Exam 14: Capital Structure

Southwest U's campus book store sells course packs for $15 each, the variable cost per pack is $9, fixed costs to produce the packs are $200,000, and expected annual sales are 50,000 packs. What are the pre-tax profits from sales of course packs?

Other things held constant, firms that use assets that can be sold easily (like trucks) tend to use more debt than firms whose assets are harder to sell (like those engaged in research and development).

Modigliani and Miller's first article led to the conclusion that capital structure is "irrelevant" because it has no effect on a firm's value. However, that article was criticized because it assumed that no taxes existed. MM then revised their original article to include corporate taxes, and this model led to the conclusion that a firm's value would be maximized if it used (almost) 100% debt.

Gator Fabrics Inc. currently has zero debt . It is a zero growth company, and additional firm data are shown below. Now the company is considering using some debt, moving to the new capital structure indicated below. The money raised would be used to repurchase stock at the current price. It is estimated that the increase in risk resulting from the additional leverage would cause the required rate of return on equity to rise somewhat, as indicated below. If this plan were carried out, by how much would the WACC change, i.e., what is WACCOld - WACCNew? Wd 55% Orig. cost of equity, rs 10.0% Wc 45% New cost of equity = rs 11.0% Interest rate new = rd 7.0% Tax rate 40%

Which of the following statements is CORRECT?

Modigliani and Miller's first article led to the conclusion that capital structure is "irrelevant" because it has no effect on a firm's value.

Business risk is affected by a firm's operations. Which of the following is NOT directly associated with (or does not directly contribute to) business risk?

Which of the following statements is CORRECT? As a firm increases the operating leverage used to produce a given quantity of output, this

According to Modigliani and Miller (MM), in a world without corporate income taxes the use of debt has no effect on the firm's value.

Which of the following statements best describes the optimal capital structure?

Senate Inc. is considering two alternative methods for producing playing cards. Method 1 involves using a machine with a fixed cost (mainly depreciation) of $12,000 and variable costs of $1.00 per deck of cards. Method 2 would use a less expensive machine with a fixed cost of only $5,000, but it would require a variable cost of $1.50 per deck. The sales price per deck would be the same under each method. At what unit output level would the two methods provide the same operating income (EBIT)?

A major contribution of the Miller model is that it demonstrates, other things held constant, that

The graphical probability distribution of ROE for a firm that uses financial leverage would tend to be more peaked than the distribution if the firm used no leverage, other things held constant.

Other things held constant, firms with more stable and predictable sales tend to use more debt than firms with less stable sales.

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

A firm's capital structure does not affect its free cash flows as discussed in the text, because FCF reflects only operating cash flows, which are available to service debt, to pay dividends to stockholders, and for other purposes.

Monroe Inc. is an all-equity firm with 500,000 shares outstanding. It has $2,000,000 of EBIT, and EBIT 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), and its tax rate is 40%. The company is considering issuing $5,000,000 of 9.00% bonds and using the proceeds to repurchase stock. The risk-free rate is 4.5%, the market risk premium is 5.0%, and the firm's beta is currently 0.90. However, the CFO believes the beta would rise to 1.10 if the recapitalization occurs. Assuming the shares could be repurchased at the price that existed prior to the recapitalization, what would the price per share be following the recapitalization? (Hint: P0 = EPS/rs because EPS = DPS.)

The Miller model begins with the Modigliani and Miller (MM) model without corporate taxes and then adds personal taxes.

Modigliani and Miller's second article, which assumed the existence of corporate income taxes, led to the conclusion that a firm's value would be maximized, and its cost of capital minimized, if it used (almost) 100% debt. However, this model did not take account of bankruptcy costs. The existence of bankruptcy costs leads to the assumption of an optimal capital structure where the debt ratio is less than 100%.

According to Modigliani and Miller (MM), in a world with corporate income taxes the optimal capital structure calls for approximately 100% debt financing.