Question 1

Match between columns
                        Premises: Operating leverage

Accepted Answer

The Answer of Price minus variable cost as a percent is...

Question 2

The use of cheaper debt by a firm will decrease the cost of equity because of the decreased risk as the weighted average cost of capital remains unchanged.

Accepted Answer

The use of cheaper debt by a firm may decrease the cost of debt, but it will not necessarily decrease the cost of equity. In fact, the cost of equity may increase if investors perceive that the increased debt increases the risk of the firm. The weighted average cost of capital may change depending on the proportion of debt and equity used by the firm.

Question 3

Match between columns
                        Premises: Financial leverage

Accepted Answer

The Answer of Price minus variable cost as a percent is...

Question 4

Match between columns
                        Premises: Degree of total leverage

Accepted Answer

The Answer of Amplifies business risk. and Creates financial risk. is...

Question 5

Match between columns
                        Premises: Contribution margin

Accepted Answer

The Answer of Creates financial risk. and Price minus variable is...

Question 6

Alasco Inc.'s 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%. Revenues are $32.2 million. Compute Alasco's degree of total leverage (DTL).

Accepted Answer

The answer of Alasco Inc.'s fixed operating costs are $20.8...

Question 7

The U.S. tax system favors a firm's use of debt because interest is tax deductible.

Accepted Answer

Interest payments on debt are usually tax-deductible expenses for firms, which makes borrowing more attractive than raising equity capital. This preference for debt financing creates a tax advantage for firms that use debt, leading to a bias in favor of debt financing over equity financing in the U.S. tax system.

Question 8

Operating leverage increases as the proportion of __________________ increases. ​

Accepted Answer

Operating leverage is the degree to which a company uses fixed costs in its operations. Therefore, as the proportion of fixed costs increases, operating leverage also increases. This is because a higher proportion of fixed costs means that changes in revenue will have a greater impact on the company's profits. In contrast, a higher proportion of variable costs means that changes in revenue will have a smaller impact on profits because the variable costs will also increase or decrease with revenue. Therefore, option B - Fixed costs - is the correct answer.

Question 9

A firm with a capital structure with a large proportion of fixed costs will have a higher degree of operating leverage , while a company with a large amount of variable costs will have a lower degree of operating leverage.

Accepted Answer

This statement is true. Operating leverage measures how much of a company's costs are fixed vs. variable, and a higher proportion of fixed costs means that a company's profits will be more sensitive to changes in revenue. Conversely, a higher proportion of variable costs means that a company's profits will be less sensitive to changes in revenue.

Question 10

Leverage adds variability to financial performance when operating results changes which means performance is __________________ with more leverage. ​ ​

Accepted Answer

Leverage amplifies the impact of changes in operating results, making it riskier. This is because with more debt, a company has fixed interest payments to make regardless of its operating performance. If operating results decline, the company still has to make those interest payments, which can lead to financial distress. Conversely, if operating results improve, leverage can amplify the positive impact on earnings and financial performance.

Question 11

Modgliani and Miller's mathematical model included a number of restrictions on the behavior of firms and individuals that made the model not very realistic.   Those restrictions included: ​

Accepted Answer

Modigliani and Miller's model assumed that there were no income taxes (A), that securities traded in perfectly efficient capital markets with no transactions costs (B), and that investors and firms could borrow as much as they wanted at the same rate (C). These assumptions made the model simpler and easier to work with mathematically, but they also made it less realistic.

Question 12

The EBIT-EPS analysis provides a means for managers to quantify and analyze the trade-off between results and risk involved by moving from various levels of leverage.

Accepted Answer

This statement is true. The EBIT-EPS analysis is a financial tool that helps managers understand the impact of changing levels of leverage (debt) on a company's earnings per share (EPS) and earnings before interest and taxes (EBIT). It allows managers to evaluate different capital structure options and determine the optimal level of debt financing that balances the benefits of increased earnings with the risks associated with higher debt levels.

Question 13

Hamming & Heim Corp's capital of $3,000,000 is currently 100% equity. For the coming year, they are forecasting that earnings before interest and tax (EBIT)will be $1,240,000. The firm's stock is selling at its book value of $12 per share. 
Hamming & Heim is considering restructuring capital by buying back its own stock with cash raised by issuing debt until it reaches a capital structure that's 40% debt. The firm will pay 10% interest on any debt issued for this purpose. Assume there is no change in EBIT as a result of the capital structure change and that the tax rate is 40%. 
a. How many shares of stock does Hamming & Heim need to repurchase in order to achieve the target capital structure of 40% debt and 60% equity? 
b. What is Hamming & Heim's Degree of Financial Leverage (DFL)after implementing the refinancing plan? (round to the nearest two decimal places)
c. What was Hamming & Heim's Return on Capital Employed (ROCE)before implementing the refinancing plan? 
d. Will the restructuring improve the firm's ROE and EPS performance?

Accepted Answer

The answer of Hamming & Heim Corp's capital of $3,000,000...

Question 14

Managers seeking an optimal capital structure face a trade-off between ______________ saving benefits from increased _____________________ and increasing risk. ​ ​

Accepted Answer

Managers seeking an optimal capital structure have to consider the trade-off between tax-saving benefits from increased debt and increasing risk. While increasing debt can lead to tax shields and lower cost of capital, too much debt can increase the risk of financial distress and bankruptcy. Therefore, a balance needs to be struck to find the optimal capital structure that maximizes tax benefits while minimizing risk. In this case, option B is the best choice because it explicitly mentions the trade-off between tax and debt.

Question 15

General guidelines for managers regarding capital structure include all of the following except; ​

Accepted Answer

Option A is incorrect as healthy profits and little debt may indicate that the firm has a strong capital structure, but there could still be potential benefits to taking on additional debt. The other options, B and C, are both generally accepted guidelines for managers regarding capital structure.

Question 16

Typically, firms with a higher degree of operating leverage have an increased risk of failure due to a high level of debt.

Accepted Answer

Operating leverage refers to the amount of fixed costs that a firm has relative to its variable costs. When a firm has a higher degree of operating leverage, it means that a larger percentage of its costs are fixed rather than variable. This can lead to greater profitability when sales are high, but it also means that when sales are low, the firm still has to pay those fixed costs, which can put it at risk of defaulting on its debt obligations. Therefore, firms with a high degree of operating leverage are generally considered to have an increased risk of failure due to their higher level of debt.

Question 17

Assume the following selected financial information about a firm that is about to restructure capital by exchanging equity for debt: 
  a. If the firm operates in the world of the Modigliani-Miller model with taxes but without bankruptcy costs what would be the market value of its equity after the restructuring? 
b. By how much would the firm's total value and therefore shareholder wealth increase as a result of the swap? Explain. 
c. Would we be able to answer the questions in part a and b precisely in the MM model with taxes and bankruptcy costs? Why?

Accepted Answer

The answer of Assume the following selected financial information about...

Question 18

Southern Inc. has EBIT of $3,500,000, and total capital of $20,000,000 that is 15% debt. There are 1,700,000 shares of stock outstanding which sell at book value. The firm pays 10% interest on its debt and is subject to a combined state and federal tax rate of 40%. Southern plans to restructure its capital to 60% debt. 
a. Make a simple calculation that indicates whether at the current level of profitability more debt will enhance results? Draw a conclusion in fifteen words or less. 
b. Calculate EPS, and DFL at the current and proposed structures using the following worksheet: 
($000 except for EPS, DFL and Shares)
  c. Use your results to point out two conflicting influences the change will have on stock price.

Accepted Answer

The answer of Southern Inc. has EBIT of $3,500,000, and...

Quiz 14: Capital Structure and Leverage

Match the following:

The use of cheaper debt by a firm will decrease the cost of equity because of the decreased risk as the weighted average cost of capital remains unchanged.

Match the following:

Match the following:

Match the following:

Alasco Inc.'s 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%. Revenues are $32.2 million. Compute Alasco's degree of total leverage (DTL).

The U.S. tax system favors a firm's use of debt because interest is tax deductible.

Operating leverage increases as the proportion of __________________ increases.

A firm with a capital structure with a large proportion of fixed costs will have a higher degree of operating leverage , while a company with a large amount of variable costs will have a lower degree of operating leverage.

Leverage adds variability to financial performance when operating results changes which means performance is __________________ with more leverage.

Modgliani and Miller's mathematical model included a number of restrictions on the behavior of firms and individuals that made the model not very realistic. Those restrictions included:

The EBIT-EPS analysis provides a means for managers to quantify and analyze the trade-off between results and risk involved by moving from various levels of leverage.

Managers seeking an optimal capital structure face a trade-off between saving benefits from increased _______ and increasing risk.

General guidelines for managers regarding capital structure include all of the following except;

Typically, firms with a higher degree of operating leverage have an increased risk of failure due to a high level of debt.

Quiz 14: Capital Structure and Leverage

Match the following:

The use of cheaper debt by a firm will decrease the cost of equity because of the decreased risk as the weighted average cost of capital remains unchanged.

Match the following:

Match the following:

Match the following:

Alasco Inc.'s 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%. Revenues are $32.2 million. Compute Alasco's degree of total leverage (DTL).

The U.S. tax system favors a firm's use of debt because interest is tax deductible.

Operating leverage increases as the proportion of __________________ increases. ​

A firm with a capital structure with a large proportion of fixed costs will have a higher degree of operating leverage , while a company with a large amount of variable costs will have a lower degree of operating leverage.

Leverage adds variability to financial performance when operating results changes which means performance is __________________ with more leverage. ​ ​

Modgliani and Miller's mathematical model included a number of restrictions on the behavior of firms and individuals that made the model not very realistic. Those restrictions included: ​

The EBIT-EPS analysis provides a means for managers to quantify and analyze the trade-off between results and risk involved by moving from various levels of leverage.

Managers seeking an optimal capital structure face a trade-off between ______________ saving benefits from increased _____________________ and increasing risk. ​ ​

General guidelines for managers regarding capital structure include all of the following except; ​

Typically, firms with a higher degree of operating leverage have an increased risk of failure due to a high level of debt.

Operating leverage increases as the proportion of __________________ increases.

Leverage adds variability to financial performance when operating results changes which means performance is __________________ with more leverage.

Modgliani and Miller's mathematical model included a number of restrictions on the behavior of firms and individuals that made the model not very realistic. Those restrictions included:

Managers seeking an optimal capital structure face a trade-off between saving benefits from increased _______ and increasing risk.

General guidelines for managers regarding capital structure include all of the following except;