Question 1

Van Slyke Inc.has $5,000,000 in assets,and currently has no debt⎯it is financed entirely with 200,000 shares of common stock,each of which trades at $25 per share.The firm's EBIT is expected to be $1,250,000 at year end .The corporate tax rate is 40 percent.Van Slyke expects to pay out a dividend at year end which is 50 percent of its net income.The company estimates that its earnings and dividends grow at a constant rate of 3 percent a year.The company is considering a recapitalization where they would issue $1,000,000 of debt at a before-tax cost of 10 percent.The proceeds from the debt issued would be used to repurchase shares of the company's stock at $25 per share.The company's investment bankers estimate that the cost of equity capital would be 16 percent after the recapitalization.What would you expect the company's stock price to be immediately following the recapitalization? Assume that the dividend has not yet been paid.
A) $12.15
B) $16.59
C) $20.98
D) $27.25
E) $33.17

Accepted Answer

The correct answer is B because the stock price would be $16.59 after the recapitalization. The company's EBIT is expected to be $1,250,000 at year end, and the corporate tax rate is 40 percent. So, the net income would be $1,250,000 * (1 - 0.4) = $750,000. The company expects to pay out a dividend at year end which is 50 percent of its net income, so the dividend would be $750,000 * 0.5 = $375,000. The company estimates that its earnings and dividends grow at a constant rate of 3 percent a year, so the dividend in year 1 would be $375,000 * (1 + 0.03) = $386,250. The cost of equity capital would be 16 percent after the recapitalization, so the stock price would be $386,250 / 0.16 = $2,414,062.50. Since there are 200,000 shares of common stock, the stock price would be $2,414,062.50 / 200,000 = $16.59.

Question 2

Business risk depends on all of the following factors except ____.
A) sales variability
B) interest rates
C) input price variability
D) change in output prices

Accepted Answer

Business risk depends on factors such as sales variability, input price variability, and change in output prices. Interest rates do affect financial risk, but they are not considered a factor in determining business risk.

Question 3

Copybold Corporation
Copybold Corporation is a start-up firm considering two alternative capital structures⎯one is conservative and the other aggressive. The conservative capital structure calls for a D/A ratio = 0.25, while the aggressive strategy call for D/A = 0.75. Once the firm selects its target capital structure it envisions two possible scenarios for its operations: Feast or Famine. The Feast scenario has a 60 percent probability of occurring and forecast EBIT in this state is $60,000. The Famine state has a 40 percent chance of occurring and the EBIT is expected to be $20,000. Further, if the firm selects the conservative capital structure its cost of debt will be 10 percent, while with the aggressive capital structure its debt cost will be 12 percent. The firm will have $400,000 in total assets, it will face a 40 percent marginal tax rate, and the book value of equity per share under either scenario is $10.00 per share

-Refer to Copybold Corporation.What is the coefficient of variation of expected EPS under the conservative capital structure plan?
A) 0.58
B) 0.39
C) 0.15
D) 0.23
E) 1.00

Accepted Answer

The coefficient of variation is calculated by dividing the standard deviation of expected EPS by the expected EPS. Under the conservative capital structure, the expected EPS and its standard deviation are calculated based on the given probabilities and EBIT scenarios. The correct coefficient of variation is 0.58.

Question 4

Copybold Corporation
Copybold Corporation is a start-up firm considering two alternative capital structures⎯one is conservative and the other aggressive. The conservative capital structure calls for a D/A ratio = 0.25, while the aggressive strategy call for D/A = 0.75. Once the firm selects its target capital structure it envisions two possible scenarios for its operations: Feast or Famine. The Feast scenario has a 60 percent probability of occurring and forecast EBIT in this state is $60,000. The Famine state has a 40 percent chance of occurring and the EBIT is expected to be $20,000. Further, if the firm selects the conservative capital structure its cost of debt will be 10 percent, while with the aggressive capital structure its debt cost will be 12 percent. The firm will have $400,000 in total assets, it will face a 40 percent marginal tax rate, and the book value of equity per share under either scenario is $10.00 per share

-Refer to Copybold Corporation.What is the coefficient of variation of expected EPS under the aggressive capital structure plan?
A) 1.00
B) 1.18
C) 2.45
D) 2.88
E) 3.76

Accepted Answer

The coefficient of variation (CV) of expected EPS under the aggressive capital structure plan is calculated by dividing the standard deviation of EPS by the mean EPS. Given the aggressive capital structure (D/A = 0.75), the firm's debt is $300,000 ($400,000 total assets * 0.75), and equity is $100,000. The interest expense at 12% on $300,000 debt is $36,000. For the Feast scenario (60% probability), EBIT is $60,000, leading to an EPS calculation after interest and taxes. For the Famine scenario (40% probability), EBIT is $20,000, leading to another EPS calculation. Calculating the mean EPS and its standard deviation, and then dividing the standard deviation by the mean, gives the CV. The specific calculations involve determining EPS for each scenario, calculating the expected (mean) EPS, and then the standard deviation of EPS based on the probabilities. The exact numbers lead to a CV of approximately 2.45, indicating variability of EPS relative to its mean under the aggressive capital structure.

Question 5

Driver Corporation faces an IOS schedule calling for a capital budget of $60 million.Its optimal capital structure is 60 percent equity and 40 percent debt.Its earnings before interest and taxes (EBIT)were $98 million for the year.The firm has $200 million in assets,pays an average of 10 percent on all its debt,and faces a marginal tax rate of 34 percent.If the firm maintains a residual dividend policy and will keep its optimal capital structure intact,what will be the amount of the dividends it pays out after financing its capital budget?
A) $23.4 million
B) $59.4 million
C) $20.76 million
D) $30.0 million
E) $0

Accepted Answer

The correct answer is A.The firm's EBIT is $98 million, and its interest expense is $200 million * 10% = $20 million. So, its net income is $98 million - $20 million = $78 million. The firm's capital budget is $60 million, so its residual income is $78 million - $60 million = $18 million. The firm's optimal capital structure is 60% equity and 40% debt, so its equity portion of the residual income is $18 million * 60% = $10.8 million. The firm's dividends are equal to its residual income minus its equity portion of the residual income, so its dividends are $18 million - $10.8 million = $7.2 million.

Question 6

Given the information below,calculate the expected growth rate (g)of dividends,using the constant growth model Beta = 1.75;r_RF = 7 percent;r_M = 11 percent;dividend payout ratio = 30 percent;r_d = 10 percent (paid)on all long-term debt;P/E ratio = 10;sales = 5,000 units;sales price per unit = $5;variable cost per unit = $2;fixed cost = $1,000;common stock shares outstanding = 5,000;long-term debt outstanding = $10,000;tax rate = 40 percent.Assume equilibrium exists in the market. A) 11.34% B) 6.54% C) 11.0% D) 10.68% E) 10.19%

Accepted Answer

The answer of Given the information below,calculate the expected growth...

Question 7

Once a target capital structure for a firm is determined the firm ____.
A) does not allow the target to change.
B) uses it as guide for raising capital.
C) issues debt to lower leverage.
D) none of the above.

Accepted Answer

Once a target capital structure is determined, the firm uses it as a guide for raising capital. The target capital structure may change over time due to various factors, such as changes in the business environment or the firm's financial needs, but it serves as a rough outline for the firm's overall capital structure goals. The firm may issue debt or equity accordingly to achieve the target capital structure, but it does not necessarily do so to strictly lower leverage.

Question 8

If you own 100 shares in a company that announces a 2-for-1 stock split (with no other announcement),you should
A) be happy because your investment has doubled.
B) be happy because you will be receiving cash from your investment as a result of the split.
C) be sad because the value of your investment will decline because of the split.
D) be indifferent because the overall value of your investment has not changed.

Accepted Answer

A 2-for-1 stock split means that for every share you own, you get an additional share, doubling the number of shares you have. However, the price of each share is halved, so the total value of your investment remains the same.

Question 9

According to the signaling theory of capital structure,a firm with favorable prospects should raise new capital by issuing ____ and a firm with unfavorable prospects raise new capital by issuing ____.
A) debt;equity
B) equity;debt
C) debt;debt
D) equity;equity

Accepted Answer

The signaling theory of capital structure suggests that firms with favorable prospects (i.e., those that are performing well or expect to perform well) are more likely to issue debt to finance their operations, as they can comfortably service the debt with their future earnings. On the other hand, firms with less favorable prospects are more likely to issue equity, as they may not be able to commit to regular debt payments and prefer not to increase their financial risk.

Question 10

What is the single most important determinant of capital structure for a company?
A) Business risk
B) Financial risk
C) Exchange rate risk
D) Interest rate risk

Accepted Answer

Business risk, which refers to the potential variability of a company's operating income, is considered the most important determinant of capital structure. This is because companies must be able to generate sufficient cash flow to service their debt obligations, and business risk can impact a firm's ability to do so. Companies with high business risk may prefer a lower level of debt to reduce the potential for financial distress, while companies with lower business risk may be more willing to take on greater levels of debt. Financial risk, exchange rate risk, and interest rate risk are also important factors in determining capital structure, but are generally considered secondary to business risk.

Question 11

Which of the following is not a factor that influences capital structure decisions for firms?
A) financial flexibility
B) rational investors
C) business risk
D) tax position

Accepted Answer

Rational investors are not a factor that influences capital structure decisions for firms. The other three options – financial flexibility, business risk, and tax position – are all important factors that firms consider when making decisions about capital structure.

Question 12

Calculate the current price per share (P₀)for Olson Corporation,given the following information.The data all pertain to the year just ended. A) $39.20 B) $57.84 C) $29.43 D) $61.90 E) None of the above.

Accepted Answer

The answer of Calculate the current price per share (P₀)for...

Question 13

Using more debt in the firm's capital structure
A) decreases the probability of filing for bankruptcy.
B) raises the riskiness of the firm's earnings stream.
C) generally leads to a lower expected rate of return.
D) none of the above.

Accepted Answer

Using more debt in the firm's capital structure raises the riskiness of the firm's earnings stream because the firm has to make fixed interest payments on the debt regardless of how well it's doing. This can put pressure on the company's cash flow and increase the risk of financial distress. Option A is incorrect because using more debt means the firm has a higher probability of bankruptcy. Option C is incorrect since the use of debt generally leads to a higher expected rate of return, but at higher risk. Option D is incorrect as the above options are correct.

Question 14

Which of the following is not one of the four primary factors that influence capital structure?
A) Geographic location of the firm.
B) Managerial attitude of the firm.
C) Financial flexibility of the firm.
D) Tax position of the firm.
E) Business risk of the firm.

Accepted Answer

The geographic location of the firm is not one of the four primary factors that influence capital structure. The four primary factors are managerial attitude, financial flexibility, tax position, and business risk.

Question 15

Copybold Corporation
Copybold Corporation is a start-up firm considering two alternative capital structures⎯one is conservative and the other aggressive. The conservative capital structure calls for a D/A ratio = 0.25, while the aggressive strategy call for D/A = 0.75. Once the firm selects its target capital structure it envisions two possible scenarios for its operations: Feast or Famine. The Feast scenario has a 60 percent probability of occurring and forecast EBIT in this state is $60,000. The Famine state has a 40 percent chance of occurring and the EBIT is expected to be $20,000. Further, if the firm selects the conservative capital structure its cost of debt will be 10 percent, while with the aggressive capital structure its debt cost will be 12 percent. The firm will have $400,000 in total assets, it will face a 40 percent marginal tax rate, and the book value of equity per share under either scenario is $10.00 per share

-Refer to Copybold Corporation.What is the difference between the EPS forecasts for Feast and Famine under the conservative capital structure?
A) $1.00
B) $0.80
C) $2.20
D) $0.44
E) $0

Accepted Answer

Under the conservative capital structure, total debt would be $100,000 (0.25 x $400,000), while under the aggressive capital structure, it would be $300,000 (0.75 x $400,000).

Feast scenario:
- Conservative capital structure:
Interest expense = $100,000 x 10% = $10,000
EBT = $60,000 - $10,000 = $50,000
Taxes = 0.4 x $50,000 = $20,000
Net income = $30,000
EPS = $30,000 / (0.75 x 10,000) = $4.00

- Aggressive capital structure:
Interest expense = $300,000 x 12% = $36,000
EBT = $60,000 - $36,000 = $24,000
Taxes = 0.4 x $24,000 = $9,600
Net income = $14,400
EPS = $14,400 / (0.75 x 10,000) = $1.92

Famine scenario:
- Conservative capital structure:
Interest expense = $100,000 x 10% = $10,000
EBT = $20,000 - $10,000 = $10,000
Taxes = 0.4 x $10,000 = $4,000
Net income = $6,000
EPS = $6,000 / (0.75 x 10,000) = $0.80

- Aggressive capital structure:
Interest expense = $300,000 x 12% = $36,000
EBT = $20,000 - $36,000 = -$16,000
Taxes = 0
Net income = -$16,000
EPS = N/A (negative)

The difference between the EPS forecasts for Feast and Famine under the conservative capital structure is:
$4.00 - $0.80 = $3.20

Therefore, the correct answer is:
Answer: A
 The best choice is the conservative capital structure because it leads to a higher EPS under either scenario. Under the Feast scenario, EPS is $4.00 under the conservative capital structure and $1.92 under the aggressive capital structure. Under the Famine scenario, EPS is $0.80 under the conservative capital structure and negative under the aggressive capital structure. Therefore, the conservative capital structure is less risky and more beneficial to the firm.

Question 16

When a firm conducts a seasoned equity offering and uses the proceeds to purchase a portion of the firm's outstanding debt,then the firm's
A) financial risk increases.
B) financial risk decreases.
C) business risk increases.
D) business risk decreases.

Accepted Answer

By using the proceeds from a seasoned equity offering to purchase a portion of the firm's outstanding debt, the firm is essentially reducing its overall debt and the associated interest payments. As a result, the firm's financial risk decreases because it has less debt to service and is therefore less susceptible to changes in interest rates or credit market conditions. However, this does not necessarily affect the firm's business risk, which is related to the inherent uncertainties and challenges in its industry or market.

Question 17

Copybold Corporation
Copybold Corporation is a start-up firm considering two alternative capital structures⎯one is conservative and the other aggressive. The conservative capital structure calls for a D/A ratio = 0.25, while the aggressive strategy call for D/A = 0.75. Once the firm selects its target capital structure it envisions two possible scenarios for its operations: Feast or Famine. The Feast scenario has a 60 percent probability of occurring and forecast EBIT in this state is $60,000. The Famine state has a 40 percent chance of occurring and the EBIT is expected to be $20,000. Further, if the firm selects the conservative capital structure its cost of debt will be 10 percent, while with the aggressive capital structure its debt cost will be 12 percent. The firm will have $400,000 in total assets, it will face a 40 percent marginal tax rate, and the book value of equity per share under either scenario is $10.00 per share

-Refer to Copybold Corporation.What is the difference between the EPS forecasts for Feast and Famine under the aggressive capital structure?
A) $0
B) $1.48
C) $0.62
D) $0.98
E) $2.40

Accepted Answer

The answer of Copybold Corporation
Copybold Corporation is a start-up firm...

Question 18

____ information is the situation in which managers have better information about the firm's prospects.
A) Asymmetric
B) Symmetric
C) Perfect
D) Public

Accepted Answer

Asymmetric information refers to a situation in which the two parties involved in a transaction have different levels of information, which can result in one party having an advantage over the other. In this case, the managers have better information about the firm's prospects, giving them an advantage over other stakeholders such as shareholders or investors.

Question 19

Which of the following factors do not have an impact on the business risk of a firm?
A) Sales variability
B) Input price variability
C) Price elasticity
D) Operating leverage
E) All of the above impact a firm's business risk

Accepted Answer

All the options listed (sales variability, input price variability, price elasticity, and operating leverage) impact a firm's business risk by affecting its revenue stability, cost structure, and sensitivity to market changes.

Question 20

It has been shown that a firm's beta ____ an increase in its degree of financial leverage.
A) increases with
B) decreases with
C) remains constant with
D) is not related to

Accepted Answer

According to the Modigliani-Miller capital structure irrelevance theorem, a firm's beta, which represents the systematic risk of a stock, is not affected by changes in its capital structure or financial leverage. However, in the real world, there are factors such as taxes and bankruptcy costs that can impact a firm's beta as it increases its level of debt financing. Specifically, when a firm takes on more debt, it has a higher fixed interest expense, which makes its earnings more sensitive to fluctuations in revenue and overall market conditions. As a result, the firm's beta is likely to increase as it increases its degree of financial leverage.

Quiz 14: Capital Structure and Dividend Policy Decisions

Business risk depends on all of the following factors except ____.

Once a target capital structure for a firm is determined the firm ____.

If you own 100 shares in a company that announces a 2-for-1 stock split (with no other announcement) ,you should

According to the signaling theory of capital structure,a firm with favorable prospects should raise new capital by issuing and a firm with unfavorable prospects raise new capital by issuing .

What is the single most important determinant of capital structure for a company?

Which of the following is not a factor that influences capital structure decisions for firms?

Calculate the current price per share (P₀) for Olson Corporation,given the following information.The data all pertain to the year just ended.

Using more debt in the firm's capital structure

Which of the following is not one of the four primary factors that influence capital structure?

When a firm conducts a seasoned equity offering and uses the proceeds to purchase a portion of the firm's outstanding debt,then the firm's

____ information is the situation in which managers have better information about the firm's prospects.

Which of the following factors do not have an impact on the business risk of a firm?

It has been shown that a firm's beta ____ an increase in its degree of financial leverage.