Exam 14: Capital Structure and Leverage

Your firm's debt ratio is only 5.00%,but the new CFO thinks that more debt should be employed.She wants to sell bonds and use the proceeds to buy back and retire common shares so the percentage of common equity in the capital structure (w_c)= 1 − w_d.Other things held constant,and based on the data below,if the firm increases the percentage of debt in its capital structure (w_d)to 60.0%,by how much would the ROE change,i.e.,what is ROE_New − ROE_Old? ​

Which of the following statements is CORRECT?

You plan to invest in one of two home delivery pizza companies,High and Low,that were recently founded and are about to commence operations.They are identical except for their use of debt (w_d)and the interest rates on their debt⎯High uses more debt and thus must pay a higher interest rate.Based on the data given below,how much higher or lower will High's expected EPS be versus that of Low,i.e.,what is EPS_High − EPS_Low?

Your company plans to produce a new product,a wireless computer mouse.Two machines can be used to make the mouse,Machines A and B.The price per mouse will be $25.00 regardless of which machine is used.The fixed and variable costs associated with the two machines are shown below.At the expected sales level of 75,000 units,how much higher or lower will the firm's expected EBIT be if it uses Machine B with high fixed costs rather than Machine A with low fixed costs,i.e.,what is EBIT_B − EBIT_A?

As the text indicates,a firm's financial risk can and should be divided into separate market and diversifiable risk components.

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.

A group of venture investors is considering putting money into Lemma Books,which wants to produce a new reader for electronic books.The variable cost per unit is estimated at $250,the sales price would be set at twice the VC/unit,or $500,and fixed costs are estimated at $750,000.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 the minimum profit goal? (Hint: Use the break-even formula,but include the required profit in the numerator.)

Which of the following statements is CORRECT?