Question 1

As the text indicates,a firm's financial risk has identifiable market risk and diversifiable risk components.

Accepted Answer

A) True 
 B)False

Question 2

After an intensive research and development effort,two methods for producing playing cards have been identified by the Turner Company.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)?

Accepted Answer

A)  5,000 decks 
B)  10,000 decks 
C)  15,000 decks 
D)  20,000 decks 
E)  25,000 decks 
A)  5,000 decks 
B)  10,000 decks 
C)  15,000 decks 
D)  20,000 decks 
E)  25,000 decks

Question 3

The world-famous discounter,Fernwood Booksellers,specializes in selling paperbacks for $7 each.The variable cost per book is $5.At current annual sales of 200,000 books,the publisher is just breaking even.It is estimated that if the authors' royalties are reduced,the variable cost per book will drop by $1.Assume authors' royalties are reduced and sales remain constant; how much more money can the publisher put into advertising (a fixed cost)and still break even?

Accepted Answer

A)  $600,000 
B)  $466,667 
C)  $333,333 
D)  $200,000 
E)  None of the above 
A)  $600,000 
B)  $466,667 
C)  $333,333 
D)  $200,000 
E)  None of the above

Question 4

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.

Accepted Answer

A) True 
 B)False

Question 5

Larsen Films' is analyzing its cost structure.Its fixed operating costs are $470,000,its variable costs of $2.80 per unit produced,and its products sell for $4.00 per unit.What is the company's breakeven point,i.e.,at what unit sales volume would income equal costs?

Accepted Answer

A)  391,667 
B)  411,250 
C)  431,813 
D)  453,403 
E)  476,073 
A)  391,667 
B)  411,250 
C)  431,813 
D)  453,403 
E)  476,073

Question 6

A new company to produce state-of-the-art car stereo systems is being considered by Jagger Enterprises.The sales price would be set at 1.5 times the variable cost per unit; the VC/unit is estimated to be $2.50; and fixed costs are estimated at $120,000.What sales volume would be required in order to break even,i.e.,to have an EBIT of zero for the stereo business?

Accepted Answer

A)  86,640 
B)  91,200 
C)  96,000 
D)  100,800 
E)  105,840 
A)  86,640 
B)  91,200 
C)  96,000 
D)  100,800 
E)  105,840

Question 7

A venture capital investment group received a proposal from Wireless Solutions to produce a new smart phone.The variable cost per unit is estimated at $250,the sales price would be set at twice the VC/unit,fixed costs are estimated at $750,000,and 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 this profit goal?

Accepted Answer

A)  4,513 
B)  4,750 
C)  5,000 
D)  5,250 
E)  5,513 
A)  4,513 
B)  4,750 
C)  5,000 
D)  5,250 
E)  5,513

Question 8

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?
 $$\begin{array}{l}
\begin{array} { l } 
\underline{({\text { Applicable to Both Firms }})}\
\text { Assets } & \$ 200 \
\text { EBIT } & \$ 40\
\text { Tax rate } & 35  \%\
\end{array}

\begin{array} { l } 
\underline{( {\text { Firm HD's Data }})}\
\text { Debt ratio } & 50 \%\
\text { Interest rate } & 12 \%  \
\end{array}

\begin{array} { l } 
 \underline{({\text { Firm LD's Data }})}\
\text { Debt ratio } & 30 \%\
\text { Interest rate } & 10 \%  \
\end{array}

\end{array}$$

Accepted Answer

A)  2.18% 
B)  2.29% 
C)  2.41% 
D)  2.54% 
E)  2.66% 
A)  2.18% 
B)  2.29% 
C)  2.41% 
D)  2.54% 
E)  2.66%

Question 9

Bailey and Sons 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 Bailey's beta be if it used no debt,i.e.,what is its unlevered beta?

Accepted Answer

A)  0.64 
B)  0.67 
C)  0.71 
D)  0.75 
E)  0.79 
A)  0.64 
B)  0.67 
C)  0.71 
D)  0.75 
E)  0.79

Question 10

Serendipity Inc.is re-evaluating its debt level.Its current capital structure consists of 80% debt and 20% common equity,its beta is 1.60,and its tax rate is 35%.However,the CFO thinks the company has too much debt,and he is considering moving to a capital structure with 40% debt and 60% equity.The risk-free rate is 5.0% and the market risk premium is 6.0%.By how much would the capital structure shift change the firm's cost of equity?

Accepted Answer

A)  -5.20% 
B)  -5.78% 
C)  -6.36% 
D)  -6.99% 
E)  -7.69% 
A)  -5.20% 
B)  -5.78% 
C)  -6.36% 
D)  -6.99% 
E)  -7.69%

Question 11

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

Accepted Answer

A)  Sales price variability. 
B)  The extent to which operating costs are fixed. 
C)  The extent to which interest rates on the firm's debt fluctuate. 
D)  Input price variability. 
E)  Demand variability. 
A)  Sales price variability. 
B)  The extent to which operating costs are fixed. 
C)  The extent to which interest rates on the firm's debt fluctuate. 
D)  Input price variability. 
E)  Demand variability.

Question 12

Different borrowers have different risks of bankruptcy,and bankruptcy is costly to lenders.Therefore,lenders charge higher rates to borrowers judged to be more at risk of going bankrupt.

Accepted Answer

A) True 
 B)False

Question 13

Which of the following statements is CORRECT?

Accepted Answer

A)  Since debt financing is cheaper than equity financing, raising a company's debt ratio will always reduce its WACC. 
B)  Increasing a company's debt ratio will typically reduce the marginal cost of both debt and equity financing. However, this action still may raise the company's WACC. 
C)  Increasing a company's debt ratio will typically increase the marginal cost of both debt and equity financing. However, this action still may lower the company's WACC. 
D)  Since a firm's beta coefficient it not affected by its use of financial leverage, leverage does not affect the cost of equity. 
E)  Since debt financing raises the firm's financial risk, increasing a company's debt ratio will always increase its WACC. 
A)  Since debt financing is cheaper than equity financing, raising a company's debt ratio will always reduce its WACC. 
B)  Increasing a company's debt ratio will typically reduce the marginal cost of both debt and equity financing. However, this action still may raise the company's WACC. 
C)  Increasing a company's debt ratio will typically increase the marginal cost of both debt and equity financing. However, this action still may lower the company's WACC. 
D)  Since a firm's beta coefficient it not affected by its use of financial leverage, leverage does not affect the cost of equity. 
E)  Since debt financing raises the firm's financial risk, increasing a company's debt ratio will always increase its WACC.

Question 14

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

Accepted Answer

A)  Minimize the cost of debt (rd). 
B)  Obtain the highest possible bond rating. 
C)  Minimize the cost of equity (rs). 
D)  Minimize the weighted average cost of capital (WAC
C) . 
E)  Maximize the earnings per share (EPS). 
A)  Minimize the cost of debt (rd). 
B)  Obtain the highest possible bond rating. 
C)  Minimize the cost of equity (rs). 
D)  Minimize the weighted average cost of capital (WAC
C) . 
E)  Maximize the earnings per share (EPS).

Question 15

Daylight Solutions is considering a recapitalization that would increase its debt ratio and increase its interest expense.The company would issue new bonds and use the proceeds to buy back shares of its common stock.The company's CFO thinks the plan will not change total assets or operating income,but that it will increase earnings per share (EPS).Assuming the CFO's estimates are correct,which of the following statements is CORRECT?

Accepted Answer

A)  If the plan reduces the WACC, the stock price is also likely to decline. 
B)  Since the plan is expected to increase EPS, this implies that net income is also expected to increase. 
C)  If the plan does increase the EPS, the stock price will automatically increase at the same rate. 
D)  Under the plan there will be more bonds outstanding, and that will increase their liquidity and thus lower the interest rate on the currently outstanding bonds. 
E)  Since the proposed plan increases Daylight's financial risk, the company's stock price still might fall even if EPS increases. 
A)  If the plan reduces the WACC, the stock price is also likely to decline. 
B)  Since the plan is expected to increase EPS, this implies that net income is also expected to increase. 
C)  If the plan does increase the EPS, the stock price will automatically increase at the same rate. 
D)  Under the plan there will be more bonds outstanding, and that will increase their liquidity and thus lower the interest rate on the currently outstanding bonds. 
E)  Since the proposed plan increases Daylight's financial risk, the company's stock price still might fall even if EPS increases.

Question 16

Which of the following statements is CORRECT?

Accepted Answer

A)  If a firm lowered its fixed costs while increasing its variable costs, holding total costs at the present level of sales constant, this would decrease its operating leverage. 
B)  The debt ratio that maximizes EPS generally exceeds the debt ratio that maximizes share price. 
C)  If a company were to issue debt and use the money to repurchase common stock, this action would have no impact on its basic earning power ratio. (Assume that the repurchase has no impact on the company's operating income.) 
D)  If changes in the bankruptcy code made bankruptcy less costly to corporations, this would likely reduce the average corporation's debt ratio. 
E)  Increasing financial leverage is one way to increase a firm's basic earning power (BEP). 
A)  If a firm lowered its fixed costs while increasing its variable costs, holding total costs at the present level of sales constant, this would decrease its operating leverage. 
B)  The debt ratio that maximizes EPS generally exceeds the debt ratio that maximizes share price. 
C)  If a company were to issue debt and use the money to repurchase common stock, this action would have no impact on its basic earning power ratio. (Assume that the repurchase has no impact on the company's operating income.) 
D)  If changes in the bankruptcy code made bankruptcy less costly to corporations, this would likely reduce the average corporation's debt ratio. 
E)  Increasing financial leverage is one way to increase a firm's basic earning power (BEP).

Question 17

Which of the following statements is CORRECT?

Accepted Answer

A)  The optimal capital structure simultaneously maximizes EPS and minimizes the WACC. 
B)  The optimal capital structure minimizes the cost of equity, which is a necessary condition for maximizing the stock price. 
C)  The optimal capital structure simultaneously minimizes the cost of debt, the cost of equity, and the WACC. 
D)  The optimal capital structure simultaneously maximizes stock price and minimizes the WACC. 
E)  As a rule, the optimal capital structure is found by determining the debt-equity mix that maximizes expected EPS. 
A)  The optimal capital structure simultaneously maximizes EPS and minimizes the WACC. 
B)  The optimal capital structure minimizes the cost of equity, which is a necessary condition for maximizing the stock price. 
C)  The optimal capital structure simultaneously minimizes the cost of debt, the cost of equity, and the WACC. 
D)  The optimal capital structure simultaneously maximizes stock price and minimizes the WACC. 
E)  As a rule, the optimal capital structure is found by determining the debt-equity mix that maximizes expected EPS.

Question 18

Cartwright Communications is considering making a change to its capital structure to reduce its cost of capital and increase firm value.Right now,Cartwright has a capital structure that consists of 20% debt and 80% equity,based on market values.(Its D/S ratio is 0.25.)The risk-free rate is 6% and the market risk premium,rM -rRF,is 5%.Currently the company's cost of equity,which is based on the CAPM,is 12% and its tax rate is 40%.What would be Cartwright's estimated cost of equity if it were to change its capital structure to 50% debt and 50% equity?

Accepted Answer

A)  13.00% 
B)  13.64% 
C)  14.35% 
D)  14.72% 
E)  15.60% 
A)  13.00% 
B)  13.64% 
C)  14.35% 
D)  14.72% 
E)  15.60%

Question 19

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

Accepted Answer

A) True 
 B)False

Exam 15: Capital Structure Decisions

As the text indicates,a firm's financial risk has identifiable market risk and diversifiable risk components.

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.

Larsen Films' is analyzing its cost structure.Its fixed operating costs are $470,000,its variable costs of $2.80 per unit produced,and its products sell for $4.00 per unit.What is the company's breakeven point,i.e.,at what unit sales volume would income equal costs?

Bailey and Sons 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 Bailey's beta be if it used no debt,i.e.,what is its unlevered beta?

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

Different borrowers have different risks of bankruptcy,and bankruptcy is costly to lenders.Therefore,lenders charge higher rates to borrowers judged to be more at risk of going bankrupt.

Which of the following statements is CORRECT?

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

Which of the following statements is CORRECT?

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.

An Overview of Financial Management and the Financial Environment

Financial Statements, cash Flow, and Taxes

Analysis of Financial Statements

Time Value of Money

Bonds, bond Valuation, and Interest Rates

Risk and Return

Valuation of Stocks and Corporations

Financial Options and Applications in Corporate Finance

The Cost of Capital

The Basics of Capital Budgeting: Evaluating Cash Flows

Cash Flow Estimation and Risk Analysis

Corporate Valuation and Financial Planning

Agency Conflicts and Corporate Governance

Distributions to Shareholders: Dividends and Repurchases

Supply Chains and Working Capital Management

Multinational Financial Management

Public and Private Financing: Initial Offerings, seasoned Offerings, and Investment Banks

Extension 18 A: Rights Offerings

Lease Financing

Hybrid Financing: Preferred Stock, warrants, and Convertibles

Dynamic Capital Structures

Mergers and Corporate Control

Enterprise Risk Management

Bankruptcy, reorganization, and Liquidation

Portfolio Theory and Asset Pricing Models

Real Options

Providing and Obtaining Credit

Advanced Issues in Cash Management and Inventory Control

Pension Plan Management

Financial Management in Not For Profit Businesses

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