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Exam 14: Capital Structure

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Question 21

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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?

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

F) A) and D)
G) None of the above

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Question 22

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

A) An increase in the corporate tax rate.
B) An increase in the personal tax rate.
C) An increase in the company's operating leverage.
D) The Federal Reserve tightens interest rates in an effort to fight inflation.
E) The company's stock price hits a new high.

F) A) and B)
G) B) and E)

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Question 23

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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.

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

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%.

A firm's capital structure does not affect its free cash flows as discussed in the text, because FCF reflects only operating cash flows, which are available to service debt, to pay dividends to stockholders, and for other purposes.

Southwest U's campus book store sells course packs for $15 each, the variable cost per pack is $9, fixed costs to produce the packs are $200,000, and expected annual sales are 50,000 packs. What are the pre-tax profits from sales of course packs?

A major contribution of the Miller model is that it demonstrates, other things held constant, that

Other things held constant, firms that use assets that can be sold easily (like trucks) tend to use more debt than firms whose assets are harder to sell (like those engaged in research and development).

Which of the following statements is CORRECT?

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

The Miller model begins with the Modigliani and Miller (MM) model without corporate taxes and then adds personal taxes.

According to Modigliani and Miller (MM), in a world without corporate income taxes the use of debt has no effect on the firm's value.

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

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.

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

Monroe Inc. is an all-equity firm with 500,000 shares outstanding. It has $2,000,000 of EBIT, and EBIT 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) , and its tax rate is 40%. The company is considering issuing $5,000,000 of 9.00% bonds and using the proceeds to repurchase stock. The risk-free rate is 4.5%, the market risk premium is 5.0%, and the firm's beta is currently 0.90. However, the CFO believes the beta would rise to 1.10 if the recapitalization occurs. Assuming the shares could be repurchased at the price that existed prior to the recapitalization, what would the price per share be following the recapitalization? (Hint: P0 = EPS/rs because EPS = DPS.)

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.

Senate Inc. is considering two alternative methods for producing playing cards. Method 1 involves using a machine with a fixed cost (mainly depreciation) of $12,000 and variable costs of $1.00 per deck of cards. Method 2 would use a less expensive machine with a fixed cost of only $5,000, but it would require a variable cost of $1.50 per deck. The sales price per deck would be the same under each method. At what unit output level would the two methods provide the same operating income (EBIT) ?

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 WACCOld - WACCNew? Wd 55% Orig. cost of equity, rs 10.0% Wc 45% New cost of equity = rs 11.0% Interest rate new = rd 7.0% Tax rate 40%