chapter 13- Page 17

Capital structure and st%ck price

Capital structure and st%ck price

Capital structure and st%ck price

Capital structure and st%ck price

e. < ?9.-9 Capital structure and E"#

Capital structure and E"#

Capital structure, leverage, and WACC

b. =.?2: c. 1"."?: d. 19.=9: e. 11.-2:

ercent euity ercent euity ercent e*uity