Exam 14: Capital Structure and Leverage

El Capitan Foods has a capital structure of 40% debt and 60% equity, its tax rate is 35%, and its beta (leveraged) is 1.25. Based on the Hamada equation, what would the firm's beta be if it used no debt, i.e., what is its unlevered beta?

If a firm borrows money, it is using financial leverage.

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

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

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

As a consultant to First Responder Inc., you have obtained the following data (dollars in millions)(WACC - g)Oper. income (EBIT)New cost of equity (rs)Interest rate (rd) 8.00%

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

Companies HD and LD have identical tax rates, total assets, and basic earning power ratios, and their basic earning power exceeds their before-tax cost of debt, rd. However, Company HD has a higher debt ratio and thus more interest expense than Company LD. Which of the following statements is CORRECT?

Which of the following statements is CORRECT, holding other things constant?

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

Which of the following would tend to increase a firm's target debt ratio, other things held constant?

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 sale 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)?

Gator Fabrics Inc. currently has zero debt. It is a zero growth company, and it has the data shown below. Now the company is considering using some debt, moving to the new debt/assets ratio 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? New Debt/Assets 55% Orig. cost of equity, rs 10.0% New Equity/Assets 45% New cost of equity = rs 11.0% Interest rate new = rd 7.0% Tax rate 40%

Your firm has $500 million of total assets, its basic earning power is 15%, and it currently has no debt in its capital structure. The CFO is contemplating a recapitalization where it would issue debt at a cost of 10% and use the proceeds to buy back some of its common stock, paying book value. If the company goes ahead with the recapitalization, its operating income, total assets, and tax rate would remain unchanged. Which of the following is most likely to occur as a result of the recapitalization?

Companies HD and LD have the same total assets, operating income (EBIT), tax rate, and business risk. Company HD, however, has a much higher debt ratio than LD. Also, both companies' basic earning power (BEP) ratios exceed their cost of debt (rd). Which of the following statements is CORRECT?

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.

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

Based on the information below, what is the firm's optimal capital structure?

According to the signaling theory of capital structure, firms first use common equity for their capital, then use debt if and only if they can raise no more equity on "reasonable" terms. This occurs because the use of debt financing signals to investors that the firm's managers think that the future does not look good.