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Exam 12: Capital Structure

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Question 31

True/False

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The TIE ratio depends on the percentage of debt in the capital structure of the firm, the interest rate on the debt, and the profitability of the firm.

A) True
B) False

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Question 32

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Which of the following is correct?

A) Generally, debt to total assets ratios do not vary much among different industries although they do vary for firms within a particular industry.
B) Utilities generally have very high ordinary equity ratios due to their need for vast amounts of equity supported capital.
C) The drug industry has a high debt to ordinary equity ratio because their earnings are very stable and thus, can support the large interest costs associated with higher debt levels.
D) Wide variations in capital structures exist between industries and also between individual firms within industries and are influenced by unique firm factors including managerial attitudes.
E) Since most shares sell at or around their book values, using accounting values provides an accurate picture of a firm's capital structure.

F) A) and D)
G) A) and E)

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Question 33

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Bell Brothers has R3,000,000 in sales.Its fixed costs are estimated to be R100,000, and its variable costs are equal to fifty cents for every rand of sales.The company has R1,000,000 in debt outstanding at a before-tax cost of 10 percent.If Bell Brothers' sales were to increase by 20 percent, how much of a percentage increase would you expect in the company's net income?

A firm expects to have a 15 percent increase in sales over the coming year.If it has operating leverage equal to 1.25 and financial leverage equal to 3.50, then what will be the percentage change in EPS?

Firm A has a higher degree of business risk than Firm B.Firm A can offset this by using less financial leverage.Therefore, the variability of both firms' expected EBITs could actually be identical.

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 aggressive capital structure?

If we consider only agency costs associated with the issuance of debt, then this implies that the firm should move toward 100 percent debt financing.

Which of the following factors does not affect a firm's business risk?

Risk can be apportioned between financial and business risk.Financial risk and business risk are related in that, as business risk increases so does financial risk, although the correlation between the two is not perfect.

A firm that has high interest payments relative to other companies is said to have

The optimal capital structure is that capital structure which strikes a balance between risk and return such that the firm's share price is maximised.

Business risk will not affect a firm's beta, because beta is determined by the market and thus is outside the control of the firm.

If the debt ratio is 50 percent, the interest rate on all debt is 8 percent, the tax rate is 50 percent, and the return on equity is 10 percent, then the ratio of earnings before interest and taxes (EBIT) to total assets, or the basic earning power ratio, must be

If debt financing is used, which of the following is correct?

Given the information below, calculate the expected growth rate (g) of dividends, using the constant growth model P0 = , Beta = 1.75; rRF = 7 percent; rM = 11 percent; dividend payout ratio = 30 percent; rd = 10 percent (paid) on all long-term debt; P/E ratio = 10; sales = 5,000 units; sales price per unit = R5; variable cost per unit = R2; fixed cost = R1,000; ordinary shares outstanding = 5,000; long-term debt outstanding = R10,000; tax rate = 40 percent.Assume equilibrium exists in the market.

Two firms, although they operate in different industries, have the same expected earnings per share and the same standard deviation of expected EPS.Thus, the two firms must have the same business risk.

If a firm uses no debt, the uncertainty inherent in projections of future returns on equity can be described as business risk.

If a firm is operating at its optimal capital structure, then its weighted average cost of capital must be __________ and its value must be __________.

The firm's target capital structure is consistent with which of the following?

If we include the cost of bankruptcy in the MM analysis of capital structure in a world with taxes, we would tend to believe that the cost of debt increases as leverage increases and that there is probably an optimal capital structure.