Managerial Finance – Problem Review Set – Capital Structure and Leverage

1)
If a firm utilizes debt financing, an X% decline in earnings before interest
and taxes (EBIT) will result in a decline in earnings per share that is
larger than X.

a. True
b. False

2)
Firm A has a higher degree of business risk than Firm B. Firm A can offset
this by using less financial leverage. Therefore, the variability of both
firms' expected EBITs could actually be identical.

a. True
b. False

3)
It is possible that two firms could have identical financial and operating
leverage, yet have different degrees of risk as measured by the variability
of EPS.

a. True
b. False

4)
Which of the following events is likely to encourage a company to raise its
target debt ratio, other things held constant?

a. An increase in the corporate tax rate.

b. An increase in the personal tax rate.
c. An increase in the company’s operating leverage.
d. The Federal Reserve tightens interest rates in an effort to fight
inflation.
e. The company's stock price hits a new high.

5)
The firm’s target capital structure should be consistent with which of the
following statements?

a. Maximize the earnings per share (EPS).

b. Minimize the cost of debt (rd).
c. Obtain the highest possible bond rating.
d. Minimize the cost of equity (rs).
e. Minimize the weighted average cost of capital (WACC).
6)
Which of the following statements is CORRECT? As a firm increases the
operating leverage used to produce a given quantity of output, this will

a. normally lead to an increase in its fixed assets turnover ratio.

b. normally lead to a decrease in its business risk.
c. normally lead to a decrease in the standard deviation of its expected
EBIT.
d. normally lead to a decrease in the variability of its expected EPS.
e. normally lead to a reduction in its fixed assets turnover ratio.

7)
Reynolds Resorts is currently 100% equity financed. The CFO is considering a
recapitalization plan under which the firm would issue long-term debt with a
yield of 9% and use the proceeds to repurchase common stock. The
recapitalization would not change the company’s total assets, nor would it
affect the firm’s basic earning power, which is currently 15%. The CFO
believes that this recapitalization would reduce the WACC and increase stock
price. Which of the following would also be likely to occur if the company
goes ahead with the recapitalization plan?

a. The company’s net income would increase.

b. The company’s earnings per share would decline.
c. The company’s cost of equity would increase.
d. The company’s ROA would increase.
e. The company’s ROE would decline.

8)
Vu Enterprises expects to have the following data during the coming year.
What is Vu's expected ROE?

Assets $200,000 Interest rate 8%

D/A 65% Tax rate 40%
EBIT $25,000

a. 12.51%
b. 13.14%
c. 13.80%
d. 14.49%
e. 15.21%

9)
Ang Enterprises has a levered beta of 1.10, its capital structure consists of
40% debt and 60% equity, and its tax rate is 40%. What would Ang's beta be if
it used no debt, i.e., what is its unlevered beta?

a. 0.64
b. 0.67
c. 0.71
d. 0.75
e. 0.79
10)
Firms HD and LD are identical except for their level of debt and the
interest rates they pay on debt--HD has more debt and pays a higher
interest rate on that debt. Based on the data given below, what is the
difference between the two firms' ROEs?

Applicable to Both Firms Firm HD's Data Firm LD's Data

Assets $200 Debt ratio 50% Debt ratio 30%
EBIT $40 Interest rate 12% Interest rate 10%
Tax rate 35%

a. 2.18%
b. 2.29%
c. 2.41%
d. 2.54%
e. 2.66%

11)
Michaely Inc. is an all-equity firm with 200,000 shares outstanding. It has
$2,000,000 of EBIT, which is expected to remain constant in the future. The
company pays out all of its earnings, so earnings per share (EPS) equal
dividends per shares (DPS). Its tax rate is 40%.

The company is considering issuing $5,000,000 of 10.0% bonds and using the
proceeds to repurchase stock. The risk-free rate is 6.5%, the market risk
premium is 5.0%, and the beta is currently 0.90, but the CFO believes beta
would rise to 1.10 if the recapitalization occurs.

Assuming that the shares can be repurchased at the price that existed prior
to the recapitalization, what would the price be following the
recapitalization?

a. $65.77
b. $69.23
c. $72.69
d. $76.33
e. $80.14

12)
The MM model is the same as the Miller model, but with zero corporate taxes.

a. True
b. False
13)
The major contribution of the Miller model is that it demonstrates that

a. personal taxes increase the value of using corporate debt.

b. personal taxes decrease the value of using corporate debt.
c. financial distress and agency costs reduce the value of using
corporate debt.
d. equity costs increase with financial leverage.
e. debt costs increase with financial leverage.

14)
Which of the following statements concerning capital structure theory is NOT
CORRECT?

a. The major contribution of Miller's theory is that it demonstrates that

personal taxes decrease the value of using corporate debt.
b. Under MM with zero taxes, financial leverage has no effect on a firm’s
value.
c. Under MM with corporate taxes, the value of a levered firm exceeds the
value of the unlevered firm by the product of the tax rate times the
market value dollar amount of debt.
d. Under MM with corporate taxes, rs increases with leverage, and this
increase exactly offsets the tax benefits of debt financing.
e. Under MM with corporate taxes, the effect of business risk is
automatically incorporated because rsL is a function of rsU.

15)
The Kimberly Corporation is a zero growth firm with an expected EBIT of $100,000
and a corporate tax rate of 30%. Kimberly uses $500,000 of 12.0% debt, and the
cost of equity to an unlevered firm in the same risk class is 16.0%.

i
. What is the value of the firm according to MM with corporate taxes?
a. $475,875
b. $528,750
c. $587,500
d. $646,250
e. $710,875

ii
. What is the firm's cost of equity?
a. 21.0%
b. 23.3%
c. 25.9%
d. 28.8%
e. 32.0%

iii
. Assume that the firm's gain from leverage according to the Miller model is
$126,667. If the effective personal tax rate on stock income is TS = 20%,
what is the implied personal tax rate on debt income?
a. 16.4%
b. 18.2%
c. 20.2%
d. 22.5%
e. 25.0%
Solution Key

1) a
2) b
3) a
4) a
5) e
6) e
7) c
8) a
9) e
10) c
11) b
12) b
13) b
14) d
15i) c
15ii) e
15iii) e
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