Corporate Finance - Questions Flashcards
Which of the following is least likely to be a reason why a firm’s actual capital structure may vary from the target capital structure?
a) The firm decides to issue additional equity because management believes the firm’s stock is overpriced.
b) The firm decides to finance a low risk project with 100% debt to improve the project’s profitability.
c) The firm decides to issue additional debt due to a temporary discount in underwriting fees for corporate debt.
correct answer – B. A firm should always finance a project based on the firm’s weighted average cost of capital, although when evaluating a project, the firm may apply a risk factor to adjust the risk of the project. A corporate manager generally cannot deem some projects as being financed by debt and some by equity as all projects are effectively financed proportionately based on the firm’s capital structure. In practice, a firm’s actual capital structure will float around its target. For a firm that does have a target capital structure, the actual structure may vary from the target due to market value fluctuations, or management’s desire to exploit an opportunity in a particular financing source.
Which of the following statements regarding Modigliani and Miller’s Proposition II with taxes is most accurate?
A)The tax shield provided by debt causes the WACC to increase as leverage increases.
B)
Companies should use a 50% equity/50% debt capital structure to maximize value.
C)
The value of the firm is maximized at the point where the WACC is minimized.
C. The tax shield provided by debt causes the WACC to decrease as leverage increases. The value of the firm is maximized at the point where the WACC is minimized, which is 100% debt under the MM assumptions.
Which of the following statements most accurately characterizes how debt ratings may affect a firm’s capital structure policy?
A)
A firm may be deterred from increasing the use of debt to avoid having its credit rating reduced below some minimum acceptable level.
B)
Because credit ratings are based upon cash flow coverage of interest expense, they are not influenced by the firm’s capital structure.
C)
Firms that have their credit ratings reduced below investment grade are not able to issue additional debt.
Correct Answer A: Credit ratings can be factored into management’s capital structure policy if a firm has a minimum rating objective, and this is likely to be adversely affected by issuing additional debt.
Which of the following statements most accurately characterizes how debt ratings may affect a firm’s capital structure policy?
A)
A firm may be deterred from increasing the use of debt to avoid having its credit rating reduced below some minimum acceptable level.
B)
Because credit ratings are based upon cash flow coverage of interest expense, they are not influenced by the firm’s capital structure.
C)
Firms that have their credit ratings reduced below investment grade are not able to issue additional debt.
A Credit ratings can be factored into management’s capital structure policy if a firm has a minimum rating objective, and this is likely to be adversely affected by issuing additional debt.
Which of the following is least likely an appropriate method for an analyst to estimate a firm’s target capital structure?
A)
Use the firm’s current proportions of debt and equity based on market values, with an adjustment for recent trends in its capital structure.
B)
Use average capital structure weights for the firm’s industry, based on book values of debt and equity.
C)
Use the firm’s current capital structure, based on market values of debt and equity.
B. For an analyst, target capital structure should always be based on market values of debt and equity. The other two choices are appropriate methods for estimating a firm’s capital structure for analysis. (Module 34.2, LOS 34.d)
To determine their target capital structures in practice, it is least likely that firms will:
A)
use the book value of their debt to make financing decisions.
B)
match the maturities of their debt issues to specific firm investments.
C)
determine an optimal capital structure based on the expected costs of financial distress.
C). While it is a useful theoretical concept, in practice determining an optimal capital structure based on the cost savings of debt and the expected costs of financial distress is not feasible. Because debt rating companies often use book values of debt, firms use book values of debt when choosing financing sources. It is common for firms to match debt maturities to the economic lives of specific investments. (Module 34.2, LOS 34.d)
During a period of expansion in the economy, compared to firms with lower operating leverage, earnings growth for firms with high operating leverage will be:
A) lower.
B) higher.
C)unaffected.
H. If a high percentage of a firm’s total costs are fixed, the firm is said to have high operating leverage. High operating leverage, other things held constant, means that a relatively small change in sales will result in a large change in operating income. Therefore, during an expansionary phase in the economy a highly leveraged firm will have higher earnings growth than a lesser leveraged firm. The opposite will happen during an economic contraction.
Which of the following statements regarding the impact of financial leverage on a company’s net income and return on equity (ROE) is most accurate?
A)
Using financial leverage increases the volatility of ROE for a level of volatility in operating income.
B)
If a firm has a positive operating profit margin, using financial leverage will always increase ROE.
C)
Increasing financial leverage increases both risk and potential return of existing bondholders.
a. If a firm is financed with 100% equity, there is a direct relationship between changes in the firm’s ROE and changes in operating income. Adding financial leverage (debt) to the firm’s capital structure will cause ROE to become much more volatile and ROE will change more rapidly for a given change in operating income. The increased volatility in ROE reflects an increase in both risk and potential return for equity holders. Note that financial leverage results in increased default risk, but since existing bond holders are compensated by coupon interest and return of principal, their potential return is unchanged. Although financial leverage will generally increase ROE if a firm has a positive operating margin (EBIT/Sales), if the operating margin were small, the added interest expense could turn the firm’s net profit margin negative, which would in turn make ROE negative.
n the last period, Foster, Inc., sold 20,000 units at $31 per unit. Fixed costs were $180,000 and variable costs were $310,000. In the current period, Foster sold 25,000 units. If Foster’s variable cost per unit and fixed costs remained unchanged, it would report income for the current period of:
A)
$130,500.
B)
$157,000.
C)
$207,500.
c. Income = 31 × 25,000 – 180,000 – (25/20) × 310,000 = 207,500. (Module 35.1, LOS 35.d)
If a 10% increase in sales causes earnings per share to increase from $1.00 to $1.50, and if the firm has no debt, then what is its degree of operating leverage?
A) 5.0.
B) 4.2.
C) 4.7.
The percentage change in earnings that results from a 1% change in sales is a firm’s degree of total leverage. Here, the percent change in EPS is ($1.50 / $1.00) – 1 = 50%, and DTL = %ΔEPS / %ΔSales = 50% / 10% = 5.0. Because this firm has no debt, its degree of financial leverage is 1.0 and its degree of total leverage equals its degree of operating leverage, which must also be 5.0.
Stromburg Corporation’s sales are $75,000,000. Fixed costs, including research and development, are $40,000,000, while variable costs amount to 30% of sales. Stromburg plans an expansion which will generate additional fixed costs of $15,000,000, decrease variable costs to 25% of sales, and permit sales to increase to $100,000,000. What is Stromburg’s degree of operating leverage at the new projected sales level?
A) 3.50.
B) 3.75.
C) 4.20.
Sales = $100,000,000
VC of 25% of sales = 25,000,000
FC of 40,000,000 + 15,000,000 = 55,000,000
DOL= [100,000,000 – 25,000,000] / [100,000,000 – 25,000,000 – 55,000,000] = 3.75
Myron Jackson is a private equity fund manager specializing in distressed companies. His investment philosophy is based on the principle that capital structure problems can be fixed, but industry characteristics dictate business models. Jackson would most likely be interested in distressed firms with which of the following characteristics?
A)
High operating risk and low financial risk.
B)
High financial risk and low operating risk.
C)
High operating risk and high financial risk.
b. Financial risk refers to the capital structure, while operating risk refers to the operating cost structure. A firm’s capital structure is well within the control of management as to how much debt to assume. In contrast, a firm’s operating cost structure is usually driven by industry characteristics. This distressed firm’s specialist would be looking for firms with capital structure problems that can be solved with an increase in equity capital and a reduction in debt financing. Changing the operating characteristics of the industry is far more challenging.
For a profitable company, issuing debt in order to retire common stock will most likely:
A)
increase both net income and return on equity.
B)
decrease both operating income and net income.
C)
increase both the level and variability of return on equity.
C. (correct) An increase in debt will increase interest expense, which will decrease net income but not operating income, which is calculated before subtracting interest expense. For a profitable firm, the decrease in net income will be offset by the decrease in equity from the repurchase of common stock, so that ROE increases. The effect of the increase in financial leverage will, however, increase the variability of ROE for a given change in operating earnings. (Module 35.1, LOS 35.c)
Jayco, Inc. has a division that makes red ink for the accounting industry. The unit has fixed costs of $10,000 per month, and is expected to sell 40,000 bottles of ink per month. If the variable cost per bottle is $2.00 what price must the division charge in order to breakeven?
A) $2.25.
B) $2.50.
C) $2.75.
A. (correct)
40,000 = $10,000/(P - $2)
40,000P – $80,000 = $10,000
P = $90,000/40,000 = $2.25.
The following information reflects the projected operating results for Opstalan, a catalog printer.
Sales = $5.0 million.
Variable Costs = 40% of sales.
Fixed Costs = $1.0 million.
Interest expense = $105,000.
Tax Rate = 0.0%.
Opstalan’s degree of total leverage (DTL) is closest to:
A)2.58.
B)1.59.
C) 1.41.
Explanation
1) First, calculate the operating results:
Opstalan Annual Operating Results
Sales $5,000,000
– Variable Costs1 2,000,000
Contribution Margin 3,000,000
– Fixed Costs 1,000,000
EBIT 2,000,000
– Interest Expense 105,000
EBT = Earnings 1,895,000
1Variable costs = 0.40 × 5,000,000
2) Second, calculate DOL = (Sales – Variable Costs) / (Sales – Variable Costs – Fixed Costs) = 3,000,000 / 2,000,000 = 1.50
3) Third, calculate DFL = EBIT / (EBIT – I) = 2,000,000 / 1,895,000 = 1.06.
4) Finally, calculate DTL = DOL × DFL = 1.50 × 1.06 = 1.59.
(Module 35.1, LOS 35.b)
