Exam 14: Capital Structure and Leverage

As a consultant to First Responder Inc.,you have obtained the following data (dollars in millions).The company plans to pay out all of its earnings as dividends,hence g = 0.Also,no net new investment in operating capital is needed because growth is zero.The CFO believes that a move from zero debt to 20.0% debt would cause the cost of equity to increase from 10.0% to 12.0%,and the interest rate on the new debt would be 8.0%.What would the firm's total market value be if it makes this change? Hints: Find the FCF,which is equal to NOPAT = EBIT(1 − T)because no new operating capital is needed,and then divide by (WACC − g).

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?

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.

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.

The Modigliani and Miller (MM)articles implicitly assumed that bankruptcy did not exist.That led to the development of the "trade-off" model,where the firm's value first rises with the use of debt due to the tax shelter of debt,but later falls as more debt is added because the potential costs of bankruptcy begin to more than offset the tax shelter benefits.Under the trade-off theory,an optimal capital structure exists.

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

Gator Fabrics Inc.currently has zero debt .It is a zero growth company,and additional firm data are shown below.Now the company is considering using some debt,moving to the new capital structure 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 WACC_Old − WACC_New?

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

Which of the following statements is CORRECT?

Southeast U's campus book store sells course packs for $15.00 each,the variable cost per pack is $11.00,fixed costs for this operation are $300,000,and annual sales are 100,000 packs.The unit variable cost consists of a $4.00 royalty payment,V_R,per pack to professors plus other variable costs of V_O = $7.00.The royalty payment is negotiable.The book store's directors believe that the store should earn a profit margin of 10% on sales,and they want the store's managers to pay a royalty rate that will produce that profit margin.What royalty per pack would permit the store to earn a 10% profit margin on course packs,other things held constant?

Assume that you and your brother plan to open a business that will make and sell a newly designed type of sandal.Two robotic machines are available to make the sandals,Machine A and Machine B.The price per pair will be $20.00 regardless of which machine is used.The fixed and variable costs associated with the two machines are shown below.What is the difference between the break-even points for Machines A and B? (Hint: Find BE_B − BE_A)

Which of the following events is likely to encourage a company to raise its target debt ratio,other things held constant?

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

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,r_d(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?

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.

Which of the following statements is CORRECT?

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

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.

Firms HD and LD are identical except for their use of debt and the interest rates they pay⎯HD has more debt and thus must pay a higher interest rate.Based on the data given below,how much higher or lower will HD's ROE be versus that of LD,i.e.,what is ROE_HD − ROE_LD?