TB_Chapter13-1.doc

(Difficul

(Difficulty: ty: E = Easy, M E = Easy, M = Medium, and T = = Medium, and T = TTough)ough)

Multiple

Multiple Choice:

Choice: Conceptual

Conceptual

 Easy

 Easy::

Buussiinneessss rriisskk AAnnsswweerr:: cc DDiiffff:: EE 1

1_{.. A dA dececrereasase ie in tn the he dedebt bt raratitio wo wilill gl genenereralally ly hahave ve no eno effffecect ont on}

. . a.

a. FiFinanancnciaial ril risksk.. b.

b. ToTotatal rl risisk.k. c.

c. BuBusisineness ss ririsksk.. d.

d. MaMarkrket ret risisk.k. e.

e. NoNone of thne of the aboe above is cve is cororrerectct. . (I(It wilt will affl affecect eact each tyh tye of rise of riskk above.!

above.!

B

Buussiinneessss rriisskk AAnnsswweerr:: dd DDiiffff:: EE "

"_{.. BuBusisineness ss ririsk sk is is coconcncerernened d wiwith th ththe e ooereratatioions ns of of ththe e fifir#r#. . $h$hicich h of of ththee}

following is not associated with (or not a art

following is not associated with (or not a art of! business risk%of! business risk%

a.

a. &e#&e#and and varvariabiabiliility.ty. b.

b. 'al'ales res rice vice variariabiabilitlity.y. c.

c. The eThe etent to tent to which owhich oeraterating cosing costs are fts are fied.ied. d.

d. )hang)hanges in re*uires in re*uired retured returns due to finanns due to financing deccing decisionisions.s. e.

e. The abThe ability tility to chango change rice rices as coes as costs chsts change.ange.

B

Buussiinneessss rriisskk AAnnsswweerr:: dd DDiiffff:: EE NN +

+_{.. $h$hicich oh of thf the foe follllowowining fg facactotors rs wowoululd ad affffecect a ct a co#o#aanyny,s b,s bususininesess rs risisk%k%}

a.

a. The leveThe level of uncertl of uncertainty reainty regardigarding the de#ang the de#and for its rond for its roduct.duct. b.

b. The The degredegree of e of oeraoerating ting leverleverage.age. c.

c. The a#The a#ount of ount of debt in debt in its caits caital stital structuructure.re. d.

d. 'ta'tate#te#entents a and b ars a and b are core correcrect.t. e.

e. All oAll of the sf the state#tate#ents aents above above are corre correct.rect.

CHAPTE !"

CHAPTE !"

CAP#TA$ %T&CT&E A'D $EEAE

CAP#TA$ %T&CT&E A'D $EEAE

B

Buussiinneesss s aannd d ffiinnaanncciiaal l rriisskk AAnnsswweerr: : d Dd Diiffff: : EE

--_{.. $h$hicich oh of tf the he fofollllowowining g ststatate#e#enents ts is is #o#ost st cocorrrrecect%t%}

a.

a. A A fifir#r#,s ,s bbususininesess s ririssk k is is sosolelely ly dedetterer#i#inened d by by ththe e fifinanancnciaiall characteristics of its industry.

characteristics of its industry. b.

b. The factThe factors that affors that affect a fir#,s buect a fir#,s businessiness risk are detes risk are deter#iner#ined artly byd artly by in

indudusstrtry y chchararacacteteririststicics s anand d artartly ly bby y ececonono#o#ic ic cconondidititionons.s. nfortunately/ these and other factors that affect a fir#,s business nfortunately/ these and other factors that affect a fir#,s business risk are not sub0ect to any degree of

risk are not sub0ect to any degree of #anagerial control.#anagerial control.

c.

c. ne of the bene of the benefnefits to a fir# of beiits to a fir# of being at or near its tang at or near its targerget cait caitaltal structure is that financial fleibility beco#es #uch

structure is that financial fleibility beco#es #uch less i#ortant.less i#ortant.

d.

d. The fir#,The fir#,s financs financial risk #ay have boial risk #ay have both #arket risth #arket risk and diversik and diversifiabfiablele risk co#onents.

risk co#onents. e.

e. None None of the of the statestate#ents #ents above above is coris correct.rect.

O

Oppttiimmaal l ccaappiittaal l ssttrruuccttuurree AAnnsswweerr: : e e DDiiffff: : EE 2

2_{.. $h$hicich oh of tf the he fofollllowowining g ststatate#e#enents ts is is #o#ost st cocorrrrecect%t%}

a.

a. As a As a rulrule/ the e/ the ototi#ai#al l cacaitaital l strstructucture is found by ure is found by detdeter#er#iniining theng the debt3e*uity #i that #ai#i4es eected 56'.

debt3e*uity #i that #ai#i4es eected 56'. b.

b. ThThe e ootiti#a#al l cacaiitatal l ststruructcturure e sisi#u#ultltananeoeoususly ly #a#aii#i#i4e4es s 5656' ' anandd #ini#i4es the $A)).

#ini#i4es the $A)). c.

c. The otiThe oti#al cai#al caital strutal structure #icture #ini#i4ni#i4es the cost of e*ues the cost of e*uity/ whiity/ which is ach is a necessary condition for #ai#i4ing the stock

necessary condition for #ai#i4ing the stock rice.rice.

d.

d. The oti#The oti#al al cacaitaital l strstructucture si#ulure si#ultantaneoueously #ini#sly #ini#i4ei4es s the cost the cost ofof debt/ the cost of e*uity/ and the $A)).

debt/ the cost of e*uity/ and the $A)). e.

e. None None of the of the statestate#ents #ents above above is coris correct.rect.

O

Oppttiimmaal l ccaappiittaal l ssttrruuccttuurree AAnnsswweerr: : c c DDiiffff: : EE 7

7_{.. FrFroo# # tthe inhe infoforr#a#atition beon belolow/ sew/ selelecct t tthe ohe otiti##al caal caiitatal l ststruructcturure e fforor}

Minnow 5ntertain#ent )o#any. Minnow 5ntertain#ent )o#any. a.

a. &ebt 8 -9&ebt 8 -9:; 5*uit:; 5*uity 8 79:; 56' 8 <"y 8 79:; 56' 8 <".=2; 't.=2; 'tock riock rice 8 <"7.2ce 8 <"7.29.9. b.

b. &ebt 8 29&ebt 8 29:; 5*uit:; 5*uity 8 29:; 56' 8 <+y 8 29:; 56' 8 <+.92; 't.92; 'tock riock rice 8 <">.=ce 8 <">.=9.9. c.

c. &ebt 8 79&ebt 8 79:; 5*uit:; 5*uity 8 -9:; 56' 8 <+y 8 -9:; 56' 8 <+.1>; 't.1>; 'tock riock rice 8 <+1."ce 8 <+1."9.9. d.

d. &ebt 8 >9&ebt 8 >9:; 5*uit:; 5*uity 8 "9:; 56' 8 <+y 8 "9:; 56' 8 <+.-"; 't.-"; 'tock riock rice 8 <+9.-ce 8 <+9.-9.9. e.

e. &ebt 8 ?9&ebt 8 ?9:; 5*uit:; 5*uity 8 +9:; 56' 8 <+y 8 +9:; 56' 8 <+.+1; 't.+1; 'tock riock rice 8 <+9.9ce 8 <+9.99.9.

O

Oppttiimmaal l ccaappiittaal l ssttrruuccttuurree AAnnsswweerr: : e e DDiiffff: : EE ?

?_{.. $h$hiich of ch of tthe fohe follllowowining g ststatate#e#enents bets best dest descscrribibes thes the e ootiti#a#al l ccaaititalal}

structure% structure% a.

a. The otiThe oti#al cai#al caital strutal structure icture is the #i of debs the #i of debt/ e*uitt/ e*uity/ and referredy/ and referred stock that #ai#i4es the co#any,s earnings er share (56'!.

stock that #ai#i4es the co#any,s earnings er share (56'!. b.

b. The otiThe oti#al cai#al caital strutal structure is the #icture is the #i of debt/ e*ui of debt/ e*uity/ and refty/ and referrederred stock that #ai#i4es the co#any,s stock rice.

stock that #ai#i4es the co#any,s stock rice. c.

c. The otiThe oti#al cai#al caital strutal structure is the #icture is the #i of debt/ e*ui of debt/ e*uity/ and refty/ and referrederred stock that #ini#i4es the

stock that #ini#i4es the co#aco#any,s weighteny,s weighted d averaaverage ge cost of cost of caitcaitalal ($A))!.

($A))!. d.

B

Buussiinneesss s aannd d ffiinnaanncciiaal l rriisskk AAnnsswweerr: : d Dd Diiffff: : EE

--_{.. $h$hicich oh of tf the he fofollllowowining g ststatate#e#enents ts is is #o#ost st cocorrrrecect%t%}

a.

a. A A fifir#r#,s ,s bbususininesess s ririssk k is is sosolelely ly dedetterer#i#inened d by by ththe e fifinanancnciaiall characteristics of its industry.

characteristics of its industry. b.

b. The factThe factors that affors that affect a fir#,s buect a fir#,s businessiness risk are detes risk are deter#iner#ined artly byd artly by in

indudusstrtry y chchararacacteteririststicics s anand d artartly ly bby y ececonono#o#ic ic cconondidititionons.s. nfortunately/ these and other factors that affect a fir#,s business nfortunately/ these and other factors that affect a fir#,s business risk are not sub0ect to any degree of

risk are not sub0ect to any degree of #anagerial control.#anagerial control.

c.

c. ne of the bene of the benefnefits to a fir# of beiits to a fir# of being at or near its tang at or near its targerget cait caitaltal structure is that financial fleibility beco#es #uch

structure is that financial fleibility beco#es #uch less i#ortant.less i#ortant.

d.

d. The fir#,The fir#,s financs financial risk #ay have boial risk #ay have both #arket risth #arket risk and diversik and diversifiabfiablele risk co#onents.

risk co#onents. e.

e. None None of the of the statestate#ents #ents above above is coris correct.rect.

O

Oppttiimmaal l ccaappiittaal l ssttrruuccttuurree AAnnsswweerr: : e e DDiiffff: : EE 2

2_{.. $h$hicich oh of tf the he fofollllowowining g ststatate#e#enents ts is is #o#ost st cocorrrrecect%t%}

a.

a. As a As a rulrule/ the e/ the ototi#ai#al l cacaitaital l strstructucture is found by ure is found by detdeter#er#iniining theng the debt3e*uity #i that #ai#i4es eected 56'.

debt3e*uity #i that #ai#i4es eected 56'. b.

b. ThThe e ootiti#a#al l cacaiitatal l ststruructcturure e sisi#u#ultltananeoeoususly ly #a#aii#i#i4e4es s 5656' ' anandd #ini#i4es the $A)).

#ini#i4es the $A)). c.

c. The otiThe oti#al cai#al caital strutal structure #icture #ini#i4ni#i4es the cost of e*ues the cost of e*uity/ whiity/ which is ach is a necessary condition for #ai#i4ing the stock

necessary condition for #ai#i4ing the stock rice.rice.

d.

d. The oti#The oti#al al cacaitaital l strstructucture si#ulure si#ultantaneoueously #ini#sly #ini#i4ei4es s the cost the cost ofof debt/ the cost of e*uity/ and the $A)).

debt/ the cost of e*uity/ and the $A)). e.

e. None None of the of the statestate#ents #ents above above is coris correct.rect.

O

Oppttiimmaal l ccaappiittaal l ssttrruuccttuurree AAnnsswweerr: : c c DDiiffff: : EE 7

7_{.. FrFroo# # tthe inhe infoforr#a#atition beon belolow/ sew/ selelecct t tthe ohe otiti##al caal caiitatal l ststruructcturure e fforor}

Minnow 5ntertain#ent )o#any. Minnow 5ntertain#ent )o#any. a.

a. &ebt 8 -9&ebt 8 -9:; 5*uit:; 5*uity 8 79:; 56' 8 <"y 8 79:; 56' 8 <".=2; 't.=2; 'tock riock rice 8 <"7.2ce 8 <"7.29.9. b.

b. &ebt 8 29&ebt 8 29:; 5*uit:; 5*uity 8 29:; 56' 8 <+y 8 29:; 56' 8 <+.92; 't.92; 'tock riock rice 8 <">.=ce 8 <">.=9.9. c.

c. &ebt 8 79&ebt 8 79:; 5*uit:; 5*uity 8 -9:; 56' 8 <+y 8 -9:; 56' 8 <+.1>; 't.1>; 'tock riock rice 8 <+1."ce 8 <+1."9.9. d.

d. &ebt 8 >9&ebt 8 >9:; 5*uit:; 5*uity 8 "9:; 56' 8 <+y 8 "9:; 56' 8 <+.-"; 't.-"; 'tock riock rice 8 <+9.-ce 8 <+9.-9.9. e.

e. &ebt 8 ?9&ebt 8 ?9:; 5*uit:; 5*uity 8 +9:; 56' 8 <+y 8 +9:; 56' 8 <+.+1; 't.+1; 'tock riock rice 8 <+9.9ce 8 <+9.99.9.

O

Oppttiimmaal l ccaappiittaal l ssttrruuccttuurree AAnnsswweerr: : e e DDiiffff: : EE ?

?_{.. $h$hiich of ch of tthe fohe follllowowining g ststatate#e#enents bets best dest descscrribibes thes the e ootiti#a#al l ccaaititalal}

structure% structure% a.

a. The otiThe oti#al cai#al caital strutal structure icture is the #i of debs the #i of debt/ e*uitt/ e*uity/ and referredy/ and referred stock that #ai#i4es the co#any,s earnings er share (56'!.

stock that #ai#i4es the co#any,s earnings er share (56'!. b.

b. The otiThe oti#al cai#al caital strutal structure is the #icture is the #i of debt/ e*ui of debt/ e*uity/ and refty/ and referrederred stock that #ai#i4es the co#any,s stock rice.

stock that #ai#i4es the co#any,s stock rice. c.

c. The otiThe oti#al cai#al caital strutal structure is the #icture is the #i of debt/ e*ui of debt/ e*uity/ and refty/ and referrederred stock that #ini#i4es the

stock that #ini#i4es the co#aco#any,s weighteny,s weighted d averaaverage ge cost of cost of caitcaitalal ($A))!.

($A))!. d.

T Taarrggeet t ccaappiittaal l ssttrruuccttuurree AAnnsswweerr: : e e DDiiffff: : EE > >_{.. TThhe e ffiirr##,,s s ttaarrggeet t ccaaiittaal l ssttrruuccttuurre e iis s ccoonnssiisstteennt t wwiitth h wwhhiicch h oof f tthhee} following% following% a.

a. Mai#Mai#u# eu# earninarnings gs er ser share hare (56'!(56'!.. b.

b. MinMini#ui#u# co# cost ost of def debt (bt (kkdd!.!.

c.

c. MiMinini#u#u# # ririsksk.. d.

d. MinMini#ui#u# co# cost ost of e*f e*uituity (ky (kss!.!.

e.

e. Mini#Mini#u# weighu# weighted averted average cost oage cost of caitf caital ($A)al ($A))!.)!.

L

Leevveerraagge e aannd d ccaappiittaal l ssttrruuccttuurree AAnnsswweerr: : d Dd Diiffff: : EE =

=_{.. $h$hicich of th of the fhe folollolowiwing ing is lis likekely tly to eno encocoururagage a coe a co##anany to uy to use #se #orore dee debtbt}

in its caital structure% in its caital structure% a.

a. An inAn increascrease in the in the core cororate orate ta rata rate.te. b.

b. An inAn increascrease in the in the erse ersonal tonal ta rata rate.e. c.

c. A decreaA decrease in the co#se in the co#any,s deany,s degree of oegree of oeratinrating leverag leverage.ge. d.

d. 'ta'tate#te#entents a and c ars a and c are core correcrect.t. e.

e. All oAll of the sf the state#tate#ents aents above above are corre correct.rect.

L

Leevveerraagge e aannd d ccaappiittaal l ssttrruuccttuurree AAnnsswweerr: : e De Diiffff: : EE 19

19_{.. $h$hicich oh of tf the he fofollllowowining sg statatete#e#entnts is is #s #osost ct cororrerectct%%}

a.

a. A reducA reductiotion in n in the corthe corororate ta ratate ta rate is e is liklikely to increly to increasease the e the debdebtt ratio of the average cororation.

ratio of the average cororation. b.

b. An incrAn increasease in e in the erthe ersonsonal ta rate is likeal ta rate is likely to increly to increase the debase the debtt ratio of the average cororation.

ratio of the average cororation. c.

c. If If chchanangeges s in in ththe e babanknkruruttcy cy cocode de #a#ake ke babanknkruruttcy cy leless ss cocoststly ly toto cor

corororatiationsons/ / thethen n thithis s wouwould ld liklikely ely redreduce the uce the debdebt t ratratio io of of thethe average cororation.

average cororation. d.

d. All oAll of the sf the state#tate#ents aents above above are corre correct.rect. e.

e. None None of the of the statestate#ents #ents above above is coris correct.rect.

L

Leevveerraagge e aannd d ccaappiittaal l ssttrruuccttuurree AAnnsswweerr: : e De Diiffff: : EE 11

11_{.. $$hhiicch h oof f tthhe e ffoolllloowwiinng g ssttaattee##eenntts s iis s lliikkeelly y tto o eennccoouurraagge e a a ffiirr# # ttoo}

increase its debt ratio in its caital structure% increase its debt ratio in its caital structure% a.

a. Its sIts sales bales beco#e eco#e less sless stable table over tover ti#e.i#e. b.

b. Its Its corocororate rate ta ta rate rate declideclines.nes. c.

c. ManagManage#ent bee#ent believelieves that the fir#s that the fir#,s stock is ove,s stock is overvalurvalued.ed. d.

d. 'ta'tate#te#entents a and b ars a and b are core correcrect.t. e.

e. None None of the of the statestate#ents #ents above above is coris correct.rect.

L

Leevveerraagge e aannd d ccaappiittaal l ssttrruuccttuurree AAnnsswweerr: : a Da Diiffff: : EE 1"

1"_{.. $h$hicich of thh of the foe follllowowining fag factctorors is lis is likekely to ely to encncouourarage a coge a corrororatatioion ton to}

increase the roortion of debt in its caital structure% increase the roortion of debt in its caital structure% a.

a. An inAn increascrease in the in the core cororate orate ta rata rate.te. b.

b. An inAn increascrease in the in the erse ersonal tonal ta rata rate.e. c.

e.

e. An incAn increase irease in eecn eected bated bankrunkrutcy cotcy costs.sts.

L

Leevveerraagge e aannd d ccaappiittaal l ssttrruuccttuurree AAnnsswweerr: : e De Diiffff: : EE 1+

1+_{.. $h$hicich of th of the fhe folollolowiwing wng wouould ild incncrereasase the the lie likekelilihohood tod thahat a cot a co##anany woy woululdd}

increase its debt ratio in its caital structure% increase its debt ratio in its caital structure% a.

a. An increAn increase in costase in costs incurrs incurred when filed when filing for baning for bankrutkrutcy.cy. b.

b. An inAn increascrease in the in the core cororate orate ta rata rate.te. c.

c. An inAn increascrease in the in the erse ersonal tonal ta rata rate.e. d.

d. A decA decrease rease in the in the fir#,fir#,s busis business rness risk.isk. e.

e. 'ta'tate#te#entents b and d ars b and d are core correcrect.t.

L

Leevveerraagge e aannd d ccaappiittaal l ssttrruuccttuurree AAnnsswweerr: : a Da Diiffff: : E NE N

1-1-_{.. $$hhiicch h oof f tthhe e ffoolllloowwiinng g ffaaccttoorrs s iis s lliikkeelly y tto o eennccoouurraagge e a a ccoo##aanny y ttoo}

increase its debt ratio% increase its debt ratio% a.

a. An inAn increascrease in the in the core cororate orate ta rata rate.te. b.

b. An inAn increascrease in the in the erse ersonal tonal ta rata rate.e. c.

c. Its Its assetassets bes beco#e co#e less less li*uili*uid.d. d.

d. Both Both statestate#ents #ents a and a and c are c are correcorrect.ct. e.

e. All oAll of the sf the state#tate#ents aents above above are corre correct.rect.

L

Leevveerraagge e aannd d ccaappiittaal l ssttrruuccttuurree AAnnsswweerr: : c Dc Diiffff: : E NE N 12

12_{.. @o@onnes )es )o. co. cururrerentntly ily is 19s 199 e9 errcecent ent e*u*uitity fiy finanancnceded. . ThThe coe co##anany isy is}

considering

considering changing changing its caital its caital structure. structure. More secificMore secifically/ @onally/ @ones, )Fes, )F is considering a recaitali4ation lan in which the fir# would issue long3 is considering a recaitali4ation lan in which the fir# would issue long3 ter# debt with a yield of = ercent and use the roceeds to reurchase ter# debt with a yield of = ercent and use the roceeds to reurchase co##o

co##on stock. n stock. The recaThe recaitalitali4atii4ation would not chon would not change the coange the co#any#any,s total,s total assets nor would it affect the co#any,s basic earning ower/ which is assets nor would it affect the co#any,s basic earning ower/ which is curre

currently 12 ently 12 ercentrcent. . The )F esThe )F esti#atti#ates that the res that the recaiecaitali4tali4ation wiation willll red

reduce the co#uce the co#anany,s $A)y,s $A)) and incre) and increase its stoase its stock ricck rice. e. $hi$hich of thech of the fol

followlowing is ing is alsalso o liklikely to ely to occoccur ur if the if the co#co#anany y goegoes s aheahead ad witwith h thethe lanned recaitali4ation%

lanned recaitali4ation% a.

a. The cThe co#ano#any,s ney,s net inct inco#e wio#e will incll increaserease.. b.

b. The co#The co#any,any,s earnis earnings er shngs er share wilare will decreal decrease.se. c.

c. The coThe co#any#any,s cos,s cost of e*ut of e*uity wility will incrl increase.ease. d.

d. The The co#aco#any,s ny,s A A will will increincrease.ase. e.

e. The The co#aco#any,s ny,s 5 5 will will decredecrease.ase.

L

Leevveerraagge e aannd d ccaappiittaal l ssttrruuccttuurree AAnnsswweerr: : e De Diiffff: : E NE N 17

17_{.. $h$hicich oh of tf the he fofollllowowining sg statatete#e#entnts is is #s #osost ct cororrerectct%%}

a.

a. $hen a co#$hen a co#any incrany increases iteases its debt ratis debt ratio/ the costo/ the costs of both e*uis of both e*uity andty and debt caita

debt caital increase. l increase. Therefore/ the Therefore/ the weighted aweighted average cost verage cost of caitalof caital ($A))! #ust also increase.

($A))! #ust also increase. b.

b. ThThe e cacaiitatal l ststruructcturure e ththat at #a#aii#i#i4e4es s ststocock k rricice e is is gegeneneraralllly y ththee caital structure that also #ai#i4es earnings

caital structure that also #ai#i4es earnings er share.er share.

c.

c. 'in'ince ce debdebt t finfinancancing is ing is checheaeaer r thathan n e*ue*uity finanity financincing/ increg/ increasiasing ng aa co#any,s debt ratio will always reduce the co#any,s $A)).

co#any,s debt ratio will always reduce the co#any,s $A)). d.

e.

e. None None of the of the statestate#ents #ents above above is coris correct.rect.

L

Leevveerraagge e aannd d ccaappiittaal l ssttrruuccttuurree AAnnsswweerr: : c Dc Diiffff: : EE 1?

1?_{.. $h$hicich oh of tf the he fofollllowowining sg statatete#e#entnts is is #s #osost ct cororrerectct%%}

a.

a. $hen a co#$hen a co#any incrany increases iteases its debt ratis debt ratio/ the costo/ the costs of e*uity ans of e*uity and debtd debt caital both increase. Therefore/ the weighted average cost of caital caital both increase. Therefore/ the weighted average cost of caital ($A))! #ust also increase.

($A))! #ust also increase. b.

b. ThThe e cacaiitatal l ststruructcturure e ththat at #a#aii#i#i4e4es s ststocock k rricice e is is gegeneneraralllly y ththee caital structure that also #ai#i4es earnings

caital structure that also #ai#i4es earnings er share.er share.

c.

c. All elsAll else e*uale e*ual/ an / an incincrearease in the corose in the cororatrate ta rate woule ta rate would tend tod tend to encourage a co#any to increase its debt ratio.

encourage a co#any to increase its debt ratio. d.

d. 'ta'tate#te#entents a and b ars a and b are core correcrect.t. e.

e. 'ta'tate#te#entents a and c ars a and c are core correcrect.t.

C

Caappiittaal l ssttrruuccttuurre e aannd d WWAACCCC AAnnsswweerr: : e e DDiiffff: : EE 1>

1>_{.. $h$hicich oh of tf the he fofollllowowining sg statatete#e#entnts is is #s #osost ct cororrerectct%%}

a.

a. 'in'ince ce debdebt t finfinancancing raiseing raises s the fir#,the fir#,s s finfinancancial riskial risk/ / incincreareasinsing g aa co#any,s debt ratio will always increase the co#any,s $A)).

co#any,s debt ratio will always increase the co#any,s $A)). b.

b. 'in'ince ce debdebt t finfinancancing is ing is checheaeaer r thathan n e*ue*uity finanity financincing/ increg/ increasiasing ng aa co#any,s debt ratio will always reduce the co#any,s $A)).

co#any,s debt ratio will always reduce the co#any,s $A)). c.

c. IncIncreareasinsing g a a co#co#anany,s debt ratio will y,s debt ratio will tytyicaically reduclly reduce e the #argithe #arginalnal costs of both debt and e*uity financing; however/ it still #ay raise costs of both debt and e*uity financing; however/ it still #ay raise the co#any,s $A)).

the co#any,s $A)). d.

d. 'ta'tate#te#entents a and c ars a and c are core correcrect.t. e.

e. None None of the of the statestate#ents #ents above above is coris correct.rect.

C

Caappiittaal l ssttrruuccttuurree, , OOAA, , aannd d OOEE AAnnsswweerr: : d Dd Diiffff: : EE 1=

1=_{.. iidgdgefefieield 5ld 5ntntererrrisises hes has tas tototal aal assssetets of <s of <+9+99 #i9 #illllioion. n. ThThe coe co##ananyy}

cu

currrrenentltly y has no has no dedebt in bt in itits s cacaiitatal l ststruructcturure. e. ThThe e coco##anany,y,s s babasisicc e

eaarrnniinng g oowweer r iis s 112 2 eerrcceenntt. . ThThe e ccoo##aanny y iis s ccoonnttee##llaattiinng g aa re

recacaiitatalili4a4atition on whwherere e it it wiwill ll isissusue e dedebt bt at at 19 19 eercrcenent t anand d ususe e ththee rocee

roceeds to buy back sds to buy back shares of thhares of the co#anye co#any,s co##o,s co##on stock. n stock. If the co#If the co#anyany roceeds with the recaitali34ation its oerating inco#e/ total assets/ and roceeds with the recaitali34ation its oerating inco#e/ total assets/ and ta rate will re#ain the sa#e.

ta rate will re#ain the sa#e. $hich of the following will occur as a$hich of the following will occur as a result of the recaitali4ation%

result of the recaitali4ation% a.

a. The The co#aco#any,s ny,s A A will will declidecline.ne. b.

b. The The co#aco#any,s ny,s 5 5 will will increincrease.ase. c.

c. The co#The co#any,any,s basic es basic earninarning ower wig ower will declill decline.ne. d.

d. 'ta'tate#te#entents a and b ars a and b are core correcrect.t. e.

e. All oAll of the sf the state#tate#ents aents above above are corre correct.rect.

C

Caappiittaal l ssttrruuccttuurree, , WWAACCCC, , TT!!EE, , aannd d EE""## AAnnsswweerr: : a a DDiiffff: : EE "9

"9_{.. $h$hicich oh of tf the he fofollllowowining sg statatete#e#entnts is is #s #osost ct cororrerectct%%}

a.

a. The caiThe caital strutal structucture that #aire that #ai#i4#i4es stock rices stock rice e is also the is also the cacaitaitall structure that #ini#i4es the weighted average cost of caital ($A))!. structure that #ini#i4es the weighted average cost of caital ($A))!. b.

structure that #ai#i4es the fir#,s ti#es interest earned (TI5! ratio. d. 'tate#ents a and b are correct.

e. 'tate#ents b and c are correct.

Capital structure t$e%r& Answer: d Diff: E "1_{. $hich of the following state#ents about caital structure theory is #ost}

correct%

a. 'ignaling theory suggests fir#s should in nor#al ti#es #aintain reserve borrowing caacity that can be used if an esecially good invest#ent oortunity co#es along.

b. In general/ an increase in the cororate ta rate would cause fir#s to use less debt in their caital structures.

c. According to the trade3off theory/C an increase in the costs of bankrutcy would lead fir#s to reduce the a#ount of debt in their caital structures.

d. 'tate#ents a and c are correct.

e. All of the state#ents above are correct.

 'iscellane%us capital structure c%ncepts Answer: c Diff: E N ""_{. $hich of the following state#ents is #ost correct%}

a. If )ongress were to ass legislation that increases the ersonal ta rate/ but decreases the cororate ta rate/ this would encourage co#anies to increase their debt ratios.

b. If a co#any were to issue debt and use the #oney to reurchase co##on stock/ this action would have no i#act on the co#any,s return on

assets. (Assu#e that the reurchase has no i#act on the co#any,s

oerating inco#e.!

c. If a co#any were to issue debt and use the #oney to increase assets/ this action would increase the co#any,s return on e*uity. (Assu#e that the co#any,s return on assets re#ains unchanged.!

d. 'tate#ents a and b are correct. e. 'tate#ents b and c are correct.

(inancial leverage and E"# Answer: a Diff: E "+_{. Dolga 6ublishing is considering a roosed increase in its debt ratio/}

which will also increase the co#any,s interest eense. The lan would involve the co#any issuing new bonds and using the roceeds to buy back shares of its co##on stock. The co#any,s )F eects that the lan will not change the co#any,s total assets or oerating inco#e. Eow3ever/ the co#any,s )F does esti#ate that it will increase the co#any,s earnings er share (56'!. Assu#ing the )F,s esti#ates are correct/ which of the following state#ents is #ost correct%

a. 'ince the roosed lan increases Dolga,s financial risk/ the co#any,s stock rice still #ight fall even though its 56' is eected to increase.

b. If the lan reduces the co#any,s $A))/ the co#any,s stock rice is also likely to decline.

d. 'tate#ents a and b are correct. e. 'tate#ents a and c are correct.

(inancial leverage and E"# Answer: c Diff: E "-_{. $hich of the following state#ents is #ost correct%}

a. Increasing financial leverage is one way to increase a fir#,s basic earning ower (B56!.

b. Fir#s with lower fied costs tend to have greater oerating leverage. c. The debt ratio that #ai#i4es 56' generally eceeds the debt ratio that

#ai#i4es share rice.

d. 'tate#ents a and b are correct. e. 'tate#ents a and c are correct.

(inancial leverage and rati%s Answer: d Diff: E "2_{. )o#any A and )o#any B have the sa#e ta rate/ the sa#e total assets/ and}

the sa#e basic earning ower. Both co#anies have a basic earning ower

that eceeds their before3ta costs of debt/ kd. Eowever/ )o#any A has a

higher debt ratio and higher interest eense than )o#any B. $hich of the following state#ents is #ost correct%

a. )o#any A has a lower net inco#e than B. b. )o#any A has a lower A than B.

c. )o#any A has a lower 5 than B. d. 'tate#ents a and b are correct.

e. None of the state#ents above is correct.

(inancial leverage and rati%s Answer: ) Diff: E "7

.

basic earning ower of "9 ercent. Fir#  is 199 ercent e*uity financed/ while Fir#  is financed with 29 ercent debt and 29 ercent e*uity. Fir# ,s debt has a before3ta cost of > ercent. Both fir#s have ositive net inco#e. $hich of the following state#ents is #ost correct%

a. The two co#anies have the sa#e ti#es interest earned (TI5! ratio. b. Fir#  has a lower A than Fir# .

c. Fir#  has a lower 5 than Fir# . d. 'tate#ents a and b are correct. e. 'tate#ents b and c are correct.

 Medium:

Optimal capital structure Answer: d Diff: '  

"?_{. As a general rule/ the caital structure that}

a. Mai#i4es eected 56' also #ai#i4es the rice er share of co##on stock.

b. Mini#i4es the interest rate on debt also #ai#i4es the eected 56'. c. Mini#i4es the re*uired rate on e*uity also #ai#i4es the stock rice. d. Mai#i4es the rice er share of co##on stock also #ini#i4es the

weighted average cost of caital.

Operating and financial leverage Answer: e Diff: '   ">_{. $hich of the following state#ents is #ost correct%}

a. Fir#s whose sales are very sensitive to changes in the business cycle are #ore likely to rely on debt financing.

b. Fir#s with large ta loss carry forwards are #ore likely to rely on debt financing.

c. Fir#s with a high oerating leverage are #ore likely to rely on debt financing.

d. 'tate#ents a and c are correct.

e. None of the state#ents above is correct.

(inancial leverage and rati%s Answer: c Diff: '   "=_{. )o#any A and )o#any B have the sa#e total assets/ oerating inco#e}

(5BIT!/ ta rate/ and business risk. )o#any A/ however/ has a #uch higher debt ratio than )o#any B. )o#any A,s basic earning ower (B56! eceeds

its cost of debt financing (kd!. $hich of the following state#ents is

#ost correct%

a. )o#any A has a higher return on assets (A! than )o#any B.

b. )o#any A has a higher ti#es interest earned (TI5! ratio than )o#any B.

c. )o#any A has a higher return on e*uity (5! than )o#any B/ and its risk/ as #easured by the standard deviation of 5/ is also higher than )o#any B,s.

d. 'tate#ents b and c are correct.

e. All of the state#ents above are correct.

Limits %f leverage Answer: d Diff: '  

+9_{. $hich of the following are ractical difficulties associated with caital}

structure and degree of leverage analyses%

a. It is nearly i#ossible to deter#ine eactly how 6G5 ratios or e*uity

caitali4ation rates (ks values! are affected by different degrees of

financial leverage.

b. Managers, attitudes toward risk differ and so#e #anagers #ay set a target caital structure other than the one that would #ai#i4e stock rice.

c. Managers often have a resonsibility to rovide continuous service; they #ust reserve the long3run viability of the enterrise. Thus/ the goal of e#loying leverage to #ai#i4e short3run stock rice and #ini#i4e caital cost #ay conflict with long3run viability.

d. All of the state#ents above are correct.

e. None of the state#ents above reresents a serious i#edi#ent to the ractical alication of leverage analysis in caital structure deter#ination.

#ignaling t$e%r& Answer: ) Diff: '  

+1_{. If you know that your fir# is facing relatively oor rosects but needs}

new caital/ and you know that investors do not have this infor#ation/ signaling theory would redict that you would

a. Issue debt to #aintain the returns of e*uity holders.

b. Issue e*uity to share the burden of decreased e*uity returns between old and new shareholders.

c. Be indifferent between issuing debt and e*uity.

d. 6ostone going into caital #arkets until your fir#,s rosects i#rove.

e. )onvey your inside infor#ation to investors using the #edia to eli#inate the infor#ation asy##etry.

Capital structure and WACC Answer: d Diff: '   +"_{. $hich of the following state#ents is #ost correct%}

a. The oti#al caital structure #ini#i4es the $A)).

b. If the after3ta cost of e*uity financing eceeds the after3ta cost of debt financing/ fir#s are always able to reduce their $A)) by increasing the a#ount of debt in their caital structure.

c. Increasing the a#ount of debt in a fir#,s caital structure is likely to increase the costs of both debt and e*uity financing.

d. 'tate#ents a and c are correct. e. 'tate#ents b and c are correct.

Capital structure and WACC Answer: ) Diff: '  

++_{. $hich of the following state#ents is #ost correct%}

a. A fir# can use retained earnings without aying a flotation cost. Therefore/ while the cost of retained earnings is not 4ero/ the cost of retained earnings is generally lower than the after3ta cost of debt financing.

b. The caital structure that #ini#i4es the fir#,s weighted average cost of caital is also the caital structure that #ai#i4es the fir#,s stock rice.

c. The caital structure that #ini#i4es the fir#,s weighted average cost of caital is also the caital structure that #ai#i4es the fir#,s earnings er share.

d. If a fir# finds that the cost of debt financing is currently less than the cost of e*uity financing/ an increase in its debt ratio will always reduce its weighted average cost of caital.

 'iscellane%us capital structure c%ncepts Answer: a Diff: ' 

+-_{. $hich of the following state#ents is #ost correct%}

a. In general/ a fir# with low oerating leverage has a s#all roortion of its total costs in the for# of fied costs.

b. An increase in the ersonal ta rate would not affect fir#s, caital structure decisions.

c. A fir# with high business risk is #ore likely to increase its use of financial leverage than a fir# with low business risk/ assu#ing all else e*ual.

d. 'tate#ents a and b are correct.

e. All of the state#ents above are correct.

 'iscellane%us capital structure c%ncepts Answer: c Diff: ' 

+2_{. $hich of the following state#ents is correct%}

a. Business riskC is differentiated fro# financial riskC by the fact that financial risk reflects only the use of debt/ while business risk reflects both the use of debt and such factors as sales variability/ cost variability/ and oerating leverage.

b. If cororate ta rates were decreased while other things were held constant/ and if the Modigliani3Miller ta3ad0usted tradeoff theory of caital structure were correct/ this would tend to cause cororations to increase their use of debt.

c. If cororate ta rates were decreased while other things were held constant/ and if the Modigliani3Miller ta3ad0usted tradeoff theory of caital structure were correct/ this would tend to cause cororations to decrease their use of debt.

d. The oti#al caital structure is the one that si#ultaneously (1! #ai#i4es the rice of the fir#,s stock/ ("! #ini#i4es its $A))/ and (+! #ai#i4es its 56'.

e. None of the state#ents above is correct.

Tough:

 *ariati%ns in capital structures Answer: d Diff: T

+7_{. $hich of the following is correct%}

a. Henerally/ debt to total assets ratios do not vary #uch a#ong different industries although they do vary for fir#s within a articular industry. b. tilities generally have very high co##on e*uity ratios due to their

need for vast a#ounts of e*uity3suorted caital.

c. The drug industry has a high debt to co##on e*uity ratio because their earnings are very stable and thus/ can suort the large interest costs associated with higher debt levels.

d. $ide variations in caital structures eist between industries and also between individual fir#s within industries and are influenced by uni*ue fir# factors including #anagerial attitudes.

e. 'ince #ost stocks sell at or around their book values/ using accounting values rovides an accurate icture of a fir#,s caital structure.

Multiple Choice: P*o+lems

 Easy:

Determining price fr%m EB!T Answer: e Diff: E

+?_{. The 6rice )o#any will roduce 22/999 widgets net year. Dariable costs}

will e*ual -9 ercent of sales/ while fied costs will total <119/999. At what rice #ust each widget be sold for the co#any to achieve an 5BIT of <=2/999% a. <".99 b. <-.-2 c. <2.99 d. <2.+? e. <7."1

Breakeven price Answer: a Diff: E

+>_{. Teas 6roducts Inc. has a division that #akes burla bags for the citrus}

industry. The division has fied costs of <19/999 er #onth/ and it

eects to sell -"/999 bags er #onth. If the variable cost er bag is <".99/ what rice #ust the division charge in order to break even%

a. <"."-b. <".-? c. <".>" d. <+.12 e. <".99

 Medium:

 New financing Answer: a Diff: ' 

+=_{. The Alt#an )o#any has a debt ratio of ++.++ ercent/ and it needs to}

raise <199/999 to eand. Manage#ent feels that an oti#al debt ratio

would be 17.7? ercent. 'ales are currently <?29/999/ and the total

assets turnover is ?.2. Eow should the eansion be financed so as to roduce the desired debt ratio%

a. 199: e*uity b. 199: debt

c. "9 ercent debt/ >9 ercent e*uity d. -9 ercent debt/ 79 ercent e*uity e. 29 ercent debt/ 29 ercent e*uity

 Net %perating inc%me Answer: ) Diff: ' 

-9_{. The )ongress )o#any has identified two #ethods for roducing laying}

cards. ne #ethod involves using a #achine having a fied cost of

<19/999 and variable costs of <1.99 er deck of cards. The other #ethod would use a less eensive #achine (fied cost 8 <2/999!/ but it would re*uire greater variable costs (<1.29 er deck of cards!. If the selling rice er deck of cards will be the sa#e under each #ethod/ at what level of outut will the two #ethods roduce the sa#e net oerating inco#e% a. 2/999 decks

b. 19/999 decks c. 12/999 decks d. "9/999 decks e. "2/999 decks

C$ange in )reakeven v%lume Answer: ) Diff: '  

-1_{. Eensley )ororation uses breakeven analysis to study the effects of}

eansion ro0ects it considers. )urrently/ the fir#,s lastic bag

business seg#ent has fied costs of <1"9/999/ while its unit rice er

carton is <1."9 and its variable unit cost is <9.79. The fir# is

considering a new bag #achine and an auto#atic carton folder as #odifications to its eisting roduction lines. $ith the eansion/ fied costs would rise to <"-9/999/ but variable cost would dro to <9.-1 er unit. ne key benefit is that Eensley can lower its wholesale rice to its distributors to <1.92 er carton (that is/ its selling rice!/ and this would likely #ore than double its #arket share/ as it will beco#e the lowest cost roducer. $hat is the change in the breakeven volu#e with the roosed ro0ect% a. 199/999 units b. 1?2/999 units c. ?2/999 units d. "99/999 units e. 9 units

Breakeven and e+pansi%n Answer: c Diff: '  

-"_{. Martin )ororation currently sells 1>9/999 units er year at a rice of}

<?.99 er unit; its variable cost is <-."9 er unit; and fied costs are

<-99/999. Martin is considering eanding into two additional states/

which would increase its fied costs to <729/999 and would increase its variable unit cost to an average of <-.-> er unit. If Martin eands/ it

eects to sell "?9/999 units at <?.99 er unit. By how #uch will

Martin,s breakeven sales dollar level change% a. < 1>+/+++

b. < -27/299 c. < >92/227 d. < =19/77? e. <1/"99/999

Breakeven Answer: d Diff: '  

-+_{. 5lehant Books sells aerback books for <? each. The variable cost er}

book is <2. At current annual sales of "99/999 books/ the ublisher is 0ust breaking even. It is esti#ated that if the authors, royalties are

reduced/ the variable cost er book will dro by <1. Assu#e authors,

royalties are reduced and sales re#ain constant; how #uch #ore #oney can the ublisher ut into advertising (a fied cost! and still break even% a. <799/999

b. <-77/77? c. <+++/+++ d. <"99/999 e. <1?2/""2

Operating decisi%n Answer: d Diff: '  

--_{. Musgrave )ororation has fied costs of <-7/999 and variable costs that}

are +9 ercent of the current sales rice of <".12. At a rice of <".12/ Musgrave sells -9/999 units. Musgrave can increase sales by 19/999 units by cutting its unit rice fro# <".12 to <1.=2/ but variable cost er unit won,t change. 'hould it cut its rice%

a. No/ 5BIT decreases by <7/999. b. No/ 5BIT decreases by <"29. c. es/ 5BIT increases by <11/299. d. es/ 5BIT increases by <>/929. e. es/ 5BIT increases by <2/929.

Capital structure and st%ck price Answer: c Diff: '  

-2_{. The following infor#ation alies to ott 5nterrisesJ}

erating inco#e (5BIT! <+99/999 'hares outstanding 1"9/999

&ebt <199/999 56' <1.-2

Interest eense < 19/999 'tock rice <1?.-9

Ta rate -9:

The co#any is considering a recaitali4ation where it would issue <+->/999 worth of new debt and use the roceeds to buy back <+->/999 worth

of co##on stock. The buyback will be undertaken at the re3

recaitali4ation share rice (<1?.-9!. The recaitali4ation is not

eected to have an effect on oerating inco#e or the ta rate. After the recaitali4ation/ the co#any,s interest eense will be <29/999.

Assu#e that the recaitali4ation has no effect on the co#any,s rice earnings (6G5! ratio. $hat is the eected rice of the co#any,s stock following the recaitali4ation%

a. <12.+9 b. <1?.?2 c. <1>.99 d. <1=.9+ e. <"9.->

Capital structure and st%ck price Answer: e Diff: '  

-7_{. A consultant has collected the following infor#ation regarding oung}

6ublishingJ

Total assets <+/999 #illion Ta rate -9:

erating inco#e (5BIT! <>99 #illion &ebt ratio 9:

Interest eense <9 #illion $A)) 19:

Net inco#e <->9 #illion MGB ratio 1.99K

'hare rice <+".99 56' 8 &6' <+."9

The co#any has no growth oortunities (g 8 9!/ so the co#any ays out all of its earnings as dividends (56' 8 &6'!. oung,s stock rice can be calculated by si#ly dividing earnings er share by the re*uired return on e*uity caital/ which currently e*uals the $A)) because the co#any has no debt.

The consultant believes that the co#any would be #uch better off if it were to change its caital structure to -9 ercent debt and 79 ercent e*uity. After #eeting with invest#ent bankers/ the consultant concludes that the co#any could issue <1/"99 #illion of debt at a before3ta cost of ? ercent/ leaving the co#any with interest eense of <>- #illion. The <1/"99 #illion raised fro# the debt issue would be used to reurchase stock at <+" er share. The reurchase will have no effect on the fir#,s 5BIT; however/ after the reurchase/ the cost of e*uity will increase to 11 ercent. If the fir# follows the consultant,s advice/ what will be its esti#ated stock rice after the caital structure change%

a. <+".99 b. <++.-> c. <+1."= d. <+".2= e. <+-.?"

Tough:

amada e-uati%n and c%st %f e-uit& Answer: a Diff: T -?

.

ight now/ 'i#on has a caital structure that consists of "9 ercent debt and >9 ercent e*uity. (Its &G5 ratio is 9."2.! The risk3free rate is 7

ercent and the #arket risk re#iu#/ kM L kF/ is 2 ercent. )urrently the

co#any,s cost of e*uity/ which is based on the )A6M/ is 1" ercent and

its ta rate is -9 ercent. $hat would be 'i#on,s esti#ated cost of

e*uity if it were to change its caital structure to 29 ercent debt and 29 ercent e*uity% a. 1-.+2: b. +9.99: c. 1-.?": d. 12.79: e. 1+.7-:

Optimal capital structure and amada e-uati%n Answer: d Diff: T ->_{. Aaron Athletics is trying to deter#ine its oti#al caital structure. The}

co#any,s caital structure consists of debt and co##on stock. In order to esti#ate the cost of debt/ the co#any has roduced the following tableJ

&ebt3to3total3 5*uity3to3total3 &ebt3to3e*uity Bond Before3ta assets ratio (wd! assets ratio (wc! ratio (&G5! rating cost of debt

9.19 9.=9 9.19G9.=9 8 9.11 AA ?.9: 9."9 9.>9 9."9G9.>9 8 9."2 A ?."

9.+9 9.?9 9.+9G9.?9 8 9.-+ A >.9

9.-9 9.79 9.-9G9.79 8 9.7? BB >.>

9.29 9.29 9.29G9.29 8 1.99 B =.7

The co#any,s ta rate/ T/ is -9 ercent.

The co#any uses the )A6M to esti#ate its cost of co##on e*uity/ ks. The

risk3free rate is 2 ercent and the #arket risk re#iu# is 7 ercent.

Aaron esti#ates that if it had no debt its beta would be 1.9. (Its

unlevered beta/C b/ e*uals 1.9.!

n the basis of this infor#ation/ what is the co#any,s oti#al caital structure/ and what is the fir#,s weighted average cost of caital ($A))! at this oti#al caital structure%

a. wc 8 9.=; wd 8 9.1; $A)) 8 1-.=7:

b. wc 8 9.>; wd 8 9."; $A)) 8 19.=7:

c. wc 8 9.?; wd 8 9.+; $A)) 8 ?.>+:

d. wc 8 9.7; wd 8 9.-; $A)) 8 19.12:

e. wc 8 9.2; wd 8 9.2; $A)) 8 19.1>:

Capital structure and st%ck price Answer: d Diff: T

-=_{. iy 6asta )ororation (6)! has a constant growth rate of ? ercent. The}

co#any retains +9 ercent of its earnings to fund future growth. 6),s

eected 56' (56'1! and ks for various caital structures are given below.

$hat is the oti#al caital structure for 6)%

&ebtGTotal Assets 5ected 56' ks

"9: <".29 12.9: +9 +.99 12.2 -9 +."2 17.9 29 +.?2 1?.9 ?9 -.99 1>.9 a. &ebtGTotal Assets 8 "9: b. &ebtGTotal Assets 8 +9: c. &ebtGTotal Assets 8 -9: d. &ebtGTotal Assets 8 29: e. &ebtGTotal Assets 8 ?9:

Capital structure and st%ck price Answer: ) Diff: T

29_{. Hiven the following choices/ what is the oti#al caital structure for}

)hi )o.% (Assu#e that the co#any,s growth rate is " ercent.!

&ividends )ost of

&ebt atio 6er 'hare 5*uity (ks!

9: <2.29 11.2: "2 7.99 1".9 -9 7.29 1+.9 29 ?.99 1-.9 ?2 ?.29 12.9 a. 9: debt; 199: e*uity b. "2: debt; ?2: e*uity c. -9: debt; 79: e*uity d. 29: debt; 29: e*uity e. ?2: debt; "2: e*uity

Capital structure and st%ck price Answer: a Diff: T

21_{. Flood Motors is an all3e*uity fir# with "99/999 shares outstanding. The}

co#any,s 5BIT is <"/999/999/ and 5BIT is eected to re#ain constant over ti#e. The co#any ays out all of its earnings each year/ so its earnings er share e*uals its dividends er share. The co#any,s ta rate is -9 ercent.

The co#any is considering issuing <" #illion worth of bonds (at ar! and using the roceeds for a stock reurchase. If issued/ the bonds would have an esti#ated yield to #aturity of 19 ercent. The risk3free rate in the econo#y is 7.7 ercent/ and the #arket risk re#iu# is 7 ercent. The co#any,s beta is currently 9.=/ but its invest#ent bankers esti#ate that the co#any,s beta would rise to 1.1 if it roceeds with the recaitali4ation.

Assu#e that the shares are reurchased at a rice e*ual to the stock #arket rice rior to the recaitali4ation. $hat would be the co#any,s stock rice following the recaitali4ation%

a. <21.1-b. <2+.>2 c. <27.9" d. <7>.=? e. <?7.9+

Capital structure and st%ck price Answer: a Diff: T 2"_{. 5tchabarren 5lectronics has #ade the following forecast for the uco#ing}

year based on the co#any,s current caitali4ationJ

Interest eense <"/999/999

erating inco#e (5BIT! <"9/999/999

5arnings er share <+.79

The co#any has <"9 #illion worth of debt outstanding and all of its debt yields 19 ercent. The co#any,s ta rate is -9 ercent. The co#any,s

rice earnings (6G5! ratio has traditionally been 1"/ so the co#any

forecasts that under the current caitali4ation its stock rice will be <-+."9 at year end.

The co#any,s invest#ent bankers have suggested that the co#any recaitali4e. Their suggestion is to issue enough new bonds at a yield of 19 ercent to reurchase 1 #illion shares of co##on stock. Assu#e that the stock can be reurchased at today,s <-9 stock rice.

Assu#e that the reurchase will have no effect on the co#any,s oerating inco#e; however/ the reurchase will increase the co#any,s dollar

interest eense. Also/ assu#e that as a result of the increased

financial risk the co#any,s rice earnings (6G5! ratio will be 11.2 after the reurchase. Hiven these assu#tions/ what would be the eected year3 end stock rice if the co#any roceeded with the recaitali4ation%

a. <->.+9 b. <-".27 c. <--.?7 d. <-9.+-e. <-7.=9

Capital structure and st%ck price Answer: d Diff: T

2+_{. ascheid 5nterrises is an all3e*uity fir# with 1?2/999 shares}

outstanding. The co#any,s stock rice is currently <>9 a share. The

co#any,s 5BIT is <"/999/999/ and 5BIT is eected to re#ain constant over ti#e. The co#any ays out all of its earnings each year/ so its earnings

er share e*uals its dividends er share. The fir#,s ta rate is +9

ercent.

The co#any is considering issuing <>99/999 worth of bonds and using the

roceeds for a stock reurchase. If issued/ the bonds would have an

esti#ated yield to #aturity of > ercent. The risk3free rate is 2 ercent

and the #arket risk re#iu# is also 2 ercent. The co#any,s beta is

currently 1.9/ but its invest#ent bankers esti#ate that the co#any,s beta would rise to 1." if it roceeded with the recaitali4ation. $hat would be the co#any,s stock rice following the reurchase transaction%

a. <197.7? b. <19".7+ c. <

??.1-e. < ?9.-9

Capital structure and E"# Answer: d Diff: T

2-_{. Buchanan Brothers anticiates that its net inco#e at the end of the year}

will be <+.7 #illion (before any recaitali4ation!. The co#any currently

has =99/999 shares of co##on stock outstanding and has no debt. The

co#any,s stock trades at <-9 a share. The co#any is considering a

recaitali4ation/ where it will issue <19 #illion worth of debt at a yield to #aturity of 19 ercent and use the roceeds to reurchase co##on stock. Assu#e the stock rice re#ains unchanged by the transaction/ and the co#any,s ta rate is +- ercent. $hat will be the co#any,s earnings er share/ if it roceeds with the recaitali4ation%

a. <"."+ b. <".-2 c. <+."7 d. <-.2" e.

<2.2-Capital structure and E"# Answer: a Diff: T

22_{. T)E )ororation is considering two alternative caital structures with the}

following characteristics.

 A B

&ebtGAssets ratio 9.+ 9.?

kd 19: 1-:

The fir# will have total assets of <299/999/ a ta rate of -9 ercent/ and a book value er share of <19/ regardless of the caital structure. 5BIT is eected to be <"99/999 for the co#ing year. $hat is the difference in earnings er share (56'! between the two alternatives%

a. <".>? b. <?.7" c. <-.?> d. <+.9+ e. <1.1=

Capital structure, leverage, and WACC Answer: d Diff: T N

27_{. 6ennington Airlines currently has a beta of 1.". The co#any,s caital}

structure consists of <? #illion of e*uity and <+ #illion of debt. The co#any is considering changing its caital structure. nder the roosed lan the co#any would increase its debt by <" #illion and use the roceeds to reurchase co##on stock. ('o/ after the lan is co#leted/ the co#any

will have <2 #illion of debt and <2 #illion of e*uity.! The co#any

esti#ates that if it goes ahead with the lan/ its bonds will have a

no#inal yield to #aturity of >.2 ercent. The co#any,s ta rate is -9

ercent. The risk3free rate is 7 ercent and the #arket risk re#iu# is ? ercent. $hat is the co#any,s esti#ated $A)) if it goes ahead with the lan%

b. =.?2: c. 1"."?: d. 19.=9: e. 11.-2:

 Multiple Part:

(The following information applies to the next four problems.)

)oybold )ororation is a start3u fir# considering two alternative caital structures/ one is conservative and the other aggressive. The conservative caital structure calls for a &GA ratio 8 9."2/ while the aggressive strategy calls for &GA 8 9.?2. nce the fir# selects its target caital structure/ it envisions two ossible scenarios for its oerationsJ Feast or Fa#ine. The Feast scenario has a 79 ercent robability of occurring and forecasted 5BIT in this state is <79/999. The Fa#ine state has a -9 ercent chance of occurring and eected 5BIT is <"9/999. Further/ if the fir# selects the conservative caital structure its cost of debt will be 19 ercent/ while with the aggressive caital structure its debt cost will be 1" ercent. The fir# will have <-99/999 in total assets/ it will face a -9 ercent #arginal ta rate/ and the book value of e*uity er share under either scenario is <19.99 er share.

Capital structure and E"# Answer: e Diff: '  

2?_{. $hat is the difference between the 56' forecasts for Feast and Fa#ine}

under the aggressive caital structure%

a. < 9

b. <1.-> c. <9.7" d. <9.=> e. <".-9

Capital structure and E"# Answer: ) Diff: '   2>_{. $hat is the difference between the 56' forecasts for Feast and Fa#ine}

under the conservative caital structure% a. <1.99

b. <9.>9 c. <"."9 d.

<9.--e. < 9

Capital structure and C* %f E"# Answer: c Diff: '  

2=_{. $hat is the coefficient of variation of eected 56' under the aggressive}

caital structure% a. 1.99 b. 1.1> c. ".-2 d. ".>> e. +.?7

Capital structure and C* %f E"# Answer: a Diff: '  

79_{. $hat is the coefficient of variation of eected 56' under the}

conservative caital structure% a. 9.2>

b. 9.+= c. 9.12 d. 9."+ e. 1.99

(The following information applies to the next three problems.) )urrently/ the Fotooulos )ororation,s balance sheet is as followsJ

Assets <2 billion &ebt <1 billion

)o##on e*uity - billion

Total assets <2 billion Total debt  co##on e*uity <2 billion

The book value of the co#any (both debt and co##on e*uity! e*uals its #arket

value (both debt and co##on e*uity!. Further#ore/ the co#any has deter#ined

the following infor#ationJ

 The co#any esti#ates that its before3ta cost of debt is ?.2 ercent.

 The co#any esti#ates that its levered beta is 1.1.

 The risk3free rate is 2 ercent.

 The #arket risk re#iu#/ kM L kF/ is 7 ercent.

 The co#any,s ta rate is -9 ercent.

In addition/ the Fotooulos )ororation is considering a recaitali4ation. The roosed lan is to issue <1 billion worth of debt and to use the #oney to

reurchase <1 billion worth of co##on stock. As a result of this

recaitali4ation/ the fir#,s si4e will not change.

Capital structure and WACC Answer: c Diff: E N

71_{. $hat is Fotooulos, current $A)) (before the roosed recaitali4ation!%}

a. 2.=": b. =.>>: c. 19.1>: d. 19.?>: e. 11.+>:

amada e-uati%n and unlevered )eta Answer: c Diff: E N 7"_{. $hat is Fotooulos, current unlevered beta (before the roosed}

recaitali4ation!% a. 9.7"1+ b. 9.>=7" c. 9.=272 d. 1.99-1 e. 1."?99

amada e-uati%n and c%st %f c%mm%n e-uit& Answer: e Diff: ' N

7+_{. $hat will be the co#any,s new cost of co##on e*uity if it roceeds with}

the recaitali4ation% (EintJ Be sure that the beta you use is carried out to - deci#al laces.!

a. 19.?-: b. 11.7": c. 1"."?: d. 1".7": e. 1+.9+:

(The following information applies to the next two problems.)

An analyst has collected the following infor#ation regarding the Milbrett )ororationJ

 Total assets 8 <199 #illion.

 Basic earning ower (B56! 8 "9:.

 Ta rate 8 -9:.

)urrently/ the co#any has no debt or referred stock and its interest eense and referred dividends e*ual 4ero. The book value and #arket value of co##on

e*uity e*uals <199 #illion. The co#any has 2 #illion outstanding shares of

co##on stock/ and its stock rice is <"9 a share.

Milbrett is considering a recaitali4ation/ where they will issue <"9 #illion of debt and use the roceeds to buy back co##on stock at the current rice of <"9 a

share. As a result of the recaitali4ation/ the si4e of the fir# will not

change. Assu#e that the newly3issued debt will have a before3ta cost of

> ercent. Assu#e that the recaitali4ation will have no effect on the

co#any,s basic earning ower.

Capital structure, financial leverage, and rati%s Answer: d Diff: E N

7-_{. $hich of the following is likely to occur following the recaitali4ation%}

a. The co#any,s net inco#e will increase. b. The co#any,s A will increase.

c. The co#any,s oerating inco#e will decrease. d. The co#any,s 5 will increase.

e. None of the state#ents above is correct.

Capital structure and E"# Answer: c Diff: T N

72_{. Assu#e that after the recaitali4ation the co#any,s ti#es3interest3}

earned ratio will be 1".2. $hat is Milbrett,s eected earnings er

share following the recaitali4ation% a.

<".--b. <".7" c. <".?7 d. <".>9 e. <".>>