Chapter 14: Capital Structure Management in Practice PDF

CHAPTER 14: CAPITAL STRUCTURE MANAGEMENT IN PRACTICE 1. Raw material and direct labor costs are examples of a. fixed costs b. overhead costs c. variable costs d. capital costs ANSWER: c 2. When fixed operating costs are incurred by the firm, a change in...

CHAPTER 14: CAPITAL STRUCTURE MANAGEMENT IN PRACTICE 1. Raw material and direct labor costs are examples of a. fixed costs b. overhead costs c. variable costs d. capital costs ANSWER: c 2. When fixed operating costs are incurred by the firm, a change in is magnified into a relatively larger change in earnings before interest and taxes. a. overhead expenses b. interest charges c. labor costs d. sales revenue ANSWER: d 3. When fixed capital costs are incurred by the firm, a change in is magnified into a larger change in earnings per share. a. earnings before interest and taxes b. overhead expenses c. interest charges d. preferred dividends ANSWER: a 4. The percentage change in a firm’s EBIT that results in a 1% change in sales or output is known as the a. degree of combined leverage b. degree of financial leverage c. degree of operating leverage d. degree of business risk ANSWER: c 5. The total variability of the firm’s EPS associated with a change in sales is an indication of combined leverage and is best measured by a. DOL b. DFL c. DOL + DFL d. DOL × DFL ANSWER: d © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 14: Capital Structure Management in Practice 6. In the analysis of financial leverage, all of the following are referred to as fixed charges except: a. bond interest b. common stock dividends c. bank interest d. preferred stock dividends ANSWER: b 7. The degree of combined leverage is defined as the percentage change in earnings per share resulting from a given percentage change in a. operating costs b. interest charges c. common stock dividends d. sales (or output) ANSWER: d 8. The degree of combined leverage is equal to the degree of operating leverage the degree of financial leverage. a. added to b. divided by c. multiplied by d. subtracted from ANSWER: c 9. Rent, insurance, and the salaries of top management are examples of: a. fixed costs b. capital costs c. variable costs d. fluctuating costs ANSWER: a 10. A firm that employs relatively large amounts of labor- saving equipment in its operations will have a relatively degree of operating leverage. a. low b. constant c. insignificant d. high ANSWER: d © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 14: Capital Structure Management in Practice 11. A firm that employs a relatively large proportion of debt and preferred stock in its capital structure will have a relatively degree of financial leverage. a. low b. high c. insignificant d. constant ANSWER: b 12. The degree of combined leverage is equal to the multiplied by the. a. degree of operating leverage, variable cost ratio b. degree of financial leverage, variable cost ratio c. degree of operating leverage, degree of financial leverage d. degree of operating leverage, fixed cost ratio ANSWER: c 13. A firm is considering the purchase of assets that will increase its fixed operating costs. The firm should decrease the proportion of it employs in its capital structure if it wants to maintain its existing degree of combined leverage. a. debt b. warrants c. common stock d. common stock and warrants ANSWER: a 14. To balance the operating and financial risks that are so variable for a multinational company, Nestle allows its foreign operating subsidiaries operational flexibility and follows a financing strategy. a. decentralized, centralized b. centralized, centralized c. centralized, decentralized d. decentralized, decentralized ANSWER: a 15. The degree of financial leverage is defined as the percentage change in a. EBIT resulting from a given percentage change in sales b. EPS resulting from a given percentage changes in sales c. EBIT resulting from a given percentage change in EPS d. EPS resulting from a given percentage change in EBIT ANSWER: d © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 14: Capital Structure Management in Practice 16. An analytical technique called can be used to help determine when debt financing is advantageous and when equity financing is advantageous. a. DFL-EPS analysis b. EBIT-EPS analysis c. DCL-EPS analysis d. DOL-EBIT analysis ANSWER: b 17. Cash insolvency analysis evaluates the adequacy of a firm’s cash position in a a. bankruptcy proceeding b. non-normal environment c. highly competitive environment d. recessionary environment ANSWER: d 18. Financial leverage causes a firm’s to change at a rate greater than the change in. a. EBIT; EPS b. EPS; EBIT c. EBIT; sales d. sales; EBIT ANSWER: b 19. In EBIT-EPS analysis, the indifference point is found at the point where for the two alternative financing plans are equal. a. EBIT b. EPS c. stock prices d. DOL ANSWER: b 20. A firm which has a 2.5 DOL (degree of operating leverage) would find that an 8% increase in EBIT would result from a increase in sales. a. 3.2% b. 5.4% c. 20.0% d. 2.0% ANSWER: a © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 14: Capital Structure Management in Practice 21. A negative DOL indicates the percentage in operating losses that occurs as the result of a 1% increase in output. a. increase b. reduction c. change d. none of these ANSWER: b 22. A DFL (degree of financial leverage) of 3.0 indicates that a 27% increase in EPS is the result of a increase in EBIT. a. 81% b. 3% c. 9% d. 6% ANSWER: c 23. The use of increasing amounts of combined leverage the risk of financial distress. a. decreases b. increases c. has no effect on d. creates diversity in ANSWER: b 24. A firm is said to be if it is unable to meet its current obligations. a. cash insolvent b. bankrupt c. free cash challenged d. technically insolvent ANSWER: d 25. Illinois Tool Company’s (ITC) fixed operating costs are $1,260,000 and its variable cost ratio (i.e., variable costs as a fraction of sales) is 0.70. The firm has $3,000,000 in bonds outstanding at an interest rate of 8 percent. ITC has 30,000 shares of $5 preferred stock and 150,000 shares of common stock outstanding. ITC is in the 50 percent corporate income tax bracket. Forecasted sales for next year are $9 million. What is ITC’s degree of operating leverage at a sales level of $9 million? a. 1.60 b. 1.875 c. 3.0 d. 1.26 ANSWER: b RATIONALE: Solution: DOL = [$9,000,000 – 0.7($9,000,000)]/[$9,000,000 – 0.7($9,000,000) – $1,260,000] © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 14: Capital Structure Management in Practice = 1.875 26. Illinois Tool Company’s (ITC) fixed operating costs are $1,260,000 and its variable cost ratio (i.e., variable costs as a fraction of sales) is 0.70. The firm has $3,000,000 in bonds outstanding at an interest rate of 8 percent. ITC has 30,000 shares of $5 preferred stock and 150,000 shares of common stock outstanding. ITC is in the 50 percent corporate income tax bracket. Forecasted sales for next year are $9 million. What is ITC’s degree of financial leverage at an EBIT level of $1,440,000? a. 1.20 b. 1.875 c. 3.0 d. 1.60 ANSWER: d RATIONALE: Solution: DFL = $1,440,000/[$1,440,000 – 0.08($3,000,000) – $150,000/(1 – 0.5)] = 1.60 27. Illinois Tool Company’s (ITC) fixed operating costs are $1,260,000 and its variable cost ratio (i.e., variable costs as a fraction of sales) is 0.70. The firm has $3,000,000 in bonds outstanding at an interest rate of 8 percent. ITC has 30,000 shares of $5 preferred stock and 150,000 shares of common stock outstanding. ITC is in the 50 percent corporate income tax bracket. Forecasted sales for next year are $9 million. What is ITC’s degree of combined leverage at a sales level of $10 million? a. 2.00 b. 1.72 c. 2.50 d. 1.25 ANSWER: c RATIONALE: Solution: DCL = $10,000,000 – 0.70($10,000,000)/[$10,000,000 – 0.7($10,000,000) – $1,260,000 – 0.08($3,000,000) – ($150,000)/(1 – 0.5)] DCL = 2.50 28. Suppose that ITC’s degree of combined leverage (DCL) is 3.00 at a sales volume of $9 million. Determine ITC’s percentage change in earnings per share (EPS) if forecasted sales increase by 20 percent to $10,800,000. a. 60% b. 50% c. 32% d. 30% ANSWER: a RATIONALE: Solution: % change EPS = 3.00(20%) = 60% © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 14: Capital Structure Management in Practice 29. The Lincoln Mint produces various types of one ounce silver commemorative medals for sale to collectors. The cost of producing and selling a given medal is as follows: Fixed costs: Design and preparation of dies $ 8,000 Promotion and selling expenses 25,000 Administrative overhead 7,000 Total $40,000 Variable costs: Silver blanks $ 6.00 Striking medals 0.50 Mailing expenses 3.50 Total $ 10.00 Projected selling price: $ 14.00 What is the degree of operating leverage at an output level of 15,000 units? a. 0.0 b. 1.0 c. 3.0 d. cannot be determined from the information provided ANSWER: c RATIONALE: Solution: DOL = [($14 – $10)(15,000)]/[($14 – $10)(15,000) – $40,000] = 3.0 30. Last year Avator’s operating income (EBIT) increased by 22 percent while its dollar sales increased by 15%. What is Avator’s degree of operating leverage (DOL)? a. 0.68 b. 2.0 c. 1.47 d. 0.32 ANSWER: c RATIONALE: Solution: DOL = 22%/15% = 1.47 31. Kermit’s Hardware’s (KH) fixed operating costs are $20.8 million and its variable cost ratio is 0.30. The firm has $10 million in bonds outstanding with a coupon interest rate of 9%. KH has 200,000 shares of common stock outstanding. The firm has revenues of $32.2 million and its marginal tax rate is 40%. Compute KH’s degree of operating leverage. a. 14.81 b. 5.19 c. 12.95 d. 4.54 ANSWER: c RATIONALE: Solution: VC = $32.2(0.30) = 9.66 EBIT = $32.2 – $20.8 – $9.66 = $1.74 DOL = ($32.2 – $9.66)/$1.74 = 12.95 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 14: Capital Structure Management in Practice 32. Kermit’s Hardware’s (KH) fixed operating costs are $20.8 million and its variable cost ratio is 0.30. The firm has $10 million in bonds outstanding with a coupon interest rate of 9%. KH has 200,000 shares of common stock outstanding. The firm has revenues of $32.2 million and its marginal tax rate is 40%. Compute KH’s degree of financial leverage. a. 1.22 b. 2.07 c. 1.09 d. 1.04 ANSWER: b RATIONALE: Solution: EBIT = $32.2 – $20.8 – $9.66 = $1.74 DFL = $1.74/($1.74 – $0.9) = 2.07 33. Kermit’s Hardware’s (KH) fixed operating costs are $20.8 million and its variable cost ratio is 0.30. The firm has $10 million in bonds outstanding with a coupon interest rate of 9%. KH has 200,000 shares of common stock outstanding. The firm has revenues of $32.2 million and its marginal tax rate is 40%. Compute KH’s degree of combined leverage. a. 26.8 b. 5.5 c. 29.1 d. 4.7 ANSWER: a RATIONALE: Solution: DCL = 12.95 × 2.07 = 26.8 Check: DCL = ($32.2 – $9.66)/($1.74 – $0.9) = 26.83 34. Weis Products has fixed operating costs of $20 million and a variable cost ratio of 0.55. Weis has 4 million common shares outstanding and a marginal tax rate of 45%. What is Weis’s degree of operating leverage at an expected sales level of $150 million? a. 1.00 b. 1.74 c. 1.42 d. 1.32 ANSWER: c RATIONALE: Solution: EBIT = $150 – $20 – 0.55($150) = $47.5 DOL = [$150 – 0.55(150)]/47.5 = 1.42 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 14: Capital Structure Management in Practice 35. Kenzel has an EPS of $4.20 and sales are $9 million. If the firm has a degree of operating leverage of 4.0 and a degree of financial leverage of 5.2, forecast EPS if the firm expects a 4% sales decline. a. $0.71 b. $3.49 c. $4.03 d. $3.33 ANSWER: a RATIONALE: Solution: DCL = 4.0 × 5.2 = 20.8 EPS decline = 4%(20.8) = 83.2% Forecasted EPS = $4.20(1 – 0.832) = $0.7056 36. Leigh Fibers expects its operating income over the coming year to equal $2.5 million with a standard deviation of $800,000. Leigh must pay interest charges of $1.2 million next year and preferred dividends of $300,000. Leigh’s marginal tax rate is 35%. What is the probability that Leigh will have negative EPS next year if its operating income is expected to be normally distributed? (Problem requires normal distribution table.) a. 14.7% b. 5.2% c. 10.6% d. 15.7% ANSWER: a RATIONALE: Solution: Loss level = $1,200,000 + $300,000/(1 – 0.35) = $1,661,538 z = ($1,661,538 – $2,500,000)/$800,000 = –1.048 From Table V, p = 14.7% 37. Chemex has a cash and marketable securities balance of $200 million. Management expects free cash flows of $320 million during the coming year. If management is considering a restructuring of its capital structure that would add an additional $350 million of annual fixed financial charges, what is the expected cash balance at the end of the year? a. –$30 million b. $170 million c. $230 million d. $470 million ANSWER: b RATIONALE: Solution: CB = $200 + $320 – $350 = $170 (million) © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 14: Capital Structure Management in Practice 38. The Albany Corporation has a present capital structure consisting of common stock ($200 million, 10 million shares) and debt ($150 million, 8%). The company is planning a major expansion and is undecided between two financing plans. Plan A: Equity financing. Under this plan, an additional 2.5 million shares of common stock will be sold at $15 each. Plan B: Debt financing. Under this plan, $37.5 million of 10% long-term debt will be sold. What is the EBIT-EPS indifference point? Assume a 40 percent marginal tax rate. a. $33.9 million b. $30.75 million c. $37.0 million d. $12.9 million ANSWER: b RATIONALE: Solution: [(EBIT – $12 – $3.75)(1 – 0.40)]/10 = [(EBIT – $12)(1 – 0.40)]/(10 + 2.5) EBIT = $30.75 million 39. The Albany Corporation has a present capital structure consisting of common stock ($200 million, 10 million shares) and debt ($150 million, 8%). The company is planning a major expansion and is undecided between two financing plans. Plan A: Equity financing. Under this plan, an additional 2.5 million shares of common stock will be sold at $15 each. Plan B: Debt financing. Under this plan, $37.5 million of 10% long-term debt will be sold. What happens to the EBIT indifference point if the interest rate on the new debt decreases and the common stock price remains constant? a. the indifference point increases b. the indifference point decreases c. the indifference point does not change d. cannot be determined from the information provided ANSWER: b RATIONALE: Solution: No calculations needed © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 14: Capital Structure Management in Practice 40. Two companies, Jefferson and Jackson, are virtually identical in all aspects of their operations except that the two companies differ in their capital structures, as shown below: Jefferson Jackson Debt (10%) $200 million $100 million Common equity $300 million $400 million No. shares outstanding 15 million 20 million Both companies have $500 million in total assets and both have a 40% marginal tax rate. What is the EPS for Jefferson at an EBIT level of $50 million? a. –$1.20 b. $1.20 c. $2.20 d. $3.33 ANSWER: b RATIONALE: Solution: EBT = $50 – $20 = $30 EAT = $30(1 – 0.4) = $18 EPS = $18,000,000/15,000,000 = $1.20 41. Two companies, Jefferson and Jackson, are virtually identical in all aspects of their operations except that the two companies differ in their capital structures, as shown below: Jefferson Jackson Debt (10%) $200 million $100 million Common equity $300 million $400 million No. shares outstanding 15 million 20 million Both companies have $500 million in total assets and both have a 40% marginal tax rate. What is the EPS for Jackson at an EBIT level of $50 million? a. $1.50 b. $1.20 c. $2.00 d. $2.50 ANSWER: b RATIONALE: Solution: EBT = $50 – $10 = $40 EAT = $40(1 – 0.4) = $24 EPS = $24,000,000/20,000,000 = $1.20 42. Onex expects to have an EBIT of $240,000 with a standard deviation of $90,000. The distribution of operating income is approximately normal. What is the probability that Onex will have an EBIT that is below $0? a. 0.47% b. 2.67% c. 0.38% d. 2.25% ANSWER: c RATIONALE: Solution: z = ($0 – $240,000)/$90,000 = –2.67 From Table V, p = 0.38% © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 14: Capital Structure Management in Practice 43. Alace is an all equity firm with 10 million shares outstanding that is evaluating two alternative financing plans. With the first plan, Alace will sell 1 million shares of common stock at $15 each. Under the second plan, the firm would sell $15 million of 12 percent long-term debt. If Alace has a marginal tax rate of 35 percent, what is the EBlT-EPS indifference point? a. $12.9 million b. $19.8 million c. $11.7 million d. $18.0 million ANSWER: b RATIONALE: Solution: (EBJT– $1.8)(1 – 0.35)/10 = (EBIT – 0)(1 – 0.35)/(10 + I) EBlT = $19.8 million 44. Knight Moves is considering two alternative financing plans. The firm is expected to operate at the $75 million EBlT level. Under Plan D (debt financing) EPS is expected to be $2.25, and under Plan E (equity financing) EPS is expected to be $1.82. If the market is expected to assign a PIE ratio of 12 to the debt plan and 15 to the equity plan, which plan should Knight pursue? a. debt b. equity c. indifferent between the two alternatives d. neither is satisfactory ANSWER: b RATIONALE: Solution: Debt Plan Price= 12($2.25) = $27.00 Equity Plan Price= 15($1.82) = $27.30 45. Dagger Company has a current capital structure consisting of$60 million in long-term debt with an interest rate of 9% and $60 million in common equity (12 million shares). The firm is considering an expansion plan costing $23 million. The expansion plan can be financed with additional long-term debt at a 12% interest rate or the sale of new common stock at $8 per share. The firm’s marginal tax rate is 40%. Determine the indifference level of EBIT for the two financing plans. a. –$30.24 million b. $18.36 million c. $30.24 million d. $19.68 million ANSWER: d RATIONALE: Solution: EBIT* = $19.68 (million) © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 14: Capital Structure Management in Practice 46. The Ames Company has an expected EBIT of $16 million with a standard deviation of $8 million. The indifference point between a debt financing alternative and a common stock financing alternative was computed to be $12 million. Determine the probability that the equity financing alternative will be superior to the debt financing alternative (i.e., have a higher EPS). (Problem requires normal distribution table.) a. 50.0% b. 30.85% c. 69.15% d. cannot be computed ANSWER: b RATIONALE: Solution: The probability that the equity financing alternative will result in a higher EPS is equal to the probability that the EBIT level will be less than $12 million, or z = ($12.0 – $16.0)/$8.0 = –0.50 The probability of a value less than 0.50 standard deviations to the left of the mean is 0.3085 or 30.85%, from Table V. 47. Centex, a producer of telephone systems for small businesses, has current sales of$43 million and variable operating costs of$27.95 million. Centex expects to increase sales in the coming year by 15% while keeping fixed operating costs constant at $9.1 million. What is the DOL for Centex? a. 3.3 b. 2.5 c. 7.2 d. 1.0 ANSWER: b RATIONALE: Solution: DOL = EBIT0 = 43 – 27.95 – 9.1 = $5.95 EBIT1 = 49.45 – 49.45(0.65) – 9.1 = $8.2075 Variable cost ratio = 27.95/43 = 0.65 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 14: Capital Structure Management in Practice 48. TCA Cable has fixed operating cost of $2.6 million, and its variable cost ratio is 0.30. TCA has $4.0 in bonds outstanding with a coupon interest rate of 12%. TCA has 1.0 million common shares and 1,000,000 shares of $1.75 preferred stock outstanding. Total revenues for TCA Cable are $14.2 million. If TCA has a marginal tax rate of 40%, what is its degree of combined leverage? a. 2.1 b. 1.0 c. 1.9 d. 2.5 ANSWER: d RATIONALE: Solution: DCL = 49. Borkstran has sales of $7.8 million, a variable cost ratio of 0.6, EBIT of $1.1 million, and a degree of combined leverage of 3.4. What is Borkstran’s degree of financial leverage? a. 1.20 b. 0.73 c. 2.29 d. 0.84 ANSWER: a RATIONALE: Solution: DOL = (7.8 – 4.68)/1.1 = 2.84 DFL = DCL/DOL = 3.4/2.84 = 1.20 50. Archive Storage earned $3.20 a share on sales of $13.6 million. Archive has determined that its degree of operating leverage is 1.87 and its degree of financial leverage is 2.91. If sales are expected to increase 15%, what will be the EPS forecast? a. $2.61 b. $4.60 c. $5.81 d. $3.68 ANSWER: c RATIONALE: Solution: DCL = 1.87(2.91) = 5.44 % change in EPS = 5.44(15) = 81.6 Forecasted EPS = 3.20(1.816) = $5.81 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 14: Capital Structure Management in Practice 51. Last year Alpine Growers experienced a 34% increase in earnings per share on 11% increase in sales. If management knows that Alpine’s DOL is 1.5, what is its DFL? a. 3.09 b. 2.06 c. 3.55 d. 1.67 ANSWER: b RATIONALE: Solution: DCL = 34/11 = 3.09 DFL = 3.09/1.5 = 2.06 52. If a firm sees its EPS increase 27% on a 12% increase in sales, what is the firm’s DOL. During the same period the firm saw its EBIT increase only 8%. a. 1.50 b. 3.38 c. 1.34 d. 0.67 ANSWER: d RATIONALE: Solution: DOL = 8%/12% = 0.67 53. Given the following financial data for Boston Technology, compute the firm’s degree of combined leverage. Assume a marginal tax rate of 40%. 2010 2011 Sales $700,000 $760,000 Fixed costs 175,000 190,000 Variable costs 406,000 448,000 EBIT 119,000 122,000 Interest 42,000 46,000 Shares outstanding 100,000 102,000 a. 0.29 b. –0.38 c. –0.15 d. 0.38 ANSWER: b RATIONALE: Solution: 2010 2011 EBIT $119,000 $122,000 I 42,000 46,000 EBT 77,000 76,000 T 30,800 30,400 EAT $ 46,200 $ 45,600 EPS $ 0.462 $ 0.447 DCL = [($0.447 – $0.462)/$0.462]/[($760,000 – $700,000)/$700,000] = –0.38 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 14: Capital Structure Management in Practice 54. ASG expects next year’s operating income (EBIT) to equal $22 million, with a standard deviation of $16 million. The coefficient of variation of operating income is equal to 0.73. Interest expenses will be $9 million next year and debt retirement will require a principal payment of $2.5 million. ASG’s marginal tax rate is 40%. If EBIT is normally distributed, what is the probability that ASG will have a negative EPS next year? a. 20.9% b. 25.5% c. 23.3% d. 25.8% ANSWER: a RATIONALE: Solution: z = ($9.0 – $22.0)/16.0 = –0.81 From Table V, at z = – 0.81; p = 0.2090 55. Sulzar’s capital structure consists only of common stock (20 million shares), but the firm is planning a major expansion which will require $100 million of new capital. Sulzar has a choice of obtaining the needed capital through the sale of 5 million shares of common stock at $20 per share or the sale of $100 million of first mortgage bonds that would have a coupon rate of 9%. If Sulzar has a marginal tax rate of 40%, calculate the EBIT-EPS indifference point. a. $45 million b. $36 million c. $5 million d. $9 million ANSWER: a RATIONALE: Solution: [(EBIT – $9.0)(0.60)]/20 = [(EBIT – 0 )(0.60)]/25 EBIT* = $45 (million) 56. Given the following financial data for Cosmos, compute the firm’s degree of combined leverage. 2010 2011 Sales $780,000 $874,000 Fixed costs 195,000 218,500 Variable costs 460,200 524,400 EBIT 124,800 131,100 Interest 46,800 52,400 EPS $0.42 $0.51 a. $0.42 b. 8.37 c. –2.15 d. 1.78 ANSWER: d RATIONALE: Solution: DCL = [($0.51 – $0.42)/$0.42]/[($874,000 – $780,000)/$780,000] = 1.78 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 14: Capital Structure Management in Practice 57. Given the following financial data for Cosmos, compute the firm’s degree of financial leverage. Last Year This Year Sales $780,000 $874,000 Fixed costs 195,000 218,500 Variable costs 460,200 524,400 EBIT 124,800 131,100 Interest 46,800 52,400 EPS $0.42 $0.51 a. 23.81 b. 4.24 c. 0.42 d. 2.18 ANSWER: b RATIONALE: Solution: DFL = [($0.51 – $0.42)/$0.42]/[($131,100 – $124,800)/$124,800] = 4.24 58. Higgins currently has 2 million shares of common stock outstanding that are selling for $32 per share. Higgins also has a $20 million mortgage bond outstanding that has an 11 percent coupon rate. Higgins is considering two alternatives to financing a major expansion. Plan A is to sell $10 million of additional long-term debt with a 12.5 percent coupon. Plan B is to sell 200,000 shares of common stock at $30 per share and $4 million in long-term debt with an 11.25 percent coupon. What is the EBIT indifference level between these two alternatives? Assume the marginal tax rate is 40 percent. a. $1,374,000 b. $11,450,000 c. $4,554,000 d. $2,650,000 ANSWER: b RATIONALE: Solution: (EBIT – $3.45)(0.6)/2 = (EBIT – $2.65)(0.6)/2.2 EBIT* = $11.45 million 59. Onyx expects to have an EBIT of $240,000 with a standard deviation of $110,000. The distribution of operating income is approximately normal. If Onyx has interest expenses of $50,000, what is the probability that it will have an operating income that is below $0? a. 4.27% b. 1.46% c. 0.02% d. 2.4% ANSWER: b RATIONALE: Solution: z = ($0 – $240,000)/$110,000 = –2.18; From Table V, p = 1.46% © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 14: Capital Structure Management in Practice 60. Midwest Can Company is considering opening a new plant in St. Louis that is expected to produce an average EBIT of $3 million per year. To finance this new plant, Midwest is considering two financing plans. The first plan is to sell 600,000 shares of common stock at $15 each. The second plan is to sell 200,000 shares of common stock at $15 each and $6 million of 13 percent long-term debt. If Midwest has a marginal tax rate of 40 percent, what is the EBIT-EPS indifference point for this plant? a. $702,000 b. $234,000 c. $2,234,000 d. $1,170,000 ANSWER: d RATIONALE: Solution: (EBIT – $780,000)(0.6)/200,000 = 0.6EBIT/600,000 EBIT* = $1,170,000 61. Ipsy Dipsy Preschools, Inc. has a capital structure that consists of 60% common equity (2.0 million shares), 30% long-term debt ($10 million with 12% coupon), and 10% preferred stock ($50 par value with $4.75 dividend). The company is planning a major plant expansion and is undecided between the following two financing plans: 1) Equity financing: Sale of 400,000 shares of common at $10 each. 2) Debt financing: Sale of$4 million of 12.5 percent long-term bonds. Calculate the EBIT-EPS indifference point. Assume the marginal tax rate is 40%. a. $4.253 million b. $3.051 million c. $3.654 million d. $4.728 million ANSWER: a RATIONALE: Solution: Total current capitalization= $10,000,000 debt/0.3 = $33,333,333 Preferred stock= 0.10 × $33,333,333 = $3,333,333 Preferred shares = $3,333,333/$50 = 66,667 Preferred dividends = 66,667 × $4.75 = $316,668.25 EBIT* = $4,727,779 or $4.728 million © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 14: Capital Structure Management in Practice 62. River Rafts has determined that its expected EBIT for the coming year is $8.3 million. The EBIT is approximately normally distributed with a standard deviation of $5.1 million. If River Rafts has $1.9 million in annual interest payments, what is the probability that the firm will have negative earnings? a. 4.65% b. 10.47% c. 5.16% d. 35.20% ANSWER: b RATIONALE: Solution: z = 63. Twin City Printing is considering two financial alternatives for financing a major expansion program. Under either alternative EBIT is expected to be $15.6 million. Currently the firm’s capital structure consists of 4 million shares of common stock and $35 million in 11% long-term bonds. Under the debt financing alternative $10 million in 12% long­term bonds will be sold and under the equity financing alternative the firm would sell 500,000 shares of common stock. The PIE under the debt alternative would be 15 and the PIE under the equity alternative would be 16. The firm’s marginal tax rate is 40%. Which alternative would produce the higher stock price? a. debt-stock price of $23.70 b. debt-stock price of $32.29 c. equity-stock price of $25.12 d. equity-stock price of $33.28 ANSWER: c RATIONALE: Solution: Equity Debt EBIT $15,600,000 $15,600,000 I 3,850,000 5,050,000 EBT 11,750,000 10,550,000 Taxes 4,700,000 4,220,000 EAT $ 7,050,000 $ 6,330,000 EPS = $7,050,000/4,500,000 = $1.567 $6,330,000/4,000,000 = $1.583 Price 16 × $1.57 = $25.12 15 × $1.58 = $23.70 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 14: Capital Structure Management in Practice 64. Sitco has a total of $12 million in cash and marketable securities. Free cash flows during the coming year are expected to be $47 million with a standard deviation of$31 million. Assume that Sitco’s free cash flows are approximately normally distributed. What is the probability that Sitco will run out of cash during the coming year? a. 29.98% b. 34.83% c. 97.13% d. 2.87% ANSWER: d RATIONALE: Solution: z = 65. Crown Data (CD) has a current capital structure that consists of$120 million in common equity (15 million shares) and $80 million in long-term debt with an average interest rate of 11 percent. CD is considering an expansion project that will cost $22 million. The project will be financed either by issuing long-term debt at a cost of 12.5 percent, or the sale of new common stock at $35 per share. The firm’s marginal tax rate is 40%. What is the EBIT indifference point between the two financing options? a. $71.5 million b. $77.2 million c. $68.3 million d. $1.0 million ANSWER: b RATIONALE: Solution: EBIT* = $77.2 million 66. In considering EBIT-EPS analysis, which of the following statements is/are correct? a. If the expected earnings are above the indifference point, the debt option is preferred. b. If the expected earnings are below the indifference point, the equity option is preferred. c. Both statements a and b are correct. d. Neither statement a nor b is correct. ANSWER: c 67. What type of security is used to purchase a target company in a leveraged buy-out? a. common stock b. dividends c. debt d. retained earnings ANSWER: c © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 14: Capital Structure Management in Practice 68. A change in EBIT is magnified into a larger change in EPS. This means that financial leverage is using as its fulcrum. a. short-term costs b. fixed costs c. variable costs d. retained earnings ANSWER: b 69. In using Nestle Corporation as a model, when a subsidiary is first formed, about one-half of the financing needed to acquired fixed assets comes from: a. debt b. federal funds c. tax breaks d. equity from the parent company ANSWER: d 70. Some companies use debt or preferred stock financing instead of common stock financing. The purpose is: a. to retain control b. to facilitate record-keeping c. to maintain privacy d. to prevent audit problems ANSWER: a 71. There are three categories of costs: fixed costs, variable costs and semi-variable costs. Which of the following is a semi-variable cost? a. depreciation b. labor costs c. raw materials d. management salaries ANSWER: d © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 14: Capital Structure Management in Practice 72. Fanny Nanny Weight Monitors, Inc. is considering two financial alternatives for financing a major expansion program. Under either alternative, EBIT is expected to be $12.5million. Currently the firm’s capital structure consists of 2 million shares of common stock and $15 million in 6% long-term bonds. Under the debt financing alternative $8 million in 4% long-term bonds will be sold and under the equity financing alternative the firm would sell 150,000 shares of common stock. The P/E under the debt alternative would be 21 and the P/E under the equity alternative would be 22. The firm’s marginal tax rate is 40%. Which alternative would produce the higher stock price? a. debt–stock price of $57.36 b. debt–stock price of $70.98 c. equity–stock price of $71.28 d. equity–stock price of $85.32 ANSWER: c RATIONALE: Solution: Debt Equity EBIT $12,500,000 $12,500,000 I 1,220,000 900,000 EBT 11,280,000 11,600,000 Taxes 4,512,000 4,640,000 EAT $ 6,768,000 $ 6,960,000 EPS = $6,940,800/2,000,000 = $3.38 $6,960,000/2,150,000 = $3.24 Price 21 × $3.38 = $70.98 22 × $3.24 = $71.28 73. Dippity Doodle Noodle Makers has a capital structure that consists of2.0 million shares outstanding and $2.0 million of debt at 8% interest. The company is planning a major plant expansion must decide between the following two financing plans. Option 1 is to increase debt by $1.0 million at 9% interest and sell 10,000 new shares of stock at $50 per share. Option 2 is to sell 30,000 new shares of stock at $50 per share. What would be the indifference point and considering that EBIT is expected to be $10,000,000 which option would be best a. Indifference of $10,750,000. Use stock option. b. Indifference of $1,600,000. Use stock option. c. Indifference of $16,270,000. Use the debt option. d. Indifference of $9,250,000. Use the debt option. ANSWER: d RATIONALE: Solution: 1.01 EBIT – 252,500 = EBIT – 160,000 1.01 EBIT – 1EBIT = 252,500 – 160,000.01 EBIT = 92,500 EBIT = 9,250,000 Indifference Point © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 14: Capital Structure Management in Practice 74. What is the degree of operating leverage for Flippin’ Out Company, a maker of scuba flippers, if the firm sells its finished product for $50 per unit with variable costs per unit of $15? The company has fixed operating costs of $2,000,000 and sells 200,000 units (the answer is rounded). a. 2.0 b. 3.7 c. 6.5 d. 1.4 ANSWER: d RATIONALE: Solution: 75. Magnificent Manes Hair Salons is forecasting a 17% increase in sales. What would be its degree of operating leverage if it anticipates that its EBIT will go from $150,000 to $175,000 during the same time frame? a. 1.76 b. 2.5 c..98 d. 1.11 ANSWER: c RATIONALE: Solution: (175,000 – $150,000)/150,000 = $25,000/150,000 = 16.67% 16.67%117% = 0.98 76. What would be the degree of financial leverage for Foggy Futures Weather Forecasters if the company has earnings before interest and taxes of$750,000, has a 4.5% loan on $1,000,000 and is in the 38% tax bracket? The firm does not have any preferred stock outstanding. a. 1.22 b. 1.78 c. 1.06 d. 97 ANSWER: c RATIONALE: Solution: © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 14: Capital Structure Management in Practice 77. What would be the degree of financial leverage for Under A Cloud Skydiving School if the company will have earnings before interest and taxes of $750,000 which would be a 15% increase? The firm had EPS of $1.25 but, with the increased earnings, anticipates paying $1.37. a..80 b. 1.08 c. 2.01 d. 1.25 ANSWER: a RATIONALE: Solution: 78. In evaluating degree of operating leverage, it is best that the firm’s DOL is: a. higher than 1 b. higher than 2 c. lower than 1 d. equal to 1 ANSWER: c 79. In evaluating a firm’s degree of financial leverage, financial risk is with an increase in DFL. a. increased b. decreased c. not impacted d. reflective of excess inventory ANSWER: a 80. What are the effects of leverage on shareholder wealth and the cost of capital? ANSWER: Firms are limited in the amount of combined leverage that can be used by the firm to increase BPS and shareholder wealth. Excessive amounts of financial leverage can cause the market value of the firm to decline and the cost of capital to increase. As the risk of financial distress increases, investors will require a higher rate of return on funds supplied to the firm. This increase will result in the firm having to pay a higher cost for funds, which will offset the returns gained from the combined leverage. The end result is a decline in the market value of the firm and a rise in its cost of capital. 81. Explain the difference between short-run costs and long-run costs. ANSWER: Short run costs vary directly with the level of sales, whereas other costs remain constant regardless of sales. Costs that are closely tied to sales are called variable costs and those costs that are independent of sales are fixed costs. It is with these short-run costs that a firm can determine its breakeven point. Long-run costs are always variable costs because a firm can change the size of its physical facilities and the number of management personnel in response to changes in the level of sales. © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 14: Capital Structure Management in Practice 82. Why does a firm use operating and financial leverage? In what ways does it help the firm, in what ways does it hurt the firm? ANSWER: A firm uses operating and financial leverage in the hope of earning returns in excess of the fixed costs of its assets and liabilities. This will increase the returns to common stockholders. However, it also increases the variability or risk of these returns. Leverage magnifies shareholders’ potential losses as well as potential gains. Leverage concepts highlight the risk-return trade-off of various types of financial decisions. 83. List the five steps developed to assist financial managers in making capital structure decisions. ANSWER: The steps are: 1. Compute the expected level of EBIT after the expansion 2. Estimate the variability of this level of operating earnings. 3. Compute the indifference point between the two financing alternatives 4. Analyze these estimates in the context of the risk the firm is willing to assume. 5. Examine the market evidence to determine whether the proposed capital structure is too risky. 84. Some firms prefer to use debt or preferred stock for financing to retain control. Explain the rationale behind this method. ANSWER: Some firms choose debt or preferred stock financing to avoid selling new shares of common stock. When new voting common stock is sold, the relative control position of existing stockholders is diluted. Diluted control is especially important to smaller firms with significant family ownership. 85. In what way does management’s willingness to assume risk impact the firm? ANSWER: Its willingness to assume risk often has a major impact on the capital structure chosen by the firm, although the relative risk aversion of management does not influence the firm’s optimal capital structure. Some managers adopt unusually risky or unusually low-risk capital structures. When a suboptimal capital structure is chosen the financial marketplace will normally penalize a firm for this action by downgrading its credit rating level. © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.