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Exam 12: Capital Structure

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Question 21

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Which of the following statements is correct?

A) The degree of operating leverage (DOL) depends on a company's fixed costs, variable costs, and sales.The DOL formula assumes (1) that fixed costs are constant and (2) that variable costs are a constant proportion of sales.
B) The degree of total leverage (DTL) is equal to the DOL plus the degree of financial leverage (DFL) .
C) Arithmetically, financial leverage and operating leverage offset one another so as to keep the degree of total leverage constant.
D) The above statements are all true.
E) The above statements are all false.

F) C) and D)
G) A) and B)

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Question 22

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According to MM, in a world without taxes, the optimal capital structure for a firm should approach 100 percent debt financing.

A) True
B) False

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Question 23

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If a given change in EBIT results in a larger relative change in EPS then we can definitely say that the firm has

Which of the following statements is most correct?

One of the implications of signaling theory for capital structure decisions is that firms should normally seek to maintain a reserve borrowing capacity.

Other things held constant, an increase in financial leverage will increase a firm's market (or systematic) risk as measured by its beta coefficient.

All else equal, if a firm increases its leverage (either operating, financial, or both) , its weighted average cost of capital probably will

According to the trade-off theory of capital structure, the __________ benefit of increasing debt is traded-off against the __________ cost of increasing debt to determine the firm's optimal capital structure.

You are the president of a small, publicly traded corporation.Since you believe that your firm's share price is temporarily depressed, all additional capital funds required during the current year will be raised using debt.Thus, the appropriate marginal cost of capital for the current year is the after-tax cost of debt.

Generally speaking, companies in Italy and Japan use less debt in their capital structure than companies in the United States or Canada.

Which of the following statements is correct?

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 R60,000.The Famine state has a 40 percent chance of occurring and the EBIT is expected to be R20,000.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 R400,000 in total assets, it will face a 40 percent marginal tax rate, and the book value of equity per share under either scenario is R10.00 per share. -Refer to Copybold Corporation.What is the difference between the EPS forecasts for Feast and Famine under the conservative capital structure?

According to the signaling theory of capital structure, the issuance of equity for a firm with various financing alternatives signals that the firm has unfavorable prospects which it wants to share with new shareholders.

The combination of debt and equity that maximises a firm's value is known as the

Although the exact relationship between a firm's degree of financial leverage and its beta is difficult to estimate, it has been shown both theoretically and empirically that a firm's beta increases with its degree of financial leverage.

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 R60,000.The Famine state has a 40 percent chance of occurring and the EBIT is expected to be R20,000.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 R400,000 in total assets, it will face a 40 percent marginal tax rate, and the book value of equity per share under either scenario is R10.00 per share. -Refer to Copybold Corporation.What is the coefficient of variation of expected EPS under the conservative capital structure plan?

If the announcement of a share sale does in fact trigger a decline in share price, this reinforces the effects of flotation costs incurred with new equity issues.Further, this implies a larger break in the MCC schedule.

The weighted average cost of capital (WACC) declines as more of the lowest cost component is added.What limits a firm from using nearly all debt is that as the debt ratio rises, the absolute interest expense gets very large.The large interest expense reduces income and results in a debt ratio limit even though the WACC continues to decline.

Assume that a firm has a DFL of 1.25.If sales increase by 20 percent, the firm will experience a 60 percent increase in EPS, and it will have an EBIT of R100,000.What will be the EBIT for this firm if sales do not increase?

If the firm's actual debt ratio is below its target level, expansion capital should be raised by issuing equity in order to preserve the firm's borrowing capacity.