Quiz 1s

Quiz

Capital Structure

1. Capital structure refers to how the firm finances its operations and growth through a combination of ________

a. Equity types

b. Security types

c. Types of earnings

d. Types of debt

Answer: B

2. ________ capital structure refers to a combination of debt and equity that maximizes the value of the firm.

a. An optimal

b. An irrelevant

c. A perfect

d. A minimal

Answer: A

3. The return to the investor is the ________.

a. Reward to the borrower

b. Cost to the borrower

c. Cost to the manager

d. Internal rate of return

Answer: B

4. Which of the statements below is FALSE?

a. The "riskier" borrower will most likely have to pay a lower cost for funds.

b. In the bond market, we see different rates as the different yields on bonds for different companies.

c. In the equity market, we see different rates as the different required returns for companies due to their different betas.

d. In general, the cost of funds for an individual or company will be directly related to the lender's view of the risk of repayment of the funds.

Answer: A

5. In general, the cost of funds for an individual or company will be directly related to the lender's view of the risk of repayment of the funds.

Answer: TRUE

6. ________ is the degree to which a firm or individual utilizes borrowed money to make money.

a. Variable leverage

b. Fixed leverage

c. Operating leverage

d. Financial leverage

Answer: D

7. Financial leverage is the degree to which a firm or individual utilizes ________.

a. Borrowed money to pay wages

b. Borrowed money to pay dividends

c. Borrowed money to magnify equity earnings

d. Borrowed money to diminish equity earnings

Answer: C

8. The process of borrowing money from others to make money on your idea is commonly known in the investment world as ________.

a. "Losing other people's money"

b. "Using other people's money"

c. "Abusing other people's money"

d. "Misusing other people's money"

Answer: B

9. One way of measuring the advantage of financial leverage to the owners of the company is ________.

a. To examine the earnings per share (EPS) of a company before borrowing from debt lenders

b. To examine the earnings per share (EPS) of a company after borrowing from debt lenders

c. To examine the dividends per share (DPS) of a company before and after borrowing from debt lenders

d. To examine the earnings per share (EPS) of a company before and after borrowing from debt lenders

Answer: D

10. If earnings reflect a return greater than the cost of debt, then ________.

a. The more debt the company has sold, the worse off the shareholders are

b. The less debt the company has sold, the better off the shareholders are

c. The more debt the company has sold, the better off the shareholders are

d. The more debt the company has bought, the better off the shareholders are

Answer: C

11. If company earnings reflect a rate of return less than the cost of debt, then more debt ________.

a. Will increase the percentage of earnings available for distribution to the equity owners

b. Will lower the percentage of earnings available for distribution to the debt owners

c. Will increase the percentage of dividends available for distribution to the equity owners

d. Will lower the percentage of earnings available for distribution to the equity owners

Answer: D

12. If company earnings give a rate of return less than the cost of debt, then it may be advantageous for the firm to be ________.

a. All-equity

b. Owned mostly by debt holders

c. Half owned by debt holders

d. One-third owned by equity holders

Answer: A

13. Merck & Co. Inc. and Pfizer Inc. are two companies listed on the Dow Jones index (US). They are alike except in borrowing choices. Merck has no debt financing, and Pfizer Inc. uses debt financing. The EBIT for both companies is $800. Company 1 has 400 shares outstanding and pays no interest. Pfizer Inc. has 300 shares outstanding and pays $250 in interest. What is the EPS for each company?

a. Both companies have an EPS of $2.00

b. Both companies have an EPS of $1.83

c. Merck & Co. Inc. Have an EPS of $2.00 and Pfizer Inc. has an EPS of $1.83

d. Merck & Co. Inc. Have an EPS of $2.00 and Pfizer Inc. has an EPS of $1.50

Answer: C

Comment: Merck & Co. Inc. Net Income = EBIT - interest = $800 - 0 = $800.

EPS = Net Income / Share Outstanding = $800 / 400 = $2.00.

Pfizer Inc. Net Income = EBIT - interest = $800 - $250 = $550.

EPS = Net Income / Share Outstanding = $550 / 300 = $1.83.

14. The decision on capital structure seems to be related to the expected earnings of the company: ________.

a. The less the earnings, the more debt we should sell

b. The more the earnings, the more debt we should sell

c. The more the earnings, the less debt we should sell

d. None of these

Answer: B

15. Leverage magnifies both gains and losses.

Answer: TRUE

16. Fresh out of SP Jain Center of Management, Mr. Pankaj, the new CFO of Pankaj Brothers, wants to shake things up at his sleepy little food company. The firm is currently an all-equity firm because "that's the way we've always done it." Under pressure from a new group of major stockholders, however, he considering acquiring some debt (leverage) in an effort to boost earnings per share. The company currently has 600 shares, but he is thinking about borrowing $6,000 at 10% per year and buying back 200 of those shares. What level of EBIT would make this an attractive strategy?

a. $2,000

b. $1,800

c. $1,600

d. $1,400

Answer: B

Comment: Set the two EPS's of SC Co., before and after debt, equal to each other and solve for EBIT. Thus,

All-equity EPS = EBIT/600shares

Leveraged EPS = (EBIT - $6000 × 10%)/400 shares

So EBIT/600 = (EBIT - $600)/400.

Solving, we get EBIT = $1,800.

17. Coffee Treat, a coffee chain is the gulf is looking at two possible capital structures. Currently, the firm is an all-equity firm with $600,000 in assets and 100,000 shares outstanding. The market value of each share is $6.00. The CEO of Coffee Treat is thinking of leveraging the firm by selling $300,000 of debt financing and retiring 50,000 shares, leaving 50,000 shares outstanding. The cost of debt is 5% annually, and the current corporate tax rate for Coffee Treat is 30%. The CEO believes that Coffee Treat will earn $50,000 per year before interest and taxes. Which of the statements below is TRUE?

a. All-equity EPS is $0.35

b. 50/50 debt-to-equity EPS is $0.49

c. Shareholders will be better off with a price of $0.14 per share under a firm with $300,000 in debt financing versus a firm that is all-equity

d. Statements (A) through (C) are all true

Answer: D

Comment: Find the EPS under the two financing structures with an EBIT of $50,000:

With All-Equity: EPS = $50,000 X (1-0.3) / 100,000 = $0.35

Annual Interest Payment for Debt = $300,000 × 0.05 = $15,000.

With 50/50 Debt to Equity: EPS = ($50,000 - $15,000) x (1-0.3) / 50,000 = $0.49

So the shareholders will be better off by $0.14 per share under a firm with $300,000 in debt financing versus a firm that is all equity. The CEO of Coffee Treat Corp. should add debt to the firm as it would benefit the owners of the company.

18. Given a choice, firms will exhaust the cheapest source of external funding first before moving on to the ________ source.

a. More economic

b. Most cheap

c. Most expensive

d. Next cheapest

Answer: D

19. Which of the formulations below expresses the weighted average cost of capital (WACC) formula?

a. WACC = (E/V) × Re + (D/V) × Rd x ( 1 - Tc)

b. WACC = (E/V) × Re + (D/V) × Rd × (1 - Tc)

c. WACC = (E/V) × Re × (1 - Tc) + (D/V) × Rd

d. WACC = (E/V) × Rd + (D/V) × Re × (1 - Tc)

Answer: A

20. Consider the Modigliani and Miller's world of corporate taxes. An unleveraged (all-equity) firm value is $100 million. By adding debt, the annual interest expense is $10 million, the corporate tax rate is 40%, and the discount rate on the tax shield is 10%. What is the gain to leverage or the value added from issuing debt?

a. $100 million

b. $120 million

c. $140 million

d. $160 million

Answer: C

Comment: We first compute the tax shield: = (Interest Expense X Tax Rate) / Discount Rate = ($10 million X 0.4) / 0.10 = $40 million. We can now compute firm value: VL = VE + Tax Shield = $100 million + $40 million = $140 million.

21. Fuji Inc. is registered as a business in the film-making industry. It can borrow in the debt market at 9%. Its cost of equity with 50% debt is 12%. Its corporate tax rate is 30%. If the M&M world of taxes holds, what is the WACC for Fuji with 50% debt financing?

a. 8.75%

b. 8.90%

c. 9.00%

d. 9.15%

Answer: D

Comment: WACC = (E/V) × Re + (D/V) × Rd × (1 - Tc) = (1/2) × 12% + (1/2) × 9% × (1 - 0.3) = 6.00% + 3.15% = 9.15%.

22. When bankruptcy is added to the M&M world of capital structure, which of the following statements is true as more debt is added to the financing mix of the company?

a. The interest tax shield is a benefit to equity holders, although they bear increasing risk.

b. The advantage of the tax shield starts to be offset by financial distress costs.

c. The WACC of the company starts to increase past a certain level of debt.

d. All of the above

Answer: D

23. A rising WACC ________ the values of the firm's future cash flows

a. Increases

b. Reduces

c. Keeps constant

d. Has no effect on

Answer: B

24. At the optimal debt-to-equity ratio, the cost of capital (WACC) is ________ for the firm. This point reflects the maximum benefit of leverage.

a. The lowest

b. The highest

c. At the midpoint

d. Irrelevant

Answer: A

25. Roxy Broadcasting has an annual EBIT of $3,500,000 and a WACC of 14%. The current tax rate is 40%. Roxy will have the same EBIT forever. The company currently has debt of $6,250,000 with a cost of debt of 14%. Roxy will sell $12,500,000 more of debt and retire stock with the proceeds. What is the value of equity in the higher-levered firm? What is the government’s value in the higher-levered firm?

Comments: Present Value of Cash Flow = ($3,500,000/0.14) = $25,000,000

V_E = $25,000,000 (1 - 0.40) = $15,000,000

V_L = V_E + (D ´ T_C)

$15,000,000 + ($18,750,000 ´ 0.40) = $22,500,000

Equity only slice: $25,000,000 - $18,750,000 = $6,250,000 (1 - 0.40) = $3,750,000

Government’s value: $25,000,000 - $18,750,000 = $6,250,000(0.40) = $2,500,000