Business Finance Final Jason Satchel NWMSU

Financial leverage is the:

( Incorrect. )Financial risk results from using financial leverage. When financial leverage is created, a firm intensifies the business risk borne by the common stockholders. See 12-1: The Target Capital Structure

Equity monitoring costs are lower in the United States than in other countries because:

(Got Incorrect) Actual bankruptcy, and even the threat of potential bankruptcy, imposes a costly burden on firms with large amounts of debt. See 12-6: Variations in Capital Structures among Firms

Which of the following would be considered part of a firm's business risk?

(Got Incorrect) Business risk is defined as the uncertainty inherent in projections of future returns, if the firm uses no debt or debt-like financing. See 12-1: The Target Capital Structure

Everything else equal, in which of the following situations will a firm's degree of operating leverage (DOL) increase? Assume the firm currently generates a positive net operating income.

(Got Incorrect) The degree of operating leverage (DOL) is defined as the percentage change in net operating income (NOI) associated with a given percentage change in sales. See 12-3: Degree of Leverage

Olson Corporation has a beta coefficient of 1.5 at a debt/assets ratio equal to 40 percent. The risk-free rate of return, rRF, is 5 percent and the market return, rM, is 9 percent. Based on the capital asset pricing model (CAPM), what is Olson's required rate of return on its common equity?

(Got Incorrect) The required rate of return on equity is computed by CAPM using the applying the equation: Risk-free rate + [(Required return on an average stock - Risk-free rate of return) × Beta]. See 12-2: Determining the Optimal Capital Structure

Which of the following situations would intensify the business risk borne by a firm's common stockholders?

(Got Incorrect) The use of debt intensifies the firm's business risk borne by the common stockholders. See 12-1: The Target Capital Structure

Which of the following statements concerning a firm's times-interest earned (TIE) ratio is correct?

(Got incorrect) The times-interest-earned (TIE) ratio is a ratio that measures the firm's ability to meet its annual interest obligations. See 12-4: Liquidity and Capital Structure

Suppose that a firm has a degree of financial leverage (DFL) that is greater than 1.0; that is, DFL > 1. If the firm's sales decrease by 1 percent, its ______ will decrease by more than 1 percent.

(Incorrect.) Leverage is created when a firm has fixed costs associated either with its sales and production operations or with the types of financing it uses. See 12-3: Degree of Leverage

Which of the following statements concerning a firm's degree of financial leverage (DFL) is correct?

(Incorrect.) Leverage is created when a firm has fixed costs associated either with its sales and production operations or with the types of financing it uses. See 12-3: Degree of Leverage

________ is a measure that indicates a firm's ability to meet the annual interest obligations on its outstanding debt.

(Incorrect.) The degree of operating leverage (DOL) is defined as the percentage change in net operating income (NOI) associated with a given percentage change in sales. See 12-3: Degree of Leverage

Assume that a firm's degree of financial leverage (DFL) is 1.2. If sales this year increase by 20 percent, the firm expects a 60 percent increase in earnings per share (EPS). What is the firm's degree of operating leverage of the firm?

(Incorrect.) The degree of operating leverage of the firm can be computed using the following formula: Degree of total leverage = Percentage increase in EPS × Percentage increase in sales = DOL × DFL See 12-3: Degree of Leverage

A times-interest-earned (TIE) ratio that is less than 1 suggests that a firm _____.

(Incorrect.) The times-interest-earned (TIE) ratio is computed by dividing earnings before interest and taxes (EBIT) by interest expense. See 12-4: Liquidity and Capital Structure

This year, Ferro Inc. generated sales of $10 million. Its fixed operating cost is $1 million and its variable cost ratio is 30 percent of sales. Ferro has $60 million of debt outstanding with a before-tax cost of 12 percent. Which of the following statements about Ferro's times interest earned (TIE) ratio is correct?

(Incorrect.) The times-interest-earned (TIE) ratio measures a firm's ability to meet its annual interest obligations. See 12-4: Liquidity and Capital Structure

Everything else equal, and for one particular firm, in which of the following capital structures would the common stockholders have to bear the greatest amount of of business risk?

1 percent equity and 99 percent debt

Bouchard Company's stock sells for $20 per share, its last dividend (D0) was $1.00, its growth rate is a constant 6 percent, and the company must pay flotation cost equal to 20 percent when it issues new common stock. What is Bouchard's cost of issuing new common stock?

12.63%

Following are the results of the capital structure analysis SoCal Irrigation just completed: Proportion of Debt; 20%, 40, 60, 80 Stock Price; $55.5, 45.15, 45.20, 44.95 Earnings Per Share; $1.2, 1.26, 1.22, 1.18

60%

A firm's ______ is the combination of debt and equity it uses to finance its assets.

Capital Structure

Which of the following statements is true of the capital structure of companies in Germany?

Companies in Germany raise most of their corporate debt through bank loans.

Quick Launch Rocket Company, expects its sales to increase by 50 percent in the coming year. The firm's current earnings per share (EPS) is $3.25. Its degree of operating leverage is 1.6 and its degree of financial leverage is 2.1. What is the firm's projected EPS for the coming year?

Correct. Projected earnings per share (EPS1) = (EPS0) × [1 + (DTL × %ΔSales)] = $3.25 [1 + (1.6 × 2.1 × 0.5)] = $3.25[1 + 3.36(0.5)] = $3.25 × 2.68 = $8.71 See 12-3: Degree of Leverage

Trueware Corporation is a start-up firm with a capital structure that includes 25 percent debt. Trueware has no preferred stock. The firm has two possible scenarios for its operations: Ruby or Emerald. The Ruby scenario has a 70 percent probability of occurring and the forecast earnings before interest and taxes (EBIT) in this scenario is $80,000. The Emerald scenario has a 30 percent chance of occurring and the EBIT is expected to be $32,000. Further, the firm's cost of debt is 10 percent. The firm has $500,000 in total assets and its marginal tax rate is 30 percent. The company has 22,000 shares of common stock outstanding. Calculate the difference in earnings per share (EPS) for the capital structure

Correct. Total assets = $500,000; Debt = 0.25 × Total assets = 0.25 × $500,000 = $125,000 Equity = (1 − 0.25) × Total assets = 0.75 × $500,000 = $375,000 Net income (NIRuby) = [EBIT - (Cost of debt × Total debt)] × (1 - Tax rate) Net income (NIRuby) = [$80,000 - (0.10 × $125,000)] × (1 - 0.3) = $47,250 EPSRuby = Net income/Number of shares outstanding EPSRuby = $47,250/22,000 shares = $2.15 per share Net income (NIEmerald) = [EBIT - (Cost of debt × Total debt)] × (1 - Tax rate) Net income (NIEmerald) = [$32,000 - (0.10 × $125,000)] × (1 - 0.3) = $13,650 EPSEmerald = Net income/Number of shares outstanding EPSEmerald = $13,650/22,000 shares = $0.62 per share Difference between the earnings per share = $2.15 - $0.62 = $1.53 per share See 12-2: Determining the Optimal Capital Structure

A firm's risk can be partitioned into financial risk and business risk. An increase in the financial risk results in a decrease in business risk.

False

According to the signaling theory to explain differences in firms' capital structures, an announcement of a new stock issue by a mature, seasoned firm that has numerous financing alternatives generally is seen as a signal that the its future prospects are very positive.

False

Companies in Italy and Japan use less debt in their capital structures than companies in the United States and Canada.

False

If the debt/assets ratio increases, the costs of both debt and equity normally decrease.

False

It is fairly easy to determine how changes in a firm's degree of financial leverage (DFL) affect its P/E ratio.

False

Which of the following statements concerning differences in capital structures and financing alternatives around the world is correct?

In many countries, the costs to monitor companies' debt are lower than in the United States because foreign firms use substantially greater amounts of bank loans to finance assets than do U.S. companies.

What does a degree of financial leverage (DFL) of 2.0 indicate?

Incorrect. DFL is calculated by dividing the percentage change in EPS by the percentage change in EBIT. See 12-3: Degree of Leverage

According to the signaling theory, a firm with unfavorable future prospects might issue common stock in an effort to:

Incorrect. Managers have substantially more and better information about their firms than do outside investors. This is called asymmetric information, and it has an important effect on decisions to use either debt or equity to finance capital projects. See 12-5: Capital Structure Theory

According to the basic capital structure theory proposed by Modigliani and Miller (MM), when will a firm's value be maximum?

Incorrect. The MM theory is showed under a very restrictive set of assumptions including that such financial costs as personal income taxes, brokerage costs, and bankruptcy do not exist. A firm's value rises continuously as more debt is used because of the tax deductibility of interest on corporate debt. See 12-5: Capital Structure Theory

A firm sets a target capital structure to use when raising new funds in an effort to:

Minimize its weighted average cost of capital (WACC).

The combination of debt financing and equity financing that maximizes a firm's value is known as its:

Optimal capital structure.

A degree of operating leverage (DOL) equal to 1.5 times indicates that for every 1 percent change in _____.

Sales there will be a 1.5 percent change in earnings before interest and taxes (EBIT)

A firm should raise capital according to its optimal capital structure so as to maximize its _____.

Stock Price

What is the formula for calculating the times-interest earned (TIE) ratio?

TIE ratio = Earnings before interest and taxes ÷ Interest charges

Among industrialized countries, which of the following uses the lowest proportion of debt?

The United Kingdom

Which of the following factors would tend to reduce a firm's business risk?

The firm takes actions to improve the stability of its day-to-day operations.

According to the signaling theory to explain differences in firms' capital structures, if a firm raises new capital by issuing debt rather than by issuing stock, it is a signal that the firm has very good future prospects.

True

In the United States, equity monitoring costs are lower than most other developed countries.

True

The degree of operating leverage is defined as the percentage change in earnings before interest and taxes (EBIT) associated with a given percentage change in sales.

True

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

True

Under normal circumstances, the weighted average cost of capital (WACC) is used as the firm's required rate of return because:

as long as the firm's investments earn returns greater than its WACC, the value of the firm will not decrease.

A company's capital structure consists of common stock only, which amounts to $14 million. However, this year, the company plans to issue $7 million of debt, and use the proceeds to repurchase $7 million of its existing equity. The stock repurchase should not change the size of the company. As a result, any change in the firm's earnings per share (EPS) must be a result of the change in its:

capital structure.

If a firm's times-interest-earned (TIE) ratio decreases, the probability that it will default on its outstanding debt also decreases.

false

If a firm increases the proportions of debt and preferred stock that are contained in its capital structure, its _____.

financial risk will increase

Operating leverage refers to the presence of _____.

fixed operating costs

A firm should continue to invest in capital budgeting projects until its marginal cost of capital is equal to the:

marginal return (internal rate of return, IRR) generated by the last project purchased.

The percentage change in earnings before interest and taxes (EBIT) associated with a given percentage change in sales is known as the degree of _____.

operating leverage

Everything else equal, if a firm with favorable future prospects raises funds by issuing new shares of common stock, _____.

the price of its stock will increase when future profits are realized by the firm