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Exam 13: Capital Structure and Leverage

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Question 31

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You have been hired by a new firm that is just being started. The CFO wants to finance with 60% debt, but the president thinks it would be better to hold the percentage of debt in the capital structure (wd) to only 10%. Other things held constant, and based on the data below, if the firm uses more debt, by how much would the ROE change, i.e., what is ROENew ? ROEOld? $\begin{array} { l r l l } {\quad\quad\quad\quad\underline{\text { Operating Data}} } && {\quad\quad\quad \underline{\text { Other Data } }} \\\text { Capital } & \$ 4,000 & \text { Higher } \mathrm {w} _ { \mathrm { d } } & 60 \% \\\text { ROIC } = \text { EBIT } ( 1 - \mathrm { T } ) / \text { Capital } & 13.00 \% & \text { Higher interest rate } & 13 \% \\\text { Tax rate }& 35 \% & \text { Lower } \mathrm { w } _ { \mathrm { d } } & 10 \% \\ & & \text { Lower interest rate } & 9 \%\end{array}$

A) 5.44%
B) 5.73%
C) 6.03%
D) 6.33%
E) 6.65%

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

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Question 32

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Your firm's debt ratio is only 5.00%, but the new CFO thinks that more debt should be employed. She wants to sell bonds and use the proceeds to buy back and retire common shares so the percentage of common equity in the capital structure (wc) = 1 ? wd. Other things held constant, and based on the data below, if the firm increases the percentage of debt in its capital structure (wd) to 60.0%, by how much would the ROE change, i.e., what is ROENew ? ROEOld? $\begin{array} { l c l c } { \quad \quad\quad\quad\quad\underline{\text { Operating Data} } } & & { \quad\quad\quad\underline{\text { Other Data} } } \\\text { Capital } & \$ 150,000 & \text { Old} \mathrm {w }_ { d } & 5 \% \\ \text { ROIC = EBIT } ( 1 - \text { T) } / \text { Capital } & 13.00 \% & \text { Old interest rate } & 10 \% \\\text { Tax rate } & 35 \% & \text { New } \mathrm {w} _ { d } & 60 \% \\& & \text { New interest rate } & 12 \%\end{array}$

A) 6.73%
B) 7.09%
C) 7.46%
D) 7.83%
E) 8.22%

F) All of the above
G) D) and E)

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Question 33

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As the text indicates, a firm's financial risk can and should be divided into separate market and diversifiable risk components.

Firms HD and LD are identical except for their use of debt and the interest rates they pay HD has more debt and thus must pay a higher interest rate. Based on the data given below, how much higher or lower will HD's ROE be versus that of LD, i.e., what is ROEHD ? ROELD? 80) $\begin{array}{c}\begin{array}{lr}\underline{\text { Applicable to Both Firms }}\\ \text { Capital } \quad \$ 3,000,000 \\\text { EBIT } \quad \$ 500,000 \\\text { Tax rate } \quad 35 \%\end{array}\begin{array}{lll}\underline{\text { Firm HD's Data }}\\ \mathrm{w}_{\mathrm{d}} \quad\quad\quad\quad 70 \% \\\text { Int. rate } \quad 12 \% \\\\\end{array}\begin{array}{lll}\underline{\text { Firm LD's Data }} \\\mathrm{w}_{\mathrm{d}} \quad\quad\quad\quad 20 \% \\\text { Int. rate } \quad 10 \%\\\\\end{array}\end{array}$

In a world with no taxes, Modigliani and Miller (MM) show that a firm's capital structure does not affect its value. However, when taxes are considered, MM show a positive relationship between debt and value, i.e., the firm's value rises as it uses more and more debt, other things held constant.

Provided a firm does not use an extreme amount of debt, operating leverage typically affects only EPS, while financial leverage affects both EPS and EBIT.

Different borrowers have different risks of bankruptcy, and if a borrower goes bankrupt, its lenders will probably not get back the full amount of funds that they loaned. Therefore, lenders charge higher rates to borrowers judged to be more likely to go bankrupt.

Other things held constant, firms that use assets that can be sold easily (like trucks) tend to use more debt than firms whose assets are harder to sell (like those engaged in research and development).

Modigliani and Miller (MM), in their second article, took account of taxes, bankruptcy, and other factors that were assumed away in their original article. Once they took account of all these assumptions, they concluded that every firm has a unique optimal capital structure. Moreover, a manager can use the second MM model to determine his or her firm's optimal debt ratio.

It is possible for Firms A and B to have identical financial and operating leverage, yet for Firm A to have more risk as measured by the variability of EPS. This would occur if Firm A has more business risk than Firm B.

According to Modigliani and Miller (MM), in a world without corporate income taxes the use of debt has no effect on the firm's value.

Firms U and L each have the same amount of assets, investor-supplied capital, and both have a return on investors' capital (ROIC) of 12%. Firm U is unleveraged, i.e., it is 100% equity financed, while Firm L is financed with 50% debt and 50% equity. Firm L's debt has an after-tax cost of 8%. Both firms have positive net income and a 35% tax rate. Which of the following statements is CORRECT?

The graphical probability distribution of ROE for a firm that uses financial leverage would tend to be more peaked than the distribution if the firm used no leverage, other things held constant.

The Miller model begins with the Modigliani and Miller (MM) model with corporate taxes and then adds personal taxes.

Southwest U's campus book store sells course packs for $15 each, the variable cost per pack is $9, fixed costs to produce the packs are $200,000, and expected annual sales are 50,000 packs. What are the pre-tax profits from sales of course packs?

Companies HD and LD have identical amounts of assets, investor-supplied capital, operating income (EBIT) , tax rates, and business risk. Company HD, however, has a higher debt ratio than LD. Company HD's return on investors' capital (ROIC) exceeds its after-tax cost of debt, rd(1 − T) . Which of the following statements is CORRECT?

Modigliani and Miller's first article led to the conclusion that capital structure is "irrelevant" because it has no effect on a firm's value.

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

If a firm borrows money, it is using financial leverage.