DOL and c$anges in EB!T Answer: a Diff: E
1+A3>1. Mavill Motors has annual sales of <12/999. Its variable costs e*ual 79
ercent of its sales/ and its fied costs e*ual <1/999. If the co#any,s sales increase 19 ercent/ what will be the ercentage increase in the co#any,s earnings before interest and taes (5BIT!%
a. 1":
b. 1-:
c. 17:
d. 1>:
e. "9:
DTL and f%recast E"# Answer: d Diff: E
1+A3>". Quick aunch ocket )o#any/ a satellite launching fir#/ eects its
sales to increase by 29 ercent in the co#ing year as a result of NA'APs recent roble#s with the sace shuttle. The fir#Ps current 56' is
<+."2. Its degree of oerating leverage is 1.7/ while its degree of financial leverage is ".1. $hat is the fir#Ps ro0ected 56' for the co#ing year using the &T aroach%
a. < +."2 b. < 2.-7 c. <19.="
d. < >.?1 e. <1=.7+
C$ange in E"# Answer: ) Diff: E
1+A3>+. our fir#Ps 56' last year was <1.99. ou eect sales to increase by 12
ercent during the co#ing year. If your fir# has a degree of oerating leverage e*ual to 1."2 and a degree of financial leverage e*ual to +.29/
then what is its eected 56'%
a. <1.+->1 b. <1.727+
c. <1.=>1+
d. <"."-"?
e. <".2>-+
Medium:
DOL c$ange Answer: a Diff: '
1+A3>-. 'tro#burg )ororation #akes surveillance e*ui#ent for intelligence
organi4ations. Its sales are <?2/999/999. Fied costs/ including research and develo#ent/ are <-9/999/999/ while variable costs a#ount to +9 ercent of sales. 'tro#burg lans an eansion which will generate additional fied costs of <12/999/999/ decrease variable costs to "2 ercent of sales/ and also er#it sales to increase to
<199/999/999. $hat is 'tro#burgPs degree of oerating leverage at the new ro0ected sales level%
a. +.?2 b. -."9 c. +.29 d. -.7?
e. +.++
DOL Answer: d Diff: '
1+A3>2. The Rdegree of leverageR concet is designed to show how changes in
sales will affect 5BIT and 56'. If a 19 ercent increase in sales causes 56' to increase fro# <1.99 to <1.29/ and if the fir# uses no debt/ then what is its degree of oerating leverage%
a. +.7 b. -."
c. -.?
d. 2.9 e. 2.2
DOL in sales d%llars Answer: c Diff: '
1+A3>7. Marcus )ororation currently sells 129/999 units a year at a rice of
<-.99 a unit. Its variable costs are aroi#ately +9 ercent of sales/
and its fied costs a#ount to 29 ercent of revenues at its current outut level. Although fied costs are based on revenues at the current outut level/ the cost level is fied. $hat is MarcusPs degree of oerating leverage in sales dollars%
a. 1.9 b. "."
c. +.2 d. -.9 e. 2.9
DOL, D(L, and DTL Answer: c Diff: '
1+A3>?. 6Q Manufacturing )ororation has <1/299/999 in debt outstanding. The
co#anyPs before3ta cost of debt is 19 ercent. 'ales for the year totaled <+/299/999 and variable costs were 79 ercent of sales. Net inco#e was e*ual to <799/999 and the co#anyPs ta rate was -9 ercent.
If 6QPs degree of total leverage is e*ual to 1.-9/ what is its degree of oerating leverage%
a. 1.12 b. 1.99 c. 1.""
d. 1.1"
e. ".7>
DTL and interest e+pense Answer: d Diff: '
1+A3>>. )oats )or. generates <19/999/999 in sales. Its variable costs e*ual >2
ercent of sales and its fied costs are <299/999. Therefore/ the co#any,s oerating inco#e (5BIT! e*uals <1/999/999. The co#any esti#ates that if its sales were to increase 19 ercent/ its net inco#e and 56' would increase 1?.2 ercent. $hat is the co#any,s interest eense% (Assu#e that the change in sales would have no effect on the co#any,s ta rate.!
a. <199/999 b. <192/>?-c. <111/2>-d. <1-"/>2?
e. <>2?/1-"
DTL Answer: e Diff: '
1+A3>=. Alvare4 Technologies has sales of <+/999/999. The co#any,s fied
oerating costs total <299/999 and its variable costs e*ual 79 ercent of sales/ so the co#any,s current oerating inco#e is <?99/999. The co#any,s interest eense is <299/999. $hat is the co#any,s degree of total leverage (&T!%
a. 1.?1-b. +.199 c. +."29 d. +.299 e. 7.999
DTL and c$ange in N! Answer: e Diff: ' 1+A3=9. Bell Brothers has <+/999/999 in sales. Its fied costs are esti#ated to
be <199/999/ and its variable costs are e*ual to fifty cents for every dollar of sales. The co#any has <1/999/999 in debt outstanding at a before3ta cost of 19 ercent. If Bell BrothersP sales were to increase by "9 ercent/ how #uch of a ercentage increase would you eect in the co#anyPs net inco#e%
a. 12.77:
b. 1>.++:
c. 1=."-:
d. "1.29:
e. "+.9>:
E+pected EB!T Answer: c Diff: '
1+A3=1. Assu#e that a fir# currently has 5BIT of <"/999/999/ a degree of total leverage of ?.2/ and a degree of financial leverage of 1.>?2. If sales decline by "9 ercent net year/ then what will be the fir#Ps eected 5BIT in one year%
a. <"/-99/999 b. <1/799/999 c. < -99/999 d. <+/799/999 e. <1/+29/999
E+pected EB!T Answer: d Diff: '
1+A3=". Assu#e that a fir# has a degree of financial leverage of 1."2. If sales
increase by "9 ercent/ the fir# will eerience a 79 ercent increase in 56'/ and it will have an 5BIT of <199/999. $hat will be the 5BIT for this fir# if sales do not increase%
a. <11+/-1"
b. <199/999 c. < >-/+?2 d. < 7?/27>
e. < -"/112
E+pected EB!T Answer: e Diff: '
1+A3=+. Sulwicki )ororation wants to deter#ine the effect of an eansion of its sales on its oerating inco#e (5BIT!. The fir#Ps current degree of oerating leverage is ".2. It ro0ects new unit sales to be 1?9/999/ an increase of -2/999 over last yearPs level of 1"2/999 units. ast yearPs 5BIT was <79/999. Based on a degree of oerating leverage of ".2/ what is this yearPs eected 5BIT with the increase in sales%
a. < 79/999 b. <1?2/999 c. <199/999 d. < =9/999
Degree %f financial leverage Answer: d Diff: ' 1+A3=-. A co#any currently sells ?2/999 units annually. At this sales level/
its 5BIT is <- #illion/ and its degree of total leverage is ".9. The fir#Ps debt consists of <12 #illion in bonds with a =.2 ercent couon.
The co#any is considering a new roduction #ethod which will entail an increase in fied costs but a decrease in variable costs/ and will result in a degree of oerating leverage of 1.7. The resident/ who is concerned about the stand3alone risk of the fir#/ wants to kee the degree of total leverage at ".9. If 5BIT re#ains at <- #illion/ what a#ount of bonds #ust be retired to acco#lish this%
a. <>.-" #illion b. <=.1= #illion c. <?.7+ #illion d. <7.2> #illion e. <-.-- #illion
Tough:
(inancial leverage, DOL, and DTL Answer: a Diff: T 1+A3=2. A co#any has an 5BIT of <- #illion/ and its degree of total leverage is
".-. The fir#,s debt consists of <"9 #illion in bonds with a 19 ercent yield to #aturity. The co#any is considering a new roduction rocess that will re*uire an increase in fied costs but a decrease in variable costs. If adoted/ the new rocess will result in a degree of oerating leverage of 1.-. The resident wants to kee the degree of total leverage at ".-. If 5BIT re#ains at <- #illion/ what a#ount of bonds
#ust be outstanding to acco#lish this (assu#ing the yield to #aturity re#ains at 19 ercent!%
a. <17.? #illion b. <1>.2 #illion c. <1=." #illion d. <1=.> #illion e. <"9.1 #illion
DOL, D(L, and fi+ed %perating c%sts Answer: c Diff: T 1+A3=7. incoln odging Inc. esti#ates that if its sales increase 19 ercent
then its net inco#e will increase 1> ercent. The co#any,s 5BIT e*uals
<".- #illion/ and its interest eense is <-99/999. The co#any,s oerating costs include fied and variable costs. $hat is the level of the co#any,s fied oerating costs%
a. < -29/999 b. < 777/77?
c. <1/"99/999 d. <"/999/999 e. <"/1"2/999
CHAPTE !"
A'%E% A'D %.$&T#.'%
1. Business risk Answer: c Diff: E
". Business risk Answer: d Diff: E
+. Business risk Answer: d Diff: E N
The correct answer is state#ent d. 'tate#ents a and b are correct. Both relate directly to the business side of the fir#. 'tate#ent c/ on the other hand/ is related to the financial risk of the fir#. 'ince state#ents a and b are correct/ state#ent d is the correct choice.
-. Business and financial risk Answer: d Diff: E 2. Optimal capital structure Answer: e Diff: E
The oti#al caital structure #ai#i4es the fir#,s stock rice and #ini#i4es the fir#,s $A)).
7
. Optimal capital structure Answer: c Diff: E
?. Optimal capital structure Answer: e Diff: E
>. Target capital structure Answer: e Diff: E
=. Leverage and capital structure Answer: d Diff: E
19Both an increase in the cororate ta rate and a decrease in the co#any,s degree of oerating leverage will encourage the fir# to use #ore debt in its caital structure. Therefore/ the correct choice is state#ent d.
. Leverage and capital structure Answer: e Diff: E
'tate#ent e is the correct choice. owering the cororate ta rate reduces the ta advantages of debt leading fir#s to use less debt financing. If the
ersonal ta rate were to increase/ individuals would now find interest received on cororate debt less attractive/ causing fir#s to utili4e less debt financing. An increase in the costs of bankrutcy would lead fir#s to use less debt in order to reduce the robability of having to incur these higher costs.
11. Leverage and capital structure Answer: e Diff: E
'tate#ent e is correct. ess stable sales would lead a fir# to reduce its debt ratio. A lower cororate ta rate reduces the ta advantage of the deductibility of interest eense. This reduction in the ta shield rovided by debt would encourage less use of debt. If #anage#ent believes the fir#,s stock is overvalued/ then it would want to issue e*uity rather than debt/
thereby increasing the fir#,s e*uity ratio.
1". Leverage and capital structure Answer: a Diff: E
'tate#ent a is correct; all the other state#ents are false. 'ince interest is ta deductible/ it would #ake sense to increase debt if the cororate ta rate rises. Interest received by individual investors is not ta ee#t/ so an increase in the ersonal ta rate would not encourage a fir# to increase its
eected bankrutcy costs would encourage a co#any to use less debt.
1+. Leverage and capital structure Answer: e Diff: E
If the costs incurred when filing for bankrutcy increased/ fir#s would be
enali4ed #ore if they filed for bankrutcy and would be less willing to take that risk. Therefore/ they would reduce debt levels to hel avoid bankrutcy risk/ so state#ent a is false. An increase in the cororate ta rate would
#ean that fir#s would get larger ta breaks for interest ay#ents. Therefore/
fir#s have an incentive to increase interest ay#ents/ in order to reduce taes. Therefore/ they will increase their debt ratios/ so state#ent b is true. An increase in the ersonal ta rate decreases the after3ta return that investors will receive. Fir#s will have to issue debt at higher interest rates in order to rovide investors with the sa#e after3ta returns they used to receive. This will raise fir#s, costs of debt/ which will increase their
$A))s/ so fir#s will not increase their debt ratios. Therefore/ state#ent c is false. If a fir#,s business risk decreases/ then this will tend to increase its debt ratio. Therefore/ state#ent d is true. 'ince both state#ents b and d are true/ the correct choice is state#ent e.
1-. Leverage and capital structure Answer: a Diff: E N
The correct answer is state#ent a. If cororate ta rates increase/ then co#anies get a larger ta advantage fro# debt in their caital structure/ so they will increase their debt ratios. If ersonal taes increase/ bondholders will ay #ore taes and will de#and a higher rate of return fro# co#anies to co#ensate the#. Therefore/ co#anies will need to ay higher interest rates/
which #akes debt #ore eensive. Therefore/ an increase in the ersonal ta
rate will not encourage cororations to increase their debt ratios. If their assets beco#e less li*uid/ co#anies will have to ay a higher interest rate on their bonds. (e#e#ber/ k 8 k U I6 U &6 U M6 U 6. If assets are less li*uid/ 6 increases.! This #akes the debt #ore eensive and #akes co#anies less likely to increase their debt ratios.
12. Leverage and capital structure Answer: c Diff: E N
The correct answer is state#ent c. The co#any will have higher debt interest
ay#ents/ so net inco#e will decline. Thus/ state#ent a is false. The effect on 56' is a#biguous. 5arnings decline (NI!/ but so will the nu#ber of shares.
Therefore/ state#ent b is false. The fir#,s recaitali4ation will not change total assets. Eowever/ since net inco#e declines/ A will decrease; so state#ent d is false. As long as the B56 ratio is greater than the cost of debt/ 5 will increase. Eowever/ you don,t have enough infor#ation to deter#ine the cost of debt/ so you can #ake no deter#ination about 5. Thus/
state#ent e is false. The increase in debt will increase the risk to shareholders/ so the cost of e*uity will increase. Therefore/ state#ent c is correct.
17. Leverage and capital structure Answer: e Diff: E N
debt will likely lead to an increase in the $A)). But this is not true across all levels of debt. VThink of a fir# with no debtJ increasing the debt ratio to 0ust 19: will robably lower the $A))W. This also elains why state#ent c is incorrect. A fir# with a high debt ratio (i.e./ =9:! will likely increase its $A)) by further increasing its debt. 'tate#ent b is incorrect. Although 56' is #ai#i4ed/ the total value of the co#any #ay be co#ro#ised. This contrasts with state#ent d. The caital structure that #ai#i4es stock rice should #ini#i4e the $A)). 'o/ state#ent d is also incorrect.
1?. Leverage and capital structure Answer: c Diff: E k
$A))
&GA ratio
'tate#ent a is false. The $A)) does not necessarily increase. e#e#ber/ you are relacing high cost e*uity with low cost debt. $hen there is very little debt in the caital structure/ the $A)) will actually decrease. ('ee the diagra# above.! The caital structure that #ai#i4es stock rice is not necessarily the caital structure that #ai#i4es 56'/ so state#ent b is false.
If the cororate ta rate increases/ co#anies will obtain a bigger ta
advantage for their interest ay#ents. Thus/ they #ay increase their debt levels to take advantage of this situation/ and this would raise debt ratios.
Therefore/ the correct answer is state#ent c.
1>. Capital structure and WACC Answer: e Diff: E
'tate#ent a is false; if you are to the left of the fir#,s oti#al caital structure on the $A)) curve/ increasing a co#any,s debt ratio will actually decrease the fir#,s $A)). 'tate#ent b is false; if you are to the right of the fir#,s oti#al caital structure on the $A)) curve/ increasing a co#any,s debt ratio will actually increase the fir#,s $A)). 'tate#ent c is false; as you increase the fir#,s debt ratio the cost of debt will increase because you,re using #ore debt. Because you,re using #ore debt the cost of e*uity also increases because the fir#,s financial risk has increased. Fro# state#ents a and b you can see that whether the $A)) is increased deends on where you are on the $A)) curve relative to the fir#,s oti#al caital structure. Therefore/
the correct answer is state#ent e.
1=. Capital structure, OA, and OE Answer: d Diff: E
'tate#ents a and b are correct; therefore/ state#ent d is the aroriate choice. A 8 NIGTA. If total assets re#ain the sa#e/ but NI decreases (because of the new interest ay#ent!/ A will decrease. NI will fall/ but not as #uch in co#arison to the a#ount that co##on e*uity will fall because B56 X k / thus 5 8 NIG)5 will rise. B56 will re#ain the sa#e. B56 8 5BITGTA/ where
'tate#ent a is correct; the other state#ents are false. The caital structure that #ai#i4es the fir#,s stock rice generally calls for a debt ratio that is lower than the one that #ai#i4es 56'. The fir# could #ai#i4e its TI5 by having no debt (that is 4ero interest ay#ents!. But/ this caital structure would robably not #ai#i4e the fir#,s stock rice.
"1. Capital structure t$e%r& Answer: d Diff: E
'tate#ents a and c are correct; therefore/ state#ent d is the correct choice.
An increase in the cororate ta rate reduces the after3ta cost of debt #aking it #ore attractive relative to e*uity. Thus/ fir#s #ight be eected to use
#ore debt in their caital structure rather than less debt.
"". 'iscellane%us capital structure c%ncepts Answer: c Diff: E N
The correct answer is state#ent c. 'tate#ent a is not correct. @ust the oosite is true33we would eect co#anies to use less debt. 'tate#ent b is not correct. The additional debt would result in an increase in interest eense and a decrease in net inco#e. 'ince assets are unchanged/ the co#anyPs A #ust decrease. 'tate#ent c is correct. The additional debt would be used to urchase additional assets. $e are told that the A stays the sa#e. Therefore/ if assets increase/ it #ust #ean that net inco#e also increases. There is no change in e*uity/ so the 5 of the fir# #ust increase.
"+ . (inancial leverage and E"#
Answer: a Diff: E
'tate#ent a is true; a higher 56' does not always #ean that the stock rice will increase. 'tate#ent b is false; a lower $A)) will #ean a higher stock
rice. 'tate#ent c is false; 56' can increase 0ust because shares outstanding decline. (The fir#,s net inco#e will decline because its interest eense increases.!
"-. (inancial leverage and E"# Answer: c Diff: E
'tate#ent a is false because B56 8 5BITGTotal assets. The etent to which the fir# uses debt financing does not affect 5BIT or total assets. 'tate#ent b is false because fir#s with a high ercentage of fied costs have a high degree of oerating leverage by definition.
"2. (inancial leverage and rati%s Answer: d Diff: E
B56 8 5BITGTA. 'ince they both have the sa#e total assets and the sa#e B56/
then 5BIT #ust be the sa#e for both co#anies. If A has a higher debt ratio and higher interest eense than B/ and they both have the sa#e 5BIT and ta
rate/ then A #ust have a lower NI than B. Therefore/ state#ent a is true. If A has a lower NI than B but both have the sa#e total assets/ then A,s A (NIGTA! #ust be lower than B,s A. Therefore/ state#ent b is true. If both co#anies have the sa#e total assets but A,s debt ratio is higher than B,s/
then A,s e*uity #ust be lower (since Total assets 8 Total debt U Total e*uity!.
If A has less e*uity/ and a lower NI than B/ it is not ossible to 0udge which co#any,s 5 (NIG5Q! is higher.
"7. (inancial leverage and rati%s Answer: ) Diff: E
interest eense and does. The TI5 ratio is 5BITGInt. If the two co#anies have the sa#e 5BIT/ the one with the lower interest eense (Fir# !/ will have a higher TI5. Therefore/ state#ent a is false. Fir#s and have the sa#e 5BIT/ but Fir# has a higher interest eense/ so its net inco#e will be lower than Fir# . 'ince A is e*ual to NIGTA/ and the two fir#s have the sa#e total
interest eense and does. The TI5 ratio is 5BITGInt. If the two co#anies have the sa#e 5BIT/ the one with the lower interest eense (Fir# !/ will have a higher TI5. Therefore/ state#ent a is false. Fir#s and have the sa#e 5BIT/ but Fir# has a higher interest eense/ so its net inco#e will be lower than Fir# . 'ince A is e*ual to NIGTA/ and the two fir#s have the sa#e total