Q&A Hero

Q: When using an EPS-EBIT chart to evaluate a pure debt financing and pure equity financing plan, A) the debt financing plan line will graph with a steeper slope than the equity financing plan line. B) the debt financing plan line will have a lower level of EBIT at EPS = 0. C) the line of the two financing plans will intersect on the EBIT axis. D) the slope of the equity financing plan line will be steeper than the debt financing plan line below the intersection of the two lines.

Q: The Modigliani and Miller hypothesis does NOT work in the "real world" because A) interest expense is tax deductible, providing an advantage to debt financing. B) higher levels of debt increase the likelihood of bankruptcy, and bankruptcy has real costs for any corporation. C) dividend payments are fixed and tax deductible for the corporation. D) both A and B

Q: Above the EBIT-EPS indifference point, a more heavily levered financial plan will produce greater EPS.

Q: One danger of EBIT-EPS analysis is that it ignores the implicit cost of debt financing.

Q: Because there are no fixed financing costs, a common stock plan line in an EBIT-EPS analysis chart will have a less-steep slope than will a bond plan line.

Q: An EBIT-EPS analysis allows the decision maker to visualize the impact of different financing plans on EPS over a range of EBIT levels.

Q: The EBIT-EPS indifference point is the level of production at which the company's EBIT equals its EPS.

Q: Given taxes and bankruptcy costs exist, as financial leverage increases, the weighted average cost of capital first decreases and then increases.

Q: How do agency costs and free cash flow relate to capital structure management?

Q: The "threat hypothesis" A) reduces management's tendency to spend freely. B) encourages management to use debt to further their own interests. C) increases the agency problem. D) increases agency monitoring costs.

Q: The market value of a leveraged firm is equal to the market value of an unleveraged firm A) plus the present value of tax shields minus the present value of financial distress costs plus the present value of agency costs. B) plus the present value of tax shields plus the present value of financial distress costs plus the present value of agency costs. C) minus the present value of tax shields minus the present value of financial distress costs minus the present value of agency costs. D) plus the present value of tax shields minus the present value of financial distress costs minus the present value of agency costs.

Q: Which of the following would be considered the firm's optimal capital structure? A) Stock Price = $25, Earnings Per Share = $10, Cost of Equity Capital = 15% B) Stock Price = $23, Earnings Per Share = $11, Cost of Equity Capital = 18% C) Stock Price = $24, Earnings Per Share = $12, Cost of Equity Capital = 17% D) Stock Price = $20, Earnings Per Share = $12, Cost of Equity Capital = 20%

Q: A firm's optimal capital structure occurs where? A) EPS are maximized, and WACC is minimized. B) Stock price is maximized, and EPS are maximized. C) Stock price is maximized, and WACC is maximized. D) WACC is minimized, and stock price is maximized.

Q: Which of the following would NOT be a part of a firm's capital structure? A) short-term notes payable B) long-term bonds C) preferred stock D) common stock

Q: Optimal capital structure is A) the mix of permanent sources of funds used by the firm in a manner that will maximize the company's common stock price. B) the mix of all items that appear on the right-hand side of the company's balance sheet. C) the mix of funds that will minimize the firm's cost of equity capital. D) the mix of funds that will maximize the firm's interest tax shield.

Q: When deciding upon how much debt financing to employ, most practitioners would cite which of the following as the most important influence on the level of the debt ratio? A) providing a borrowing reserve B) maintaining desired bond rating C) ability to adequately meet financing charges D) exploiting advantages of financial leverage

Q: According to the moderate view of capital costs and financial leverage, as the use of debt financing increases, A) the cost of capital continuously decreases. B) the cost of capital remains constant. C) the cost of capital continuously increases. D) there is an optimal level of debt financing.

Q: One component of a firm's financial structure which is NOT a component of its capital structure is A) common stock. B) accounts payable. C) long-term debt. D) preferred stock.

Q: Which of the following statements is MOST correct concerning a corporation's optimal capital structure? A) The optimal capital structure maximizes the present value of the interest tax shield. B) The optimal capital structure occurs at the point where the market value of the levered firm is maximized. C) The optimal capital structure minimizes the present value of financial distress costs and agency costs. D) The optimal capital structure occurs where the present value of the interest tax shield equals the present value of the firm's bankruptcy costs.

Q: Assuming no corporate taxes, the independence hypothesis suggests that a firm's weighted average cost of capital will A) remain constant regardless of capital structure because the cost of debt and the cost of equity are the same. B) remain constant because the cost of equity will be increasing as the amount of debt increases due to the increased risk. C) increase proportionally with the increase in the amount of debt a firm uses. D) decrease proportionally with the increase in the amount of debt a firm uses.

Q: The Modigliani and Miller hypothesis suggests that capital structure doesn't matter. All of the following conditions need to be met for this hypothesis to be true EXCEPT A) corporate income is not subject to taxation. B) capital structure consists only of stocks and bonds. C) securities are traded in perfect or efficient markets. D) all corporate net income is paid out as dividends.

Q: The optimal capital structure is the funds mix that will A) minimize the use of debt. B) achieve an equal proportion of debt, preferred stock, and common equity. C) minimize the firm's composite cost of capital. D) maximize total leverage.

Q: Capital structure is the mix of the long-term sources of funds used by the firm.

Q: The control hypothesis suggests that shareholders prefer an increase in the firm's debt in order to reduce the agency costs associated with excessive free cash flow.

Q: The implicit cost of debt takes into consideration the change in the cost of common equity brought on by using additional debt.

Q: If we ignore bankruptcy and agency costs then the optimal capital structure for a firm under the moderate view would be 100% debt.

Q: The independence hypothesis suggests that the cost of equity decreases as financial leverage increases.

Q: The independence hypothesis allows for bankruptcy and agency costs.

Q: A corporation's debt capacity is the maximum proportion of debt that the corporation can include in its capital structure and still maintain its lowest composite cost of capital.

Q: A saucer-shaped or U-shaped weighted average cost of capital curve results from the tax deductibility of interest, which results in the downward slope, followed by the recognition of potential financial distress costs, that cause the upward slope as the amount of debt ratio increases.

Q: Corporations that are heavily committed to investments in fixed assets that are expected to produce cash flow over many years generally favor long-term debt to the extent that they borrow.

Q: Borrowing funds using short-term debt, such as commercial paper, and using the proceeds to invest in long-term investments, creates a refinancing risk that can force firms to sell assets at distressed prices if financing becomes unavailable.

Q: Two key components of a prudent capital structure are the debt maturity composition and the debt to equity composition.

Q: Financial structure is equal to non-interest bearing liabilities, such as accounts payable and accruals, plus capital structure, which includes short- and long-term debt, preferred stock, and common equity.

Q: Financial structure is another term for capital structure.

Q: A firm's cost of capital is not affected by the composition of the right-hand side of the firm's balance sheet, but rather is determined by the firm's mix of assets.

Q: The tax shield on interest is calculated by multiplying the interest rate paid on debt by the principal amount of the debt and the firm's marginal tax rate.

Q: Other things the same, the use of debt financing reduces the firm's total tax bill resulting in a higher total market value.

Q: The moderate view of capital structure theory allows for the tax-deductibility of interest expense.

Q: The independence hypothesis suggests that the total market value of the firm's outstanding securities is unaffected by its capital structure.

Q: The objective of capital structure management is to maximize the market value of the firm's common stock.

Q: According to the moderate view of capital structure theory, the cost of common equity is constant regardless of the debt financing level.

Q: Financial structure includes long- and short-term sources of funds.

Q: Higher bankruptcy costs will result in optimal capital structures using more long-term debt financing.

Q: The optimal capital structure occurs when operating leverage equals financial leverage.

Q: Capital structure is equal to financial structure minus current liabilities.

Q: Raising funds internally is effectively increasing the investment of the firm's existing common shareholders.

Q: Welker Products sells small kitchen gadgets for $15 each. The gadgets have a variable cost of $4 per unit, and Welker Products' fixed operating costs are $220,000 per year. Welker Products' capital structure includes 55% debt and 45% equity. Annual interest expense is $25,000, and the corporate tax rate is 35%.a. Calculate the break-even point in units.b. If Welker Products sells 25,000 units, calculate the firm's EBIT and net income.c. If sales increase ten percent from 25,000 units to 30,000 units, estimate the firm's expected EBIT and net income.d. Does Welker Products use operating leverage and/or financial leverage? Explain.

Q: How do operating and financial leverage interact to affect the volatility of a firm's earnings per share?

Q: The following information pertains to the Classic Burger Restaurant chain:Sales$600,000Variable costs300,000Total contribution margin300,000Fixed costs100,000EBIT200,000Interest expense50,000Earnings before taxes150,000Taxes (30%)45,000Net income$105,000a. If sales increase by 10%, what will be the new level of EPS if the firm has 100,000 shares outstanding?b. What is the percentage increase in EPS? Explain the difference between the percentage increase in sales and the percentage increase in EPS.

Q: Which of the following statements about combined (operating & financial) leverage is true? A) If a firm employs both operating and financial leverage, any percent change in sales will produce a larger percent change in earnings per share. B) A firm that is in a capital-intensive industry should use a higher level of financial leverage than a firm that employs low levels of operating leverage. C) Usage of both operating and financial leverage reduces a firm's risk. D) High operating leverage and high financial leverage offset one another, meaning that if sales increase by 10%, then EPS will also increase by 10%.

Q: Which of the following statements about financial leverage is true? A) Financial leverage is the responsiveness of the firm's EBIT to fluctuations in sales. B) Financial leverage involves the incurrence of fixed operating costs in the firm's income stream. C) Financial leverage is the responsiveness of the firm's EPS to fluctuations in EBIT. D) Financial leverage reduces a firm's risk.

Q: Financial leverage has to do with A) the usage of fixed cost financial securities to finance a portion of a firm's assets. B) using common stock to finance a portion of a firm's assets. C) the incurrence of fixed operating costs in the firm's income stream. D) a high gross profit margin.

Q: Which of the following statements about operating leverage is true? A) Operating leverage reduces a firm's risk. B) Operating leverage is the responsiveness of the firm's EBIT to fluctuations in sales. C) Operating leverage involves the usage of fixed cost financial securities in the operation of a business. D) Operating leverage is the responsiveness of the firm's EPS to fluctuations in sales.

Q: Operating leverage has to do with A) borrowing money to finance a firm's growth. B) using preferred stock to increase sales volume. C) the incurrence of fixed operating costs in the firm's income stream. D) financing with fixed cost sources of capital.

Q: If a firm has no operating leverage and no financial leverage, then a 10% increase in sales will have what effect on EPS? A) EPS will remain the same. B) EPS will increase by 10%. C) EPS will decrease by 10%. D) EPS will increase by less than 10%.

Q: Financial leverage is distinct from operating leverage since it accounts for A) use of debt and preferred stock. B) variability in fixed operating costs. C) variability in sales. D) changes in EBIT.

Q: Operating leverage refers to A) financing a portion of the firm's assets with securities bearing a fixed rate of return. B) the additional chance of insolvency borne by the common shareholder. C) the incurrence of fixed operating costs in the firm's income stream. D) a high degree of variable costs of production.

Q: Financing a portion of a firm's assets with securities bearing a fixed rate of return in hopes of increasing the return to stockholders refers to A) business risk. B) financial leverage. C) operating leverage. D) combined leverage.

Q: Financial leverage could mean financing some of a firm's assets with A) preferred stock. B) retained earnings. C) private equity capital. D) sales revenues.

Q: A firm that uses large amounts of debt financing in an industry characterized by a high degree of business risk would have ________ earnings per share fluctuations resulting from changes in levels of sales. A) no B) constant C) large D) small

Q: Bristal Boats, Inc. reports sales of $4,000,000, variable costs of $500,000, fixed operating costs of $1,250,000, and interest expense of $350,000. The corporation's EBIT is $3,250,000 and its marginal tax rate is 30%. If the corporation is able to increase its sales by 25%, then A) its EBIT will increase by 25% and its EPS will increase by 25%. B) its EBIT will increase by more than 25% and its EPS will increase by less than 25%. C) its EBIT and EPS will both increase, but less than 25% due to fixed costs and taxes. D) its EBIT will increase by more than 25% and its EPS will increase by more than the percentage increase in EBIT.

Q: Amalgamated Mining, Inc. has very high operating leverage due to the capital intensive nature of the steel business. The firm's CEO is concerned about the variability in the firm's EPS if sales should drop, and decides to take action. Which of the following will reduce the variability in the firm's EPS for a given change in sales? A) The CEO may increase the firm's financial leverage and hence reduce the variability by using non-shareholder money to support the business. B) The CEO may decrease the firm's financial leverage, thus lowering the firm's total leverage. C) The CEO may increase the firm's total leverage by raising money from the sale of common stock. D) The CEO may issue more corporate bonds and use the proceeds to pay off short-term liabilities.

Q: ACME, Inc. reported the following income statement for 2009:Sales$2,500,000Variable Costs900,000Fixed Operating Costs700,000EBIT900,000Interest Expense200,000EBT700,000Taxes (30%)210,000Net Income$490,000Earnings Per Share$4.90If ACME's sales next year increase by 20%, ACME's EBIT will increaseA) 20%, showing no operating leverage.B) 20%, showing no financial leverage.C) over 35%, due to operating leverage.D) over 35%, due to operating leverage and financial leverage.

Q: ACME, Inc. reported the following income statement for 2009:Sales$2,500,000Variable Costs900,000Fixed Operating Costs700,000EBIT900,000Interest Expense200,000EBT700,000Taxes (30%)210,000Net Income$490,000Earnings Per Share$4.90If ACME's sales next year increase by 20%, what will ACME's earnings per share be?A) $5.76B) $6.45C) $7.14D) $7.58

Q: Dakota Oil, Inc. reported that its sales and EBIT increased by 10%, but its EPS increased by 30%. The much larger change in earnings per share could be the result of A) high operating leverage. B) high financial leverage. C) a high percentage of credit sale collections from prior years. D) high fixed costs of production.

Q: Which of the following transactions will lower a company's financial leverage? A) A mortgage loan is obtained and the proceeds are used to pay off existing short-term debt. B) Preferred stock is sold and the proceeds are used to pay off existing short-term debt. C) Common stock is sold and the proceeds are used to pay off existing short-term debt. D) Short-term debt is obtained to get the company through a period of negative net income and cash flow.

Q: All of the following are likely to result in the use of less debt in a company's capital structure EXCEPT A) desire to maintain financial flexibility. B) desire to maintain a high credit rating. C) insufficient internal funds. D) a decrease in a company's marginal tax rate.

Q: Because financial markets can be extremely volatile, with bond and stock prices changing significantly from day to day, a firm's management has much greater control over the firm's operating leverage than over its financial leverage.

Q: If a firm's production process requires high operating leverage (use of fixed costs), then the firm should finance its assets with debt, so that the cost of capital will be reduced and financing costs will remain fixed.

Q: Because fixed costs do not vary with a firm's revenues, firms with high levels of fixed cost enjoy lower levels of operating risk because their costs are more certain, making budgeting easier.

Q: The presence of debt and/or preferred stock in a firm's financial structure means the firm is using financial leverage.

Q: If a company sells bonds and uses the proceeds to buy back common stock, the company's financial leverage with increase.

Q: An increase in financial leverage will increase the absolute value of EPS, everything else equal.

Q: The more fixed-charge securities (such as bonds and preferred stock) the firm employs in its financial structure, the greater its financial leverage.

Q: Operating leverage is the responsiveness of a firm's EBIT to changes in sales revenues.

Q: Financial leverage is typically more under the control of management than is operating leverage because the nature of the product often dictates the type of production process needed.

Q: Operating leverage is measured as the responsiveness of the firm's earnings before interest and taxes relative to fluctuations in sales.

Q: Operating leverage contributes ultimately to the variability of a firm's earnings per share.

Q: Operating leverage means financing a portion of a firm's earnings per share with debt.