Question 1

Assume the following selected financial information about a firm that is about to restructure capital by exchanging equity for debt:  What is the market value of the firm's equity after the restructuring according to the Modigliani-Miller model with taxes but without bankruptcy costs?

Accepted Answer

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

Question 2

Zahn Enterprises pays $3 million annually to its bondholders and $7.5 million annual to its stockholders. The required rates of return are 9 percent and 15 percent, respectively, by the bondholders and stockholders. What is the value of Zahn Enterprises?

Accepted Answer

The value of Zahn Enterprises can be calculated by dividing the annual payments to bondholders and stockholders by their respective required rates of return. For bondholders: $3 million / 9% = $33.33 million. For stockholders: $7.5 million / 15% = $50 million. Adding these values together gives $33.33 million + $50 million = $83.33 million.

Question 3

Dittmar Corp. is considering an operational change that will increase its DOL from 2.0 to 3.0. It will be funding this change with debt so that its DFL will increase from 1.2 to 1.5. Analysts believe that the overall change could increase sales by as much as 10% if it is successful, but could decrease sales by 6% if it is not successful. What is the range of possible changes in EPS based on this information?

Accepted Answer

The range of possible changes in EPS can be calculated using the Degree of Total Leverage (DTL), which is the product of the Degree of Operating Leverage (DOL) and the Degree of Financial Leverage (DFL). The initial DTL is 2.0 * 1.2 = 2.4, and the new DTL after the changes will be 3.0 * 1.5 = 4.5. The percentage change in EPS for a given percentage change in sales is equal to the percentage change in sales times the DTL. Therefore, for a 10% increase in sales, the increase in EPS would be 10% * 4.5 = 45%. For a 6% decrease in sales, the decrease in EPS would be 6% * 4.5 = 27%. Thus, the range of possible changes in EPS is a decrease of 27% to an increase of 45%.

Question 4

A firm's degree of financial leverage is 2 and the degree of operating leverage is 2.5. What is their degree of total leverage?

Accepted Answer

The formula for the degree of total leverage is DTL = DOL * DFL. 
DTL = 2.5 * 2 = 5.0. Thus, the answer is C.

Question 5

Financial risk is not directly associated with ____.

Accepted Answer

Financial risk is primarily associated with the way a company finances its operations, particularly through debt financing, rather than its operational performance. EBIT (Earnings Before Interest and Taxes) reflects a company's operational performance without considering how it is financed (i.e., the impact of debt), making it not directly associated with financial risk. In contrast, ROE (Return on Equity), EPS (Earnings Per Share), and net income can all be affected by the company's financial structure and thus are related to financial risk.

Question 6

Kermit's Hardware's (KH)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%. KH has 200,000 shares of common stock outstanding. The firm has revenues of $32.2 million and its marginal tax rate is 40%. Compute KH's degree of total leverage.

Accepted Answer

The degree of total leverage is calculated as follows:DTL = (1 + (1 - T) * (D/E)) / (1 - VC)where:DTL = degree of total leverageT = marginal tax rateD = debtE = equityVC = variable cost ratioIn this case, we have:T = 40%D = $10 millionE = $20.8 millionVC = 0.30Plugging these values into the formula, we get:DTL = (1 + (1 - 0.40) * (10 / 20.8)) / (1 - 0.30)DTL = (1 + 0.60 * 0.48) / 0.70DTL = 1.291 / 0.70DTL = 1.844Therefore, the degree of total leverage is 1.844, which is closest to choice A) 26.8.

Question 7

ROE can be converted to EPS by multiplying ROE by ____.

Accepted Answer

ROE (Return on Equity) can be converted to EPS (Earnings Per Share) by multiplying ROE by the ratio of equity to the number of shares. This is because EPS is derived from the earnings attributable to each share, which is essentially the return on equity distributed over all outstanding shares.

Question 8

A firm's degree of financial leverage is 2 and the degree of operating leverage is 2.5. An uncertain economic outlook could mean a 10% reduction in the current level of sales. The firm is considering an increase of its degree of financial leverage to 3 by issuing additional debt. The degree of total leverage suggests that the sales volatility could result in a decrease in EPS of as much as:

Accepted Answer

The degree of total leverage (DTL) is the product of the degree of operating leverage (DOL) and the degree of financial leverage (DFL). Initially, DTL = 2.5 * 2 = 5. If the firm increases its DFL to 3, then DTL = 2.5 * 3 = 7.5. A 10% decrease in sales with a DTL of 7.5 results in a 75% decrease in EPS.

Question 9

Assume the following selected financial information about a firm that is about to restructure capital by exchanging equity for debt:  Which of following would be true as a result of the restructuring according to the Modigliani-Miller model with taxes but without bankruptcy costs?

Accepted Answer

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

Question 10

Last year Alpine Growers experienced a 34% increase in earnings per share on 11% increase in sales. If management knows that Alpine's DOL is 1.5, what is its DFL?

Accepted Answer

DOL (Degree of Operating Leverage) = % Change in EPS ÷ % Change in Sales
1.5 = 34% ÷ 11%
% Change in EBIT = % Change in Sales x DOL = 11% x 1.5 = 16.5%
DFL (Degree of Financial Leverage) = % Change in EPS ÷ % Change in EBIT
DFL = 34% ÷ 16.5% = 2.06

Question 11

Business risk is associated with ____.

Accepted Answer

Business risk is the risk associated with the operating performance of a company, such as its ability to generate revenue and manage expenses. Leverage (A) and the level of equity (C) relate to financial risk, while the interest on debt (B) is a component of financial risk caused by the use of debt financing.

Question 12

A product has a contribution margin of 20% and sells for $100.00 per unit. Assuming fixed costs of $2 million and a goal to have an EBIT of $1 million, how many units of the product must be sold?

Accepted Answer

To find the number of units needed to achieve the desired EBIT, we use the formula: (Fixed Costs + Target EBIT) / Contribution Margin per Unit. The contribution margin per unit is 20% of $100, which is $20. Therefore, ($2,000,000 + $1,000,000) / $20 = 150,000 units.

Question 13

A firm's EPS increased 27% on a 12% increase in sales. At the same time its EBIT increased 8% what is the firm's DFL?

Accepted Answer

The Degree of Financial Leverage (DFL) is calculated as the percentage change in EPS divided by the percentage change in EBIT. Given that EPS increased by 27% and EBIT increased by 8%, DFL = 27% / 8% = 3.375, which rounds to 3.36, making option B correct.

Question 14

If a product has a contribution margin of 40% and has a price of $5.00 per unit, how many units must be sold to breakeven assuming a fixed cost of $800,000.00?

Accepted Answer

The answer of If a product has a contribution margin...

Question 15

If the DFL equals one, then ____.

Accepted Answer

A DFL of one means that financial risk does not impact ROE, so ROCE would equal ROE regardless of financial leverage. This does not affect EPS or business risk. Therefore, option A is correct.

Question 16

If a firm has no debt and EBIT increases by 10%, then one can expect ____.

Accepted Answer

If a firm has no debt, an increase in EBIT directly translates to an increase in net income by the same percentage, assuming taxes remain constant.

Question 17

Illinois Tool Company's (ITC)degree of total leverage (DTL)is 3.00 at a sales volume of $9 million. Determine ITC's percentage change in earnings per share (EPS)if forecasted sales increase by 20 percent to $10,800,000.

Accepted Answer

The degree of total leverage (DTL) is used to measure the sensitivity of the company's earnings per share (EPS) to a change in sales. The formula for calculating the percentage change in EPS given a percentage change in sales is: Percentage Change in EPS = DTL × Percentage Change in Sales. Given that the DTL is 3.00 and the forecasted sales increase is 20 percent, the calculation would be: Percentage Change in EPS = 3.00 × 20% = 60%.

Question 18

A firm performs capital restructuring in order to ____.

Accepted Answer

The purpose of capital restructuring is to reach an optimal capital structure, which balances the use of debt and equity in order to maximize the value of the firm. This does not necessarily involve adding more leverage or eliminating all debt, but rather finding the right balance that minimizes the cost of capital and maximizes shareholder value. Increasing risk by adding more equity or increasing leverage may not necessarily lead to an optimal capital structure.

Question 19

If a firm does not have debt, then ____.

Accepted Answer

If the firm does not have debt, it means that it is operating with only equity financing. This implies that there are no interest payments or principal repayments due to creditors, so the financial risk of the firm is low. Financial risk is the risk associated with the use of debt in capital structure, and it increases as a company takes on more debt. Therefore, if the firm has no debt, it has no financial risk. However, it does not mean that the firm has no business risk, which is the risk that arises from the nature of the firm's operations, competition, economic conditions, etc. Furthermore, the relationship between ROA and ROE is not necessarily affected by the presence or absence of debt.

Question 20

A firm's degree of financial leverage is 1.5 and the degree of operating leverage is 2.0. What is their degree of total leverage?

Accepted Answer

The degree of total leverage is calculated by multiplying the degree of financial leverage (1.5) by the degree of operating leverage (2.0), which equals 3.0.

Quiz 14: Capital Structure and Leverage

Assume the following selected financial information about a firm that is about to restructure capital by exchanging equity for debt: What is the market value of the firm's equity after the restructuring according to the Modigliani-Miller model with taxes but without bankruptcy costs?