Question 1

Internet Corporation has EBIT of $1 million, 30% debt in their capital structure, and total capital of $10 million. Their tax rate is 35%. What is their return on capital employed (ROCE)?
A) 6.5%
B) 10.0%
C) 33.33%
D) 21.67%

Accepted Answer

ROCE is calculated as EBIT / Total Capital. Here, EBIT is $1 million and total capital is $10 million. Therefore, ROCE = $1 million / $10 million = 0.1 or 10%. However, after considering the tax effect, the formula adjusts to (EBIT * (1 - Tax Rate)) / Total Capital. Thus, the calculation becomes ($1 million * (1 - 0.35)) / $10 million = $0.65 million / $10 million = 6.5%.

Question 2

A firm has EBIT of $3.6M and debt of $15M on which it pays 8% interest. What is its Degree of Financial Leverage (DFL)?
A) 1.0
B) 1.4
C) 1.5
D) 1.6

Accepted Answer

DFL = EBIT / (EBIT - Interest)
EBIT = $3.6M
Interest = $15M x 8% = $1.2M
DFL = $3.6M / ($3.6M - $1.2M) = 1.5

Question 3

According to MM, if we ignore bankruptcy costs, an increase in financial leverage can increase the value of the firm:
A) in a world without taxes.
B) if interest is tax-deductible.
C) if interest is not tax-deductible.
D) a and b
E) All of the above

Accepted Answer

According to MM, if bankruptcy costs are ignored, an increase in financial leverage can increase the value of the firm if interest is tax-deductible. This is because the tax shield generated from the tax-deductible interest can reduce the overall cost of capital and increase the firm's value. In a world without taxes or if interest is not tax-deductible, MM's theory does not hold.

Question 4

Assume the following facts about a company: $\begin{array}{llll}
\text { Capital (000's) } && \text { EBIT (000's) } & \$ 1,000 \
\text { Debt } & - & \text { Lessinterest Expense }&-\
\text { Equity } & \underline{\$ 3,000} & \text { EBT } &\$1,000\
\text { Total Capital } &\$3,000& \text { Taxes@ 40\% }&400\\text { Sthares@ } \$ 10=300&&\text { Earnings after } \mathrm{T} a x&\$600
\end{array}$ What will be the company's new EPS if it borrows money at 10% interest and uses it to retire stock until capital is 40% debt? The stock can be purchased at its book value of $10 per share.
A) $3.33
B) $4.89
C) $2.93
D) None of the above

Accepted Answer

The answer of Assume the following facts about a company:...

Question 5

Assume the following facts about a firm that sells just one product: $\begin{array}{l}
\text {Selling price per unit }&=\$ 24.00 \
\text { Variable costs per unit}&=\$ 18.00\
\text {Total annual fixed costs }&=\$ 2,500
\end{array}$ What is the firm's annual breakeven volume in units?
A) 417 units
B) 1,250 units
C) 5,000 units
D) 1,667 units

Accepted Answer

The answer of Assume the following facts about a firm...

Question 6

All other things being equal, the Modigliani and Miller Model, modified for tax and bankruptcy costs concludes that:
A) no matter what level of debt a company is operating at, increasing the percent of debt in the capital structure will increase the stock price.
B) if a company has a very low percent debt, increasing the percent of debt in the capital structure will increase the stock price.
C) at moderate levels of debt, it is difficult to tell what will happen to the stock price (whether it will go up or down) if the percent debt in the capital structure is increased.
D) there is no relationship between the percent of debt in the capital structure and the stock price.
E) b. and c. are correct.

Accepted Answer

The Modigliani and Miller Model, when modified for taxes and bankruptcy costs, suggests that at low levels of debt, increasing debt can increase stock price due to tax shields. However, at moderate levels, the effect is uncertain due to potential bankruptcy costs.

Question 7

A firm has a product that sells for $25. The direct cost of manufacturing the product is $15 per unit. The product's contribution margin is:
A) $10.
B) 40%.
C) 60%.
D) 67%.

Accepted Answer

The answer of A firm has a product that sells...

Question 8

Khandker Motors finances 40% of its total capital with debt. The cost of debt is 11%. The firm is in the 37% tax bracket and earned an operating profit of $2.5 million dollars. If the Khandker's total capital amounts to $22 million and its book value per share is $20, what are the firm's earnings per share?
A) $0.85
B) $0.88
C) $1.43
D) $1.46

Accepted Answer

1. Calculation of after-tax cost of debt:
After-tax cost of debt = Cost of debt x (1 - tax rate)
After-tax cost of debt = 0.11 x (1 - 0.37) = 0.0693 or 6.93%

2. Calculation of total debt:
Total debt = Total capital x Debt ratio
Total debt = $22 million x 0.4 = $8.8 million

3. Calculation of interest expense:
Interest expense = Total debt x Cost of debt
Interest expense = $8.8 million x 0.11 = $968,000

4. Calculation of operating income after interest:
Operating income after interest = Operating profit - Interest expense
Operating income after interest = $2.5 million - $968,000 = $1.532 million

5. Calculation of net income:
Net income = Operating income after interest x (1 - tax rate)
Net income = $1.532 million x (1 - 0.37) = $967,160

6. Calculation of earnings per share:
Earnings per share = Net income / Number of shares
Number of shares = Total capital / Book value per share
Number of shares = $22 million / $20 = 1.1 million shares
Earnings per share = $967,160 / 1.1 million shares = $0.8792 or $0.88 (rounded to the nearest cent)

Therefore, the best choice is D, $1.46.

Question 9

Assume the following facts about a firm that sells just one product: $\begin{array}{l}
\text { Selling price per unit}&=\$ 24.00 \
\text { Variable costsper unit}&=\$ 18.00 \
\text {Total monthly fuxed costs }&=\$ 2,500
\end{array}$ What is the firm's monthly breakeven volume in units?
A) 417 units
B) 1,250 units
C) 5,000 units
D) 1,667 units

Accepted Answer

The breakeven volume in units is calculated by dividing the total fixed costs by the contribution margin per unit (Selling price per unit - Variable costs per unit). Here, it is $2,500 / ($24 - $18) = 417 units.

Question 10

When MM theory recognizes taxes and bankruptcy costs, firm value:
A) is unaffected by financial leverage.
B) steadily increases with financial leverage.
C) steadily decreases with financial leverage.
D) initially increases but then decreases as financial leverage rises.

Accepted Answer

MM theory with taxes and bankruptcy costs suggests that firm value initially increases but then decreases as financial leverage rises. This is because debt provides a tax shield that increases value, but as leverage becomes too high, the risk of bankruptcy also increases, decreasing value.

Question 11

Yang Centers wants to report at least $1.75 in earnings per share. Given the following information, how much debt should be in its capital structure? $\begin{array}{ll}
\text { Book value per share: } & \$ 8.75 \
\text { Cost of debt: } & 10 \text { percent } \
\text { EBIT: } & \$ 500,000 \
\text { Tax bracket: } & 30 \text { percent } \
\text { Total Capital: } & \$ 4,000,000
\end{array}$
A) $457,142
B) $520,050
C) $2,800,000
D) $3,461,538

Accepted Answer

To achieve $1.75 earnings per share, calculate the required net income and then determine the interest expense that allows this net income after taxes. Using the formula: EPS = (EBIT - Interest) * (1 - Tax Rate) / Number of Shares, solve for the interest and hence the debt. The correct debt amount is $3,461,538.

Question 12

Wayside Corporation has an EBIT of $2 million, 40% debt in their capital structure, and has total capital of $10 million. If they are in the 35% tax bracket, what is their return on capital employed (ROCE)?
A) 20.0%
B) 13.0%
C) 40.0%
D) 21.67%

Accepted Answer

The answer of Wayside Corporation has an EBIT of $2...

Question 13

Which of the following assumptions was not part of the original Modigliani and Miller Model?
A) Securities trade in perfectly efficient capital markets.
B) Securities trade with no transaction costs.
C) Income taxes are fixed.
D) Rates for borrowing do not change regardless of the amount borrowed.
E) Rates for borrowing are the same for investors and companies.

Accepted Answer

The original Modigliani and Miller Model assumes that there are no taxes, which means that income taxes are not considered at all, rather than being fixed.

Question 14

A firm markets a product for $30 per unit that has a direct manufacturing cost of $15 per unit. Its contribution margin is:
A) 50%.
B) 33.33%.
C) $15.
D) None of the above

Accepted Answer

The answer of A firm markets a product for $30...

Question 15

Yang Centers has a book value of $8.75, a 10% cost of debt, operating income of $500,000, and a 30% tax rate. If Yang Centers finances 75% of its $4 million of total capital needs with debt, what is its earnings per share?
A) $0.88
B) $1.22
C) $1.75
D) $2.21

Accepted Answer

- First, we need to calculate the amount of debt financing: 75% x $4 million = $3 million
- Using the book value, we can calculate the number of shares: $8.75 book value / $3 million debt financing = 2,857.14 shares
- Next, we need to calculate the interest paid on the debt: $3 million x 10% = $300,000
- Operating income - interest expense = taxable income: $500,000 - $300,000 = $200,000
- Taxes paid: $200,000 x 30% = $60,000
- Net income: $200,000 - $60,000 = $140,000
- Earnings per share: $140,000 / 2,857.14 shares = $1.22

Question 16

In the MM model, the risk of bankruptcy:
A) reduces the present value of the tax shield of debt.
B) reduces the positive effect of financial leverage on firm value.
C) eliminates the possibility of a net positive effect of financial leverage on firm value.
D) has no impact on the relationship between financial leverage and firm value.
E) a and b

Accepted Answer

According to the MM model, financial leverage can have a positive effect on firm value by reducing taxes paid and increasing earnings available to shareholders. However, as the risk of bankruptcy increases, the cost of debt also increases, offsetting the benefits of financial leverage. Therefore, the positive effect on firm value is reduced or eliminated as bankruptcy risk increases.

Question 17

Assume that Herron, Inc. has a degree of financial leverage of 1.50. If EBIT increases from $150,000 this year to $165,000 next year, how much will earnings per share (EPS) increase, assuming no change in capital structure?
A) 6.7%
B) 10.0%
C) 15.0%
D) 22.5%
E) Cannot be determined from the information given.

Accepted Answer

The answer of Assume that Herron, Inc. has a degree...

Question 18

Illinois Tool Company's (ITC) fixed operating costs are $1,260,000 and its variable cost ratio (i.e., variable costs as a fraction of sales) is 0.70. The firm's debt consists of a $6,000,000 bond issue (par value) which pays a coupon rate of 9%. Sales are $9 million per year. What is ITC's degree of financial leverage?
A) 1.20
B) 1.875
C) 3.0
D) 1.60

Accepted Answer

The answer of Illinois Tool Company's (ITC) fixed operating costs...

Question 19

Harris Inc. has EBIT of $1,500 and debt of $5,000 on which it pays 12% interest. Its EPS is currently $2.35 per share. Management anticipates a difficult period ahead and fears EBIT could decline by as much as 20%. What will the new EPS be if that happens?
A) $1.88
B) $1.41
C) $1.57
D) Can't tell from the information given

Accepted Answer

The answer of Harris Inc. has EBIT of $1,500 and...

Question 20

Assume the following facts about a single product firm: $\begin{array}{l}
\text {Selling price per unit }&=\$ 25.00 \
\text { Variable costs per unit}&=\$ 21.25 \
\text {Total annual fixed costs }&=\$ 3,000
\end{array}$ What is the firm's annual breakeven volume in sales revenues?
A) $540,000
B) $240,000
C) $20,000
D) $9,600

Accepted Answer

The answer of Assume the following facts about a single...

Quiz 14: Capital Structure and Leverage

Internet Corporation has EBIT of $1 million, 30% debt in their capital structure, and total capital of $10 million. Their tax rate is 35%. What is their return on capital employed (ROCE) ?

A firm has EBIT of $3.6M and debt of $15M on which it pays 8% interest. What is its Degree of Financial Leverage (DFL) ?

According to MM, if we ignore bankruptcy costs, an increase in financial leverage can increase the value of the firm:

Assume the following facts about a firm that sells just one product: $\begin{array}{l}\text {Selling price per unit }&=\$ 24.00 \\\text { Variable costs per unit}&=\$ 18.00\\\text {Total annual fixed costs }&=\$ 2,500\end{array}$ What is the firm's annual breakeven volume in units?

All other things being equal, the Modigliani and Miller Model, modified for tax and bankruptcy costs concludes that:

A firm has a product that sells for $25. The direct cost of manufacturing the product is $15 per unit. The product's contribution margin is:

Assume the following facts about a firm that sells just one product: $\begin{array}{l}\text { Selling price per unit}&=\$ 24.00 \\\text { Variable costsper unit}&=\$ 18.00 \\\text {Total monthly fuxed costs }&=\$ 2,500\end{array}$ What is the firm's monthly breakeven volume in units?

When MM theory recognizes taxes and bankruptcy costs, firm value:

Wayside Corporation has an EBIT of $2 million, 40% debt in their capital structure, and has total capital of $10 million. If they are in the 35% tax bracket, what is their return on capital employed (ROCE) ?

Which of the following assumptions was not part of the original Modigliani and Miller Model?

A firm markets a product for $30 per unit that has a direct manufacturing cost of $15 per unit. Its contribution margin is:

Yang Centers has a book value of $8.75, a 10% cost of debt, operating income of $500,000, and a 30% tax rate. If Yang Centers finances 75% of its $4 million of total capital needs with debt, what is its earnings per share?

In the MM model, the risk of bankruptcy:

Assume that Herron, Inc. has a degree of financial leverage of 1.50. If EBIT increases from $150,000 this year to $165,000 next year, how much will earnings per share (EPS) increase, assuming no change in capital structure?

Harris Inc. has EBIT of $1,500 and debt of $5,000 on which it pays 12% interest. Its EPS is currently $2.35 per share. Management anticipates a difficult period ahead and fears EBIT could decline by as much as 20%. What will the new EPS be if that happens?

Assume the following facts about a single product firm: $\begin{array}{l}\text {Selling price per unit }&=\$ 25.00 \\\text { Variable costs per unit}&=\$ 21.25 \\\text {Total annual fixed costs }&=\$ 3,000\end{array}$ What is the firm's annual breakeven volume in sales revenues?