Deck 12: Designing an Optimal Capital Structure

Question 1

Which of the following is NOT a common characteristic of issuing short-term debt?

A)Issuing short-term debt increases uncertainty compared to a long-term fixed-rate issue.
B)Issuing short-term debt provides more frequent financing opportunities.
C)Short-term interest rates are typically HIGHER than long-term rates.
D)Short-term debt financing could be problematic in the event of an economy-wide liquidity crisis.

Answer 1

C

Question 2

Figure 12.1: Selected information for Crane Manufacturing Inc.
$$\begin{array} { | l | c | c | } \hline & \text { ALL EQUTTY } & \text { EQUTYY AND DEBT } \\\hline & & \\\hline \text { Number of shares } & 500,000 & 300,000 \\\hline \text { Interest expense } & \$ 0 & \$ 100,000 \\\hline \text { Tax rate } = 30 \% & & \\\hline\end{array}$$

-Calculate an EBIT break-even between a debt firm (DF)and an all-equity firm (EF)based on the following information: DF interest = $60,000,DF number common shares = 5,000,EF number of common shares = 12,000,and tax rate = 40 percent.

A)EBIT = $234,547 and EPS = 10.35
B)EBIT = $146,312 and EPS = $7.02
C)EBIT = $102,857 and EPS = $5.14
D)EBIT = $91,217 and EPS = $4.18

Answer 2

EBIT = $102,857 and EPS = $5.14

Question 3

________ depends on any excess cash that a firm has above and beyond day-to-day working capital needs,as well as a firm's capacity to issue more debt while maintaining its current credit rating.

A)Financial flexibility
B)Shareholder control
C)Risk and timing
D)Impact and cost

Answer 3

A

Question 4

Which of the following statements is generally NOT true?

A)A firm should attempt to match the nature of a project with the duration of the financing it needs.
B)Short-term debt usually carries lower interest rates than long-term debt with comparable default risk.
C)Issuing variable rate debt increases financial uncertainty relative to issuing fixed-rate debt.
D)All of the above statements are true.

Question 5

________ refers to the ease with which a firm is able to tap-in to sources of capital.

A)Shareholder control
B)Financial flexibility
C)Risk and timing
D)Impact and cost

Question 6

Which of the following is NOT a common characteristic of issuing long-term debt?

A)Issuing long-term debt decreases uncertainty compared to a short-term fixed-rate issue.
B)Issuing long-term debt provides more frequent financing opportunities.
C)Long-term interest rates are typically HIGHER than short-term rates.
D)Long-term debt may be preferred because short-term debt financing could be problematic in the event of an economy-wide liquidity crisis.

Question 7

If a firm were simply concerned with minimizing costs of incremental financing,then the straightforward choice would be:

A)debt.
B)new equity.
C)retained earnings.
D)half debt and half equity financing.

Question 8

Assume that a firm's earnings per share (EPS)are expected to be $1.35 next year and that analysts have determined that an appropriate forward-looking multiple is 20 times the projected earnings.What should the stock price be?

A)$11.35
B)$20.00
C)$27.00
D)$28.75

Question 9

Figure 12.1: Selected information for Crane Manufacturing Inc.
$$\begin{array} { | l | c | c | } \hline & \text { ALL EQUTTY } & \text { EQUTYY AND DEBT } \\\hline & & \\\hline \text { Number of shares } & 500,000 & 300,000 \\\hline \text { Interest expense } & \$ 0 & \$ 100,000 \\\hline \text { Tax rate } = 30 \% & & \\\hline\end{array}$$

-Given the information in Figure 12.1,what is the break-even EBIT-EPS for Crane Manufacturing Inc.?

A)EBIT = $100,000 and EPS = $0.15
B)EBIT = $250,000 and EPS = $0.35
C)EBIT = $350,000 and EPS = $0.45
D)EBIT = $400,000 and EPS = $0.65

Question 10

Which of the following statements is TRUE?

A)Issuing equity automatically hurts existing shareholders.
B)Equity is less expensive than debt because of the dividend tax shield found with equity.
C)If a firm takes on a positive NPV project financed with new equity,existing shareholders will benefit.
D)All of the above are true.

Question 11

________ is measured by the proportional amount of debt in the firm's capital structure.

A)Relative risk
B)Business risk
C)Operating risk
D)Financial risk

Question 12

A firm whose debt to equity ratio ________ the industry average will ________ future financing flexibility by financing with equity at the next opportunity but doing so may sacrifice earnings per share.

A)is less than; maximize
B)exceeds; minimize
C)exceeds,maximize
D)None of the above.

Question 13

Which of the following statements is NOT true?

A)If new equity shares are issued at a fair price then the existing shareholders should not suffer a negative impact.
B)Issuing equity automatically hurts existing shareholders.
C)If a firm takes on a positive NPV project financed with new equity,existing shareholders will benefit.
D)The cash flows from a new project should cover the return on new shares issued to pay for the project if the IRR exceeds the required rate of return.

Question 14

Financial managers should consider taking ________ financial risk when operating risk is high,but may consider taking ________ financial risk when operating risk is low.

A)less; less
B)less; more
C)more; more
D)more; less

Question 15

________ and operating risk are one in the same and are reflected in the projected variability of the earnings of the firm regardless of how the firm is financed.

A)Business risk
B)Financial risk
C)Exchange rate risk
D)Risk of equity

Question 16

If a firm takes on ________ it may be downgraded by rating agencies,resulting in ________ interest payments.

A)too much incremental debt; lower
B)too much incremental debt; higher
C)too little incremental debt; lower
D)too little incremental debt; higher

Question 17

Which of the following statements is NOT true?

A)Valuing stock by using a P/E multiple at least attempts to reflect the anticipated growth in earnings.
B)Valuing stock by using a P/E multiple at least attempts to reflect the uncertainty associated with the earnings.
C)Valuing stock by using a P/E multiple is an easy and intuitive methodology for an initial valuation technique.
D)All of the above are true.

Question 18

________ variability in revenues and a/an ________ operating margin mean higher business risk.

A)Greater; increasing
B)Lesser; declining
C)Greater; declining
D)None of the above.

Question 19

Pinnacle Financial Management projects that earnings per share for Valley Imports Inc.will increase from the current $1.75 per share to $2.00 next year.If Pinnacle recommends a P/E ratio of 12.5 for Valley Imports,what is the recommended forward looking price for the firm?

A)$21.88 per share
B)$25.00 per share
C)$23.44 per share
D)$6.25 per share

Question 20

Optimal capital structure,or debt capacity,is the debt-equity mix that:

A)puts the firm at the EBIT-EPS breakeven point.
B)maximizes shareholder control.
C)minimizes the amount of debt held by the firm.
D)maximizes the value of the firm's common equity.

Question 21

Based solely on risk considerations,a mixed debt and equity firm does not have to worry about any financial obligations related to creditors.

Question 22

Define Dual Class Shares of stock.Why would a firm consider issuing dual classes of stock? Are dual shares common in the United States? In what type of industry are they found?

Question 23

Issuing debt rather than equity will automatically increase a firm's EPS and EBIT.

Question 24

Equity provides more financial flexibility for a firm than debt.

Question 25

If bond and stock markets are efficient,then the timing of when to issue debt or equity should not matter.

Question 26

Why is the price/earnings ratio a common and popular technique for evaluating stocks? Why do fast growing firms have higher P/E ratios? What is a long-run average P/E ratio for larger publicly traded firms in the United States? What are some limitations to using this technique to evaluate stock prices?

Question 27

Optimal capital structure "first" criteria suggests that shareholder control should be ________ and that the best way to obtain that is with ________ levels of debt and ________ levels of equity.

A)high; high; low
B)low; low,high
C)low; high; low
D)high; low; high

Question 28

Creative Industries Inc.is looking to finance a new project with either debt or equity.The firm anticipates that its breakeven EPS-EBIT point is when EBIT reaches $3,000,000.If the projected EBIT are $3,500,000 for the foreseeable future,then to maximize EPS the firm should issue:

A)equity.
B)debt
C)preferred shares.
D)a dual class of equity.

Question 29

Optimal capital structure "first" criteria suggests that flexibility should be ________ and that the best way to obtain that is with ________ levels of debt and ________ levels of equity.

A)high; high; low
B)low; low; high
C)high; low; high
D)low; high; low

Question 30

If management perceives the current market equity value of their shares to be OVER valued,then management should:

A)issue new shares later after stock prices have come down so as not to further increase the price dilution found when issuing shares.
B)issue new shares now to take advantage of the market mispricing,but only if they believe the market is at least momentarily inefficient.
C)wait to issue until prices are UNDER valued so that there option values increase more rapidly.However,they would only do this if they have the best interest of shareholders in mind.
D)recommend that existing shareholders buy more shares at current market prices because they are so valuable.

Question 31

When a firm issues debt instead of equity to finance a new project,

A)bondholders take on additional voting control as a result of their ownership of the debt instruments.
B)shareholders share voting rights with bondholders.
C)shareholders maintain voting control of the company but may face additional restrictive covenants found in the bond indenture.
D)shareholders generally retain their rights to dividends owed before they are responsible for making newly contracted interest payments to bondholders.

Question 32

For an all-equity firm,the cost of equity is equal to the overall cost of capital.

Question 33

Explain why the author uses the following formula to explain the amount of money a firm needs to repay an outstanding principal balance.Support your answer with n example that shows how much in EBT a firm in a 30% tax bracket would require to repay $1,000 in principal.
Before-tax cost of debt repayment = (principal repayment)/ (1 - tax rate)

Question 34

The interest coverage ratio is equal to:

A)EBIT/interest.
B)interest/EBIT.
C)(debt + equity)/EBIT.
D)EBIT * interest.

Question 35

Optimal Capital Structure maximizes the firm's overall cost of capital.

Question 36

Ultimate ________ of a firm depends on who owns the major portion of the common shares and thus controls the direction of the firm through voting power.

A)managerial control
B)creditor control
C)shareholder control
D)government control

Question 37

Issuing equity automatically hurts existing shareholders.

Question 38

A point to keep in mind is that financial managers should consider taking less financial risk when operating risk is high,but may consider taking more financial risk when operating risk is low.

Question 39

Depending on the firm's current capital structure,as well as the capital structure following today's financing decision,the firm may be implicitly deciding on future financing as well.

Question 40

Consider a corporation that was originally 100% family owned.Which of the following statements is TRUE?

A)Each time the company issues new shares family control may be reduced.
B)If the family owns more than 50% of the shares they still have effective control of the firm.
C)Even if the family owns less than 50% of the outstanding shares they may still retain effective control of the firm,especially if there are no other large shareholders.
D)All of the above are true.

Question 41

________ refers to how a firm behaves when it feels it is protected from risk compared with how it would behave if it was fully exposed to risk.

A)Moral hazard
B)Asymmetric engineering
C)Systematic risk transfer
D)Beta blocking

Question 42

Plastic Products Inc.has a levered beta of 1.30,a debt-equity ratio of 0.50,and a tax rate of 40%.What is the value of the firm's unlevered beta?

A)0.70
B)1.00
C)1.30
D)1.60

Question 43

Cranston Cranks Inc.is a manufacturer of high quality bicycle components.The firm's levered beta is equal to 1.20.When added to a well-diversified portfolio that matches the market beta,the firm would ________ the portfolio beta.

A)increase
B)decrease
C)not affect
D)There is insufficient information to answer this question.

Question 44

White's World Wide Delivery Inc.has an unlevered beta = 1.25,a debt-equity ratio of 0.30,a tax rate of 0.20,and a levered beta = 1.55.If the firm increased the debt-equity ratio to 50%,what would be the impact on the levered beta?

A)Increase to a value of 1.75
B)No change in value.
C)Decrease to a value of 1.00
D)There is insufficient information to make a levered beta estimate.

Question 45

Optimal capital structure "first" criteria suggests that the impact on EPS should be ________ and that the best way to obtain that is with ________ levels of debt and ________ levels of equity.

A)high; low; high
B)low; high; low
C)high; high; low
D)low; low; high

Question 46

Which of the following does your author suggest is NOT a lesson learned from the the Great Recession of 2007 -2009?

A)Individuals and firms that took on too much debt suffered dramatically.
B)Firms and individuals that relied too heavily on short-term debt to finance long-term assets suffered when financial liquidity dried up.
C)The crisis started in and was mostly limited to the collapse of the U.S.housing market.
D)All of the above.

Question 47

In a recent comprehensive survey,corporate CFOs were asked why they did NOT use more equity in their capital structure.Which of the following choices was NOT cited by 50% or more of the CFOs responding to the survey?

A)EPS dilution
B)Concerns that equity was not the least expensive form of financing
C)Concerns that share price might decline
D)All of the above were cited by at least 50% of the responding CFOs.

Question 48

According to an international survey of CFOs of publicly traded firms,which of the following was NOT considered to be an important factor in determining the optimal amounts of debt in a firm's capital structure?

A)Credit ratings
B)The tax shield
C)The ability to maintain dividends
D)All of the above were considered to be important.

Question 49

Managers need to take into account a number of perspectives when assessing the "first" criteria.The ________ focuses primarily on balancing the tax shield benefits with financial distress costs.

A)competitive perspective
B)internal perspective
C)investor perspective
D)creditor perspective

Question 50

Big City Lumber Inc.has a levered beta of 1.70,a debt-equity ratio of 0.40,and a tax rate of 25%.What is the value of the firm's unlevered beta?

A)0.78
B)1.00
C)1.31
D)1.70

Question 51

It is typically easy to determine a precise mix of optimal debt and equity.

Question 52

The benefit of the ________ approach to firm valuation is that it allows us to segregate the value of a firm if it is all-equity,and the value of the tax benefits of debt.

A)capital structure
B)internal rate of return
C)net present value
D)adjusted present value

Question 53

Which of the following lessons from the Great Recession is NOT true?

A)The financial crisis really drove home the point that capital structure DOES matter in that firms with too much debt suffered greatly.
B)Firms that relied too much on short-term financing were severely affected by the global liquidity crisis.
C)Capital markets are indeed almost perfect.
D)All off the above are true.

Question 54

Managers need to take into account a number of perspectives when assessing the "first" criteria.The ________ focuses on the vision and strategic direction of the firm and how the nature and timing of projected cash outflows influence that strategy and vision.

A)competitive perspective
B)internal perspective
C)investor perspective
D)creditor perspective

Question 55

________ took place in financial markets during the Great Recession because large financial institutions took excess risks to realize abnormal positive returns in the housing market while they were simultaneously protected from abnormal losses by being "too-big-to-fail."

A)Disintermediation
B)Deregulation
C)Corporate tax reform
D)Moral hazard

Question 56

Which of the following did NOT contribute to the Great Recession of 2007-2009?

A)The collapse of the U.S.housing market.
B)The tremendous growth of the sub-prime lending market.
C)The liquidity crisis that resulted when banks became unwilling to lend into a collapsing market.
D)All of the above contributed to the Great Recession.

Question 57

If a firm has a positive debt-equity ratio,and a positive tax rate,then then levered beta for the firm must be ________ the unlevered beta for the firm.

A)less than
B)greater than
C)equal to
D)Can not definitively answer this question.

Question 58

Optimal capital structure "first" criteria suggests that risk should be ________ and that the best way to obtain that is with ________ levels of debt and ________ levels of equity.

A)high; high; low
B)low; high; low
C)low; low; high
D)high; low; high

Question 59

Managers need to take into account a number of perspectives when assessing the "first" criteria.The ________ focuses on comparing the firms capital structure with those of industry competitors.

A)competitive perspective
B)internal perspective
C)investor perspective
D)creditor perspective

Question 60

If a firm has an unlevered beta equal to 1.0 a debt-equity ratio of .50 and a tax rate of .30,calculate the value of the firm's levered beta.

A)0.65
B)1.00
C)1.35
D)1.73

Question 61

Vegan Foods Inc.has a current capital structure of 30% debt,70% equity,and are in a 40% tax bracket.However,after speaking with their investment bankers they have decided to increase their debt to 40% of total capital.Some of the firm's managers are concerned that there may an increase in risk for stockholders due to the increased financial obligations resulting from the increased debt load.Currently,the levered beta for the firm is 1.20.
Use your knowledge of levered and unlevered betas to estimate the new levered beta for existing shareholders.

Question 62

If a firm is in a zero tax bracket,then the levered and unlevered betas will be identical no matter what the debt-equity ratio.

Question 63

Larger firms and those with better credit ratings tend to also have less strict capital structure targets.

Question 64

To maximize flexibility in capital structure,it is ideal to have high levels of debt.

Question 65

EBIT break-even analysis indicates the projected EBIT level such that EPS is identical under two different debt-equity mix scenarios.

Question 66

Define moral hazard in a financial sense.What must be present for moral hazard to arise? Describe the moral hazard that occurred with the Great Recession of 2007 - 2009.How could this type of behavior be avoided in the future?

Question 67

Published betas are typically levered betas not unlevered betas if the firm in question has debt in its capital structure.

Question 68

If a firm has a positive debt-equity ratio,then the unlevered beta is greater than the levered beta.

Question 69

Optimal capital structure,or debt capacity,is the debt-equity mix that minimizes the cost of the firm's debt.

Question 70

The Global Financial Crisis or Great Recession is generally recognized as the greatest financial crisis since the Great Depression of the 1930s.