Deck 14: Capital Structure and Leverage

Question 1

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

Answer 1

C

Question 2

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

Answer 2

D

Question 3

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.

Answer 3

B

Question 4

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 5

Which of the following is the correct mathematical expression for ROCE?

A) ROCE = EBITDA ´ (1 - T) $\div$ (Debt + Equity)
B) ROCE = Net income ´ (1 - T) $\div$ (Debt + Equity)
C) ROCE = EBT ´ (1 - T) $\div$ (Debt + Equity)
D) ROCE = EBIT ´ (1 - T) $\div$ (Debt + Equity)

Question 6

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 < pretax cost of debt
D) ROCE = cost of equity

Question 7

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

Question 8

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 9

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 10

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 11

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 12

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 13

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.

Question 14

Consider the following leverage scenarios: Leverage Scenarios (000s)
$\begin{array}{llll}&\# 1 & \# 2 & \# 3 \\&0 \% \text { Debt } & 50 \% \text { Debt } & 80 \% \text { Deb }\\\text { Capital } & & & \\\text { Debt } & -\$ 1,000 & \$ 1,600 \\\text { Equity } & \$ 2,000 & 1,000 & 400 \\\text { Total capital } & 2,000 & \$ 2,000 & \$ 2,000 \\\text { Shares@ } \$ 10 &200,0007100,000&40,000\\\text { Revenue } & \$ 2,000 & \$ 2,000 & \$ 2,000 \\\text { Less costs/ expenses } & 1,800 & 1,800 & 1,800 \\\text { EBIT } & 200 & 200 & 200 \\\text { Interest expense }(10 \%) & - & 100 & 160 \\\text { EBT } & 200 & 100 & 40 \\\text { Taxes @ 40\% } & 80 & 40 & 16 \\\text { Earnings after tax } & \$ 120 & \$ 60 & \$ 24\\\text { ROE } &6\%&6\%&6\%\\\text { EPS } & \$.60&\$.60&\$.60\end{array}$ 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 15

Which of the following would increase a firm's financial leverage?

A) An increase in depreciation
B) An increase in interest expense
C) An increase in the number of shares of common stock outstanding
D) a and b

Question 16

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

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

Question 17

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

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

Question 18

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 19

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 20

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 21

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.

Question 22

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 23

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 24

Which of the following is the correct formula to calculate ROE?

A) ROE = EBT $\div$ Equity
B) ROE = EBIT $\div$ Equity
C) ROE = Net income $\div$ Equity
D) ROE = Gross profit $\div$ Equity

Question 25

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 26

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 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 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 29

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 30

The degree of operating leverage is measured by relating the percentage change in EBIT to the percentage change in:

A) sales.
B) earnings per share.
C) debt ratio.
D) share price.

Question 31

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 32

Which of the following if the correct mathematical expression of the degree of financial leverage (DFL)?

A) DFL = %ÄEBT $\div$ %ÄEPS
B) DFL = %ÄEBIT $\div$ %ÄEPS
C) DFL = %ÄEPS $\div$ %ÄEBIT
D) DFL = %ÄEPS $\div$ %ÄEBT

Question 33

Operating leverage involves the use of:

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

Question 34

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

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

Question 35

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 36

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 37

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 38

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 39

In the framework of financial leverage, risk can be viewed as:

A) the degree of variation in the return on an investment.
B) the variation in financial performance measured by ROE and EPS.
C) Neither a nor b
D) Both a and b

Question 40

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 41

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 42

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 43

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 44

The total variability of EPS associated with a change in sales is an indication of combined leverage best measured by:

A) DOL.
B) DFL.
C) DOL + DFL.
D) DOL ´ DFL.

Question 45

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 46

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 47

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 48

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 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

Which of the following is the correct mathematical expression of the degree of operating leverage (DOL)? (ÄQ is the change in volume)

A) DOL = %ÄEBT $\div$ %ÄQ
B) DOL = %ÄEBIT $\div$ %ÄQ
C) DOL = %ÄQ $\div$ %ÄEBIT
D) DOL = %ÄQ $\div$ %ÄEBT

Question 51

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 52

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 53

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 54

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 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

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 57

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 58

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 59

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 60

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 61

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 62

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 63

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 64

Assume the following facts about a company: $\begin{array}{llll}\text { Capital (000's) } && \text { EBIT (000's) } & \$ 1,000 \\\text { Debt } & - & \text { Lessinterest Expense }&-\\\text { Equity } & \underline{\$ 3,000} & \text { EBT } &\$1,000\\\text { Total Capital } &\$3,000& \text { Taxes@ 40\% }&400\\\text { Sthares@ } \$ 10=300&&\text { Earnings after } \mathrm{T} a x&\$600\end{array}$ 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 65

Assume the following facts about a firm that sells just one product: $\begin{array}{l}\text {Selling price per unit }&=\$ 24.00 \\\text { Variable costs per unit}&=\$ 18.00\\\text {Total annual fixed costs }&=\$ 2,500\end{array}$ 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 66

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.
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 67

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 68

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 69

Assume the following facts about a firm that sells just one product: $\begin{array}{l}\text { Selling price per unit}&=\$ 24.00 \\\text { Variable costsper unit}&=\$ 18.00 \\\text {Total monthly fuxed costs }&=\$ 2,500\end{array}$ 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 70

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 71

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? $\begin{array}{ll}\text { Book value per share: } & \$ 8.75 \\\text { Cost of debt: } & 10 \text { percent } \\\text { EBIT: } & \$ 500,000 \\\text { Tax bracket: } & 30 \text { percent } \\\text { Total Capital: } & \$ 4,000,000\end{array}$

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

Question 72

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%

Question 73

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 74

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 75

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 76

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 77

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 78

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 79

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 80

Assume the following facts about a single product firm: $\begin{array}{l}\text {Selling price per unit }&=\$ 25.00 \\\text { Variable costs per unit}&=\$ 21.25 \\\text {Total annual fixed costs }&=\$ 3,000\end{array}$ What is the firm's annual breakeven volume in sales revenues?

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