Deck 14: Capital Structure and Leverage

Question 1

The underlying reason that leverage may increase stock price is that under certain conditions:

A)it increases risk, which in turn requires a larger return on equity.
B)it improves performance measured in terms of EBIT and EPS.
C)it improves performance measured in terms of ROE and EPS.
D)it is cheaper to raise new debt than it is to raise new equity.

Answer 1

C

Question 2

Financial leverage may benefit shareholders when the:

A)return on capital employed is greater than the after tax cost of debt.
B)return on equity is greater than the cost of debt.
C)return on investments is less than the cost of capital.
D)None of the above

Answer 2

A

Question 3

Which of the following is most correct?

A)When the return on capital employed (ROCE)is less than the before tax cost of debt, a company can increase its ROE by trading out equity and into debt.
B)When the return on capital employed (ROCE)is more than the before tax cost of debt, a company can increase its ROE by trading out equity and into debt.
C)When the return on capital employed (ROCE)is less than the after tax cost of debt, a company can increase its ROE by trading out equity and into debt.
D)When the return on capital employed (ROCE)is more than the after tax cost of debt, a company can increase its ROE by trading out equity and into debt.

Answer 3

D

Question 4

Which of the following is correct?

A)The variation in ROE and EPS for an unleveraged firm is identical to variation in EBIT.
B)In a leveraged firm, the variation in ROE and EPS is always greater than the variation in EBIT.
C)Financial risk is the additional variation in ROE and EPS arising from the use of debt.
D)All of the above

Question 5

The use of fixed-cost financing is referred to as:

A)operating leverage.
B)a leveraged buyout.
C)financial leverage.
D)combined leverage.

Question 6

The degree of financial leverage is measured by relating the percentage change in earnings per share to the percentage change in:

A)sales.
B)EBIT.
C)debt ratio.
D)share price.

Question 7

A DFL (degree of financial leverage)of 3.0 indicates that a 27% increase in EPS is the result of a(n)____ increase in EBIT.

A)81%
B)3%
C)9%
D)6%

Question 8

If a firm's EBIT changes by 20% and it has a degree of financial leverage (DFL)of 2.5, what is the expected change in earnings per share (EPS)?

A)20%
B)40%
C)50%
D)60%

Question 9

Granting a tax deduction for corporate interest enables financial leverage to increase a firm's value by:

A)increasing EBIT.
B)decreasing the lender's share of EBIT.
C)decreasing the government's share of EBIT.
D)b and c

Question 10

The increased variability in earnings per share due to the use of debt is:

A)combined leverage.
B)business risk.
C)financial risk.
D)operating risk.

Question 11

Financial leverage is a direct function of the ratio of:

A)net income to sales.
B)EBIT to sales.
C)interest expense to EBIT.
D)net income to the number of shares of common stock.

Question 12

A firm that employs a relatively large proportion of debt in its capital structure will have a relatively ____ degree of financial leverage.

A)low
B)high
C)insignificant
D)constant

Question 13

The central issue in the study of leverage is:

A)whether leverage affects stock price.
B)whether an optimal capital structure exists that maximizes stock price.
C)whether an optimal capital structure exists that minimizes the cost of capital.
D)All of the above

Question 14

When the return on equity is equal to the return on capital employed:

A)the return on borrowed money equals the cost of borrowing the money.
B)the firm has optimized its financial leverage.
C)the firm is unleveraged.
D)All of the above

Question 15

Consider the following leverage scenarios: If under certain circumstances, financial leverage enhances performance measured by ROE and EPS, why does shifting from equity into debt have no effect in this case?

A)The company hasn't repurchased enough shares of stock with borrowed money.
B)The money the company is earning on its capital is exactly what it costs to borrow.
C)ROCE is too high.
D)ROCE is equal to the after tax cost of debt.

Question 16

The term "financial leverage" originated from the notion that there is a multiplicative effect on financial performance measured at ____ when borrowed money is used to support the firm.

A)return on assets
B)return on equity
C)earnings per share
D)Both b and c

Question 17

The use of fixed cost sources of funds, such as debt and preferred stock, affect a firm's:

A)financial risk.
B)degree of operating leverage.
C)market power.
D)business risk.

Question 18

Financial leverage has the following effect on financial performance:

A)during periods of reasonably good performance, leverage enhances results in terms of ROE and EPS.
B)leverage adds variability to financial performance making the firm's stock a riskier investment.
C)leverage always makes performance better and thereby increases stock price.
D)Both a and b

Question 19

Which of the following is true of financial leverage?

A)It affects the sensitivity of net income to changes in sales.
B)It arises from the use of debt financing.
C)It is increased by an increase in operating leverage.
D)a and b

Question 20

Financial leverage increases a firm's ROE and EPS under which of the following circumstances?

A)ROCE = cost of debt
B)ROCE > after tax cost of debt
C)ROCE
D)ROCE = cost of equity

Question 21

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

Question 22

An analytical technique called ____ can be used to help determine how much leverage a firm should use.

A)DFL-EPS analysis
B)EBIT-EPS analysis
C)DOL-EPS analysis
D)DOL-EBIT analysis

Question 23

Which of the following is an overall measure of business performance?

A)Interest coverage ratio
B)ROE
C)Debt to equity ratio
D)Revenue

Question 24

The difference between fixed and variable costs is that:

A)variable costs move up and down with changes in sales while fixed costs remain constant.
B)variable costs are only found in factory operations while fixed costs occur only in expenses.
C)fixed costs are the costs of fixed assets, everything else is a variable cost.
D)Both a and b

Question 25

Common characteristics of operating and financial leverage include:

A)both involve the substitution of fixed for variable cash outflows.
B)both are affected by a firm's investing decisions.
C)both are affected by a firm's financing decisions.
D)None of the above

Question 26

When a firm's cost structure consists principally of fixed costs,:

A)it is said to have a great deal of operating leverage.
B)those costs consist of rent, depreciation, direct labor, management salaries, direct materials, and utilities.
C)the firm might be a factory with many people and few machines.
D)All of the above

Question 27

If a firm's EBIT changes by 20% and it has a degree of financial leverage (DFL)of 2.0, what is the expected change in earnings per share (EPS)?

A)20%
B)40%
C)50%
D)60%

Question 28

The process of evaluating a firm's operations to determine the minimum volume it must sell to avoid losing money is referred to as:

A)operating leverage analysis.
B)direct analysis of operations.
C)breakeven analysis.
D)cost, volume, and profit analysis.

Question 29

Which of the following is correct?

A)Capital structure affects both financial leverage and operating leverage.
B)Cost structure affects both financial leverage and operating leverage.
C)Capital structure affects financial leverage and cost structure affects operating leverage.
D)Capital structure affects operating leverage and cost structure affects financial leverage.
E)None of the above is correct.

Question 30

The breakeven point on a breakeven diagram is:

A)the point where the fixed cost line and the revenue line intersect.
B)the point where the total cost line and the revenue line intersect.
C)the point where the total cost line intersects the horizontal axis.
D)the point where the total cost line intersects the vertical axis.

Question 31

Financial leverage involves substituting debt for equity in the firm's capital structure, operating leverage involves:

A)substituting variable costs for fixed costs in the firm's cost structure.
B)substituting fixed costs for variable costs in the firm's cost structure.
C)increasing financial risk.
D)None of the above

Question 32

A decrease in the level of a firm's interest expense (holding all other factors constant)would:

A)increase operating leverage.
B)decrease operating leverage.
C)decrease financial leverage.
D)have no impact on operating leverage.
E)c and d

Question 33

When fixed operating costs are incurred by the firm, a relative change in ____ is magnified into a larger relative change in earnings before interest and taxes.

A)overhead expenses
B)interest charges
C)labor costs
D)sales revenue

Question 34

EBIT, earnings before interest and taxes, is also called:

A)operating income.
B)net income.
C)financial income.
D)revenue.

Question 35

Which of the following is not true with respect to operating leverage?

A)Higher operating leverage insulates a firm from losses in bad times.
B)Firms with higher operating leverage have a larger contribution from each sale, so they accumulate profits or losses faster as they move away from the breakeven point in sales.
C)Increased operating leverage increases business risk.
D)Virtually all firms have at least some operating leverage.

Question 36

Operating leverage involves the use of:

A)equity and debt in equal proportions.
B)market power.
C)debt.
D)fixed costs.

Question 37

The variability in a firm's EPS is affected by:

A)variability in its sales.
B)operating leverage.
C)financial leverage.
D)a and c
E)All of the above

Question 38

Metcalf, Inc. is planning to buy a new machine to begin making one of its component parts internally rather than contracting it out to a supplier. Since this is a major investment, they plan to fund it by issuing additional common stock. Assuming that this change has no initial impact on EBIT, the change should:

A)increase operating leverage and decrease financial leverage.
B)decrease operating leverage and increase financial leverage.
C)increase both operating and financial leverage.
D)decrease both operating and financial leverage.
E)The impact on financial and operating leverage cannot be determined.

Question 39

Which of the following is true of the breakeven diagrams?

A)Cost is plotted along the vertical axis and unit sales (Q for quantity)along the horizontal axis.
B)Cost is plotted along the horizontal axis and unit sales (Q for quantity)along the vertical axis.
C)Fixed cost is plotted along the horizontal axis and variable cost along the vertical axis.
D)Revenue is plotted along the horizontal axis and unit sales (Q for quantity)along the vertical.

Question 40

Business risk, as defined in terms of variation in a firm's operating performance and measured by EBIT, would be effected by variation in all of the following, except:

A)anticipated changes in federal regulations.
B)business operations.
C)expenses.
D)revenues.

Question 41

The degree of total leverage is equal to the degree of ____ multiplied by the ____.

A)operating leverage, variable cost ratio
B)financial leverage, variable cost ratio
C)operating leverage, degree of financial leverage
D)operating leverage, fixed cost ratio

Question 42

In the MM model, as the proportion of debt in the capital structure increases, the cost of equity:

A)increases.
B)decreases.
C)remains unchanged; there is no relationship between the two.
D)initially rises rapidly, then increases slowly beyond some point.

Question 43

Yang Centers wants to report at least $1.75 in earnings per share. Given the following information, how much debt should be in its capital structure?

A)$457,142
B)$520,050
C)$2,800,000
D)$3,461,538

Question 44

Khandker Motors finances 40% of its total capital with debt. The cost of debt is 11%. The firm is in the 37% tax bracket and earned an operating profit of $2.5 million dollars. If the Khandker's total capital amounts to $22 million and its book value per share is $20, what are the firm's earnings per share?

A)$0.85
B)$0.88
C)$1.43
D)$1.46

Question 45

Which of the following assumptions was not part of the original Modigliani and Miller Model?

A)Securities trade in perfectly efficient capital markets.
B)Securities trade with no transaction costs.
C)Income taxes are fixed.
D)Rates for borrowing do not change regardless of the amount borrowed.
E)Rates for borrowing are the same for investors and companies.

Question 46

According to the MM model of capital structure, the present value of the tax shield is offset by potential ____, resulting in an optimal capital structure.

A)bankruptcy costs
B)interest expense
C)operating costs
D)a and b

Question 47

All other things being equal, the Modigliani and Miller Model, modified for tax and bankruptcy costs concludes that:

A)no matter what level of debt a company is operating at, increasing the percent of debt in the capital structure will increase the stock price. b. if a company has a very low percent debt, increasing the percent of debt in the capital structure will increase the stock price.
B)and c. are correct.
C)at moderate levels of debt, it is difficult to tell what will happen to the stock price (whether it will go up or down)if the percent debt in the capital structure is increased.
D)there is no relationship between the percent of debt in the capital structure and the stock price.
E)b. and c. are correct.

Question 48

In the MM model, the risk of bankruptcy:

A)reduces the present value of the tax shield of debt.
B)reduces the positive effect of financial leverage on firm value.
C)eliminates the possibility of a net positive effect of financial leverage on firm value.
D)has no impact on the relationship between financial leverage and firm value.
E)a and b

Question 49

The combined impact of operating leverage and financial leverage on the firm's EPS is:

A)additive.
B)geometric.
C)multiplicative.
D)None of the above

Question 50

Assume the following facts about a company: What will be the company's new EPS if it borrows money at 10% interest and uses it to retire stock until capital is 40% debt? The stock can be purchased at its book value of $10 per share.

A)$3.33
B)$4.89
C)$2.93
D)None of the above

Question 51

The degree of total 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

Question 52

Which of the following is accepted wisdom regarding the optimal capital structure?

A)For most firms, the optimal capital structure is somewhere between 30% and 50% debt.
B)A firm with good profit prospects and little to no debt is probably missing an opportunity by not using borrowed money if interest rates are reasonable.
C)Debt levels above 60% create excessive risk and should be avoided.
D)All of the above

Question 53

If a firm's sales change by 15% and it has a degree of operating leverage (DOL)of 2.0, what is the expected change in earnings before interest and taxes (EBIT)?

A)30%
B)40%
C)50%
D)60%

Question 54

Financial leverage amplifies relative changes in EBIT into larger relative changes in ROE and EPS, operating leverage amplifies:

A)relative changes in EBIT into larger relative changes in sales revenue.
B)relative changes in sales revenue into larger relative changes in EBIT.
C)relative changes in sales revenue into larger relative changes in ROE and EPS.
D)relative changes in ROE and EPS into larger relative changes in EBIT.

Question 55

A firm which has a 2.5 DOL (degree of operating leverage)would find that an 8% increase in EBIT would result from a(n)____ increase in sales.

A)3.2%
B)5.4%
C)20.0%
D)2.0%

Question 56

In the MM model, the mix of debt and equity that minimizes the cost of capital is the:

A)optimal corporate structure.
B)target financial structure.
C)optimal capital structure.
D)optimal degree of combined leverage.

Question 57

When MM theory recognizes taxes and bankruptcy costs, firm value:

A)is unaffected by financial leverage.
B)steadily increases with financial leverage.
C)steadily decreases with financial leverage.
D)initially increases but then decreases as financial leverage rises.

Question 58

According to MM, if we ignore bankruptcy costs, an increase in financial leverage can increase the value of the firm:

A)in a world without taxes.
B)if interest is tax-deductible.
C)if interest is not tax-deductible.
D)a and b
E)All of the above

Question 59

Yang Centers has a book value of $8.75, a 10% cost of debt, operating income of $500,000, and a 30% tax rate. If Yang Centers finances 75% of its $4 million of total capital needs with debt, what is its earnings per share?

A)$0.88
B)$1.22
C)$1.75
D)$2.21

Question 60

Which of the following is true of the degree of total leverage?

A)It is the product of the degree of financial leverage and the degree of operating leverage.
B)It is the sum of the degree of financial leverage and the degree of operating leverage.
C)It is the difference between the degree of financial leverage and the degree of operating leverage.
D)It is the relative change in financial leverage with respect to the operational leverage.

Question 61

If a firm's degree of operating leverage is 8, what percentage change in sales revenue is required to double the firm's EBIT?

A)100%
B)8%
C)12.5%
D)None of the above

Question 62

Assume that Herron, Inc. has a degree of financial leverage of 1.50. If EBIT increases from $150,000 this year to $165,000 next year, how much will earnings per share (EPS)increase, assuming no change in capital structure?

A)6.7%
B)10.0%
C)15.0%
D)22.5%
E)Cannot be determined from the information given.

Question 63

If a company sells 10,000 units at $25 each, has fixed costs of $20,000, and a variable cost of $20 per unit, what is its degree of operating leverage (DOL)?

A)1.67
B)2.5
C)2.0
D)1.6

Question 64

Assume the following facts about a single product firm: What is the firm's annual breakeven volume in sales revenues?

A)$6,000
B)$250,000
C)$150,000
D)$1,500

Question 65

A firm has a product that sells for $25. The direct cost of manufacturing the product is $15 per unit. The product's contribution margin is:

A)$10.
B)40%.
C)60%.
D)67%.

Question 66

Porter Productions sells video tapes for $15.00 each. Their variable cost per unit is $9.00. In addition, they incur $180,000 in fixed costs each year. What is the Porter's annual breakeven point in sales revenue?

A)$30,000
B)$180,000
C)$300,000
D)$450,000
E)$720,000

Question 67

Assume the following facts about a single product firm: What is the firm's annual breakeven volume in sales revenues?

A)$540,000
B)$240,000
C)$20,000
D)$9,600

Question 68

Porter Productions sells video tapes for $15.00 each. Their variable cost per unit is $9.00. In addition, they incur $180,000 in fixed costs each year. How many units will Porter have to produce and sell in order to generate an operating income (revenues minus expenses)of $54,000?

A)9,000 units
B)18,000 units
C)30,000 units
D)39,000 units
E)54,000 units

Question 69

If a company sells 20,000 units at $20 each, has fixed costs of $50,000 and a variable cost of $10 per unit, what is their degree of operating leverage (DOL)?

A)1.6
B)2.5
C)1.33
D)1.7

Question 70

Illinois Tool Company's (ITC)fixed operating costs are $1,260,000. Its variable costs average 70% of the price of its products. The firm currently has sales revenue of $9 million per year. What is ITC's degree of operating leverage?

A)1.60
B)1.875
C)3.0
D)None of the above

Question 71

Assume the following facts about a firm that sells just one product: What is the firm's annual breakeven volume in units?

A)417 units
B)1,250 units
C)5,000 units
D)1,667 units

Question 72

A firm markets a product for $30 per unit that has a direct manufacturing cost of $15 per unit. Its contribution margin is:

A)50%.
B)33.33%.
C)$15.
D)None of the above

Question 73

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).68
B)2.0
C)1.47
D).32

Question 74

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's debt consists of a $6,000,000 bond issue (par value)which pays a coupon rate of 9%. Sales are $9 million per year. What is ITC's degree of financial leverage?

A)1.20
B)1.875
C)3.0
D)1.60

Question 75

Porter Productions sells video tapes for $15.00 each. Their variable cost per unit is $9.00. In addition, they incur $180,000 in fixed costs each year. At 40,000 units of sale, what is Porter's degree of operating leverage (DOL)?

A)1.33
B)2.50
C)3.00
D)4.00
E)6.00

Question 76

Harris Inc. has EBIT of $1,500 and debt of $5,000 on which it pays 12% interest. Its EPS is currently $2.35 per share. Management anticipates a difficult period ahead and fears EBIT could decline by as much as 20%. What will the new EPS be if that happens?

A)$1.88
B)$1.41
C)$1.57
D)Can't tell from the information given

Question 77

Internet Corporation has EBIT of $1 million, 30% debt in their capital structure, and total capital of $10 million. Their tax rate is 35%. What is their return on capital employed (ROCE)?

A)6.5%
B)10.0%
C)33.33%
D)21.67%

Question 78

A firm has EBIT of $3.6M and debt of $15M on which it pays 8% interest. What is its Degree of Financial Leverage (DFL)?

A)1.0
B)1.4
C)1.5
D)1.6

Question 79

Assume the following facts about a firm that sells just one product: What is the firm's monthly breakeven volume in units?

A)417 units
B)1,250 units
C)5,000 units
D)1,667 units

Question 80

Wayside Corporation has an EBIT of $2 million, 40% debt in their capital structure, and has total capital of $10 million. If they are in the 35% tax bracket, what is their return on capital employed (ROCE)?

A)20.0%
B)13.0%
C)40.0%
D)21.67%