1. Which of the following does NOT affect the business risk of a firm? Variabili
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Question
1. Which of the following does NOT affect the business risk of a firm?
Variability in Sales (Price and/or Volume)
Degree of Operating Leverage
Product Diversification
Level of Debt
2. According to the tradeoff model of capital structure, which is true at the optimal capital structure?
The firm’s stock price is maximized
Earnings Per Share are maximized
The total value of equity is maximized
Return on Equity is Maximized
3. Which is NOT a reason why the costs of debt and equity might increase at an increasing rate as the level of debt rises?
The firm’s best employees begin to leave
Managers start accepting positive NPV projects
The firm must pay higher legal and accounting costs
Assets may be sold at below market prices during liquidation
4. According to the tradeoff models of capital structure, as the level of debt increases, the cost of debt will _________ while the cost of equity will _________.
a. Rise; Rise c. Fall; Fall
b. Rise; Fall d. Fall; Rise
5. The Price Co. can make widgets for $5 and sell them for $8. If fixed costs are $100,000, then how many widgets must they sell in order to have an EBIT of $50,000?
a) 30,000 b) 50,000 c) 100,000 d) 150,000
6. Adding debt will increase the firm’s ROE as long as the cost of debt is less than their ________________.
Cost of Equity
Return on Assets
Profit Margin
Basic Earning Power
7. Why might a firm’s managers/owners choose to use more than the optimal amount of debt?
To Avoid Risk
To Reserve Borrowing Capacity
To Signal Expected Future Gains
To maintain voting control
Use the following information for questions 8-11: A company is trying to decide on their use of operating and financial leverage from among four choices. Their Interest Expense is the Interest Rate times Debt. Their Tax Rate is 40%
Option Fixed Costs Variable Costs Debt Interest Rate
1. 20000 70% of Sales 0 0%
2. 50000 40% of Sales 0 0%
3. 20000 70% of Sales 500,000 10%
4. 50000 40% of Sales 500,000 10%
8. What is their Degree of Operating Leverage under option 1 if sales are $200,000?
a) 1 b) 1.5 c) 2 d) 3
9. What is their Degree of Financial Leverage under option 4 if EBIT is $120,000?
a) 1 b) 1.2 c) 1.7 d) 2.2
10. If Sales rise by 10% from 300,000 to 330,000 under option 3, then EBT will increase by what percent?
a) 13% b) 25% c) 35% d) 45%
11. At what level of Sales will the Degree of Operating Leverage = 2 under Option 2?
a) 100,000 b) 166,667 c) 250,000 d) 333,333
12. Company A and Company B have the same EBIT, tax rate, total assets, and Cost of Debt. However, Company A has a higher debt ratio than Company B. Which of the following statements is correct? (ROA = Net Income / Assets and ROE = Net Income / Equity)
a. Company A has a higher net income than Company B.
b. Company A has a lower ROA than Company B.
c. Company A has a lower ROE than Company B.
d. The two companies have the same ROE.
13. Firms with _____________ should have _________________.
Higher Operating Leverage; More Debt
Less Business Risk; More Financial Leverage
Less Volatile EBITs; Less Debt
Lower Operating Leverage; Lower Financial Leverage
Omega Corp. currently has 100,000 shares of stock outstanding but is planning on issuing debt in order to buy back stock. Their EBIT is a constant $1,000,000 regardless of how much debt they issue and they pay all net income out as dividends. Their tax rate is 40%. They have estimated the following costs of debt and costs of equity for various levels of debt.
EBIT =
1,000,000
Tax Rate =
40%
Share
Shares
Debt
rd
re
Net Inc
StkValue
FirmValue
Debt %
WACC
Price
Outstding
0
6.00%
11.00%
600,000
5,454,545
5,454,545
0.00%
11.00%
100,000
500,000
6.30%
11.40%
581,100
5,097,368
8.93%
10.72%
55.97
91,067
1,000,000
6.80%
12.00%
559,200
1,500,000
8.00%
13.00%
4,061,538
5,561,538
26.97%
10.79%
55.62
2,000,000
9.50%
14.50%
2,500,000
11.50%
16.50%
2,590,909
5,090,909
49.11%
3,000,000
14.00%
19.00%
1,831,579
4,831,579
14. What will their Net Income be if they issue $2,000,000 in debt?
a. $190,000 b. $324,000 c. $486,000 d. $810,000
15. What will their Stock Value be if they issue $1,000,000 in debt?
a. $4,190,000 b. $4,660,000 c. $5,600,000 d. $6,710,400
16. What will their WACC be if they issue $2,500,000 in debt?
a. 10.7% b. 11.8% c. 12.7% d. 14.1%
17. What will their Share Price be if they issue $0 in debt?
a. $48.62 b. $51.23 c. $54.55 d. $60
18. What will their Shares Outstanding be if they issue $1,500,000 in debt?
a. 40,615 b. 55,615 c. 62,374 d. 73,023
19. As the level of debt rises, the _______________ always.
a)Cost of Equity rises
b)WACC rises
c)Basic Earning Power falls
d)ROE rises
EBIT =
1,000,000
Tax Rate =
40%
Share
Shares
Debt
rd
re
Net Inc
StkValue
FirmValue
Debt %
WACC
Price
Outstding
0
6.00%
11.00%
600,000
5,454,545
5,454,545
0.00%
11.00%
100,000
500,000
6.30%
11.40%
581,100
5,097,368
8.93%
10.72%
55.97
91,067
1,000,000
6.80%
12.00%
559,200
1,500,000
8.00%
13.00%
4,061,538
5,561,538
26.97%
10.79%
55.62
2,000,000
9.50%
14.50%
2,500,000
11.50%
16.50%
2,590,909
5,090,909
49.11%
3,000,000
14.00%
19.00%
1,831,579
4,831,579
Explanation / Answer
1. - Product Diversification As it is a non financial aspect of a business thus is it does not affect the business risk.
2. - The firm’s stock price is maximized
3. - The firm’s best employees begin to leave - Employees have no direct relation with cost of capital
4 - B - Rise Fall
5 (8-5)/150,000 = 30,000
6. - Cost of Equity
7. To maintain voting control
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