Question 1

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 is using fixed costs as its fulcrum, meaning that a change in EBIT (earnings before interest and taxes) causes a larger change in EPS (earnings per share) because the fixed costs remain constant, leading to a greater impact on the net income available to shareholders. Short-term and variable costs do not have the same effect on leverage, and retained earnings are not directly related to leverage.

Question 2

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
 11ea10f6_a162_1404_b6b3_b712390d5280_TB2040_00 EBIT* = $4,727,779 or $4.728 million

Question 3

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 4

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

Solution:
z = ($0 - $59/$31) = -1.90 p = 2.87%

Question 5

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

Solution:
 11ea10f6_a163_4c8a_b6b3_f77ad97979e9_TB2040_11 = 750,000/705,000 = 1.06

Question 6

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 proportional to degree of financial leverage (DFL). As DFL increases, the firm relies more on debt financing to meet its obligations, which increases the fixed interest payments that must be made. This amplifies the impact of fluctuations in earnings, leading to greater financial risk.

Question 7

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, the equity needed to acquire fixed assets comes from the parent company. Nestle Corporation is known for using this strategy to finance new subsidiaries and ventures. The parent company provides the initial equity, which is used to acquire fixed assets, while the subsidiary generates its own revenue to pay for additional expenses and financing needs.

Question 8

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 acquiring company typically uses borrowing or debt financing to purchase the target company. This debt becomes a form of security for the lenders, who can seize and sell the target company's assets if the acquiring company defaults on the loan. Common stock, dividends, and retained earnings are not typically used as security in a leveraged buy-out.

Question 9

Dippity Doodle Noodle Makers has a capital structure that consists of 2.0 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:
 11ea10f6_a163_2577_b6b3_6bf324712fc1_TB2040_11 =
 11ea10f6_a163_2578_b6b3_dd8303de2377_TB2040_11 
1.01EBIT - 252,500 = EBIT - 160,000
1.01EBIT - 1EBIT = 252,500 - 160,000
.01EBIT = 92,500
EBIT = 9,250,000 Indifference Point

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

11ea10f6_a163_739b_b6b3_65d15ebb52b8_TB2040_11 11ea10f6_a163_739c_b6b3_e758f58abd81_TB2040_11 = /.15= .12/.15 = .80

Question 11

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:
((EBIT - 11.55)(1 - 0.4)/15) ? ((EBIT - 8.8)(1 - 0.4)/15.62857143)
EBIT* = $77.2 million

Question 12

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

Solution:
(175,000 - $150,000)/150,000 = $25,000/150,000 = 16.67%
16.67% /17% = .98

Question 13

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 P/E under the debt alternative would be 15 and the P/E 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

Solution:
 11ea10f6_a162_3b15_b6b3_2b4a33bb55dd_TB2040_00

Question 14

What is the degree of operating leverage for Flippin' Out Company, a maker of scuba flippers, f 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:= 11ea10f6_a163_4c89_b6b3_1707e475de3d_TB2040_11 1.4

Question 15

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

Solution:
 11ea10f6_a162_d756_b6b3_e1a9bef01c65_TB2040_00

Question 16

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 to retain control. By using debt financing, the company borrows money and agrees to pay interest and principal at a future date, without giving up ownership or control. With preferred stock financing, the company issues shares of preferred stock that provide certain rights, such as a guaranteed dividend, but do not give voting rights to the shareholder. This allows the company to maintain voting control.

Question 17

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 18

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

Statement A is correct because if expected earnings are above the indifference point, using debt financing will increase earnings per share (EPS) more than using equity financing. 
Statement B is correct because if expected earnings are below the indifference point, using equity financing will result in a higher EPS than using debt financing. Therefore, both statements A and B are correct.

Question 19

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 20

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 = ($1.9 - $8.3/$5.1) = -1.255 p = 10.47%

Quiz 14: Capital Structure Management in Practice

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

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

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.

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

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 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.

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?

What is the degree of operating leverage for Flippin' Out Company, a maker of scuba flippers, f 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) .

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

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?

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