Cfin 4 4th Edition Besley Test Bank

CFIN4
Chapter 12 – Capital Structure
1. The optimal capital structure is that capital structure which strikes a balance between risk and return such that the
firm's stock price is maximized.
a. True
b. False
ANSWER: True
DIFFICULTY: Easy
TOPICS: Optimal capital structure
2. 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.
a. True
b. False
ANSWER: False
DIFFICULTY: Easy
TOPICS: Business risk
3. If a firm uses no debt, the uncertainty inherent in projections of future returns on equity can be described as business
risk.
a. True
b. False
ANSWER: True
DIFFICULTY: Easy
4. The ability of a firm to raise sufficient capital on competitive terms under adverse conditions in order to sustain
steady operations is referred to as financial flexibility.
a. True
b. False
ANSWER: True
DIFFICULTY: Easy
TOPICS: Financial flexibility
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5. As long as a firm is near its target capital structure it will not have to concern itself with financial flexibility.
a. True
b. False
ANSWER: False
DIFFICULTY: Easy
6. The degree of financial risk is the single most important determinant of a firm's capital structure.
a. True
b. False
ANSWER: False
DIFFICULTY: Easy
TOPICS: Financial risk
7. Other things held constant, an increase in financial leverage will increase a firm's market (or systematic) risk as
measured by its beta coefficient.
a. True
b. False
ANSWER: True
DIFFICULTY: Easy
TOPICS: Financial leverage
8. Financial leverage affects both EPS and EBIT, while operating leverage only affects EBIT.
a. True
b. False
ANSWER: False
DIFFICULTY: Easy
TOPICS: Operating and financial leverage
9. The management of a firm can control the degree of total leverage to some extent.
a. True
b. False
ANSWER: True
DIFFICULTY: Easy
TOPICS: DTL
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10. Since the degree of total leverage is equal to the degree of operating leverage times the degree of financial leverage,
the degree of total leverage must always be greater than or equal to positive 1.0.
a. True
b. False
ANSWER: False
DIFFICULTY: Easy
TOPICS: DTL
11. The central result from the work of Miller and Modigliani (MM) and subsequent researchers, is that it is now
possible to precisely identify a firm's optimal capital structure.
a. True
b. False
ANSWER: False
DIFFICULTY: Easy
TOPICS: MM and optimal capital structure
12. Because creditors can foresee, to at least some extent, the costs of bankruptcy, they charge an interest rate that has
a premium built into it to compensate for the present value of bankruptcy costs.
a. True
b. False
ANSWER: True
DIFFICULTY: Easy
TOPICS: Bankruptcy costs
13. 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
ANSWER: False
DIFFICULTY: Easy
TOPICS: MM and optimal capital structure
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14. You are the president of a small, publicly traded corporation. Since you believe that your firm's stock 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.
a. True
b. False
ANSWER: False
DIFFICULTY: Easy
TOPICS: Cost of capital
15. One of the implications of signaling theory for capital structure decisions is that firms should normally seek to
maintain a reserve borrowing capacity.
a. True
b. False
ANSWER: True
DIFFICULTY: Easy
TOPICS: Reserve borrowing capacity
16. The fact that interest is tax deductible makes corporate debt less expensive than common of preferred stock.
a. True
b. False
ANSWER: True
DIFFICULTY: Easy
TOPICS: Trade-off theory
17. The probability of incurring bankruptcy increases as the firm's debt/equity ratio decreases.
a. True
b. False
ANSWER: False
DIFFICULTY: Easy
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18. According to the signaling theory of capital structure, the issuance of equity for a firm with various financing
alternatives signals that the firm has very favorable prospects which it wants to share with new shareholders.
a. True
b. False
ANSWER: False
DIFFICULTY: Easy
TOPICS: Signaling theory
19. 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.
a. True
b. False
ANSWER: True
DIFFICULTY: Easy
20. Firms which maintain an adequate reserve borrowing capacity will be able to borrow money at reasonable cost when
good investment opportunities arise.
a. True
b. False
ANSWER: True
DIFFICULTY: Easy
TOPICS: Reserve borrowing capacity
21. Firms in industries that are cyclical, oriented toward research, or subject to huge liability suits normally will maintain
high levels of debt in their capital structure.
a. True
b. False
ANSWER: False
DIFFICULTY: Easy
TOPICS: Variations in capital structures
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22. 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
ANSWER: True
DIFFICULTY: Easy
TOPICS: TIE
23. The degree of operating leverage is defined as the percentage change in operating earnings associated with a given
percentage change in sales.
a. True
b. False
ANSWER: True
DIFFICULTY: Easy
24. 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.
a. True
b. False
ANSWER: False
DIFFICULTY: Medium
25. A consistent supply of capital is essential for the long-run success of a firm. Although a firm may have access to
capital under all types of economic conditions, the concept of financial flexibility implies that the firm can obtain
capital on acceptable, competitive terms.
a. True
b. False
ANSWER: True
DIFFICULTY: Medium
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26. The benefit to the firm of the tax deductibility of interest can be lowered if the firm's marginal tax rate is reduced by
accumulated depreciation or tax-loss carry-forwards.
a. True
b. False
ANSWER: True
DIFFICULTY: Medium
TOPICS: Tax position
27. An all equity firm has some risk inherent in its operations. When the firm decides to finance some of its operations
with debt, it exposes itself to financial risk and it increases its business risk.
a. True
b. False
ANSWER: False
DIFFICULTY: Medium
TOPICS: Financial and business risk
28. 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. True
b. False
ANSWER: False
DIFFICULTY: Medium
TOPICS: Financial and business risk
29. The fact that some managers are more aggressive in their use of debt financing in attempting to boost profits does
not influence the optimal or value-maximizing capital structure.
a. True
b. False
ANSWER: True
DIFFICULTY: Medium
TOPICS: Managerial aggressiveness
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30. 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. a.
True
b. False
ANSWER: True
DIFFICULTY: Medium
31. As the percentage of debt in a firm's capital structure increases, its financial risk increases. Once the firm increases
its debt beyond the optimal level, rising interest charges result in an immediate decrease in EPS.
a. True
b. False
ANSWER: False
DIFFICULTY: Medium
TOPICS: Financial risk and EPS
32. 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.
a. True
b. False
ANSWER: False
DIFFICULTY: Medium
33. Generally, as debt is substituted for equity, risk, as measured by the coefficient of variation of EPS, increases. This
negative effect works against the positive effect of substituting debt for equity, which is that higher leverage
increases expected EPS.
a. True
b. False
ANSWER: True
DIFFICULTY: Medium
TOPICS: Financial leverage and EPS
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34. 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.
a. True
b. False
ANSWER: True
DIFFICULTY: Medium
TOPICS: Financial leverage and beta
35. 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.
a. True
b. False
ANSWER: False
DIFFICULTY: Medium
TOPICS: Limits to using debt (WACC)
36. As the debt ratio rises, the WACC is reduced because the after-tax cost of debt is usually lower than the cost of
equity. What limits the substitution of debt for equity in the capital structure is that as the debt ratio rises the costs of
both components eventually increase.
a. True
b. False
ANSWER: True
DIFFICULTY: Medium
TOPICS: Limits to using debt (WACC)
37. If Miller and Modigliani had considered the cost of bankruptcy, it is unlikely that they would have concluded that 100
percent debt financing is optimal for the firm.
a. True
b. False
ANSWER: True
DIFFICULTY: Medium
TOPICS: MM and bankruptcy costs
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38. 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.
a. True
b. False
ANSWER: False
DIFFICULTY: Medium
TOPICS: Agency costs
39. One implication of information asymmetry between investors and firm managers is that if a firm raises new capital
by issuing debt rather than by selling stock, it signals that the firm has very good prospects.
a. True
b. False
ANSWER: True
DIFFICULTY: Medium
TOPICS: Information asymmetry
40. The announcement of a stock offering by a mature firm that seems to have financing alternatives is taken as a signal
that the firm's prospects are very good.
a. True
b. False
ANSWER: False
DIFFICULTY: Medium
TOPICS: Equity signal
41. If the announcement of a stock sale does in fact trigger a decline in stock price, this reinforces the effects of
flotation costs incurred with new equity issues. Further, this implies a larger break in the MCC schedule.
a. True
b. False
ANSWER: True
DIFFICULTY: Medium
TOPICS: Equity signal and MCC
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42. 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.
a. True
b. False
ANSWER: False
DIFFICULTY: Medium
TOPICS: Target capital structure
43. One implication of the signaling theory of capital structure is that firms should borrow as much as the trade-off
theory of capital structure predicts.
a. True
b. False
ANSWER: False
DIFFICULTY: Medium
44. Generally speaking, companies in Italy and Japan use less debt in their capital structure than companies in the United
States or Canada.
a. True
b. False
ANSWER: False
DIFFICULTY: Medium
TOPICS: Global capital structure
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45. Which of the following statements is most correct?
a. Increasing financial leverage is one way to increase a firm's basic earning power (BEP).
b. Firms with lower fixed costs tend to have greater operating leverage.
c. The debt ratio which maximizes EPS generally exceeds the debt ratio which maximizes share price.
d. Both a and b are correct.
e. Both a and c are correct.
ANSWER: c
RATIONALE: Statement a is incorrect because BEP = EBIT/Total assets. The extent to which the firm uses
debt financing does not affect EBIT or total assets. Statement b is incorrect because firms
with a high percentage of fixed costs have a high degree of operating leverage by definition.
DIFFICULTY: Easy
46. Business risk is concerned with the operations of the firm. Which of the following is not associated with (or not a
part of) business risk?
a. Demand variability.
b. Sales price variability.
c. The extent to which operating costs are fixed.
d. Changes in required returns due to financing decisions.
e. The ability to change prices as costs change.
ANSWER: d
DIFFICULTY: Easy
47. Which of the following factors does not affect a firm's business risk?
a. Demand variability.
b. Input price variability.
c. Interest cost variability.
d. Operating leverage.
e. Sales price variability.
ANSWER: c
DIFFICULTY: Easy
TOPICS: Business risk determinants
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48. Which of the following statements is correct?
a. As a rule, the optimal capital structure is found by determining the debt-equity mix that maximizes expected
EPS.
b. The optimal capital structure simultaneously maximizes EPS and minimizes the WACC.
c. The optimal capital structure minimizes the cost of equity, which is a necessary condition for maximizing the
stock price.
d. The optimal capital structure simultaneously minimizes the cost of debt, the cost of equity, and the WACC.
e. Each of the above statements is false.
ANSWER: e
RATIONALE: The optimal capital structure maximizes the firm's stock price and minimizes the firm's WACC.
DIFFICULTY: Easy
49. The firm's target capital structure is consistent with which of the following?
a. Maximum earnings per share.
b. Minimum cost of debt (rd).
c. Minimum risk.
d. Minimum cost of equity (rs).
e. Minimum weighted average cost of capital.
ANSWER: e
DIFFICULTY: Easy
50. Allyson, who is the CFO of Mundane Minerals & Mining (MMM), is trying to decide whether to issue debt or
common stock to finance the capital budgeting projects she has evaluated as acceptable (that is, the projects have
positive net present values, NPV). Because MMM is a relatively small company, Allyson believes that the type of
capital she uses to finance the projects will send a signal to investors. As a result, which of the following actions
would you recommend Allyson take?
a. Issue equity, because investing in positive NPV projects is not in the best interests of the firm, and the existing
stockholders will want to share such "bad news" with new stockholders.
b. Issue equity so as to dilute ownership and share the increase in wealth that results from investing in positive
NPV projects with new stockholders.
c. Issue debt, because debt is riskier than common stock, thus the value of existing stockholders' stock will
increase more than if new equity is issued.
d. Issue debt, because investing in positive NPV projects increases the value of the firm, and the existing
stockholders probably prefer not to share such good fortune with new stockholders.
e. Investors do not care which source of funds the firm uses as long as the funds are invested in positive NPV
projects; therefore it shouldn't matter which type of capital is used.
ANSWER: d
DIFFICULTY: Easy
TOPICS: Signaling theory predictions
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51. The combination of debt and equity that maximizes a firm's value is known as the
a. degree of financial leverage (DFL).
b. maximum WACC.
c. maximum business risk.
d. optimal capital structure.
ANSWER: d
DIFFICULTY: Easy
52. A firm should raise capital according to its optimal capital structure so as to maximize its
a. earnings per share (EPS).
b. stock price.
c. weighted average cost of capital (WACC).
d. net income.
ANSWER: b
DIFFICULTY: Easy
53. If a firm is operating at its optimal capital structure, then its weighted average cost of capital must be and its
value must be .
a. maximized; maximized
b. minimized; minimized
c. maximized; minimized
d. minimized; maximized
e. None of the above is a correct answer.
ANSWER: d
DIFFICULTY: Easy
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54. Which of the following factors affects business risk?

a. sales variability
b. proportion of debt in the firm's capital structure
c. taxes
d. preferred stock dividends
ANSWER: a
DIFFICULTY: Easy
TOPICS: Business risk determinants
55. A firm that has high interest payments relative to other companies is said to have
a. a poor finance department.
b. a high degree of financial leverage
c. no financial leveraging.
d. a high degree of operating leverage.
ANSWER: b
DIFFICULTY: Easy
56. According to the text DFL stands for

a. Degree of Financial Leverage
b. Detrimental Financial Liability
c. Differential Finance Learning
d. Departmental Finance League
e. Derivative Finance Law
ANSWER: a
DIFFICULTY: Easy
57. According to the trade-off theory of capital structure, the benefit of increasing debt is traded-off against the
potential cost of due to increasing debt when determining the firm's optimal capital structure.
a. bankruptcy; tax
b. operating; tax
c. tax; operating
d. tax; bankruptcy
e. operating; bankruptcy
ANSWER: d
DIFFICULTY: Easy
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58. As a general rule, the capital structure that
a. Maximizes expected EPS also maximizes the price per share of common stock.
b. Minimizes the interest rate on debt also maximizes the expected EPS.
c. Minimizes the required rate on equity also maximizes the stock price.
d. Maximizes the price per share of common stock also minimizes the weighted average cost of capital.
e. None of the above.
ANSWER: d
DIFFICULTY: Medium
59. Which of the following statements is most correct?

a. The optimal capital structure minimizes the WACC.
b. If the after-tax cost of equity financing exceeds the after-tax cost of debt financing, firms are always able to
reduce their WACC by increasing the amount of debt in their capital structure.
c. Increasing the amount of debt in a firm's capital structure is likely to increase the cost of both debt and equity
financing.
d. Answers a and c are both correct.
e. Answers b and c are both correct.
ANSWER: d
RATIONALE: Statement b is false because it is not always true.
DIFFICULTY: Medium
TOPICS: Capital structure and WACC
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60. If debt financing is used, which of the following is correct?

a. The percentage change in net operating income is greater than a given percentage change in net income.
b. The percentage change in net operating income is equal to a given percentage change in net income.
c. The percentage change in net operating income depends on the interest rate charged on debt.
d. The percentage change in net operating income is less than the percentage change in net income.
e. The degree of operating leverage is greater than 1.
ANSWER: d
DIFFICULTY: Medium
TOPICS: Use of financial leverage

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.
ANSWER: a
DIFFICULTY: Medium

a. Suppose Company A's EPS is expected to experience a larger percentage change in response to a given
percentage change in sales than Company B's EPS. Other things held constant, Company A would appear to
have more business risk than Company B.
b. Statement a would be correct if the term "EBIT" were substituted for "EPS."
c. Statement a would be correct if the term "EBIT" were substituted for "sales."
d. Statement a would be correct if the words "financial risk" were substituted for "business risk."
ANSWER: b
DIFFICULTY: Medium
TOPICS: Financial risk
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63. Which of the following are practical difficulties associated with capital structure and degree of leverage analyses?
a. It is nearly impossible to determine exactly how P/E ratios or equity capitalization rates (rs values) are
affected by different degrees of financial leverage.
b. Managers' attitudes toward risk differ and some managers may set a target capital structure other than the
one that would maximize stock price.
c. Managers often have a responsibility to provide continuous service; they must preserve the long-run viability
of the enterprise. Thus, the goal of employing leverage to maximize short-run stock price and minimize capital
cost may conflict with long-run viability.
d. All of the above.
e. None of the above represent a serious impediment to the practical application of leverage analysis to capital
structure determination.
ANSWER: d
DIFFICULTY: Medium
TOPICS: Limits of leverage analysis

a. When financial leverage is used, the graphical probability distribution of net income would tend to be more
peaked than a distribution where no leverage is present, other things held constant.
b. From an operational standpoint the goal of maintaining financial flexibility translates into maintaining adequate
reserve borrowing capacity.
c. While business risk varies form one industry to another and can change over time, it affects all firms equally
within a particular industry.
d. The optimal capital structure is the one that maximizes EBIT, and this always calls for a debt ratio which is
lower than the one that maximizes expected EPS.
ANSWER: b
DIFFICULTY: Medium
TOPICS: Miscellaneous concepts
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a. There have been no significant observed differences in the capital structures of U.S. corporations in
comparison to their German and Japanese counterparts.
b. Different countries use essentially the same international accounting conventions with respect to reporting
assets on a historical versus replacement cost basis.
c. An analysis of both bankruptcy and equity reporting costs leads to the conclusion that U.S. firms should have
more equity and less debt than firms in Japan and Germany.
d. Equity monitoring costs are higher in the United States than in Japan and Germany.
e. Debt monitoring costs are probably lower in the United States than in Japan and Germany.
ANSWER: c
DIFFICULTY: Medium
TOPICS: International capital structures
66. Which of the following is not one of the four primary factors that influence capital structure decisions?
a. The firm's business risk.
b. The firm's tax position.
c. The firm's financial flexibility.
d. The firm's inventory valuation method.
e. The firm's managerial attitude.
ANSWER: d
DIFFICULTY: Medium
67. The optimal capital structure is the one that maximizes , and this will always be lower than the debt/equity ratio
that maximizes .
a. expected EPS; the firm's stock price
b. net income, expected EPS
c. book value of the firm; net income
d. expected EPS; book value of the firm
e. the firm's stock price; expected EPS
ANSWER: e
DIFFICULTY: Medium
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68. If a change in sales results in a greater relative change in operating income (EBIT), we know that the firm has
a. a degree of operating leverage greater than one.
b. a degree of financial leverage greater than one.
c. a degree of operating leverage less than one.
d. a degree of financial leverage less than one.
e. none of the above.
ANSWER: a
DIFFICULTY: Medium
69. If a given change in EBIT results in a larger relative change in EPS then we can definitely say that the firm has
a. a degree of operating leverage greater than one.
b. a degree of operating leverage less than one.
c. a degree of financial leverage greater than one.
e. a degree of total leverage less than one.
ANSWER: d
DIFFICULTY: Medium
70. If a given change in sales results in a larger relative change in EPS then we can definitely say that the firm has
a. a degree of financial leverage greater than one.
b. a degree of operating leverage less than one.
c. a degree of total leverage less than one.
e. a degree of total leverage greater than one.
ANSWER: c
DIFFICULTY: Medium
TOPICS: Total leverage
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71. All else equal, if a firm increases its leverage (either operating, financial, or both), its weighted average cost of
capital probably will
a. increase because risk increases.
b. decrease because risk decreases.
c. increase because risk decreases.
d. remain about the same because risk does not change.
e. change somehow, but more information is needed to determine the direction.
ANSWER: e
DIFFICULTY: Medium
TOPICS: Capital structure and risk
72. is the situation where investors and managers have the same (identical) information about the firm's future
prospects.
a. Symmetric information
b. Asymmetric information
c. Leverage
d. Target capital structure
ANSWER: a
DIFFICULTY: Medium
TOPICS: Symmetric information
73. 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 common equity ratios due to their need for vast amounts of equity supported
capital.
c. The drug industry has a high debt to common 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 stocks sell at or around their book values, using accounting values provides an accurate picture of
a firm's capital structure.
ANSWER: d
DIFFICULTY: Tough
TOPICS: Variations in capital structures
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74. Quick Launch Rocket Company, a satellite launching firm, expects its sales to increase by 50 percent in the coming
year as a result of NASA's recent problems with the space shuttle. The firm's current EPS is $3.25. Its degree of
operating leverage is 1.6, while its degree of financial leverage is 2.1. What is the firm's projected EPS for the
coming year using the DTL approach?
a. $3.25
b. $5.46
c. $10.92
d. $8.71
e. $19.63
ANSWER: d
EPS1 = EPS0 + EPS0 [DTL × (percent change in sales)]
RATIONALE:
= $3.25 [1 + (1.6)(2.1)(0.5)] = $3.25 [2.68]
EPS1 = $8.71.
DIFFICULTY: Easy
TOPICS: DTL and forecast EPS
75. 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?
a. 30%
b. 47%
c. 66%
d. 15%
e. 22%
ANSWER: c
RATIONALE: DTL = DOL × DFL = (1.25)(3.50) = 4.375
%ΔEPS = %ΔSales × DTL = (0.15)(4.375) = 65.63% ≈ 66%.
DIFFICULTY: Easy
TOPICS: Change in EPS
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76. Howell Enterprises is forecasting EPS of $4.00 per share for next year. The firm has 10,000 shares outstanding, it
pays 12 percent interest on its debt, and it faces a 40 percent marginal tax rate. Its estimated fixed costs are $80,000
while its variable costs are estimated at 40 percent of revenue. The firm's target capital structure is 40 percent
equity and 60 percent debt and it has total assets of $400,000. On what level of sales is Howell basing its EPS
forecast?
a. $1,000,000
b. $480,400
c. $316,722
d. $292,445
e. $105,280
ANSWER: d
RATIONALE: EPS1 = (Sales − Variable costs − Fixed costs − Interest) (1 − T) / Shares outstanding.
Step 1: Calculate interest expense
Debt = 0.60 × $400,000 = $240,000.
Interest = 0.12 × $240,000 = $28,800.
Step 2: Solve for EPS

EPS1 = $4.00 = (S − 0.40S − $80,000 − $28,800) × (1 − 0.40) / 10,000 = (0.60S −
$108,800) (0.6) / 10,000
$4.00 = (0.36S − $65,280) / 10,000
$105,280 = 0.36S
Sales = $292,444.44 ≈ $292,445.
Alternative method
EPS1 = (EBIT − Interest) (1 − T) / Shares outstanding.
Solve for EBIT

Net Income = EPS × Shares outstanding = $4.00 × 10,000 = $40,000.
EBT = NI / (1 − T) = $40,000 / (0.6) = $66,667.
Interest (from above) = $28,800.
EBIT = EBT + Interest = $66,667 + $28,800 = $95,467.
EBIT = EBT + Interest = $66,667 + $28,800 = $95,467.
S = 0.40S + $95,467 + 80,000

0.6S = $175,467
S = $175,467 / 0.6 = $292,445.
DIFFICULTY: Medium
TOPICS: Determining sales from EPS
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77. 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
a. 10%.
b. 14%.
c. 12%.
d. 8%.
e. 16%.
ANSWER: b
RATIONALE: Calculate the equity multiplier and use to calculate ROA:
Debt to equity = 1.0
Set TA = 1.0
Debt = 0.5
Equity = 0.5
Equity multiplier = TA/E = 1.0/0.5 = 2.0.
ROE = ROA × 2
0.10 = ROA × 2
ROA = 0.50.
Set up income statement as a percentage of TA:
NI/TA = 0.05
Interest/TA = 0.08 (0.5) = 0.04

EBIT/TA = 0.10 + 0.04 = 0.14 = 14%.
DIFFICULTY: Medium
TOPICS: EBIT
78. 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 $100,000. What will be the EBIT for this firm if sales do not increase?
a. $113,412
b. $100,000
c. $84,375
d. $67,568
e. $42,115
ANSWER: d
RATIONALE: DTL = ΔEPS/ΔSales = 60%/20% = 3.0.
DOL = DTL/DFL = 3.0/1.25 = 2.40.
Old EBIT = $100,000/ [1 + (0.20)(2.40)] = $100,000/1.48 = $67,568.
Alternate solution:
Use DFL expression to calculate change in EBIT and previous EBIT:
DFL = 1.25 = %ΔEPS/ %ΔEBIT
= 0.60/ [ΔEBIT/($100,000 − ΔEBIT)]
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= [0.60($100,000) − 0.60(ΔEBIT)]/ΔEBIT
1.25ΔEBIT = $60,000 − 0.60(ΔEBIT)
1.85ΔEBIT = $60,000
ΔEBIT = $32,432.
Old EBIT = $100,000 − $32,432 = $67,568.
DIFFICULTY: Medium
TOPICS: Expected EBIT
79. The "degree of leverage" concept is designed to show how changes in sales will affect EBIT and EPS. If a 10
percent increase in sales causes EPS to increase from $1.00 to $1.50, and if the firm uses no debt, then what is its
degree of operating leverage?
a. 3.6
b. 4.2
c. 4.7
d. 5.0
e. 5.5
ANSWER: d
RATIONALE: These two equations could be used:
DTL = (DOL)(DFL).
EPS1 = EPS0 [1 + (DTL)(%ΔSales)].
Note that EPS rises by 50%, from $1.00 to $1.50, on a 10% increase in sales, so
1.50 = 1.00[1 + (DTL)(0.1)]
1.50 = 1 + 0.1 DTL
0.1 DTL = 0.50
DTL = 5.00.
Now DTL = 5 = (DOL)(DFL)

But if Debt = 0, then DFL = 1, so DOL = DTL = 5.0.
DIFFICULTY: Medium
TOPICS: DOL
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80. Bell Brothers has $3,000,000 in sales. Its fixed costs are estimated to be $100,000, and its variable costs are equal to
fifty cents for every dollar of sales. The company has $1,000,000 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. 15.66%
b. 18.33%
c. 19.24%
d. 21.50%
e. 23.08%
ANSWER: e
Step 1: Find Degree of Total Leverage (DTL):
𝑆−𝑉 $3,000,000−0.5($3,000,000)
DTL = 𝑆−𝑉−𝐹−𝐼 = $3,000,000−0.5($3,000,000)−$100,000−0.1($100,000) = 1.1538
Step 2: Find percentage increase in net income:
%NI = (0.20) (DTL) = (0.20) (1.1538) = 0.2308 = 23.08%.
DIFFICULTY: Medium
TOPICS: DTL and change in NI
81. Calculate the current price per share (P0) for Olson Corporation, given the following information. The data all pertain
to the year just ended.
Sales = 10,000 units

Sales price per unit = $10
Variable cost per unit = $5
Fixed cost = $10,000
Long-term debt outstanding = $15,000
kd on all long-term debt = 5%
Tax rate = 30%
Common stock shares outstanding = 10,000 shares
Beta = 1.5
kRF = 5%
kM = 9%
Dividend payout ratio = 40%
Growth rate in earnings and dividends = 7%
a. $39.20
b. $57.84
c. $29.43
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CFIN4
d. $61.90
e. None of the above.
ANSWER: c
RATIONALE: Calculate net income
Sales (100,000 × $10,000) $100,000
Variable costs (10,000 × $5,000) $50,000
Fixed costs 10,000
Total costs (60,000)
EBIT $ 40,000
Interest (0.05 × $15,000) (750)
EBT $ 39,250
Taxes (EBT × 0.30) (11,775)
Net income $ 27,475
Calculate dividends per share (DPS) and required return

$27,475(0.40)
DPS = 10,000
= $1.099 ≈ $1.10
re = 0.05 + (0.09 - 0.05)1.5 = 0.11.

Use DPS, required return, and constant growth model to calculate share price.
$1.10(1.07)
P0 = 0.11−0.07
= $29.425 ≈ $29.43.
DIFFICULTY: Tough
TOPICS: Price per share
82. Given the information below, calculate the expected growth rate (g) of dividends, using the constant growth model
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 = $5; variable cost per unit = $2; fixed cost =
$1,000; common stock shares outstanding = 5,000; long-term debt outstanding = $10,000; tax rate = 40 percent.
Assume equilibrium exists in the market.
a. 11.34%
b. 6.54%
c. 11.0%
d. 10.68%
e. 10.19%
ANSWER: d
RATIONALE: Required return
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rs = 7% + (4%)1.75 = 14%
Calculate net income
[Q(P − V) − F − I] (1 − T) = NI
[5,000 ($5 − $2) − $1,000 − ($10,000 × 0.10)] (1 − 0.40) = NI
[5,000($3) − $1,000 − $1,000] 0.6 = $7,800
Calculate EPS, and use P/E and EPS to calculate P0 . Use P0 and dividend payout
ratio to calculate D0
$7,800
EPS = = $1.56.
5,000
P/E =10. (given)

P0 = (P/E) (EPS) = 10 ($1.56) = $15.60
D0 = EPS (dividend payout ratio) = $1.56(0.3) + $0.468
Use constant growth model to solve for expected growth rate
$0.486(1+𝑔)
$15.60 =
0.14−𝑔
$2.184 − $15.6g = $0.468 + $0.468g

$1.716 = $16.068g
g = 0.1068 = 10.68%
DIFFICULTY: Tough
TOPICS: Growth rate
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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
$60,000. The Famine state has a 40 percent chance of occurring and the EBIT is expected to be $20,000. 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 $400,000 in total assets, it will face a 40 percent
marginal tax rate, and the book value of equity per share under either scenario is $10.00 per share.
83. Refer to Copybold Corporation. What is the difference between the EPS forecasts for Feast and Famine under
the aggressive capital structure?
a. $0
b. $1.48
c. $0.62
d. $0.98
e. $2.40
ANSWER: e
RATIONALE: Debt = 75% = $300,000; Equity = 25% = $100,000; Total assets = $400,000.
Feast Famine
Probability 0.6 0.4
EBIT $60,000 $20,000
Interest (36,000) (36,000)
EBT $24,000 ($16,000)
Taxes (9,600) 6,400
NI $14,400 ($ 9,600)
# shares 10,000 10,000
EPS $1.44 −$0.96
Difference in EPS for aggressive capital structure:

EPSFeast − EPSFamine = $1.44 − ($0.96) = $2.40.
DIFFICULTY: Medium
TOPICS: Capital structure and EPS
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84. Refer to Copybold Corporation. What is the difference between the EPS forecasts for Feast and Famine under
the conservative capital structure?
a. $1.00
b. $0.80
c. $2.20
d. $0.44
e. $0
ANSWER: b
RATIONALE: Debt = 25% = $100,000; Equity = 75% = $300,000; Total assets = $400,000.
Feast Famine
Probability 0.6 0.4
EBIT $60,000 $20,000
Interest (10,000) (10,000)
EBT $50,000 $10,000
Taxes (20,000) 4,000
NI $30,000 ($6,000)
# shares 30,000 30,000
EPS $1.00 $0.20
Difference in EPS for conservative capital structure:

EPSFeast − EPSFamine = $1.00 − $0.20 = $0.80.
DIFFICULTY: Medium
TOPICS: Capital structure and EPS
85. Refer to Copybold Corporation. What is the coefficient of variation of expected EPS under the aggressive capital
structure plan?
a. 1.00
b. 1.18
c. 2.45
d. 2.88
e. 3.76
ANSWER: c
RATIONALE: Calculate coefficient of variation
Expected EPSAggressive:
E(EPS) = 0.6 EPSFeast + 0.4
EPSFamine = (0.6)($1.44) + 0.4(−$0.96) = $0.48.
Standard deviation
SDEPS-aggressive = [0.6($1.44 − $0.48)2 + 0.4(−$0.96 − $0.48)2 ]1/2
= [0.5530 + 0.8294]1/2 = 1.176.
CVAggressive = 1.176/0.48 ≈ 2.45.

DIFFICULTY: Medium
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CFIN4
TOPICS: Capital structure and CV of EPS
86. Refer to Copybold Corporation. What is the coefficient of variation of expected EPS under the conservative
capital structure plan?
a. 0.58
b. 0.39
c. 0.15
d. 0.23
e. 1.00
ANSWER: a
RATIONALE: Calculate coefficient of variation
Expected EPS conservative:
E(EPS) = 0.6($1.00) + 0.4($0.20)
= $0.68. Standard deviation
SDEPS-Conservative = [0.6($1.00 − $0.68)2 + 0.4($0.20 − $0.68)2 ]1/2
= [0.0614 + 0.0922]1/2 = 0.3919.
CVConservative = 0.3919/0.68 = 0.576 ≈ 0.58.

DIFFICULTY: Medium
TOPICS: Capital structure and CV of EPS
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CFIN4

Chapter 12 – Capital Structure

54. Which of the following factors affects business risk?

56. According to the text DFL stands for

59. Which of the following statements is most correct?

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

61. Which of the following statements is correct?

62. Which of the following statements is correct?

64. Which of the following statements is correct?

65. Which of the following statements is correct?

73. Which of the following is correct?

Step 2: Solve for EPS

Solve for EBIT

S = 0.40S + $95,467 + 80,000

Interest/TA = 0.08 (0.5) = 0.04

Now DTL = 5 = (DOL)(DFL)

Step 1: Find Degree of Total Leverage (DTL):

Step 2: Find percentage increase in net income:

%NI = (0.20) (DTL) = (0.20) (1.1538) = 0.2308 = 23.08%.

Sales = 10,000 units

Calculate dividends per share (DPS) and required return

re = 0.05 + (0.09 - 0.05)1.5 = 0.11.

P/E =10. (given)

Use constant growth model to solve for expected growth rate

$2.184 − $15.6g = $0.468 + $0.468g

Difference in EPS for aggressive capital structure:

Difference in EPS for conservative capital structure:

CVAggressive = 1.176/0.48 ≈ 2.45.

CVConservative = 0.3919/0.68 = 0.576 ≈ 0.58.

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