Question 1

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

Accepted Answer

The degree of total leverage is a measure that combines the effects of operating leverage (which is related to fixed operating costs) and financial leverage (which is related to fixed financial costs). It is calculated by multiplying the degree of operating leverage by the degree of financial leverage.

Question 2

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

Accepted Answer

According to the MM model, the cost of equity is a linear function of the proportion of debt in the capital structure. The more debt a company has, the higher the risk for equity investors, causing them to require a higher return on their investment. Therefore, as the proportion of debt increases, the cost of equity increases too.

Question 3

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?

Accepted Answer

The answer of Yang Centers wants to report at least...

Question 4

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?

Accepted Answer

The correct answer is D.The firm's earnings per share can be calculated as follows:EBIT = $2.5 millionInterest expense = 0.4 * $22 million * 0.11 = $0.968 millionTaxable income = $2.5 million - $0.968 million = $1.532 millionTaxes = $1.532 million * 0.37 = $0.567 millionNet income = $1.532 million - $0.567 million = $0.965 millionEarnings per share = $0.965 million / (22 million / $20) = $0.88

Question 5

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

Accepted Answer

The original Modigliani and Miller Model assumes that there are no taxes, which means that income taxes are not considered at all, rather than being fixed.

Question 6

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.

Accepted Answer

According to the Modigliani-Miller (MM) model of capital structure, while the present value of the tax shield on debt can increase firm value, this benefit is offset by potential bankruptcy costs. This interplay suggests that there might be an optimal capital structure balancing these factors, although the original MM proposition without taxes asserts capital structure irrelevance.

Question 7

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

Accepted Answer

The Modigliani and Miller Model, when modified for taxes and bankruptcy costs, suggests that initially, adding debt can increase the value of a firm (due to the tax shield on interest payments), but beyond a certain point, the costs of financial distress and bankruptcy outweigh the benefits, making the relationship between debt levels and stock price non-linear. Thus, statements b and c correctly reflect this nuanced view.

Question 8

In the MM model, the risk of bankruptcy:

Accepted Answer

According to the MM model, financial leverage can have a positive effect on firm value by reducing taxes paid and increasing earnings available to shareholders. However, as the risk of bankruptcy increases, the cost of debt also increases, offsetting the benefits of financial leverage. Therefore, the positive effect on firm value is reduced or eliminated as bankruptcy risk increases.

Question 9

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

Accepted Answer

The impact of operating leverage and financial leverage on a firm's EPS is multiplicative. Operating leverage refers to the extent to which fixed costs are present in a company's cost structure, while financial leverage refers to the extent to which a company uses debt financing. When a company has high levels of fixed costs and uses debt financing, small changes in sales can lead to much larger changes in EPS. This multiplicative effect can be seen in the formula for EPS: EPS = (Sales - Variable Costs - Fixed Costs - Interest Expense) / Shares Outstanding. As a result, the combined impact of operating and financial leverage on EPS is multiplicative.

Question 10

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.

Accepted Answer

The answer of Assume the following facts about a company:...

Question 11

The degree of total leverage is equal to the degree of operating leverage ____ the degree of financial leverage.

Accepted Answer

The degree of total leverage is calculated by multiplying the degree of operating leverage with the degree of financial leverage. Therefore, the correct choice is multiplication (C).

Question 12

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

Accepted Answer

All of the above options are accepted wisdom regarding the optimal capital structure. Option A suggests that the optimal capital structure for most firms falls between 30% and 50% debt. Option B suggests that 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. Finally, option C suggests that debt levels above 60% create excessive risk and should be avoided.

Question 13

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)?

Accepted Answer

The expected change in EBIT is calculated by multiplying the percentage change in sales by the degree of operating leverage (DOL). Therefore, a 15% change in sales with a DOL of 2.0 results in a 30% change in EBIT (15% * 2.0 = 30%).

Question 14

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

Accepted Answer

Operating leverage amplifies relative changes in sales revenue into larger relative changes in EBIT.

Question 15

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.

Accepted Answer

The degree of operating leverage (DOL) measures the percentage change in EBIT for a given percentage change in sales. With a DOL of 2.5, an 8% increase in EBIT results from a 3.2% increase in sales (8% / 2.5 = 3.2%).

Question 16

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

Accepted Answer

The MM model suggests that the optimal capital structure is the mix of debt and equity that minimizes the cost of capital. This involves finding the point where the cost of equity and the cost of debt intersect to produce the lowest overall cost of capital. Therefore, the optimal capital structure is the answer.

Question 17

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

Accepted Answer

When MM theory recognizes taxes and bankruptcy costs, the firm value initially increases as financial leverage rises because the tax shield from interest payments outweighs the increase in bankruptcy costs. However, as financial leverage continues to rise, the increase in bankruptcy costs begins to outweigh the tax shield, causing the firm value to decrease.

Question 18

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

Accepted Answer

According to Modigliani and Miller (MM), an increase in financial leverage can increase the value of the firm in a world with taxes if interest is tax-deductible. This is because the interest paid on debt is tax-deductible, which reduces the firm's taxable income and hence reduces the amount of taxes paid. This increase in cash flows to the firm increases its value. However, if interest is not tax-deductible, then an increase in financial leverage will not increase the value of the firm. In a world without taxes, an increase in financial leverage will also not increase the value of the firm as bankruptcy costs are ignored.

Question 19

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?

Accepted Answer

The answer of Yang Centers has a book value of...

Question 20

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

Accepted Answer

The degree of total leverage is the product of the degree of financial leverage and the degree of operating leverage. The degree of financial leverage measures the sensitivity of earnings per share to changes in EBIT, while the degree of operating leverage measures the sensitivity of EBIT to changes in sales. Multiplying these two measures gives us the overall sensitivity of earnings per share to changes in sales, or the degree of total leverage.

Quiz 14: Capital Structure and Leverage

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