Question 1

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?
A)1.76
B)2.5
C).98
D)1.11

Accepted Answer

(175,000 - $150,000)/150,000 = $25,000/150,000 = 16.67%
16.67%117% = 0.98

Question 2

In using Nestle Corporation as a model, when a subsidiary is first formed, about one-half of the financing needed to acquired fixed assets comes from:
A)debt
B)federal funds
C)tax breaks
D)equity from the parent company

Accepted Answer

When a subsidiary is 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 has the resources to provide the needed capital and also wants to maintain control over the subsidiary's operations. The use of debt or federal funds may not be feasible or preferred, and tax breaks are not a direct source of financing.

Question 3

Dippity Doodle Noodle Makers has a capital structure that consists of2.0 million shares outstanding and $2.0 million of debt at 8% interest.The company is planning a major plant expansion 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
A)Indifference of $10,750,000.Use stock option.
B)Indifference of $1,600,000.Use stock option.
C)Indifference of $16,270,000.Use the debt option.
D)Indifference of $9,250,000.Use the debt option.

Accepted Answer

Solution: $$\frac { E B I T - ( 160,000 + 90,000 ) } { 2,000,000 + 10,000 } = \frac { E B I T - 160,000 } { 2,000,000 + 30,000 }$$ 
1.01 EBIT - 252,500 = EBIT - 160,000
1.01 EBIT - 1EBIT = 252,500 - 160,000
.01 EBIT = 92,500
EBIT = 9,250,000 Indifference Point

Question 4

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 PIE under the debt alternative would be 15 and the PIE under the equity alternative would be 16.The firm's marginal tax rate is 40%.Which alternative would produce the higher stock price?
A)debt-stock price of $23.70
B)debt-stock price of $32.29
C)equity-stock price of $25.12
D)equity-stock price of $33.28

Accepted Answer

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Question 5

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 percent.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 percent, 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?
A)$71.5 million
B)$77.2 million
C)$68.3 million
D)$1.0 million

Accepted Answer

Solution:
 $$\frac { ( \mathrm { EBIT } - 11.55 ) ( 1 - 0.4 ) } { 15 } - \frac { ( \mathrm { EBIT } - 8.8 ) ( 1 - 0.4 ) } { 15.62857143 }$$ 
EBIT* = $77.2 million

Question 6

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?
A) 29.98%
B) 34.83%
C) 97.13%
D) 2.87%

Accepted Answer

z = $\frac { \$ 0 - \$ 59 } { \$ 31 } = - 1.90 \mathrm { p } = 2.87 \%$

Question 7

What type of security is used to purchase a target company in a leveraged buy-out?
A) common stock
B) dividends
C) debt
D) retained earnings

Accepted Answer

In a leveraged buy-out, the purchaser typically uses debt financing to acquire a majority stake in the target company. The debt is secured by the assets of the target company and/or the projected cash flows of the business. This allows the purchaser to control the target company with limited investment of their own capital. Common stock, dividends, and retained earnings are not typically used in a leveraged buy-out.

Question 8

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).
A)2.0
B)3.7
C)6.5
D)1.4

Accepted Answer

Solution: $\frac { 200,000 ( 50 - 15 ) } { 200,000 ( 50 - 15 ) - 2,000,000 } = 1.4$

Question 9

A change in EBIT is magnified into a larger change in EPS.This means that financial leverage is using as its fulcrum.
A)short-term costs
B)fixed costs
C)variable costs
D)retained earnings

Accepted Answer

Financial leverage refers to the use of fixed costs, such as interest expenses, to magnify the impact of changes in EBIT on EPS. This is because as EBIT increases, a company with fixed costs will see a greater increase in net income, and therefore EPS. On the other hand, if EBIT decreases, a company with fixed costs will experience a greater decrease in net income, and therefore EPS. Therefore, the correct choice is fixed costs.

Question 10

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.
A).80
B)1.08
C)2.01
D)1.25

Accepted Answer

$$\frac { \% \Delta \mathrm { EPS } } { \% \Delta \mathrm { EBIT } } = \frac { ( 1.37 - 1.25 ) } { 1.25 } / 0.15 = 0.12 / 0.15 = 0.80$$

Question 11

In evaluating degree of operating leverage, it is best that the firm's DOL is:
A)higher than 1
B)higher than 2
C)lower than 1
D)equal to 1

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 12

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.
A)1.22
B)1.78
C)1.06
D)97

Accepted Answer

$$\frac { 750,000 } { 750,000 - ( 0.045 \times 1,000,000 ) - 0 } = 750,000 / 705,000 = 1.06$$

Question 13

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?
A)4.65%
B)10.47%
C)5.16%
D)35.20%

Accepted Answer

Solution: z = $\frac { \$ 1.9 - \$ 8.3 } { \$ 5.1 } = 1.255 \mathrm { p } = 10.47 \%$

Question 14

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.Assume the marginal tax rate is 40%.
A)$4.253 million
B)$3.051 million
C)$3.654 million
D)$4.728 million

Accepted Answer

Solution: Total current capitalization= $10,000,000 debt/0.3 = $33,333,333
Preferred stock= 0.10 × $33,333,333 = $3,333,333
Preferred shares = $3,333,333/$50 = 66,667
Preferred dividends = 66,667 × $4.75 = $316,668.25
 $$\frac { ( \mathrm { EBIT } - 1.7 ) ( 0.6 ) - 0.317 } { 2 } = \frac { ( \mathrm { EBIT } - 1.2 ) ( 0.6 ) - 0.317 } { 2.4 }$$ 
EBIT* = $4,727,779 or $4.728 million

Question 15

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

Accepted Answer

The answer of What are the effects of leverage on...

Question 16

There are three categories of costs: fixed costs, variable costs and semi-variable costs.Which of the following is a semi-variable cost?
A)depreciation
B)labor costs
C)raw materials
D)management salaries

Accepted Answer

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

Question 17

In considering EBIT-EPS analysis, which of the following statements is/are correct?
A)If the expected earnings are above the indifference point, the debt option is preferred.
B) If the expected earnings are below the indifference point, the equity option is preferred.
C)Both statements a and b are correct.
D)Neither statement a nor b is correct.

Accepted Answer

EBIT-EPS analysis helps in determining the best financing mix for a company. If the expected earnings are above the indifference point, it means the company can easily cover its fixed interest costs, and hence the debt option is preferred. On the other hand, if the expected earnings are below the indifference point, it means the company will find it difficult to cover fixed interest costs, and hence the equity option is preferred. Therefore, both statements A and B are correct.

Question 18

Some companies use debt or preferred stock financing instead of common stock financing.The purpose is:
A)to retain control
B)to facilitate record-keeping
C)to maintain privacy
D)to prevent audit problems

Accepted Answer

Companies may choose to use debt or preferred stock financing instead of common stock financing in order to retain control over the decisions made within the company. By choosing to issue debt or preferred stock, the company does not dilute the ownership stake of its existing shareholders and can maintain control over operational decisions.

Question 19

In evaluating a firm's degree of financial leverage, financial risk is with an increase in DFL.
A)increased
B)decreased
C)not impacted
D)reflective of excess inventory

Accepted Answer

Financial risk is directly related to the degree of financial leverage (DFL), which is calculated by dividing the percentage change in earnings per share (EPS) by the percentage change in earnings before interest and taxes (EBIT). As DFL increases, so does financial risk, since a small change in EBIT can have a larger impact on EPS due to the increased proportion of fixed interest payments.

Question 20

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?
A)debt-stock price of $57.36
B)debt-stock price of $70.98
C)equity-stock price of $71.28
D)equity-stock price of $85.32

Accepted Answer

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Quiz 14: Capital Structure Management in Practice

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?

In using Nestle Corporation as a model, when a subsidiary is first formed, about one-half of the financing needed to acquired fixed assets comes from:

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

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) .

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

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.

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

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.

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

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

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

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

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