Managerial Finance -Capital Structure and Leverage

If a firm utilizes debt financing, an X% decline in earnings before interest and taxes (

EBIT

) will result in a decline in earnings per share that is larger than X.

True

False

Firm A has a higher degree of business risk than Firm B.  Firm A can offset this by using less financial leverage.  Therefore, the variability of both firms’ expected EBITs could actually be identical.

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.

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

An increase in the corporate tax rate.

An increase in the personal tax rate.

An increase in the company’s operating leverage.

The Federal Reserve tightens interest rates in an effort to fight inflation.

The company’s stock price hits a new high.

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

Maximize the earnings per share (EPS).

Minimize the cost of debt (rd).

Obtain the highest possible bond rating.

Minimize the cost of equity (rs).

Minimize the weighted average cost of capital (WACC).

Which of the following statements is CORRECT?  As a firm increases the operating leverage used to produce a given quantity of output, this will

normally lead to an increase in its fixed assets turnover ratio.

normally lead to a decrease in its business risk.

normally lead to a decrease in the standard deviation of its expected EBIT.

normally lead to a decrease in the variability of its expected EPS.

normally lead to a reduction in its fixed assets turnover ratio.

Reynolds Resorts is currently 100% equity financed.  The CFO is considering a recapitalization plan under which the firm would issue long-term debt with a yield of 9% and use the proceeds to repurchase common stock.  The recapitalization would not change the company’s total assets, nor would it affect the firm’s basic earning power, which is currently 15%.  The CFO believes that this recapitalization would reduce the WACC and increase stock price.  Which of the following would also be likely to occur if the company goes ahead with the recapitalization plan?

The company’s net income would increase.

The company’s earnings per share would decline.

The company’s cost of equity would increase.

The company’s ROA would increase.

The company’s ROE would decline.

Vu Enterprises expects to have the following data during the coming year.  What is Vu’s expected ROE?

Assets

$200

,000

Interest rate

 8%

D/A

65%

Tax rate

40%

$25,000

12.51%

13.14%

13.80%

14.49%

15.21%

Ang Enterprises 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 Ang’s beta be if it used no debt, i.e., what is its unlevered beta?

0.64

0.67

0.71

0.75

0.79

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?

Applicable to Both Firms

Firm HD’s Data

Firm LD’s Data

Debt ratio

50%

30%

$40

12%

10%

35%

2.18%

2.29%

2.41%

2.54%

2.66%

Michaely Inc. is an all-equity firm with 200,000 shares outstanding.  It has $2,000,000 of EBIT, which is expected to remain constant in the future.  The company pays out all of its earnings, so earnings per share (EPS) equal dividends per shares (DPS).  Its tax rate is 40%.

The company is considering issuing $5,000,000 of 10.0% bonds and using the proceeds to repurchase stock.  The risk-free rate is 6.5%, the market risk premium is 5.0%, and the beta is currently 0.90, but the CFO believes beta would rise to 1.10 if the recapitalization occurs.

Assuming that the shares can be repurchased at the price that existed prior to the recapitalization, what would the price be following the recapitalization?

$65.77

$69.23

$72.69

$76.33

$80.14