Exam 15: Capital Structure Decisions

The Congress Company has identified two methods for producing playing cards. One method involves using a machine having a fixed cost of $10,000 and variable costs of $1.00 per deck of cards. The other method would use a less expensive machine (fixed cost = $5,000), but it would require greater variable costs ($1.50 per deck of cards). If the selling price per deck of cards will be the same under each method, at what level of output will the two methods produce the same net operating income (EBIT)?

Which of the following statements is CORRECT?

The trade-off theory states that the capital structure decision involves a tradeoff between the costs and benefits of debt financing.

If debt financing is used, which of the following is CORRECT?

Volunteer Fabricators, Inc. (VF) 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 market value capital structure indicated below. The money raised would be used to repurchase stock. 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. EBIT = \ 80,000 Growth = 0\% Orig cost of equity, r= 10.0\% New cost of equity =r,= 11.0\% Tax rate = 40\% New Debt/Value = 20 New Equity/Value = 80 No. of shares = 10,00 Price per share = \ 48.00 Interest rate = = 7.0\% -Now assume that VF is considering changing from its original zero debt capital structure to a new capital structure with even more debt. This results in changes in the cost of debt and equity, and thus to a new WACC and a new value of operations. Assume VF raises the amount of new debt indicated below and uses the funds to purchase and hold T-bills until it makes the stock repurchase. What is the stock price per share immediately after issuing the debt but prior to the repurchase?

Financial risk refers to the extra risk stockholders bear as a result of using debt as compared with the risk they would bear if no debt were used.

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.

Which of the following statements is CORRECT?

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.

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 HD's basic earning power (BEP) exceeds its cost of debt (rd). Which of the following statements is CORRECT?

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.

Based on the information below, what is Ezzel Enterprises' optimal capital structure?

Barnes Baskets, Inc. (BB) currently has zero debt. Its earnings before interest and taxes (EBIT) are $100,000, and it is a zero growth company. BB's current cost of equity is 13%, and its tax rate is 40%. The firm has 20,000 shares of common stock outstanding selling at a price per share of $23.08. -Now assume that BB is considering changing from its original capital structure to a new capital structure with 45% debt and 55% equity. This results in a weighted average cost of capital equal to 10.4% and a new value of operations of $576,923. Assume BB raises $259,615 in new debt and purchases T-bills to hold until it makes the stock repurchase. BB then sells the T-bills and uses the proceeds to repurchase stock. How many shares remain after the repurchase, and what is the stock price per share immediately after the repurchase?

Two firms, although they operate in different industries, have the same expected earnings per share and the same standard deviation of expected EPS. Thus, the two firms must have the same business risk.

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?

Volunteer Fabricators, Inc. (VF) 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 market value capital structure indicated below. The money raised would be used to repurchase stock. 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. EBIT = \ 80,000 Growth = 0\% Orig cost of equity, r= 10.0\% New cost of equity =r,= 11.0\% Tax rate = 40\% New Debt/Value = 20 New Equity/Value = 80 No. of shares = 10,00 Price per share = \ 48.00 Interest rate = = 7.0\% -Based on the data in the previous two problems, what would the stock price be if VF issued the new debt and immediately used the proceeds to repurchase stock?

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

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

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

Stephens Electronics is considering a change in its target capital structure, which currently consists of 25% debt and 75% equity. The CFO believes the firm should use more debt, but the CEO is reluctant to increase the debt ratio. The risk-free rate, rRF, is 5.0%, the market risk premium, RPM, is 6.0%, and the firm's tax rate is 40%. Currently, the cost of equity, rs, is 11.5% as determined by the CAPM. What would be the estimated cost of equity if the firm used 60% debt? (Hint: You must first find the current beta and then the unlevered beta to solve the problem.)