Exam 14: Capital Structure

According to Modigliani and Miller (MM), in a world without taxes the optimal capital structure for a firm is approximately 100% debt financing.

A group of venture investors is considering putting money into Lemma Books, which wants to produce a new reader for electronic books. The variable cost per unit is estimated at $250, the sales price would be set at twice the VC/unit, or $500, and fixed costs are estimated at $750,000. The investors will put up the funds if the project is likely to have an operating income of $500,000 or more. What sales volume would be required in order to meet the minimum profit goal? (Hint: Use the break-even formula, but include the required profit in the numerator.)

Different borrowers have different risks of bankruptcy, and if a borrower goes bankrupt, its lenders will probably not get back the full amount of funds that they loaned. Therefore, lenders charge higher rates to borrowers judged to be more likely to go bankrupt.

Companies HD and LD have identical amounts of assets, investor-supplied capital, operating income (EBIT), tax rates, and business risk. Company HD, however, has a higher debt ratio than LD. Company HD's return on investors' capital (ROIC) exceeds its after-tax cost of debt, rd(1 - T). Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

The Miller model begins with the Modigliani and Miller (MM) model with corporate taxes and then adds personal taxes.

Your firm is currently 100% equity financed. The CFO is considering a recapitalization plan under which the firm would issue long-term debt with an after-tax yield of 9% and use the proceeds to repurchase some of its common stock. The recapitalization would not change the company's total investor-supplied capital, the size of the firm (i.e., total assets), and it would not affect the firm's return on investors' capital (ROIC), which is 15%. The CFO believes that this recapitalization would reduce the firm's WACC and increase its stock price. Which of the following would be likely to occur if the company goes ahead with the recapitalization plan?

Financial risk refers to the extra risk borne by stockholders as a result of a firm's use of debt as compared with their risk if the firm had used no debt.

A firm's business risk is largely determined by the financial characteristics of its industry, especially by the amount of debt the average firm in the industry uses.

In a world with no taxes, Modigliani and Miller (MM) show that a firm's capital structure does not affect its value. However, when taxes are considered, MM show a positive relationship between debt and value, i.e., the firm's value rises as it uses more and more debt, other things held constant.

An increase in the debt ratio will generally have no effect on which of these items?

Dyson Inc. currently finances with 20.0% debt (i.e., wd = 20%)Risk-free rate, rRF 5.00% Tax rate, T 40% Market risk premium, RPM 6.00% Current wd 20% Current beta, bL1 1.15 Target wd 60%

Firms U and L each have the same amount of assets, investor-supplied capital, and both have a return on investors' capital (ROIC) of 12%. Firm U is unleveraged, i.e., it is 100% equity financed, while Firm L is financed with 50% debt and 50% equity. Firm L's debt has an after-tax cost of 8%. Both firms have positive net income and a 35% tax rate. Which of the following statements is CORRECT?

As the text indicates, a firm's financial risk can and should be divided into separate market and diversifiable risk components.

Longstreet Inc. has fixed operating costs of $470,000, variable costs of $2.80 per unit produced, and its product sells for $4.00 per unit. What is the company's break-even point, i.e., at what unit sales volume would income equal costs?

The firm's target capital structure should do which of the following?

Modigliani and Miller's first article led to the conclusion that capital structure is extremely important, and that every firm has an optimal capital structure that maximizes its value and minimizes its cost of capital.

Companies HD and LD have identical tax rates, total assets, total investor-supplied capital, and returns on investors' capital (ROIC), and their ROICs exceed their after-tax costs of debt, rd(1 - T). However, Company HD has a higher debt ratio and thus more interest expense than Company LD. Which of the following statements is CORRECT?

Provided a firm does not use an extreme amount of debt, operating leverage typically affects only EPS, while financial leverage affects both EPS and EBIT.

A firm's treasurer likes to be in a position to raise funds to support operations whenever such funds are needed, even in "bad times." This is called "financial flexibility," and the lower the firm's debt ratio, the greater its financial flexibility, other things held constant.