Question 1

Higgins currently has 2 million shares of common stock outstanding that are selling for $32 per share. Higgins also has a $20 million mortgage bond outstanding that has an 11 percent coupon rate. Higgins is considering two alternatives to financing a major expansion. Plan A is to sell $10 million of additional long-term debt with a 12.5 percent coupon. Plan B is to sell 200,000 shares of common stock at $30 per share and $4 million in long-term debt with a 11.25 percent coupon. What is the EBIT indifference level between these two alternatives? Assume the marginal tax rate is 40 percent.
A) $1,374,000
B) $11,450,000
C) $4,554,000
D) $2,650,000

Accepted Answer

Solution:
(EBIT - $3.45)(0.6)/2 = (EBIT - $2.65)(0.6)/2.2
EBIT* = $11.45 million

Question 2

Onyx expects to have an EBIT of $240,000 with a standard deviation of $110,000. The distribution of operating income is approximately normal. If Onyx has interest expenses of $50,000, what is the probability that it will have an operating income that is below $0?
A) 4.27%
B) 1.46%
C) 0.02%
D) 2.4%

Accepted Answer

Solution:
z = ($0 - $240,000)/$110,000 = -2.18; From Table V, p = 1.46%

Question 3

Sulzar's capital structure consists only of common stock (20 million shares), but the firm is planning a major expansion which will require $100 million of new capital. Sulzar has a choice of obtaining the needed capital through the sale of 5 million shares of common stock at $20 per share or the sale of $100 million of first mortgage bonds that would have a coupon rate of 9%. If Sulzar has a marginal tax rate of 40%, calculate the EBIT-EPS indifference point.
A) $45 million
B) $36 million
C) $5 million
D) $9 million

Accepted Answer

Solution:
[(EBIT - $9.0)(0.60)]/20 = [(EBIT - 0 )(.60)]/25
EBIT* = $45 (million)

Question 4

The Ames Company has an expected EBIT of $16 million with a standard deviation of $8 million. The indifference point between a debt financing alternative and a common stock financing alternative was computed to be $12 million. Determine the probability that the equity financing alternative will be superior to the debt financing alternative (i.e., have a higher EPS). (Problem requires normal distribution table.)
A) 50.0%
B) 30.85%
C) 69.15%
D) cannot be computed

Accepted Answer

Solution:
The probability that the equity financing alternative will result in a higher EPS is equal to the probability that the EBIT level will be less than $12 million, or z = ($12.0 - $16.0)/$8.0 = -0.50
The probability of a value less than 0.50 standard deviations to the left of the mean is 0.3085 or 30.85%, from Table V.

Question 5

Alace is an all equity firm with 10 million shares outstanding that is evaluating two alternative financing plans. With the first plan, Alace will sell 1 million shares of common stock at $15 each. Under the second plan, the firm would sell $15 million of 12 percent long-term debt. If Alace has a marginal tax rate of 35 percent, what is the EBIT-EPS indifference point?
A) $12.9 million
B) $19.8 million
C) $11.7 million
D) $18.0 million

Accepted Answer

Solution:
(EBIT - $1.8)(1 - 0.35)/10 = (EBIT - 0)(1 - 0.35)/(10 + 1)
EBIT = $19.8 million

Question 6

ASG expects next year's operating income (EBIT) to equal $22 million, with a standard deviation of $16 million. The coefficient of variation of operating income is equal to 0.73. Interest expenses will be $9 million next year and debt retirement will require a principal payment of $2.5 million. ASG's marginal tax rate is 40%. If EBIT is normally distributed, what is the probability that ASG will have a negative EPS next year?
A) 20.9%
B) 25.5%
C) 23.3%
D) 25.8%

Accepted Answer

Solution:
z = ($9.0 - $22.0)/16.0 = -0.81
From Table V, at z = - 0.81; p = 0.2090

Question 7

Onex expects to have an EBIT of $240,000 with a standard deviation of $90,000. The distribution of operating income is approximately normal. What is the probability that Onex will have an EBIT that is below $0?
A) 0.47%
B) 2.67%
C) 0.38%
D) 2.25%

Accepted Answer

Solution:
z = ($0 - $240,000)/$90,000 = -2.67 From Table V, p = 0.38%

Question 8

Centex, a producer of telephone systems for small businesses, has current sales of $43 million and variable operating costs of $27.95 million. Centex expects to increase sales in the coming year by 15% while keeping fixed operating costs constant at $9.1 million. What is the DOL for Centex?
A) 3.3
B) 2.5
C) 7.2
D) 1.0

Accepted Answer

Solution:
 11ea10f6_a161_50ae_b6b3_e39d19a13d59_TB2040_00 
EBIT? = 43 - 27.95 - 9.1 = $5.95
EBIT? = 49.45 - 49.45(.65) - 9.1 = $8.2075
Variable cost ratio = 27.95/43 = .65

Question 9

Two companies, Jefferson and Jackson, are virtually identical in all aspects of their operations except that the two companies differ in their capital structures, as shown below: 
Both companies have $500 million in total assets and both have a 40% marginal tax rate.What is the EPS for Jackson at an EBIT level of $50 million?
A) $1.50
B) $1.20
C) $2.00
D) $2.50

Accepted Answer

Solution:
EBT = $50 - $10 = $40
EAT = $40(1 - 0.4) = $24
EPS = $24,000,000/20,000,000 = $1.20

Question 10

Given the following financial data for Boston Technology, compute the firm's degree of combined leverage. Assume a marginal tax rate of 40%. 
A) 0.29
B) -0.38
C) -0.15
D) 0.38

Accepted Answer

Solution:
 11ea10f6_a161_9ed1_b6b3_dbfc021402b3_TB2040_00

Question 11

Archive Storage earned $3.20 a share on sales of $13.6 million. Archive has determined that its degree of operating leverage is 1.87 and its degree of financial leverage is 2.91. If sales are expected to increase 15%, what will be the EPS forecast?
A) $2.61
B) $4.60
C) $5.81
D) $3.68

Accepted Answer

Solution:
DCL = 1.87(2.91) = 5.44
% change in EPS = 5.44(15) = 81.6
Forecasted EPS = 3.20(1.816) = $5.81

Question 12

TCA Cable has fixed operating cost of $2.6 million, and its variable cost ratio is 0.30. TCA has $4.0 in bonds outstanding with a coupon interest rate of 12%. TCA has 1.0 million common shares and 1,000,000 shares of $1.75 preferred stock outstanding. Total revenues for TCA Cable are $14.2 million. If TCA has a marginal tax rate of 40%, what is its degree of combined leverage?
A) 2.1
B) 1.0
C) 1.9
D) 2.5

Accepted Answer

Solution:
 11ea10f6_a161_50af_b6b3_8d58d63604b7_TB2040_00

Question 13

Borkstran has sales of $7.8 million, a variable cost ratio of 0.6, EBIT of $1.1 million, and a degree of combined leverage of 3.4. What is Borkstran's degree of financial leverage?
A) 1.20
B) 0.73
C) 2.29
D) 0.84

Accepted Answer

Solution:
DOL = (7.8 - 4.68)/1.1 = 2.84
DFL = DCL/DOL = 3.4/2.84 = 1.20

Question 14

Midwest Can Company is considering opening a new plant in St. Louis that is expected to produce an average EBIT of $3 million per year. To finance this new plant, Midwest is considering two financing plans. The first plan is to sell 600,000 shares of common stock at $15 each. The second plan is to sell 200,000 shares of common stock at $15 each and $6 million of 13 percent long-term debt. If Midwest has a marginal tax rate of 40 percent, what is the EBIT-EPS indifference point for this plant?
A) $702,000
B) $234,000
C) $2,234,000
D) $1,170,000

Accepted Answer

Solution:
(EBIT - $780,000)(0.6)/200,000 = .6EBIT/600,000
EBIT* = $1,170,000

Question 15

Given the following financial data for Cosmos, compute the firm's degree of combined leverage. 
A) $0.42
B) 8.37
C) -2.15
D) 1.78

Accepted Answer

Solution:
DCL = [($0.51 - $0.42)/$0.42]/[($874,000 - $780,000)/$780,000]
= 1.78

Question 16

Given the following financial data for Cosmos, compute the firm's degree of financial leverage. 
A) 23.81
B) 4.24
C) 0.42
D) 2.18

Accepted Answer

Solution:
DFL = [($0.51 - $0.42)/$0.42]/[($131,100 - $124,800)/$124,800] = 4.24

Question 17

If a firm sees its EPS increase 27% on a 12% increase in sales, what is the firm's DOL. During the same period the firm saw its EBIT increase only 8%.
A) 1.50
B) 3.38
C) 1.34
D) 0.67

Accepted Answer

Solution:
D0L = 8%/12% = 0.67

Question 18

Knight Moves is considering two alternative financing plans. The firm is expected to operate at the $75 million EBIT level. Under Plan D (debt financing) EPS is expected to be $2.25, and under Plan E (equity financing) EPS is expected to be $1.82. If the market is expected to assign a P/E ratio of 12 to the debt plan and 15 to the equity plan, which plan should Knight pursue?
A) debt
B) equity
C) indifferent between the two alternatives
D) neither is satisfactory

Accepted Answer

Solution:
Debt Plan Price = 12($2.25) = $27.00
Equity Plan Price = 15($1.82) = $27.30

Question 19

Dagger Company has a current capital structure consisting of $60 million in long-term debt with an interest rate of 9% and $60 million in common equity (12 million shares). The firm is considering an expansion plan costing $23 million. The expansion plan can be financed with additional long-term debt at a 12% interest rate or the sale of new common stock at $8 per share. The firm's marginal tax rate is 40%. Determine the indifference level of EBIT for the two financing plans.
A) -$30.24 million
B) $18.36 million
C) $30.24 million
D) $19.68 million

Accepted Answer

Solution:
 11ea10f6_a15e_b89d_b6b3_673dc2fa0e19_TB2040_11 EBIT* = $19.68 (million)

Question 20

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?
A) 3.09
B) 2.06
C) 3.55
D) 1.67

Accepted Answer

Solution:
DCL = 34/11 = 3.09
DFL = 3.09/1.5 = 2.06

Quiz 14: Capital Structure Management in Practice

Onyx expects to have an EBIT of $240,000 with a standard deviation of $110,000. The distribution of operating income is approximately normal. If Onyx has interest expenses of $50,000, what is the probability that it will have an operating income that is below $0?

Onex expects to have an EBIT of $240,000 with a standard deviation of $90,000. The distribution of operating income is approximately normal. What is the probability that Onex will have an EBIT that is below $0?

Centex, a producer of telephone systems for small businesses, has current sales of $43 million and variable operating costs of $27.95 million. Centex expects to increase sales in the coming year by 15% while keeping fixed operating costs constant at $9.1 million. What is the DOL for Centex?

Given the following financial data for Boston Technology, compute the firm's degree of combined leverage. Assume a marginal tax rate of 40%.

Archive Storage earned $3.20 a share on sales of $13.6 million. Archive has determined that its degree of operating leverage is 1.87 and its degree of financial leverage is 2.91. If sales are expected to increase 15%, what will be the EPS forecast?

Borkstran has sales of $7.8 million, a variable cost ratio of 0.6, EBIT of $1.1 million, and a degree of combined leverage of 3.4. What is Borkstran's degree of financial leverage?

Given the following financial data for Cosmos, compute the firm's degree of combined leverage.

Given the following financial data for Cosmos, compute the firm's degree of financial leverage.

If a firm sees its EPS increase 27% on a 12% increase in sales, what is the firm's DOL. During the same period the firm saw its EBIT increase only 8%.

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?