Question 1

What type of security is used to purchase a target company in a leveraged buy-out?

Accepted Answer

Leveraged buy-outs typically involve the acquisition of the target company using a significant amount of debt financing, which is secured by the assets of the target company. This allows the acquiring company to use the assets of the target company as collateral to obtain financing, while also potentially reducing the amount of equity required to complete the transaction. Common stock, dividends, and retained earnings are not typically used as security in leveraged buy-outs.

Question 2

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?

Accepted Answer

To determine which financing option results in a higher stock price, we need to calculate the earnings per share (EPS) under each alternative and then apply the respective P/E ratios.**Debt Financing:**- EBIT: $12.5 million- Interest on new debt: $8 million * 4% = $0.32 million- Total interest (existing + new): $0.9 million (existing $15 million * 6%) + $0.32 million = $1.22 million- Earnings before tax (EBT): $12.5 million - $1.22 million = $11.28 million- Taxes (40%): $11.28 million * 40% = $4.512 million- Net income: $11.28 million - $4.512 million = $6.768 million- Shares outstanding: 2 million (no new equity issued)- EPS (Debt): $6.768 million / 2 million shares = $3.384- Stock price (Debt): $3.384 * 21 (P/E ratio) = $71.064**Equity Financing:**- EBIT: $12.5 million- Interest (no change in debt): $0.9 million- Earnings before tax (EBT): $12.5 million - $0.9 million = $11.6 million- Taxes (40%): $11.6 million * 40% = $4.64 million- Net income: $11.6 million - $4.64 million = $6.96 million- Shares outstanding: 2 million + 0.15 million (new equity issued) = 2.15 million- EPS (Equity): $6.96 million / 2.15 million shares = $3.237- Stock price (Equity): $3.237 * 22 (P/E ratio) = $71.214The equity financing alternative produces a slightly higher stock price, making option C the correct choice.

Question 3

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.

Accepted Answer

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Question 4

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?

Accepted Answer

We need to use the formula for z-score: (X - μ) / σ, where X is the value we are interested in (in this case, the amount of free cash flows that would cause Sitco to run out of cash), μ is the mean of the free cash flows, and σ is the standard deviation of the free cash flows. Since we want to find the probability of running out of cash, we want to find the area under the curve to the left of the z-score corresponding to that value of X.

First, we need to find the z-score corresponding to the value of X that would cause Sitco to run out of cash. This can be calculated as (X - μ) / σ = (0 - 47) / 31 = -1.5161. Using a standard normal distribution table, we can find that the area to the left of this z-score is 0.0630.

However, we need to adjust this probability because we are interested in the probability of running out of cash, which means we want to find the probability that free cash flows will be less than or equal to zero. To make this adjustment, we need to subtract the probability of free cash flows being between zero and the mean (which we can find using the same table and the z-score corresponding to zero: (0 - 47) / 31 = -1.5161), and then divide by the probability of free cash flows being less than the mean. Doing this gives us:

P(X ≤ 0) = [P(X ≤ 0) - P(μ ≤ X ≤ 0)] / P(X < μ)
= [0.0630 - 0.4708] / 0.5
= 0.0944

Finally, we can convert this to a percentage by multiplying by 100, giving us 2.87%. Therefore, the answer is D.

Question 5

A change in EBIT is magnified into a larger change in EPS. This means that financial leverage is using ____ as its fulcrum.

Accepted Answer

Financial leverage is using fixed costs as its fulcrum, meaning that a change in EBIT (which is the amount of operating income after deducting operating expenses, including fixed costs) can have a magnified effect on EPS (earnings per share) due to the fixed costs. This is because fixed costs do not change with the level of output, so any increase in revenue will result in a greater increase in profit. On the other hand, variable costs would not magnify the effect on EPS as they change proportionally with the level of output, while short-term costs and retained earnings are not directly related to financial leverage.

Question 6

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% long-term bonds will be sold, and under the equity financing alternative the firm would sell 500,000 shares of common stock. The P/E under the debt alternative would be 15, and the P/E under the equity alternative would be 16. The firm's marginal tax rate is 40%. Which alternative would produce the higher stock price?

Accepted Answer

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Question 7

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?

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Question 8

Dippity Doodle Noodle Makers has a capital structure that consists of 2.0 million shares outstanding and $2.0 million of debt at 8% interest. The company is planning a major plant expansion and 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?

Accepted Answer

To calculate the indifference point, we need to find the point at which both finance options have the same EPS, which can be calculated as:
EBIT – interest / number of shares
For Option 1:
EBIT –0.08($2,000,000+$1,000,000) / 2,010,000 = EPS
For Option 2:
EBIT –0.08($2,000,000) / 2,030,000 = EPS
Setting the two EPS equations equal to each other and solving for EBIT gives us an indifference point of $9,250,000.
Since the expected EBIT is $10,000,000, Option 1 would result in a higher EPS and therefore would be the better choice.

Question 9

What are the effects of leverage on shareholder wealth and the cost of capital?

Accepted Answer

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Question 10

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%. 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%, 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?

Accepted Answer

To find the EBIT indifference point, we need to set the cost of debt financing equal to the cost of equity financing. This can be done with the following formula:

($22 million)(0.125) = EBIT - ($15 million)(D/E)(0.11)(1 - 0.4)
where D/E represents the debt-to-equity ratio after the financing option is chosen.

If CD issues new common stock, the debt-to-equity ratio will remain the same, so we can solve for the EBIT indifference point:

($22 million)(0.125) = EBIT - ($15 million)($80 million/ $120 million)(0.11)(0.6)
EBIT = $77.2 million

If CD issues long-term debt, the debt-to-equity ratio will change, so we need to solve for the new debt-to-equity ratio and use that in the formula:

($22 million)(0.125) = EBIT - ($120 million + $22 million)(D/E)/(1 + D/E)(0.11)(0.6)
Solving for D/E yields 0.366, so the debt would be $102.96 million and the equity would be $97.04 million. Using these values in the formula gives:

($22 million)(0.125) = EBIT - ($102.96 million/$97.04 million)(0.11)(0.6)
EBIT = $71.5 million

Comparing these results shows that issuing new common stock is the better option, as the EBIT indifference point is higher.

Question 11

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.

Accepted Answer

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Question 12

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, assuming the marginal tax rate is 40%.

Accepted Answer

The answer of Ipsy Dipsy Preschools Inc. has a capital...

Question 13

In using Nestlé Corporation as a model, when a subsidiary is first formed, about one-half of the financing needed to acquire fixed assets comes from ____.

Accepted Answer

When a subsidiary is first formed, about one-half of the financing needed to acquire fixed assets comes from equity from the parent company. This is because the parent company is usually responsible for funding and setting up the subsidiary, and they do so through investing their own equity.

Question 14

In evaluating a firm's degree of financial leverage, financial risk is ____ with an increase in DFL.

Accepted Answer

The Degree of Financial Leverage (DFL) measures the sensitivity of a company's earnings per share (EPS) to changes in its operating income, and is calculated as % change in EPS divided by % change in operating income. A higher DFL indicates that a company has a higher level of financial leverage, meaning that it relies more on debt financing to fund its operations. As a result, an increase in DFL is associated with increased financial risk, as the company's profits and earnings per share are more sensitive to changes in operating income or interest expenses.

Question 15

Some companies use debt or preferred stock financing instead of common stock financing. The purpose is to ____.

Accepted Answer

By using debt or preferred stock financing, companies are able to raise money without diluting their ownership or control of the company. Unlike common stock, debt and preferred stock do not give investors voting rights or the ability to influence major decisions. This allows the company to retain control while still raising capital.

Question 16

In considering EBIT-EPS analysis, which of the following statements is (are) correct?

Accepted Answer

In EBIT-EPS analysis, the indifference point is the level of earnings before interest and taxes (EBIT) at which the earnings per share (EPS) is the same for two different financing options, such as debt and equity.

A) If the expected earnings are above the indifference point, it means that the EBIT is higher than the level at which the EPS is the same for both options. Therefore, the debt option is preferred because it will result in higher EPS due to the interest tax shield.

B) If the expected earnings are below the indifference point, it means that the EBIT is lower than the level at which the EPS is the same for both options. Therefore, the equity option is preferred because it will result in higher EPS since there is no interest expense to be paid.

Thus, both statements are correct.

Question 17

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?

Accepted Answer

To find the probability that River Rafts will have negative earnings, we first calculate the earnings before taxes (EBT) by subtracting the interest payments from the EBIT. The expected EBT is $8.3 million - $1.9 million = $6.4 million. The standard deviation remains the same, $5.1 million. We are looking for the probability that EBT is less than $0, which means we need to find the Z-score for $0. The Z-score is calculated as (X - mean) / standard deviation = ($0 - $6.4 million) / $5.1 million = -1.2549. Looking up this Z-score in a standard normal distribution table or using a calculator, we find the probability corresponding to a Z-score of -1.2549, which is approximately 10.47%. This means there's a 10.47% chance that River Rafts will have negative earnings.

Question 18

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.)

Accepted Answer

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Question 19

In evaluating degree of operating leverage , it is best that the firm's DOL is ____.

Accepted Answer

A DOL lower than 1 indicates that the firm has low fixed costs and high variable costs, meaning that small changes in sales will not have a significant impact on profits. A DOL higher than 1 indicates that the firm has high fixed costs and low variable costs, meaning that small changes in sales will have a significant impact on profits. Therefore, having a DOL lower than 1 is preferable as it means that the firm is less risky and can withstand fluctuations in sales without experiencing significant changes in profits.

Question 20

There are three categories of costs: fixed costs, variable costs and semi-variable costs. Which of the following is a semi-variable cost?

Accepted Answer

The answer of There are three categories of costs: fixed...

Quiz 17: Capital Structure Management in Practice