Exam 14: Capital Structure and Leverage

You work for the CEO of a new company that plans to manufacture and sell a new product,a watch that has an embedded TV set and a magnifying glass crystal.The issue now is how to finance the company,with only equity or with a mix of debt and equity.Expected operating income is $400,000.Other data for the firm are shown below.How much higher or lower will the firm's expected ROE be if it uses some debt rather than all equity,i.e.,what is ROE_L − ROE_U? ​ ​

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.

Southwest U's campus book store sells course packs for $16 each.The variable cost per pack is $10,and at current annual sales of 50,000 packs,the store earns $75,000 before taxes on course packs.How much are the fixed costs of producing the course packs?

Your girlfriend plans to start a new company to make a new type of cat litter.Her father will finance the operation,but she will have to pay him back.You are helping her,and the issue now is how to finance the company,with equity only or with a mix of debt and equity.The price per unit will be $10.00 regardless of how the firm is financed.The expected fixed and variable operating costs,along with other information,are shown below.How much higher or lower will the firm's expected EPS be if it uses some debt rather than only equity,i.e.,what is EPS_L − EPS_U? ​

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%.

If a firm utilizes debt financing,a 10% decline in earnings before interest and taxes (EBIT)will result in a decline in earnings per share that is larger than 10%,and the higher the debt ratio,the larger this difference will be.

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,b_U?

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.

Dye Industries currently uses no debt,but its new CFO is considering changing the capital structure to 40.0% debt (w_d)by issuing bonds and using the proceeds to repurchase and retire common shares so the percentage of common equity in the capital structure (w_c)= 1 − w_d.Given the data shown below,by how much would this recapitalization change the firm's cost of equity,i.e.,what is r_L − r_U?

The Modigliani and Miller (MM)articles implicitly assumed,among other things,that outside stockholders have the same information about a firm's future prospects as its managers.That was called "symmetric information," and it is questionable.The introduction of "asymmetric information" led to the development of the "signaling" theory of capital structure,which postulated that firms are reluctant to issue new stock because investors will interpret such an act as a signal that the firm's managers are worried about its future.Other actions give off different signals,and the end result is that capital structure is affected by managers' perceptions about how their financing decisions will affect investors' views of the firm and thus its value.

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

Which of the following statements is CORRECT?

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,r_d(1 − T).Which of the following statements is CORRECT?

Your company,which is financed entirely with common equity,plans to manufacture a new product,a cell phone that can be worn like a wristwatch.Two robotic machines are available to make the phone,Machine A and Machine B.The price per phone will be $250.00 regardless of which machine is used to make it.The fixed and variable costs associated with the two machines are shown below,along with the capital (all equity)that must be invested to purchase each machine.The expected sales level is 25,000 units.Your company has tax loss carry-forwards that will cause its tax rate to be zero for the life of the project,so T = 0.How much higher or lower will the project's ROE be if you select the machine that produces the higher ROE,i.e.,what is ROE_B − ROE_A? (Hint: Since the firm uses no debt and its tax rate is zero,ROE = EBIT/Required investment.)

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.

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

Other things held constant,the lower a firm's tax rate,the more logical it is for the firm to use debt.

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?

Which of the following statements is CORRECT?

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