M2 Capital Structure: Part 2

Question 1

What is the optimal cost of capital?

Answer 1

The ratio of debt to equity that produces the LOWEST WACC

Question 2

Formula to calculate the growth rate

Answer 2

g = ROA * Retention / 1 - (ROA * Retention)

Retention = (1 - Dividend Payout)

Question 3

Return on sales formula

Answer 3

ROS = Inc before int incom, int exp and taxes / sales (net)

NI
(Interest income)
+Interest expense
+Tax expense

Question 4

Return on Investment Formula

Answer 4

ROI = Net Income / Avg Invested Capital

Avg invested capital = (Assets - operating leverage)

Question 5

Return on Assets formula

Answer 5

ROA = Net Income / Average Total Assets

Question 6

Return on equity formula

Answer 6

ROE = Net Income / Avg total equity

Question 7

The degree to which a company uses fixed operating costs rather than variable operating costs

Answer 7

operating leverage (i.e. higher op leverage if fixed salaries over commissions)

Question 8

Use of debt rather than equity

Answer 8

Financial Leverage

Question 9

A company that has debt in its capital structure

Answer 9

Levered firm

Question 10

Calculation for value of a levered firm

Answer 10

= value of an UNlevered firm * PV of Interest tax savings

PV of int tax savings = T * (rdebt * d) / r debt

Question 11

Total debt ratio

Answer 11

Total L / total A

Question 12

Debt to equity ratio

Answer 12

Total L / Total E

Question 13

Equity Multiplier

Answer 13

Total A / Total E

Question 14

Times Interest Earned Ratio

Answer 14

EBIT / Interest expense

Question 15

the degree to which a firm uses fixed operating costs as opposed to variable operating costs

Answer 15

operating leverage

FC/VC

Question 16

How to back into EBIT when you are given the tax rate?

Answer 16

X * (1-T) = earnings after tax

x = EBIT
*Also remember to add back the interest expense

Question 17

What is the risk to having high operating leverage?

Answer 17

Must produce sufficient sales to cover the high fixed-operating costs
more risky but has higher potential for return
*firm with high op leverage, has higher fixed costs vs variable

Question 18

A less risky entity would have a ___ debt ratio?

Answer 18

LOWER
Debt ratio = Total L / Total A

Question 19

Basic EPS formula

Answer 19

NI - PD / WACSO

Question 20

Calculate operating leverage?

Answer 20

% change in EBIT / % change in unit sales volume

Question 21

Calculate financial leverage?

Answer 21

%change in EPS / % change in EBIT

Question 22

Calculate combined leverage?

Answer 22

Degree of operating leverage * degree of financial leverage
OR
% change in EPS / % change in unit sales volume

Question 23

from SIM writing: advantages and disadvantages of debt vs equity financing (bullet points)

Answer 23

Advantages -
-after-tax cost (interest expense deduction) - no tax deduction for equity
-debt holders must be paid interest before stockholders receive dividends so debt is “safer investment’ from investor perspective”

Disadvantages -
-less attractive to creditors (impact to debt to equity ratio, times interest earned, etc.)
-Fixed cost for the company whereas dividends are at discretion so debt interest pymts MUST be met to avoid default. can be more problematic in difficult economic environments where cash may be constrained

Question 24

SIM MISTAKE!! - in calculating ratios, make sure to do what with the results if in percentage as opposed to decimals???

Answer 24

MOVE THE DECIMALS!