BEC - Financial Management - Capital Structure

Which of the following statements is correct regarding the weighted-average cost of capital (WACC)?

One of a company's objectives is to minimize the WACC. Since the weighted-average cost of capital is a true cost to the company, the objective is to always minimize cost.

Which of the following instruments has the right to the declared dividends with common shareholders?

Participating preferred stock Preferred stock combines some characteristics of common stocks and bonds. It provides financial leverage like bonds; however, if earnings fall, the non-payment of dividends will not force the issuer into bankruptcy. In addition to the "regular" dividend, participating preferred stock receives part of dividends over the amount assigned to the common stock dividend.

What is characteristic of income bonds?

Pay interest only if the issuer has earned income

What is the primary advantage of serial bonds for a purchaser?

Purchasers may select the maturity that matches their financial goals.

What is the typical reason for a corporation to use warrants?

To lower the cost of debt Warrants are rights to purchase common stock at a specified price. These options typically are attached to long-term debt or preferred stock to make a corporation's securities attractive to a wider range of investors, increasing the supply and decreasing the cost of capital.

Deep Company has 5,000 shares of 7% cumulative, $1,000 par value preferred stock and 50,000 shares of $100 par value common stock outstanding. Deep Company last declared and paid dividends on April 30, Year 1, for the year ending March 31, Year 1. There are no dividends in arrears for fiscal years ending March 31, Year 1, or earlier. For the year ending March 31, Year 4, Deep's net income is $1,500,000. Deep Company declared a common stock dividend that is 25% of net income for the fiscal year ending March 31, Year 4, to be paid on April 30, Year 4. What is the total amount of dividends to be paid on April 30, Year 4?

$1,425,000

Beam Company currently has 100,000 shares of common stock outstanding and a price-earnings ratio of 7. Net income for the recently ended year is $375,000. Beam's board of directors declared a 15-to-2 stock split. Sunshine owned 100 shares of Beam before the split. What is the approximate value of Sunshine's investment in Beam immediately after the split?

$2,625

A corporation has $50,000 in equity and a debt-to-total-assets ratio of 0.5. The firm wants to reduce this ratio to 0.2 by selling new common stock and using the proceeds to repay the principal on outstanding long-term debt. What amount of additional equity financing must the corporation obtain to accomplish this objective?

$30,000 Debt-to-total-assets ratio = Debt / Assets = Debt / (Debt + Equity) 5 = ($50,000 / ($50,000 + $50,000)). Debt must be $50,000 for a .5 debt-to-total-assets ratio and Equity is also $50,000. $30,000 additional equity will reduce the debt-to-total-assets ratio to 0.2. Increase $30,000 equity to $80,000 and debt decreases to $20,000. Debt-to-total-assets ratio = Debt / Assets = Debt / (Debt + Equity) = ($20,000 / ($20,000 + $80,000)) = 0.2.

Bates Corp. has $100,000 in bonds payable with a fair market value of $120,000. It also has 1,000 shares of common stock issued at $50 per share with a fair market value of $80 per share. What amount represents the corporation's market capitalization?

$80,000 Market capitalization = Number of outstanding shares × Market value per share = $80 × 1,000 = $80,000.

At the beginning of year 1, $10,000 is invested at 8% interest, compounded annually. What amount of interest is earned for year 2?

$864.00

Using a 360-day year, what is the current price of a $100 US Treasury bill due in 90 days discounted at an 8% rate?

$98

Which of the following formulas should be used to calculate the economic rate of return on common stock?

(Dividends + change in price) divided by beginning price

Owens Company sells 500,000 bottles of condiments annually at $3 per bottle. Variable costs are $0.60 per bottle and fixed costs are $110,000 annually. Owens has an annual interest expense of $60,000 and a 30% income tax rate.What is Owens' approximate degree of financial leverage?

1.06 Financial leverage is present when a small change in earnings before interest and taxes (EBIT) causes a relatively large change in common shareholders' return. The degree of financial leverage is EBIT / ( EBIT - Interest)

Owens Company sells 500,000 bottles of condiments annually at $3 per bottle. Variable costs are $0.60 per bottle and fixed costs are $110,000 annually. Owens has annual interest expense of $60,000 and a 30% income tax rate. What is Owens' approximate degree of operating leverage?

1.10 Operating leverage is present when a small change in sales causes a relatively large change in earnings before interest and taxes (EBIT). The degree of operating leverage is the contribution margin divided by EBIT [{500,000 units × ($3 - $0.60)} / ($1,200,000 - $110,000) = 1.10].

A company has income after tax of $5.4 million, interest expense of $1 million for the year, depreciation expense of $1 million, and a 40% tax rate. What is the company's times-interest-earned ratio?

10.0

Reinhold Company is considering a $50 million project in the upcoming year. Reinhold plans to use both debt and equity to finance the project. Reinhold's beta coefficient is estimated at 0.95. Reinhold has a 30% effective income tax rate. The equity market is expected to have average earnings of 12%. U.S. Treasury bonds currently yield 4%. Funds generated from earnings, $35 million Additional funds from $15 million 20-year, 6% bonds at a price of 102, with flotation costs of 3% of par The capital asset pricing model (CAPM) computes a security's expected return by adding the risk-free rate of return to the incremental yield of the expected market return, adjusted by the issuer's beta. What is Reinhold's expected rate of return using this model?

11.6%

A company provides the following financial information: Cost of equity 20% Cost of debt 8% Tax rate 40% Debt-to-equity ratio 0.8 What is the company's weighted-average cost of capital?

13.3%

A corporation obtains a loan of $200,000 at an annual rate of 12%. The corporation must keep a compensating balance of 20% of any amount borrowed on deposit at the bank, but normally does not have a cash balance account with the bank. What is the effective cost of the loan?

15.0% The interest paid on the loan is $200,000 times 12%, or $24,000 per year. Since the corporation must keep a compensating balance of 20% of the amount borrowed, it only has use of 80% of the loan, or $160,000. The effective cost of the loan is $24,000 divided by $160,000, or 15.0%.

For a company, the cost of common stock is 6.8% and the cost of preferred stock is 7.9%. They also determine that, in the total capital structure of the company, 55% is made up of common stock, 30% preferred stock, and the rest by debt components. Calculate the after-tax interest rate of the company given that the weighted average cost of capital is 6.66%

3.64%

Egret Company expects next year's net income to be $2 million. Egret's current capital structure is 30% debt, 30% preferred equity, and 40% common equity. Next year, Egret's plans to issue debt and common stock as needed to maintain their 30:40 ratio, not to issue more preferred stock. Interest payments on Egret's 10,000 4%, $1,000 par value bonds are current. Egret can issue up to $1 million more 4% bonds at face value. Egret's marginal tax rate is 30%. There are no dividends in arrears on Egret's 10,000 shares of 6%, $1,000 par value cumulative preferred stock. Optimal capital spending for next year is estimated at $1.4 million. Using a strict residual dividend policy, what is the approximate estimated common stock dividend payout ratio for the next year?

30%

The capital structure of Merritt Co. is 20% common equity and debt equal to 80%. The cost of common equity is 10% and the pretax cost of debt is 5%. Merritt's tax rate is 21%. What is Merritt's weighted-average cost of capital?

5.16%

For a company, the cost of common stock is 7.6% and the cost of preferred stock is 8.2%. The interest rate on the company's debt is determined to be 5.6%. They also find that, in the total capital structure of the company, 45% is made up of common stock, 30% of preferred stock and rest in debt components. Assuming that the tax rate is 30%, calculate the weighted average cost of capital.

6.86% ⇒ Weighted Average Cost of Capital = (Cost of equity multiplied by the percentage of equity in the capital structure) + (Weighted average cost of debt multiplied by the percentage of debt in capital structure) ⇒ After-tax cost of debt = Interest rate x (1-tax rate) = 5.6% x (1 - 0.3) = 3.92% ⇒ WACC = (7.6% x 45%) + (8.2% x 30%) + (3.92% x 25%) = 6.86%

A company issued common stock and preferred stock. The projected growth rate of the common stock is 5%. The current quarterly dividend on preferred stock is $1.60. The current market price of the preferred stock is $80 and the current market price of the common stock is $95. What is the expected rate of return on the preferred stock?

8%

A company is trying to determine the cost of capital for a major expansion project. A survey of commercial lenders indicates that the cost of debt is currently 8% based on the company's debt ratio of 40%. The company complies with this requirement and has determined that a stock issuance would require a 10% return in order to attract investors. Which of the following is the company's cost of capital?

9.2%

Which of the following changes would result in the highest present value?

A $100 decrease in taxes each year for four years

A call provision generally is deemed unfavorable to investors.

A callable bond may be redeemed by the issuer prior to maturity, usually with the issuer paying the face amount plus a call premium. Typically, bonds are recalled when interest rates decline, and are thus unfavorable to the bondholders, who otherwise would earn the high interest of the bond. Convertible bonds may be converted to common stock before maturity at the bondholders' option; conversion is not required. A sinking fund provision effectively mandates annual retirement of a specified portion of the bond issue; it decreases the likelihood of default, but does not disallow early redemption.

Short-term notes issued by Federal National Mortgage Association (Fannie Mae) are called

Agency securities

A company currently has 1,000 shares of common stock outstanding with zero debt. It has the choice of raising an additional $100,000 by issuing 9% long-term debt, or issuing 500 shares of common stock. The company has a 40% tax rate. What level of earnings before interest and taxes (EBIT) would result in the same earnings per share (EPS) for the two financing options?

An EBIT of $27,000 would result in EPS of $10.80 for both.

Which of the following factors would influence an entity to increase its proportion of debt financing?

An increase in the effective income tax rate An increase in the effective income tax rate would make debt financing more attractive than equity financing because interest payments are tax deductible, reducing taxes, but dividends are not. A decrease in the times-interestearned ratio indicates greater difficulty making future interest payments; an entity with a low times-interest-earned ratio will likely be able to issue debt only at high rates. An increase in economic uncertainty causes greater difficulty in predicting the ability to make future interest payments, which must be made regardless of performance, as opposed to dividends, which need not be declared in unfavorable economic periods. The federal funds rate is the rate that banks charge each other for overnight loans; an increase in the federal funds rate tends to raise all interest rates, making debt more expensive.

What is characteristic of junk bonds?

Bonds rated at less than investment grade

Which of the following factors is inherent in a firm's operations if it utilizes only equity financing?

Business risk Business risk is the riskiness of an entity's operations without any debt; in other words, risk inherent in business operations. Financial risk is the additional risk that owners bear due to an entity's decision to carry debt. Interest rate risk is applicable only when using debt. Marginal risk is not a commonly used term.

When calculating a company's cost of common stock, an analyst evaluates the following four components: risk-free rate, stock's beta coefficient, rate of return on the market portfolio, and required rate of return on the company's stock.Which of the following measurement models is being used?

Capital asset pricing model The capital asset pricing model (CAPM), also called the security market line, describes the relationship between risk and expected rates of return and is the only choice which includes the beta coefficient. The beta coefficient is a risk measure that compares the returns of the asset to the market rate over a period of time and to the market premium. Constant growth is used to determine the current price of a share relative to its dividend payments, the expected growth rate of these dividends, and the required rate of return by investors in the market.

Which of the following items represents a business risk in capital structure decisions?

Cash flow

Which of the following is an assumption of an active policy strategy for dividends?

Consistent dividend payouts are an indicator of a company's success.

What is the effect of a stock dividend?

Decreases future earnings per share

Jefferson Company finds out that its EBIT has seen an increase of 18% while the sales increased by 4.5%. Its competitor, Washington Company, experienced a 15% and 5% increase respectively. Which of the given statements is true?

Fixed costs constitute a higher proportion of its operating costs than its competitor. Operating Leverage is calculated as follows: (% Change in EBIT) / (% Change in Sales)

Which of the following types of bonds is most likely to maintain a constant market value?

Floating-rate A floating-rate bond has a variable interest rate. The interest rate is reset to equal the current market interest rate. Therefore, the market value of the bond itself will remain constant since that set price will always yield the current market rate. The market values of a zero-coupon bond, a callable bond, and a convertible bond will change as market interest rates fluctuate.

The benefits of debt financing over equity financing are likely to be highest in which of the following situations?

High marginal tax rates and few noninterest tax benefits

Pan Company's bonds are yielding 6% currently. Why is Pan's cost of debt lower than 6%?

Interest is deductible in calculating taxable income.

What is the primary disadvantage of convertible bonds for an issuer?

Investors may choose not to convert the bonds.

A firm experiencing high financial leverage wants to bring it down. Which of the following actions would not help its cause?

Issuing more debenture bonds

The optimal capitalization for an organization usually can be determined by the

Lowest total weighted-average cost of capital (WACC)

Each of the following will affect a company's return on investment, except

Maintaining the company's cost of capital at current levels

Which of the following objectives is consistent with an optimal capital structure?

Maximize the total value of the entity

Reward to risk ratio

Mean return/Standard deviation

Which of the following objectives is consistent with an optimal capital structure?

Minimum weighted average cost of capital. Capital structure is the long-term debt and equity of an entity. Optimal capital structure minimizes the cost of all capital and thus maximizes shareholder wealth, or in other words, the entity's total value. Debt generally is cheaper than equity, until high debt levels increase risk levels, driving up the weighted average cost of capital. Minimal risk is not always optimal; investors are willing to incur risk for the opportunity to achieve high returns. Maximum earnings per share (EPS) is not always optimal; steps to increase EPS may cause total market value to drop.

What is the primary advantage of zero coupon bonds for an issuer?

No annual cash outflow A zero coupon bond is issued below its face amount. The issuer pays the holder the face amount at maturity, but has no interest payments until its maturity. Issue costs are not appreciably different from other bond types. The issuer and purchaser must recognize interest expense and income, respectively, throughout the bond term.

What is characteristic of debentures?

Secured by the full faith and credit of the issuer

What is short selling?

Selling securities that are not owned by the seller Short selling involves borrowing shares from a broker, selling them, and repaying the loan with securities bought on the open market; it is done by investors that speculate that the securities will have a dramatic price decrease. Insider trading is selling securities based on inside information.

Sen Corp., a publicly-traded, mid-cap company, wanted to obtain $30 million in new capital to expand its Iowa plant. Cost of capital was a factor in making the decision. Sen Corp. could either issue new preferred stock or new debentures. Sen Corp.'s underwriter estimated that preferred stock should have an annual dividend payout of $6 and an issue price of $103 per share. The debentures should have a coupon interest rate of 9% and an issue price of $101. Sen Corp.'s marginal income tax rate was 40%. Which of the following approaches describes Sen Corp.'s best strategy?

Sen Corp. should issue the debentures since the after-tax cost of debt (5.347%) would be less than the cost of equity (5.825%)

Why is equity capital generally more expensive than debt financing?

Shareholders expect to be paid more for exposure to higher risk. Shareholders are exposed to more risk than creditors: dividend payments are not required and, in the event of liquidation, debts are repaid before shareholders' claims. Dividends are set by the board of directors, which may set a constant dividend; interest rates fluctuate on a daily basis, as they are determined by the market.

An individual holds a 10-year fixed-rate bond as an investment. Three years of its life remain. When the bond was issued, interest rates were much higher than they are now. Interest rates are expected to be stable for the next three years. Which of the following statements is correct regarding the bond?

The bond is currently selling at a premium.

A company recently issued 9% preferred stock. The preferred stock sold for $40 a share with a par of $20. The cost of issuing the stock was $5 a share. What is the company's cost of preferred stock?

The cost of preferred stock is equal to the dividend outflow (9% × $20 = $1.80) divided by the net cash inflow ($40 sales price - $5 issuance cost = $35). $1.80 / $35 = 5.1%.

Which of the following is an assumption of the residual theory of dividends?

The rate of return that investors require is not affected by dividend policy, but rather by other forces - e.g. risk of investment, market rate, etc.

Larson Corp. issued $20 million of long-term debt in the current year. What is a major advantage to Larson with the debt issuance?

The relatively low after-tax cost due to the interest deduction

In capital budgeting, which of the following items is included in the payback model calculation?

The total amount of the initial outlay for the project The payback model simply looks at the number of periods (years) it takes to recover the initial cost of an investment. It does not take into account the time value of money. The total amount of the initial outlay for the project is recovered over a number of years. It's basically cash outlay vs cash inlay. Payback method = Initial investment / After-tax net cash inflows.

What would be the primary reason for a company to agree to a debt covenant limiting the percentage of its long-term debt?

To reduce the interest rate on the bonds being sold A debt covenant is a promise to debt holders. By promising to limit the percentage of its long-term debt, the debtor assures debt holders that, even in a period of economic strain, there will be sufficient resources to make interest payments. This risk reduction makes the debt more attractive than similar instruments with the same terms except for the debt covenant, making its cost (interest rate) lower. It's basically insurance against default.

What is the largest source of short-term credit for small businesses?

Trade credit Trade credit (accounts payable) is called a spontaneous financing source because it originates automatically from purchasing transactions. Commercial paper typically is issued by large, financially strong commercial enterprises to institutional investors; it is unlikely that a small business would be able to issue commercial paper at reasonable rates.

Which of the following is most often used as a cash substitute?

Treasury bills

Commercial paper

Typically does not have an active secondary market

Unity Company has a higher degree of operating leverage than the industry average. Compared to the industry average:

Unity's profits are more sensitive to changes in sales volume. Operating leverage is present when a small change in sales causes a relatively large change in earnings before interest and taxes (EBIT); this is possible because of relatively high fixed costs and relatively low variable costs. High leverage is more risky than low leverage because fixed costs are incurred regardless of sales volume. The proportion of debt and equity financing influences financial leverage, not operating leverage.

Which of the following observations regarding the valuation of bonds is correct?

When the market rate of return is less than the stated coupon rate, the market value of the bond will be more thanits face value, and the bond will be selling at a premium.