TB 13

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

Easy:
Business risk Answer: c Diff: E
1
. A decrease in the debt ratio will generally have no effect on
.
a. Financial risk.
b. Total risk.
c. Business risk.
d. Market risk.
e. None of the above is correct. (It will affect each tye of risk
above.!
Business risk Answer: d Diff: E
"
. Business risk is concerned with the oerations of the fir#. $hich of the
following is not associated with (or not a art of! business risk%
a. &e#and variability.
b. 'ales rice variability.
c. The e(tent to which oerating costs are fi(ed.
d. )hanges in re*uired returns due to financing decisions.
e. The ability to change rices as costs change.
Business risk Answer: d Diff: E N
+
. $hich of the following factors would affect a co#any,s business risk%
a. The level of uncertainty regarding the de#and for its roduct.
b. The degree of oerating leverage.
c. The a#ount of debt in its caital structure.
d. 'tate#ents a and b are correct.
e. All of the state#ents above are correct.
Chapter 13- Page 1
CHAPTE !"
CAP#TA$ %T&CT&E A'D $E(EA)E
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 caital
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 Answer: e Diff: E
2
a. As a rule/ the oti#al caital structure is found by deter#ining the
debt3e*uity #i( that #a(i#i4es e(ected 56'.
b. The oti#al caital structure si#ultaneously #a(i#i4es 56' and
#ini#i4es the $A)).
c. The oti#al caital structure #ini#i4es the cost of e*uity/ which is a
necessary condition for #a(i#i4ing the stock rice.
d. The oti#al caital structure si#ultaneously #ini#i4es the cost of
debt/ the cost of e*uity/ and the $A)).
Optimal capital structure Answer: c Diff: E
7
. Fro# the infor#ation below/ select the oti#al caital structure for
Minnow 5ntertain#ent )o#any.
a. &ebt 8 -9:; 5*uity 8 79:; 56' 8 <".=2; 'tock rice 8 <"7.29.
b. &ebt 8 29:; 5*uity 8 29:; 56' 8 <+.92; 'tock rice 8 <">.=9.
c. &ebt 8 79:; 5*uity 8 -9:; 56' 8 <+.1>; 'tock rice 8 <+1."9.
d. &ebt 8 >9:; 5*uity 8 "9:; 56' 8 <+.-"; 'tock rice 8 <+9.-9.
e. &ebt 8 ?9:; 5*uity 8 +9:; 56' 8 <+.+1; 'tock rice 8 <+9.99.
Optimal capital structure Answer: e Diff: E
?
. $hich of the following state#ents best describes the oti#al caital
structure%
a. The oti#al caital structure is the #i( of debt/ e*uity/ and referred
stock that #a(i#i4es the co#any,s earnings er share (56'!.
b. The oti#al caital structure is the #i( of debt/ e*uity/ and referred
stock that #a(i#i4es the co#any,s stock rice.
c. The oti#al caital structure is the #i( of debt/ e*uity/ and referred
stock that #ini#i4es the co#any,s weighted average cost of caital
($A))!.
e. 'tate#ents b and c are correct.
Chapter 13 - Page 2
Target capital structure Answer: e Diff: E
>
. The fir#,s target caital structure is consistent with which of the
following%
a. Ma(i#u# earnings er share (56'!.
b. Mini#u# cost of debt (k
d
!.
c. Mini#u# risk.
d. Mini#u# cost of e*uity (k
s
!.
e. Mini#u# weighted average cost of caital ($A))!.
Leverage and capital structure Answer: d Diff: E
=
. $hich of the following is likely to encourage a co#any to use #ore debt
in its caital structure%
a. An increase in the cororate ta( rate.
b. An increase in the ersonal ta( rate.
c. A decrease in the co#any,s degree of oerating leverage.
d. 'tate#ents a and c are correct.
Leverage and capital structure Answer: e Diff: E
19
a. A reduction in the cororate ta( rate is likely to increase the debt
ratio of the average cororation.
b. An increase in the ersonal ta( rate is likely to increase the debt
ratio of the average cororation.
c. If changes in the bankrutcy code #ake bankrutcy less costly to
cororations/ then this would likely reduce the debt ratio of the
average cororation.
d. All of the state#ents above are correct.
11
. $hich of the following state#ents is likely to encourage a fir# to
increase its debt ratio in its caital structure%
a. Its sales beco#e less stable over ti#e.
b. Its cororate ta( rate declines.
c. Manage#ent believes that the fir#,s stock is overvalued.
Leverage and capital structure Answer: a Diff: E
1"
. $hich of the following factors is likely to encourage a cororation to
increase the roortion of debt in its caital structure%
c. An increase in the co#any,s degree of oerating leverage.
d. The co#any,s assets beco#e less li*uid.
Chapter 13- Page 3
e. An increase in e(ected bankrutcy costs.
1+
. $hich of the following would increase the likelihood that a co#any would
increase its debt ratio in its caital structure%
a. An increase in costs incurred when filing for bankrutcy.
b. An increase in the cororate ta( rate.
c. An increase in the ersonal ta( rate.
d. A decrease in the fir#,s business risk.
e. 'tate#ents b and d are correct.
Leverage and capital structure Answer: a Diff: E N
1-
. $hich of the following factors is likely to encourage a co#any to
increase its debt ratio%
c. Its assets beco#e less li*uid.
d. Both state#ents a and c are correct.
Leverage and capital structure Answer: c Diff: E N
12
. @ones )o. currently is 199 ercent e*uity financed. The co#any is
considering changing its caital structure. More secifically/ @ones, )F1
is considering a recaitali4ation lan in which the fir# would issue long3
ter# debt with a yield of = ercent and use the roceeds to reurchase
co##on stock. The recaitali4ation 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 recaitali4ation 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 recaitali4ation%
a. The co#any,s net inco#e will increase.
b. The co#any,s earnings er share will decrease.
c. The co#any,s cost of e*uity will increase.
d. The co#any,s A1A will increase.
e. The co#any,s A15 will decrease.
Leverage and capital structure Answer: e Diff: E N
17
a. $hen a co#any increases its debt ratio/ the costs of both e*uity and
debt caital increase. Therefore/ the weighted average cost of caital
($A))! #ust also increase.
b. The caital structure that #a(i#i4es stock rice is generally the
caital structure that also #a(i#i4es earnings er share.
c. 'ince debt financing is cheaer than e*uity financing/ increasing a
co#any,s debt ratio will always reduce the co#any,s $A)).
d. The caital structure that #a(i#i4es stock rice is generally the
caital structure that also #a(i#i4es the co#any,s $A)).
Chapter 13 - Page 4
Leverage and capital structure Answer: c Diff: E
1?
a. $hen a co#any increases its debt ratio/ the costs of e*uity and debt
caital both increase. Therefore/ the weighted average cost of caital
($A))! #ust also increase.
b. The caital structure that #a(i#i4es stock rice is generally the
caital structure that also #a(i#i4es earnings er share.
c. All else e*ual/ an increase in the cororate ta( rate would tend to
encourage a co#any to increase its debt ratio.
e. 'tate#ents a and c are correct.
Capital structure and WACC Answer: e Diff: E
1>
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 cheaer 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 tyically reduce the #arginal
costs of both debt and e*uity financing; however/ it still #ay raise
the co#any,s $A)).
Capital structure, OA, and OE Answer: d Diff: E
1=
. Aidgefield 5nterrises has total assets of <+99 #illion. The co#any
currently has no debt in its caital structure. The co#any,s basic
earning ower is 12 ercent. The co#any is conte#lating a
recaitali4ation 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 recaitali34ation its oerating inco#e/ total assets/ and
ta( rate will re#ain the sa#e. $hich of the following will occur as a
result of the recaitali4ation%
a. The co#any,s A1A will decline.
b. The co#any,s A15 will increase.
c. The co#any,s basic earning ower will decline.
Capital structure, WACC, T!E, and E"# Answer: a Diff: E
"9
a. The caital structure that #a(i#i4es stock rice is also the caital
structure that #ini#i4es the weighted average cost of caital ($A))!.
b. The caital structure that #a(i#i4es stock rice is also the caital
structure that #a(i#i4es earnings er share.
c. The caital structure that #a(i#i4es stock rice is also the caital
Chapter 13- Page 5
structure that #a(i#i4es the fir#,s ti#es interest earned (TI5! ratio.
Capital structure t$e%r& Answer: d Diff: E
"1
. $hich of the following state#ents about caital structure theory is #ost
correct%
a. 'ignaling theory suggests fir#s should in nor#al ti#es #aintain reserve
borrowing caacity that can be used if an esecially good invest#ent
oortunity co#es along.
b. In general/ an increase in the cororate ta( rate would cause fir#s to
use less debt in their caital structures.
c. According to the Btrade3off theory/C an increase in the costs of
bankrutcy would lead fir#s to reduce the a#ount of debt in their
caital structures.
'iscellane%us capital structure c%ncepts Answer: c Diff: E N
""
a. If )ongress were to ass legislation that increases the ersonal ta(
rate/ but decreases the cororate 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 reurchase co##on
stock/ this action would have no i#act on the co#any,s return on
assets. (Assu#e that the reurchase has no i#act on the co#any,s
oerating 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.!
(inancial leverage and E"# Answer: a Diff: E
"+
. Dolga 6ublishing is considering a roosed 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 oerating 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 roosed 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
Chapter 13- Page 7
(inancial leverage and E"# Answer: c Diff: E
"-
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 oerating leverage.
c. The debt ratio that #a(i#i4es 56' generally e(ceeds the debt ratio that
#a(i#i4es share rice.
(inancial leverage and rati%s Answer: d Diff: E
"2
. )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/ k
d
. 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. )o#any A has a lower net inco#e than B.
b. )o#any A has a lower A1A than B.
c. )o#any A has a lower A15 than B.
(inancial leverage and rati%s 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. The two co#anies have the sa#e ti#es interest earned (TI5! ratio.
b. Fir# F has a lower A1A than Fir# ..
c. Fir# F has a lower A15 than Fir# ..
Medium:
Optimal capital structure Answer: d Diff: '
"?
. As a general rule/ the caital 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 caital.
Chapter 13 - Page 8
Operating and financial leverage Answer: e Diff: '
">
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 oerating leverage are #ore likely to rely on debt
financing.
(inancial leverage and rati%s Answer: c Diff: '
"=
. )o#any A and )o#any B have the sa#e total assets/ oerating 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 (k
d
!. $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.
Limits %f leverage Answer: d Diff: '
+9
. $hich of the following are ractical difficulties associated with caital
structure and degree of leverage analyses%
a. It is nearly i#ossible to deter#ine e(actly how 6G5 ratios or e*uity
caitali4ation rates (k
s
values! are affected by different degrees of
financial leverage.
b. Managers, attitudes toward risk differ and so#e #anagers #ay set a
target caital structure other than the one that would #a(i#i4e stock
rice.
c. Managers often have a resonsibility to rovide continuous service;
they #ust reserve the long3run viability of the enterrise. Thus/ the
goal of e#loying leverage to #a(i#i4e short3run stock rice and
#ini#i4e caital cost #ay conflict with long3run viability.
d. All of the state#ents above are correct.
e. None of the state#ents above reresents a serious i#edi#ent to the
ractical alication of leverage analysis in caital structure
deter#ination.
Chapter 13- Page 9
#ignaling t$e%r& Answer: ) Diff: '
+1
. If you know that your fir# is facing relatively oor rosects but needs
new caital/ 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. 6ostone going into caital #arkets until your fir#,s rosects
i#rove.
e. )onvey your inside infor#ation to investors using the #edia to
eli#inate the infor#ation asy##etry.
Capital structure and WACC Answer: d Diff: '
+"
a. The oti#al caital 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 caital structure.
c. Increasing the a#ount of debt in a fir#,s caital structure is likely
to increase the costs of both debt and e*uity financing.
Capital structure and WACC Answer: ) Diff: '
++
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 caital structure that #ini#i4es the fir#,s weighted average cost
of caital is also the caital structure that #a(i#i4es the fir#,s
stock rice.
c. The caital structure that #ini#i4es the fir#,s weighted average cost
of caital is also the caital 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 caital.
e. 'tate#ents a and b are correct.
Chapter 13 - Page 10
'iscellane%us capital structure c%ncepts Answer: a Diff: '
+-
a. In general/ a fir# with low oerating leverage has a s#all roortion
of its total costs in the for# of fi(ed costs.
b. An increase in the ersonal ta( rate would not affect fir#s, caital
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.
'iscellane%us capital structure c%ncepts Answer: c Diff: '
+2
. $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 oerating leverage.
b. If cororate ta( rates were decreased while other things were held
constant/ and if the Modigliani3Miller ta(3ad0usted tradeoff theory of
caital structure were correct/ this would tend to cause cororations
to increase their use of debt.
c. If cororate ta( rates were decreased while other things were held
constant/ and if the Modigliani3Miller ta(3ad0usted tradeoff theory of
caital structure were correct/ this would tend to cause cororations
to decrease their use of debt.
d. The oti#al caital 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'.
Tough:
*ariati%ns in capital structures Answer: d Diff: T
+7
. $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*uity3suorted caital.
c. The drug industry has a high debt to co##on e*uity ratio because their
earnings are very stable and thus/ can suort the large interest costs
associated with higher debt levels.
d. $ide variations in caital 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 caital 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. <".99
b. <-.-2
c. <2.99
d. <2.+?
e. <7."1
Breakeven price Answer: a Diff: E
+>
. 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. <+.12
e. <".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 oti#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. 199: e*uity
b. 199: debt
c. "9 ercent debt/ >9 ercent e*uity
d. -9 ercent debt/ 79 ercent e*uity
e. 29 ercent debt/ 29 ercent e*uity
Chapter 13- Page 13
Net %perating inc%me Answer: ) Diff: '
-9
. 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 outut will the two #ethods roduce the sa#e net oerating inco#e%
a. 2/999 decks
b. 19/999 decks
c. 12/999 decks
d. "9/999 decks
e. "2/999 decks
C$ange in )reakeven v%lume Answer: ) Diff: '
-1
. Eensley )ororation 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
roosed 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 )ororation 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. < 1>+/+++
b. < -27/299
c. < >92/227
d. < =19/77?
e. <1/"99/999
Breakeven Answer: d Diff: '
-+
. 5lehant Books sells aerback 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. <799/999
b. <-77/77?
c. <+++/+++
d. <"99/999
e. <1?2/""2
Operating decisi%n Answer: d Diff: '
--
. Musgrave )ororation 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. No/ 5BIT decreases by <7/999.
b. No/ 5BIT decreases by <"29.
c. Ies/ 5BIT increases by <11/299.
d. Ies/ 5BIT increases by <>/929.
e. Ies/ 5BIT increases by <2/929.
Capital structure and st%ck price Answer: c Diff: '
-2
. The following infor#ation alies to Fott 5nterrisesJ
1erating inco#e (5BIT! <+99/999 'hares outstanding 1"9/999
&ebt <199/999 56' <1.-2
Interest e(ense < 19/999 'tock rice <1?.-9
Ta( rate -9:
The co#any is considering a recaitali4ation 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
recaitali4ation share rice (<1?.-9!. The recaitali4ation is not
e(ected to have an effect on oerating inco#e or the ta( rate. After the
recaitali4ation/ the co#any,s interest e(ense will be <29/999.
Assu#e that the recaitali4ation 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 recaitali4ation%
a. <12.+9
b. <1?.?2
c. <1>.99
d. <1=.9+
e. <"9.->
Chapter 13- Page 15
Capital structure and st%ck price Answer: e Diff: '
-7
. A consultant has collected the following infor#ation regarding Ioung
6ublishingJ
Total assets <+/999 #illion Ta( rate -9:
1erating inco#e (5BIT! <>99 #illion &ebt ratio 9:
Interest e(ense <9 #illion $A)) 19:
Net inco#e <->9 #illion MGB ratio 1.99K
'hare rice <+".99 56' 8 &6' <+."9
The co#any has no growth oortunities (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 caital/ 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 caital 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 reurchase
stock at <+" er share. The reurchase will have no effect on the fir#,s
5BIT; however/ after the reurchase/ 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 caital structure change%
a. <+".99
b. <++.->
c. <+1."=
d. <+".2=
e. <+-.?"
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 oti#al caital
structure. Aight now/ 'i#on has a caital 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#/ k
M
L k
AF
/ 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 caital structure to 29 ercent
debt and 29 ercent e*uity%
a. 1-.+2:
b. +9.99:
c. 1-.?":
d. 12.79:
e. 1+.7-:
Optimal capital structure and ,amada e-uati%n Answer: d Diff: T
->
. Aaron Athletics is trying to deter#ine its oti#al caital structure. The
co#any,s caital 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 5*uity3to3total3 &ebt3to3e*uity Bond Before3ta(
assets ratio (w
d
! assets ratio (w
c
! ratio (&G5! rating cost of debt

9.19 9.=9 9.19G9.=9 8 9.11 AA ?.9:
9."9 9.>9 9."9G9.>9 8 9."2 A ?."
9.+9 9.?9 9.+9G9.?9 8 9.-+ A >.9
9.-9 9.79 9.-9G9.79 8 9.7? BB >.>
9.29 9.29 9.29G9.29 8 1.99 B =.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/ k
s
. 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 oti#al caital
structure/ and what is the fir#,s weighted average cost of caital ($A))!
at this oti#al caital structure%
a. w
c
8 9.=; w
d
8 9.1; $A)) 8 1-.=7:
b. w
c
8 9.>; w
d
8 9."; $A)) 8 19.=7:
c. w
c
8 9.?; w
d
8 9.+; $A)) 8 ?.>+:
d. w
c
8 9.7; w
d
8 9.-; $A)) 8 19.12:
e. w
c
8 9.2; w
d
8 9.2; $A)) 8 19.1>:
Capital structure and st%ck price Answer: d Diff: T
-=
. Miy 6asta )ororation (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 k
s
for various caital structures are given below.
$hat is the oti#al caital structure for M6)%
&ebtGTotal Assets 5(ected 56' k
s

"9: <".29 12.9:
+9 +.99 12.2
-9 +."2 17.9
29 +.?2 1?.9
?9 -.99 1>.9
a. &ebtGTotal Assets 8 "9:
b. &ebtGTotal Assets 8 +9:
c. &ebtGTotal Assets 8 -9:
d. &ebtGTotal Assets 8 29:
e. &ebtGTotal Assets 8 ?9:
Chapter 13- Page 17
Capital structure and st%ck price Answer: ) Diff: T
29
. Hiven the following choices/ what is the oti#al caital structure for
)hi )o.% (Assu#e that the co#any,s growth rate is " ercent.!
&ividends )ost of
&ebt Aatio 6er 'hare 5*uity (k
s
!
9: <2.29 11.2:
"2 7.99 1".9
-9 7.29 1+.9
29 ?.99 1-.9
?2 ?.29 12.9
a. 9: debt; 199: e*uity
b. "2: debt; ?2: e*uity
c. -9: debt; 79: e*uity
d. 29: debt; 29: e*uity
e. ?2: debt; "2: e*uity
Capital structure and st%ck price Answer: a Diff: T
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 reurchase. 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
recaitali4ation.
Assu#e that the shares are reurchased at a rice e*ual to the stock
#arket rice rior to the recaitali4ation. $hat would be the co#any,s
stock rice following the recaitali4ation%
a. <21.1-
b. <2+.>2
c. <27.9"
d. <7>.=?
e. <?7.9+
Capital structure and st%ck price Answer: a Diff: T
2"
. 5tchabarren 5lectronics has #ade the following forecast for the uco#ing
year based on the co#any,s current caitali4ationJ
Interest e(ense <"/999/999
1erating inco#e (5BIT! <"9/999/999
5arnings er share <+.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 caitali4ation its stock rice will be
<-+."9 at year end.
The co#any,s invest#ent bankers have suggested that the co#any
recaitali4e. Their suggestion is to issue enough new bonds at a yield of
19 ercent to reurchase 1 #illion shares of co##on stock. Assu#e that
the stock can be reurchased at today,s <-9 stock rice.
Assu#e that the reurchase will have no effect on the co#any,s oerating
inco#e; however/ the reurchase 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 reurchase. Hiven these assu#tions/ what would be the e(ected year3
end stock rice if the co#any roceeded with the recaitali4ation%
a. <->.+9
b. <-".27
c. <--.?7
d. <-9.+-
e. <-7.=9
Capital structure and st%ck price Answer: d Diff: T
2+
. Fascheid 5nterrises 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 reurchase. 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 recaitali4ation. $hat would be
the co#any,s stock rice following the reurchase transaction%
a. <197.7?
b. <19".7+
c. < ??.1-
d. < ?-.7?
Chapter 13- Page 19
e. < ?9.-9
Capital structure and E"# Answer: d Diff: T
2-
. Buchanan Brothers anticiates that its net inco#e at the end of the year
will be <+.7 #illion (before any recaitali4ation!. 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
recaitali4ation/ where it will issue <19 #illion worth of debt at a yield
to #aturity of 19 ercent and use the roceeds to reurchase 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 recaitali4ation%
a. <"."+
b. <".-2
c. <+."7
d. <-.2"
e. <2.2-
Capital structure and E"# Answer: a Diff: T
22
. T)E )ororation is considering two alternative caital structures with the
following characteristics.
A B
&ebtGAssets ratio 9.+ 9.?
k
d
19: 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 caital 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. <?.7"
c. <-.?>
d. <+.9+
e. <1.1=
Capital structure, leverage, and WACC Answer: d Diff: T N
27
. 6ennington Airlines currently has a beta of 1.". The co#any,s caital
structure consists of <? #illion of e*uity and <+ #illion of debt. The
co#any is considering changing its caital structure. .nder the roosed
lan the co#any would increase its debt by <" #illion and use the roceeds
to reurchase 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.)
)oybold )ororation is a start3u fir# considering two alternative caital
structures/ one is conservative and the other aggressive. The conservative
caital 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 caital structure/ it
envisions two ossible scenarios for its oerationsJ 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 caital
structure its cost of debt will be 19 ercent/ while with the aggressive caital
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"# Answer: e Diff: '
2?
. $hat is the difference between the 56' forecasts for Feast and Fa#ine
under the aggressive caital structure%
a. < 9
b. <1.->
c. <9.7"
d. <9.=>
e. <".-9
Capital structure and E"# Answer: ) Diff: '
2>
. $hat is the difference between the 56' forecasts for Feast and Fa#ine
under the conservative caital structure%
a. <1.99
b. <9.>9
c. <"."9
d. <9.--
e. < 9
Capital structure and C* %f E"# Answer: c Diff: '
2=
. $hat is the coefficient of variation of e(ected 56' under the aggressive
caital structure%
a. 1.99
b. 1.1>
c. ".-2
d. ".>>
e. +.?7
Capital structure and C* %f E"# Answer: a Diff: '
79
. $hat is the coefficient of variation of e(ected 56' under the
conservative caital structure%
a. 9.2>
b. 9.+=
c. 9.12
d. 9."+
e. 1.99
(The following information applies to the next three problems.)
)urrently/ the Fotooulos )ororation,s balance sheet is as followsJ
Assets <2 billion &ebt <1 billion
)o##on e*uity - billion
Total assets <2 billion Total debt N co##on e*uity <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 co#any esti#ates that its before3ta( cost of debt is ?.2 ercent.
The co#any esti#ates that its levered beta is 1.1.
The risk3free rate is 2 ercent.
The #arket risk re#iu#/ k
M
L k
AF
/ is 7 ercent.
The co#any,s ta( rate is -9 ercent.
In addition/ the Fotooulos )ororation is considering a recaitali4ation.
The roosed lan is to issue <1 billion worth of debt and to use the #oney
to reurchase <1 billion worth of co##on stock. As a result of this
recaitali4ation/ the fir#,s si4e will not change.
Capital structure and WACC Answer: c Diff: E N
71
. $hat is Fotooulos, current $A)) (before the roosed recaitali4ation!%
a. 2.=":
b. =.>>:
c. 19.1>:
d. 19.?>:
e. 11.+>:
,amada e-uati%n and unlevered )eta Answer: c Diff: E N
7"
. $hat is Fotooulos, current unlevered beta (before the roosed
recaitali4ation!%
a. 9.7"1+
b. 9.>=7"
c. 9.=272
d. 1.99-1
e. 1."?99
Chapter 13- Page 23
,amada e-uati%n and c%st %f c%mm%n e-uit& Answer: e Diff: ' N
7+
. $hat will be the co#any,s new cost of co##on e*uity if it roceeds with
the recaitali4ation% (EintJ Be sure that the beta you use is carried
out to - deci#al laces.!
a. 19.?-:
b. 11.7":
c. 1"."?:
d. 1".7":
e. 1+.9+:
(The following information applies to the next two problems.)
An analyst has collected the following infor#ation regarding the Milbrett
)ororationJ
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 recaitali4ation/ 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 recaitali4ation/ 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 recaitali4ation will have no effect on the
co#any,s basic earning ower.
Capital structure, financial leverage, and rati%s Answer: d Diff: E N
7-
. $hich of the following is likely to occur following the recaitali4ation%
a. The co#any,s net inco#e will increase.
b. The co#any,s A1A will increase.
c. The co#any,s oerating inco#e will decrease.
d. The co#any,s A15 will increase.
Capital structure and E"# Answer: c Diff: T N
72
. Assu#e that after the recaitali4ation the co#any,s ti#es3interest3
earned ratio will be 1".2. $hat is Milbrett,s e(ected earnings er
share following the recaitali4ation%
a. <".--
b. <".7"
c. <".?7
d. <".>9
e. <".>>
(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 caital structure that consists of ?2
ercent co##on e*uity and "2 ercent debt.
The risk3free rate/ k
AF
/ is 2 ercent.
The #arket risk re#iu# / k
M
3 k
AF
/ is 7 ercent.
Naulls,s co##on stock has a beta of 1.".
Naulls has "93year bonds outstanding with an annual couon 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.
,amada e-uati%n and unlevered )eta Answer: c Diff: E N
77
. $hat is the co#any,s unlevered beta%
a. 9.-+
b. 9.=+
c. 1.99
d. 1.97
e. 1.--
,amada e-uati%n and c%st %f c%mm%n e-uit& 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 caital 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. 11.+7:
b. 1".7":
c. 1+.-9:
d. 1-.+9:
e. 17.-9:
(The following information applies to the next four problems.)
'tewart Inc. has <-/999/999 in total assets. The co#any,s current caital
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# (k
M
L k
AF
! is also 2 ercent. At the
fir#,s current caital 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 oerating 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'Gk
s
; where k
s
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 Answer: c Diff: E N
7>
. $hat is the co#any,s $A))%
a. 7."=:
b. >.>7:
c. =."7:
d. 19.97:
e. 19.?9:
,amada e-uati%n and unlevered )eta Answer: ) Diff: ' N
7=
. $hat is the co#any,s unlevered beta%
a. 9.-19?
b. 9.=2>+
c. 1.9999
d. 1.91-?
e. 1.+>99
,amada e-uati%n and c%st %f c%mm%n e-uit& Answer: d Diff: ' N
?9
. The co#any is considering changing its caital structure. 'ecifically/
the fir# is considering a caital 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 reurchase
co##on stock. Assu#e that if the fir# adots this change/ its total
interest e(ense would now be <"99/999. Assu#e that the caital structure
change would have no effect on the co#any,s total assets/ oerating
inco#e/ or ta( rate. Assu#e that all co##on shares will be reurchased 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 adots a
caital structure that consists of 29 ercent debt and 29 ercent co##on
e*uity%
a. 11."+:
b. 11.?1:
c. 1"."2:
d. 1".7?:
e. 1+.99:
Capital structure, leverage, and E"# Answer: c Diff: ' N
?1
. $hat would be the co#any,s earnings er share/ if it adots a caital
structure with 29 ercent debt and 29 ercent co##on e*uity%
a. <9.?2
b. <".-7
c. <+.-+
d. <-.9-
e. <7.>7
,e+ Appendi- !"A
Multiple Choice: Conceptual
Easy:
DOL, D(L, and DTL Answer: c Diff: E
1+A3
?"
a. An increase in fi(ed costs/ (holding sales and variable costs
constant! will reduce the co#any,s degree of oerating 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 oerating leverage.
d. Answers a and b are correct.
e. Answers b and c are correct.
Medium:
(inancial leverage Answer: e Diff: '
1+A3
?+
. The use of financial leverage by the fir# has a otential i#act on
which of the following%
(1! The risk associated with the fir#.
("! The return e(erienced by the shareholder.
(+! The variability of net inco#e.
(-! The degree of oerating leverage.
(2! The degree of financial leverage.
a. 1/ +/ 2
b. 1/ "/ 2
c. "/ +/ 2
d. "/ +/ -/ 2
e. 1/ "/ +/ 2
(inancial leverage Answer: d Diff: '
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 oerating 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 deend on the interest rate aid on
the debt.
d. The ercentage change in net oerating inco#e will be less than the
ercentage change in net inco#e.
e. 'ince debt is used/ the degree of oerating leverage #ust be greater
Chapter 13- Page 27
than 1.
(inancial risk Answer: ) Diff: '
1+A3
?2
a. 'uose )o#any APs 56' is e(ected to e(erience a larger ercentage
change in resonse to a given ercentage change in sales than )o#any
BPs 56'. 1ther things held constant/ )o#any A would aear 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 Answer: a Diff: '
1+A3
?7
a. The degree of oerating leverage (&1F! deends 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
roortion 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 oerating 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 oerating leverage.
d. The state#ents above are true.
e. The state#ents above are false.
Operating and financial leverage Answer: e Diff: '
1+A3
??
a. All else being e*ual/ an increase in a fir#Ps fi(ed costs will
increase its degree of oerating 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.
Chapter 13- Page 29
DOL Answer: c Diff: '
1+A3
?>
. The degree of oerating leverage has which of the following
characteristics%
a. The closer the fir# is oerating 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 outut/ other
things held constant.
c. The &1F is not a fi(ed nu#ber for a given fir#/ but will deend uon
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
oerating 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 oerating 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 oerating 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
. $hich of the following is a key benefit of using the degree of leverage
concet in financial analysis%
a. It allows decision #akers a relatively clear assess#ent of the
conse*uences of alternative actions.
b. It establishes the oti#al caital structure for the fir#.
c. It shows how a given change in leverage will affect sales.
d. All of the state#ents above.
e. 1nly state#ents a and c above are correct.
Multiple Choice: P*o+lems
Easy:
DOL and c$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. 1":
b. 1-:
c. 17:
d. 1>:
e. "9:
DTL and f%recast E"# Answer: d Diff: 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 sace shuttle. The fir#Ps current 56' is
<+."2. Its degree of oerating leverage is 1.7/ while its degree of
financial leverage is ".1. $hat is the fir#Ps ro0ected 56' for the
co#ing year using the &TF aroach%
a. < +."2
b. < 2.-7
c. <19.="
d. < >.?1
e. <1=.7+
C$ange in E"# Answer: ) Diff: 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 oerating
leverage e*ual to 1."2 and a degree of financial leverage e*ual to +.29/
then what is its e(ected 56'%
a. <1.+->1
b. <1.727+
c. <1.=>1+
d. <"."-"?
e. <".2>-+
Chapter 13- Page 31
Medium:
DOL c$ange Answer: a Diff: '
1+A3
>-
. 'tro#burg )ororation #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 oerating leverage at the
new ro0ected sales level%
a. +.?2
b. -."9
c. +.29
d. -.7?
e. +.++
DOL Answer: d Diff: '
1+A3
>2
. The Rdegree of leverageR concet 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 oerating leverage%
a. +.7
b. -."
c. -.?
d. 2.9
e. 2.2
DOL in sales d%llars Answer: c Diff: '
1+A3
>7
. Marcus )ororation currently sells 129/999 units a year at a rice of
<-.99 a unit. Its variable costs are aro(i#ately +9 ercent of sales/
and its fi(ed costs a#ount to 29 ercent of revenues at its current
outut level. Although fi(ed costs are based on revenues at the current
outut level/ the cost level is fi(ed. $hat is MarcusPs degree of
oerating leverage in sales dollars%
a. 1.9
b. "."
c. +.2
d. -.9
e. 2.9
DOL, D(L, and DTL Answer: c Diff: '
1+A3
>?
. 6QA Manufacturing )ororation 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 oerating leverage%
a. 1.12
b. 1.99
c. 1.""
d. 1.1"
e. ".7>
DTL and interest e+pense Answer: d Diff: '
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 oerating 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. <199/999
b. <192/>?-
c. <111/2>-
d. <1-"/>2?
e. <>2?/1-"
DTL Answer: e Diff: '
1+A3
>=
. Alvare4 Technologies has sales of <+/999/999. The co#any,s fi(ed
oerating costs total <299/999 and its variable costs e*ual 79 ercent
of sales/ so the co#any,s current oerating inco#e is <?99/999. The
co#any,s interest e(ense is <299/999. $hat is the co#any,s degree of
total leverage (&TF!%
a. 1.?1-
b. +.199
c. +."29
d. +.299
e. 7.999
Chapter 13- Page 33
DTL and c$ange in N! Answer: e Diff: '
1+A3
=9
. 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. 12.77:
b. 1>.++:
c. 1=."-:
d. "1.29:
e. "+.9>:
E+pected EB!T Answer: c Diff: '
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. <"/-99/999
b. <1/799/999
c. < -99/999
d. <+/799/999
e. <1/+29/999
E+pected EB!T Answer: d Diff: '
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. <11+/-1"
b. <199/999
c. < >-/+?2
d. < 7?/27>
e. < -"/112
E+pected EB!T Answer: e Diff: '
1+A3
=+
. Sulwicki )ororation wants to deter#ine the effect of an e(ansion of
its sales on its oerating inco#e (5BIT!. The fir#Ps current degree of
oerating 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 oerating leverage of ".2/ what
is this yearPs e(ected 5BIT with the increase in sales%
a. < 79/999
b. <1?2/999
c. <199/999
d. < =9/999
e. <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 couon.
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 oerating 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. <>.-" #illion
b. <=.1= #illion
c. <?.7+ #illion
d. <7.2> #illion
e. <-.-- #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 adoted/ the new rocess will result in a degree of oerating
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. <17.? #illion
b. <1>.2 #illion
c. <1=." #illion
d. <1=.> #illion
e. <"9.1 #illion
DOL, D(L, and fi+ed %perating c%sts Answer: c Diff: T
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
oerating costs include fi(ed and variable costs. $hat is the level of
the co#any,s fi(ed oerating costs%
a. < -29/999
b. < 777/77?
c. <1/"99/999
d. <"/999/999
e. <"/1"2/999
Chapter 13- Page 35
CHAPTE !"
A'%,E% A'D %.$&T#.'%
1. Business risk Answer: c Diff: E
". Business risk Answer: d Diff: E
+. Business risk Answer: d Diff: E N
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.
-. Business and financial risk Answer: d Diff: E
2. Optimal capital structure Answer: e Diff: E
The oti#al caital structure #a(i#i4es the fir#,s stock rice and #ini#i4es
the fir#,s $A)).
7
. Optimal capital structure Answer: c Diff: E
?. Optimal capital structure Answer: e Diff: E
>. Target capital structure Answer: e Diff: E
=. Leverage and capital structure Answer: d Diff: E
19Both an increase in the cororate ta( rate and a decrease in the co#any,s
degree of oerating leverage will encourage the fir# to use #ore debt in its
caital 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 cororate 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 cororate debt less attractive/ causing fir#s to utili4e less debt
financing. An increase in the costs of bankrutcy 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
'tate#ent e is correct. Fess stable sales would lead a fir# to reduce its debt
ratio. A lower cororate 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.
1". 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 cororate 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 caital structure. Increasing oerating 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 bankrutcy 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 bankrutcy increased/ fir#s would be
enali4ed #ore if they filed for bankrutcy and would be less willing to take
that risk. Therefore/ they would reduce debt levels to hel avoid bankrutcy
risk/ so state#ent a is false. An increase in the cororate 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 cororate ta( rates increase/ then
co#anies get a larger ta( advantage fro# debt in their caital 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 cororations 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. Leverage and capital structure Answer: c Diff: E N
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 recaitali4ation 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. Tyically/ the
cost of debt rises slower than the cost of e*uity. Also/ the fir# is
substituting cheaer 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 caital structure that #a(i#i4es stock rice
should #ini#i4e the $A)). 'o/ state#ent d is also incorrect.
1?. Leverage and capital structure Answer: c Diff: E
k
$A))
&GA ratio
'tate#ent a is false. The $A)) does not necessarily increase. Ae#e#ber/ you
are relacing high cost e*uity with low cost debt. $hen there is very little
debt in the caital structure/ the $A)) will actually decrease. ('ee the
diagra# above.! The caital structure that #a(i#i4es stock rice is not
necessarily the caital structure that #a(i#i4es 56'/ so state#ent b is false.
If the cororate 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.
1>. Capital structure and WACC Answer: e Diff: E
'tate#ent a is false; if you are to the left of the fir#,s oti#al caital
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 oti#al caital 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 deends on where you are
on the $A)) curve relative to the fir#,s oti#al caital structure. Therefore/
the correct answer is state#ent e.
1=. Capital structure, OA, and OE Answer: d Diff: E
'tate#ents a and b are correct; therefore/ state#ent d is the aroriate
choice. A1A 8 NIGTA. If total assets re#ain the sa#e/ but NI decreases
(because of the new interest ay#ent!/ A1A will decrease. NI will fall/ but not
as #uch in co#arison to the a#ount that co##on e*uity will fall because B56 X
k
d
/ thus A15 8 NIG)5 will rise. B56 will re#ain the sa#e. B56 8 5BITGTA/ where
TA and 5BIT re#ain the sa#e (which was given in the roble#!.
"9
. Capital structure, WACC, T!E, and E"# Answer: a Diff: E
'tate#ent a is correct; the other state#ents are false. The caital structure
that #a(i#i4es the fir#,s stock rice generally calls for a debt ratio that is
lower than the one that #a(i#i4es 56'. The fir# could #a(i#i4e its TI5 by
having no debt (that is 4ero interest ay#ents!. But/ this caital structure
would robably not #a(i#i4e the fir#,s stock rice.
"1. Capital structure t$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 cororate 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 caital 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
oosite 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 E"#
Answer: a Diff: 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
oerating 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 caital
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 k
d
. 'ince B56 is "9 ercent and k
d
is > ercent/ leverage will increase Fir# F,s A15. Therefore/ state#ent c is
false.
"?. Optimal capital structure Answer: d Diff: '
">. Operating and financial leverage Answer: e Diff: '
"=. (inancial leverage and rati%s Answer: c Diff: '
'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.
+9. Limits %f leverage Answer: d Diff: '
+1. #ignaling t$e%r& Answer: ) Diff: '
+". Capital structure and WACC Answer: d Diff: '
'tate#ent b is false because it is not always true.
++. Capital structure and WACC 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
caital structure than the one that #ini#i4es the fir#,s weighted average cost
of caital. Increasing debt increases the risk of bankrutcy/ which can
increase the costs of both debt and e*uity.
+-. 'iscellane%us capital structure c%ncepts Answer: a Diff: '
'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 oerating leverage; therefore/ fir#s with high business
risk would use less debt.
+2
. 'iscellane%us capital structure c%ncepts Answer: c Diff: '
If cororate ta( rates were decreased while other things were held constant/
and if the MM ta(3ad0usted tradeoff theory of caital structure were correct/
cororations 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 oerations if it uses no debt. The oti#al caital
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.
+7
. *ariati%ns in capital structures Answer: d Diff: T
+?. Determining price fr%m EB!T Answer: e Diff: E
5BIT 8 6Q 3 DQ 3 F)
<=2/999 8 6(22/999! 3 (9.-!6(22/999! 3 <119/999
<"92/999 8 (9.7!(22/999!6
<"92/999 8 ++/9996
6 8 <7."1.
+>
. Breakeven price Answer: a Diff: E
Total costs 8 <19/999 U <"(-"/999! 8 <=-/999.
6rice 8 <=-/999G-"/999 8 <"."-.
+=
. New financing Answer: a Diff: '
1ld debt ratio 8 9.++++; New debt ratio 8 9.177?.
TA
'ales
8 ?.2.
TA 8
?.2
<?29/999
8 <199/999.
&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 <++/+++ reresents aro(i#ately 17.7?: of total
assets following the e(ansion/ thus the fir# should finance with 199 ercent
e*uity.
-9
. Net %perating inc%me Answer: ) Diff: '
Total cost
Method 1
8 <1.99(Q! U <19/999.
Total cost
Method "
8 <1.29(Q! U <2/999.
'et e*ual and solve for QJ
Q U <19/999 8 <1.29(Q! U <2/999
<2/999 8 <9.2(Q!
19/999 8 Q.
-1
. C$ange in )reakeven v%lume Answer: ) Diff: '
)alculate the old and new breakeven volu#es using the old data and new
ro0ectionsJ
1ld Q
B5
8 <1"9/999G(<1."9 3 <9.79! 8 <1"9/999G<9.79 8 "99/999 units.
New Q
B5
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 Answer: c Diff: '
)alculate the initial breakeven volu#e in dollarsJ
1ld '
B5
8
'ales
D)
3 1
F)
8
6riceGunit
D)Gunit
3 1
F)
8
<?.99
<-."9
3 1
<-99/999
8
9.79 3 1
<-99/999
8 <1/999/999.
)alculate the new breakeven volu#e in sales dollarsJ
New '
B5
8
<?.99
<-.->
3 1
<729/999
8
9.7- 3 1
<729/999
8 <1/>92/227.
The increase in '
B
8 <1/>92/227 3 <1/999/999 8 <>92/227.
-+. Breakeven Answer: d Diff: '
<?("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 Answer: d Diff: '
)alculate 5BIT
1
at -9/999 units using the current sales riceJ
5BIT
1
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.
)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. Ies/ Musgrave should cut its
rice/ 5BIT increases by <>/929.
-2
. Capital structure and st%ck price Answer: c Diff: '
$e can do this roble# by using the 6G5 before and after the recaitali4ation.
Aecall that 6G5 8 6riceG56'.
Before reca. After reca.
5BIT <+99/999 <+99/999
Interest 319/999 329/999
5BT <"=9/999 <"29/999
Ta( (-9:! 117/999 199/999
NI <1?-/999 <129/999
'hares 1"9/999 199/999T
56' <1?-/999G1"9/999 8 <1.-2. <129/999G199/999 8 <1.29.
6G5 <1?.-9G1.-2 8 1".
T1"9/999 3 (<+->/999G<1?.-9! 8 199/999 shares.
As 6G5 8 1" after the recaitali4ation (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 Answer: e Diff: '
'te 1J Find the current nu#ber of shares outstandingJ
'hares 8 NIG56' 8 <->9 #illionG<+."9 8 129 #illion shares.
'te "J Find the nu#ber of shares after the reurchaseJ
New shares

8

129

L

<1/"99G<+"

8

129

L

+?.2

8 11".2 #illion shares.
'te +J Find the new 56' after the reurchaseJ
56' 8 V(5BIT L INT!(1 3 T!WGNew shares
8 V(<>99 L <>-! 9.7WG11".2 8 <+.>1>77?.
'te -J Find the new stock riceJ
'tock rice 8 56'GNew $A))
8 <+.>1>77?G9.11 8 <+-.?".
-?. ,amada e-uati%n and c%st %f e-uit& Answer: a Diff: T
Facts givenJ k
s
8 1":; &G5 8 9."2; k
AF
8 7:; A6
M
8 2:; T 8 -9:.
'te 1J Find the fir#,s current levered beta using the )A6MJ
k
s
8 k
AF
U A6
M
(b!
1": 8 7: U 2:(b!
b 8 1.".
'te "J Find the fir#,s unlevered beta using the Ea#ada e*uationJ
b 8 b
.
V1 U (1 3 T!(&G5!W
1." 8 b
.
V1 U (9.7!(9."2!W
1." 8 1.12b
.
1.9-+2 8 b
.
.
'te +J Find the new levered beta given the new caital 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.
'te -J Find

the

fir#,s

new

cost

of

e*uity

given

its

new

beta

and

the

)A6MJ
k
s
8 k
AF
U A6
M
(b!
k
s
8 7: U 2:(1.77=7!
k
s
8 1-.+2:.
->. Optimal capital structure and ,amada e-uati%n Answer: d Diff: T
k
AF
8 2:; k
M
3 k
AF
8 7:; k
s
8 k
AF
U (k
M
3 k
AF
!b; $A)) 8 w
d
k
d
(1 3 T! U w
c
k
s
.
Iou need to use the &G5 ratio given for each caital structure to find the
levered beta using the Ea#ada e*uation. Then/ use each of these betas with the
)A6M to find the k
s
for that caital structure. .se this k
s
and k
d
for each
caital structure to find the $A)). The oti#al caital structure is the one
that #ini#i4es the $A)).
(&G5! b 8 b
.
V1 U (1 3 T!(&G5!W k
s
8 k
AF
U (k
M
3 k
AF
!b w
c
k
d
w
d
$A))

9.11 1.977? 11.-999: 9.= ?.9: 9.1 19.7>:
9."2 1.1299 11.=999 9.> ?." 9." 19.+>
9.-+ 1."2?1 1".2-"= 9.? >.9 9.+ 19.""
/.01 2.3/// 24.3/// /.0 5.5 /.3 2/.26
1.99 1.7999 1-.7999 9.2 =.7 9.2 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?.
k
s
8 k
AF
U (k
M
3 k
AF
!b 8 2: U 7:(1.977?! 8 11.-9:.
The weights are given at 9.= and 9.1 for e*uity and debt/ resectively/ and the
k
d
for that caital structure is given as ? ercent.
$A)) 8 w
d
k
d
(1 3 T! U w
c
k
s
8 (9.1!(?:!(1 3 9.-! U (9.=!(11.-9:! 8 19.7>:.
&o the sa#e calculation for each of the caital structures and find each $A)).
The oti#al caital structure is the one that #ini#i4es the $A))/ which is
19.12:. Therefore/ the oti#al caital structure is -9: debt and 79: e*uity.
-=. Capital structure and st%ck price Answer: d Diff: T
The oti#al caital 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 6
9
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
6
9
is <".19G(12.2: 3 ?:! 8 <"-.?1. 'i#ilarly/ when the debt ratio is -9:/ &
1
8
<"."?2 and 6
9
8 <"2.">. $hen the debt ratio is 29:/ &
1
8 <".7"2 and 6
9
8
<"7."2. $hen the debt ratio is ?9:/ &
1
8 <".>9 and 6
9
8 <"2.-2. The stock
rice is highest when the debt ratio is 29:.
29
. Capital structure and st%ck price Answer: ) Diff: T
First/ calculate the stock rice for each debt level using the dividend growth
#odel/ 6
9
8 &
1
G(k
'
3 g!J
&ebt &ivGshare k
'
6
9

9: <2.29 11.2: <2.29G(9.112 3 9.9"! 8 <2?.>=.
76 0.// 27./ 80.//9:/.27 ; /./7< = 80/.//.
-9 7.29 1+.9 <7.29G(9.1+ 3 9.9"! 8 <2=.9=.
29 ?.99 1-.9 <?.99G(9.1- 3 9.9"! 8 <2>.++.
?2 ?.29 12.9 <?.29G(9.12 3 9.9"! 8 <2?.7=.
)learly/ <79.99 is the highest rice/ so "2: debt and ?2: e*uity is the oti#al
caital structure.
21. Capital structure and st%ck price Answer: a Diff: T
First/ find the co#any,s current cost of caital/ dividends er share/ and
stock riceJ
k
s
8 9.977 U (9.97!9.= 8 1":. To find the stock rice/ you still need the
dividends er share or &6' 8 (<"/999/999(1 3 9.-!!G"99/999 8 <7.99. Thus/ the
stock rice is 6
9
8 <7.99G9.1" 8 <29.99. Thus/ by issuing <"/999/999 in new
debt the co#any can reurchase <"/999/999G<29.99 8 -9/999 shares.
Now after recaitali4ation/ the new cost of caital/ &6'/ and stock rice can
be foundJ
k
s
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/ 6
9
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 recaitali4ationJ
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 recaitali4ationJ
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 <"9/999/999
Interest 7/999/999
5BT <1-/999/999
Ta(es (-9:! 2/799/999
NI < >/-99/999
56' 8 <>/-99/999G"/999/999 8 <-."9. 6G5 8 11.2. 6
9
8 (<-."9!(11.2! 8 <->.+9.
2+
. Capital structure and st%ck price Answer: d Diff: T
The bonds used in the reurchase 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 reurchasedJ <>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?.
2-. Capital structure and E"# Answer: d Diff: T
After issuing the debt/ the co#any can reurchase <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 anticiated 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
recaitali4ation.
22. Capital structure and E"# Answer: a Diff: T
)aital 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?.
)aital 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 caital structure A and caital 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 caital
structure before you can calculate the fir#,s $A)).
'te 1J )alculate the fir#,s unlevered beta using the Ea#ada e*uationJ
b
F
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.
'te "J )alculate the fir#,s new beta with the new caital structureJ
b
F
8 b
.
V1 U (1 3 T!(&G5!W
b
F
8 9.=2-2-2V1 U (9.7!(<2G<2!W
b
F
8 1.2"?+.
'te +J )alculate the fir#,s new cost of e*uity with the new caital
structureJ
k
s
8 k
AF
U (A6!b
k
s
8 7: U ?:(1.2"?+!
k
s
8 17.7=9=:.
'te -J )alculate the fir#,s new $A))J
$A)) 8 w
d
k
d
(1 3 T! U w
c
k
s
$A)) 8 9.2(>.2:!(9.7! U 9.2(17.7=9=:!
$A)) 8 19.>=22: 19.=9:.
2?. Capital structure and E"# Answer: e Diff: '
&ebt 8 ?2: 8 <+99/999; 5*uity 8 "2: 8 <199/999; BD6' 8 <19; Total assets 8
<-99/999.
Feast Fa#ine
6robability 9.7 9.-
5BIT <79/999 <"9/999
FessJ Interest +7/999 +7/999
5BT <"-/999 (<17/999!
FessJ Ta(es (-9:! =/799 (7/-99!
NI <1-/-99 (< =/799!
Y shares 19/999 19/999
56' <1.-- 3<9.=7
&ifference in 56' for aggressive caital structureJ
56'
Feast
3 56'
Fa#ine
8 <1.-- 3 (<9.=7! 8 <".-9.
2>
. 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.
Feast Fa#ine
6robability 9.7 9.-
5BIT <79/999 <"9/999
FessJ Interest 19/999 19/999
5BT <29/999 <19/999
FessJ Ta(es (-9:! "9/999 -/999
NI <+9/999 < 7/999
Y shares +9/999 +9/999
56' <1.99 <9."9
&ifference in 56' for conservative caital structureJ
56'
Feast
3 56'
Fa#ine
8 <1.99 3 <9."9 8 <9.>9.
2=
. Capital structure and C* %f E"# Answer: c Diff: '
)alculate coefficient of variation.
5(ected 56'
Aggressive
J
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.->!
"
W
Z
8 V9.22+9 U 9.>"=-W
1G"
8 1.1?7.
)D
Aggressive
8 1.1?7G9.-> ".-2.
79
. Capital structure and C* %f E"# Answer: a Diff: '
)alculate coefficient of variation.
5(ected 56' conservativeJ
5(56'! 8 9.7(<1.99! U 9.-(<9."9! 8 <9.7>.
'tandard deviationJ
'&
56'3)onservative
8 V9.7(<1.99 3 <9.7>!
"
U 9.-(<9."9 3 <9.7>!
"
W
Z
8 V9.971- U 9.9=""W
1G"
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)).
k
s
8 k
AF
U (k
M
3 k
AF
!b
k
s
8 2: U (7:!1.1
k
s
8 11.7:.
$A)) 8 w
d
k
d
(1 3 T! U w
c
k
s
$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.
b
F
8 b
.
V1 U (1 3 T!(&G5!W
1.1 8 b
.
V1 U (1 3 9.-!(1G-!W
1.1 8 b
.
V1.12W
b
.
8 9.=272.
7+. ,amada e-uati%n and c%st %f c%mm%n e-uit& Answer: e Diff: ' N
First/ we #ust find the levered beta after the recaitali4ation/ using the
unlevered beta calculated in the revious roble#.
b
F
8 b
.
V1 U (1 3 T!(&G5!W
b
F
8 9.=272V1 U (1 3 9.-!("G+!W
b
F
8 9.=272V1.-W
b
F
8 1.++=1.
k
s
8 k
AF
U (k
M
L k
AF
!b
F
k
s
8 2: U (7:!1.++=1
k
s
8 1+.9+:.
7-. Capital structure, financial leverage, and rati%s Answer: d Diff: E N
The correct answer is state#ent d. 'tate#ent a is incorrect; since oerating
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 oerating 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 oerating inco#eJ
B56 8 5BITGTA
9."9 8 5BITG<199/999/999
5BIT 8 <"9/999/999.
'te "J &eter#ine the fir#,s interest e(ense/ given the TI5 and 5BITJ
TI5 8
Interest
5BIT
1".2 8
Interest
999 / 999 / "9 <
1".2Interest 8 <"9/999/999
<1/799/999 8 Interest.
'te +J &eter#ine the fir#,s net inco#eJ
1erating inco#e <"9/999/999
Interest e(ense 1/799/999
5BT <1>/-99/999
Ta(es (-9:! ?/+79/999
Net inco#e <11/9-9/999
'te -J &eter#ine the nu#ber of shares outstanding after recaitali4ationJ
If the fir# reurchased <"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.
'te 2J &eter#ine the fir#,s 56' after recaitali4ationJ
56' 8 NIGY of shares
56' 8 <11/9-9/999G-/999/999
56' 8 <".?7.
77 . ,amada e-uati%n and unlevered )eta
Answer: c Diff: E N
b
F
8 b
.
V1 U (1 3 T!(&G5!W
1."8 b
.
V1 U (9.79!(9."2G9.?2!W
1."8 b
.
V1."W
b
.
8 1.99.
7? . ,amada e-uati%n and c%st %f c%mm%n e-uit&
Answer: c Diff: ' N
b
.
8 1.99 was calculated reviously in the roble# above.
'te 1J )alculate the new levered beta using the Ea#ada e*uation and the
unlevered beta calculated reviouslyJ
b
F
8 b
.
V1 U (1 3 T!(&G5!W
b
F
8 1.99V1 U (9.79!(9.-9G9.79!W
b
F
8 1.-9.
'te "J )alculate the new cost of e*uity using the )A6M e*uation and the new
levered betaJ
k
s
8 2: U (7:!1.-9 8 1+.-9:.
7>. Capital structure, leverage, and WACC Answer: c Diff: E N
w
d
8 "2:; w
s
8 ?2:; k
d
8 >:; k
s
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 Answer: ) Diff: ' N
b
F
8 1.12; T 8 -9:; & 8 "2:; 5 8 ?2:.

b
F
8 b
.
V1 U (1 3 T!(&G5!W
1.12 8 b
.
V1 U (9.7!(9."2G9.?2!W
1.12 8 b
.
V1."W
9.=2>+ 8 b
.
.
?9. ,amada e-uati%n and c%st %f c%mm%n e-uit& Answer: d Diff: ' N
'te 1J )alculate the new levered beta for the fir#/ using the new caital
structureJ
b
.
8 9.=2>+; New & 8 29:; New 5 8 29:; T 8 -9:.
b
F
8 b
.
V1 U (1 3 T!(&G5!W
8 9.=2>+V1 U (9.79!(9.29G9.29!W
8 1.2+++.
'te "J )alculate the fir#,s new cost of co##on e*uityJ
k
AF
8 2:; k
M
L k
AF
8 2:; b
F
8 1.2+++.
k
'
8 2: U (2:!1.2+++ 8 1".777: 1".7?:.
?1. Capital structure, leverage, and E"# Answer: c Diff: ' N
'te 1J )alculate net inco#e under the fir#,s new caital structure as
followsJ
5BIT <+99/999 (given!
Interest "99/999 (given!
5BT <199/999
Ta(es (-9:! -9/999
NI < 79/999
'te "J )alculate 56' under the fir#,s new caital 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 slit
evenly/ <" #illion in co##on e*uity and <" #illion in debt. The fir#
will borrow <1 #illion and use the roceeds to reurchase <1 #illion
worth of co##on e*uity. At the reurchase 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 <+.-+.
?"24A;. DOL, D(L, and DTL Answer: c Diff: E
?+24A;. (inancial leverage Answer: e Diff: '
?-24A;. (inancial leverage Answer: d Diff: '
?224A;. (inancial risk Answer: ) Diff: '
?724A;. Operating and financial leverage Answer: a Diff: '
??24;. Operating and financial leverage Answer: e Diff: '
?>24;. DOL Answer: c Diff: '
?=24;. De)t rati% and DOL Answer: a 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 Answer: a Diff: '
>124;. DOL and c$anges in EB!T Answer: a Diff: E
First/ find 5BIT before sales increaseJ
5BIT 8 'ales 3 ('ales D):! 3 F)
8 <12/999 3 (<12/999 9.79! 3 <1/999
,E/ APPE'D#0 !"A %.$&T#.'%
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":.
>"24;. DTL and f%recast E"# Answer: d Diff: E
56'
1
8 56'
9
U 56'
9
V&TF (ercent change in sales!W

8 <+."2V1 U (1.7!(".1!(9.2!W

8 <+."2(".7>!

8 <>.?1.
>+24;. C$ange in E"# Answer: ) Diff: E
56'
9
8 <1.99. &1F 8 1."2. 56'
1
8 %
:' 8 12:. &FF 8 +.29.
&TF 8 &1F(&FF! 8 1."2(+.29! 8 -.+?2.
56'
1
8 56'
9
V1.9 U (&TF!(:'ales!W
8 <1.99V1.9 U (-.+?2!(9.12!W
8 <1.99(1.727+! 8 <1.727+.
>-24;. DOL c$ange 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
199 3 "2
199 3 "2 3 22
8
?2
"9
8 +.?2.
>224;. DOL Answer: d Diff: '
These two e*uations could be usedJ
&TF 8 (&1F!(&FF!.
56'
1
8 56'
9
V1 U (&TF!(:'ales!W.
Note that 56' rises by 29 ercent/ fro# <1.99 to <1.29/ on a 19 ercent
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.
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 Answer: c Diff: '
.se the infor#ation rovided and the for#ula for &1F in sales dollarsJ
&1F
'
8
129/999(<-! 3 9.+(129/999!(<-!
129/999(<-! 3 9.+(129/999!(<-! 3 9.2(129/999!(<-!
&1F
'
8
999 / +99 < 999 / 1>9 < 999 / 799 <
999 / 1>9 < 999 / 799 <

&1F
'
8
999 / 1"9 <
999 / -"9 <
8 +.2.
Alternate #ethodJ
5(ress 6 as 1.9 or 199: of rice and D and F) as a ercent of riceJ
&1F
Q
8
F) ! D 6 ( Q
! D 6 ( Q

8
129/999(1.9 3 9.+!
129/999V(1.9 3 9.+! 3 9.2W
8
9.?
9."
8 +.29.
>?24;. DOL, D(L, and DTL 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 Answer: d Diff: '
Aecall that &TF 8 : change in NIG: change in sales
8 9.1?2G9.19 8 1.?2.
&TF 8
I F) D) '
D) '

1.?2 8
I 999 / 299 < 999 / 299 / > < 999 / 999 / 19 <
999 / 299 / > < 999 / 999 / 19 <

1.?2 8
I 999 / 999 / 1 <
999 / 299 / 1 <
<1/299/999 8 <1/?29/999 3 1.?2I

I 8 <1-"/>2?.1- [ <1-"/>2?.
>=24;. DTL Answer: e Diff: '
&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! Answer: e Diff: '
'te 1J Find &egree of total leverage (&TF!
&TF 8
I F D '
D '

8
<+/999/999 3 9.2(<+/999/999!
<+/999/999 3 9.2(<+/999/999! 3 <199/999 3 9.1(<1/999/999!
8
999 / +99 / 1 <
999 / 299 / 1 <
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>:.
=124;. E+pected EB!T Answer: c Diff: '
&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 revious 5BITJ
&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: '
'et u the &1F e*uation/ letting \ be the unknown new 5BITJ
Fet \ 8 New 5BIT.
&1F
Q
8 ".2 8
1"2/999
1"2/999 3 1?9/999
79/999
79/999 \
8
9.+7
79/999
79/999 \
".2(9.+7! 8
79/999
79/999 \
9.=9 8
79/999
79/999 \
<2-/999 8 \ 3 <79/999
\ 8 <11-/999.
New 5BIT 8 <11-/999.
=-24;. Degree %f financial leverage Answer: d Diff: '
&TF 8 (&1F!(&FF!
".9 8 1.7(&FF!
1."2 8 &FF.
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
9.9=2
8 <>/-"1/92+.
Must retire 8 <12/999/999 3 <>/-"1/92+ 8 <7.2> #illion of debt.
=224;. (inancial leverage, DOL, and DTL Answer: a Diff: T
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 for the new debt level/ knowing that the yield to #aturity
re#ains at 19:J
&ebt value(ITM! 8 Interest ay#ent
&ebt(9.19! 8 <1/777/7>7.11
&ebt 8 <17/777/>71.11 <17.? #illion.
=724;. DOL, D(L, and fi+ed %perating c%sts Answer: c Diff: T
$ePre given enough infor#ation to find both &FF and &TF.
&TF 8 &1F &FF
8
5BIT :
56' :

'ales :
5BIT :
8
: 56'
: 'ales
8
1>:
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 reresent fi(ed oerating costs. Thus/ F) 8 <+/799/999
3 <"/-99/999 8 <1/"99/999.

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Multiple Choice: Conceptual

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