Final Chapter 123
What is the degree of combined leverage when EBIT is $700,000, interest expense is $100,000, sales are $3,500,000, and variable costs are $1,200,000? 5.000 2.917 3.833 0.462
(3,500-1,200) / (700-100) = 3.833
Company A has an EBIT of $700,000 and interest expense of $30,000. Company B has EBIT of $1,500,000 and interest expense of $30,000. Which company has a higher degree of financial leverage? Company A Companies A and B have the same leverage Insufficient data to make a determination Company B
0 / 1 (0.0%) Answer: Company A 700,000/670,000 = 1.04 Co B: 1,500,000/1,470,000 = 1.02
A firm has EBIT of $126 million and earnings before taxes (EBT) of $101 million. What is the firms degree of financial leverage? (Round to the nearest hundredth: .00)
Answer: 1.25 DFL: 126/101 = 1.25
A firm has EBIT of $14 million and interest expense of $5 million. What is the firm's degree of financial leverage? (Round to the nearest hundredth: .00)
Answer: 1.56 DFL: 14/(14-5)=1.56
A firm has EBIT of $56 million and earnings before taxes (EBT) of $34 million. What is the firms degree of financial leverage? (Round to the nearest hundredth: .00)
Answer: 1.65 DFL: 56/34 = 1.65
Suppose a firm has variable costs of $14 million, fixed costs of $15 million, depreciation of $3 million, and EBIT of $25 million. Given this information, what is the degree of operating leverage? (Round to the nearest hundredth: .00)
Answer: 1.72 Sales: 25+3+15+14 = 57 DOL = (57-14)/25 = 1.72
Titman and Wessels (1988) do not find that transaction costs affect the capital structure of firms. (t/f)
Answer: False Titman and Wessels (1988) found that transaction costs do affect a firm's capital structure.
Which of the following is an assumption in Modigliani and Miller (1958, 1963)? Firms do not face risk. Firms have heterogeneous expectations. Firms face solvency risk. Firms do not face bankruptcy costs. None of these choices.
Answer: Firms do not face bankruptcy costs.
Which of the following is NOT a benefit of using debt to finance investment projects? Greater solvency risk Less costly than using equity financing Lower overall tax bill Retains control and ownership
Answer: Greater solvency risk
When a company uses more leverage as evidenced by a higher degree of either financial or operating leverage, what effect does it have on changes in profitability? Lower leverage results in higher income to shareholders. Higher leverage leads to lower risk. When leverage goes up liquidity goes down. Higher leverage leads to higher profitability for a given sales level.
Answer: Higher leverage leads to higher profitability for a given sales level.
While theory in Miller and Modigliani (1958, 1963) assumes that firms do not face bankruptcy risk, Castanias (1983) shows that firms that do face bankruptcy risks generally carry less debt. (tf)
tue
According to Modigliani and Miller (1958, 1963), an unlevered firm will have the same value as a levered firm. (t/f)
True
While theory in Miller and Modigliani (1958, 1963) assumes that firms do not pay taxes, Masulis (1980) finds evidence that because firms pay taxes, a firm's capital structure affects the value of the firm. (t/f)
true
Suppose a firm has sales of $15 million, variable costs of $4 million, fixed costs of $5 million, and EBIT of $5 million. Given this information, what is the degree of operating leverage? (Round to the nearest hundredth: .00)
Answer: 2.2 DOL: (15 - 4) / 5 = 2.2
A firm has sales of $15 million, variable costs of $4 million, fixed costs of $3 million, depreciation of $1 million, interest expense $2 million and taxes of $.5 million. What is the degree of combined leverage? (Round to the nearest hundredth: .00)
Answer: 2.20 DCL: (15-4)/([15-4-3-1]-2) = 2.20
A firm has EBIT of $138 million and interest expense of $77 million. What is the firm's degree of financial leverage? (Round to the nearest hundredth: .00)
Answer: 2.26 DFL: 138/(138-77) = 2.26
Suppose a firm has sales of $56 million, variable costs of $20 million, fixed costs of $16 million, and depreciation of $5 million. Given this information, what is the degree of operating leverage? (Round to the nearest hundredth: .00)
Answer: 2.40 EBIT: 56-20-16-5 $15 million DOL: (56-20)/15 = 2.40
What is the degree of operating leverage given sales of $100,000, variable costs of $75,000, and EBIT of $10,000? 2.05 10.00 1.00 2.50
Answer: 2.50 100,000 - 75,000 / 10,000 = 2.50
Suppose a firm has sales of $102 million, fixed costs of $45 million, depreciation of $13 million, and EBIT of $35 million. Given this information, what is the degree of operating leverage? (Round to the nearest hundredth: .00)
Answer: 2.66 Variable costs: 102-45-13-35=9 DOL: (102-9)/35 = 2.66
A company has a degree of operating leverage of 1.5 and a degree financial leverage of 2.2. What is the company's degree of combined leverage? (Round to the nearest hundredth: .00)
Answer: 3.30 DCL: (1.5*2.2) =3.30
A firm has sales of $150 million, variable costs of $61 million, EBIT of $44 million, and interest expense of $22 million. What is the degree of combined leverage? (Round to the nearest hundredth: .00)
Answer: 4.05 DCL: (150-61)/(44-22) = 4.05
A company has a degree of operating leverage of 2.1 and a degree financial leverage of 2.5. What is the company's degree of combined leverage? (Round to the nearest hundredth: .00)
Answer: 5.25 DCL: 2.1*2.5 = 5.25 Found in the following section(s) of the text:
Which of the following is NOT an assumption in Modigliani and Miller (1958, 1963)? Firms do not pay taxes. Firms do not face bankruptcy costs. Firms do not face transaction costs. All of these choices are assumptions made.
Answer: All of these choices are assumptions made.
What is the financial leverage of Company A? How will that leverage affect profits compared to Company B if sales decrease? For Company A, EBIT is $500,000, interest expense is $50,000, sales are $4,500,000, and variable costs are $3,000,000. Degree of financial leverage: 3.00 Profits increase as sales decrease. Degree of financial leverage: 1.11 Interest costs rise as sales decrease. Degree of financial leverage: 1.11 Profits decrease with higher leverage. Degree of financial leverage: 3.33 Profits increase as interest expense increases.
Answer: Degree of financial leverage: 1.11 Profits decrease with higher leverage. Profits decrease more as leverage increases. 500/(500 - 50) = 1.11
An increasing debt-to-equity ratio might improve the value of a firm because equity financing is less costly than debt financing. (t/f)
Answer: False Debt is generally cheaper than equity because investors view debt as less risky than equity.
The tax benefits associated with debt are higher when corporate tax rates are lower.
Answer: False As corporate tax rates increase the firm experiences a higher tax shield from interest.
Jensen and Meckling (1976) show that shareholders prefer stock issuance to bond issuance because stock holders will be able to monitor management better than bond holders. (t/f)
Answer: False Debt covenants and restrictions help to ensure management is meeting bond and shareholder expectations.
An increasing debt-to-equity ratio might decrease the value of the firm because equity financing is more effective than debt financing. (t/f)
Answer: False Equity financing is not necessarily more effective than debt financing. It is often more costly and results in giving up control and ownership in the firm.
One possible way for a firm to find its optimal debt-to-equity ratio is to find the average debt-to-equity ratio of all firms in the entire economy. (f/f)
Answer: False Found in the following section(s) of the text:
According to Modigliani and Miller (1958, 1963), an unlevered firm will not have the same cost of capital as a levered firm. (t/f)
Answer: False Holding all else equal, Modigliani and Miller (1958, 1963) found that an unlevered firm should have the same value as a levered firm.
Nationalization is a type of recapitalization that allows individuals in a particular nation to purchase shares of a company. (t/f)
Answer: False Nationalization is a process in which the nation in which the company operates purchases a controlling number of shares of the company.
The degree of operating leverage allows us to infer how much operating income will change with a change in variable costs. (t/f)
Answer: False The degree of operating leverage (DOL) measures business risk and is calculated by taking the ratio of the percentage change in operating income to the percentage change in sales.
If a company has a high degree of financial leverage, what does that tell about the firm's risk profile? Low risk Higher profits to shareholders Higher ability to pay debt Appropriate risk
Answer: Higher profits to shareholders Financial leverage also means more financing is done through debt, not equity.
What is the operating leverage of Company Y? How will that affect profits compared with Company Z, which has an operating leverage of 5.25? Company Y has an EBIT of $3,000,000, sales of $25,000,000, and variable expenses of $18,000,000. Operating leverage of 2.33 As sales increase, Company Y's profits will rise slower than Company Z's. Operating leverage of .43 As sales increase, Company Y's profits will rise slower than Company Z's. Operating leverage of .43 As sales increase, Company Y's profits will rise faster than Company Z's. Operating leverage of 2.33 As sales increase, the profits of both companies will stay the same.
Answer: Operating leverage of 2.33 As sales increase, Company Y's profits will rise slower than Company Z's. As sales increase, Company Y's profits will rise slower than Company Z's. (25-18) / 3 = 2.33
Capital structure can be defined as: Long-term financial planning Short-term financial planning The mixture of a firm's debt and equity Managing day-to-day operations
Answer: The mixture of a firm's debt and equity
What does the degree of financial leverage indicate? The cost of financed assets The reliance on debt The reliance on assets The firm's cash balance
Answer: The reliance on debt
An increasing debt-to-equity ratio might decrease the value of a firm because higher debt levels create higher costs associated with bankruptcy risk. (t/f)
Answer: True
Financial risk is the risk associated with a firm's inability to meet its debt obligations. (t/f)
Answer: True
Leveraged buyouts occur when a company issues new debt to finance the acquisition of another company. (t/f)
Answer: True
One possible way for a firm to find its optimal debt-to-equity ratio is to find the average debt-to-equity ratio for similar firms within the same industry. (t/f)
Answer: True
As debt levels increase, firms face greater financial risk. (t/f)
Answer: True Found in the following section(s) of the text:
Titman and Wessels (1988) present evidence that a firm's capital structure will depend, in part, on the presence of transaction costs. (t/f)
true
An increasing debt-to-equity ratio might improve the value of the firm because of tax shields. (t/f)
false
Firms with a higher degree of business leverage have lower pre-tax profit for a given increase in EBIT. t/f
false
If firm A has a greater degree of financial leverage than firm B, then a 1% increase in EBIT for both firms is going to result in a greater increase in pre-tax profit for firm B. (t/f)
false
Jensen and Meckling (1976) suggest that a firm's capital structure cannot affect the level of agency costs. (t/f)
false
Masulis (1980) finds that the change in stock prices surrounding changes in capital structure is unrelated to level of tax shields. (t/f)
false
One of the benefits of using equity is the associated tax benefits. (t/f)
false
Optimal debt-to-equity ratios do not exist in practice. (t/f)
false
The degree of combined leverage tells us how much EBIT increases for a given increase in Sales. (t/f)
false
The degree of combined leverage tells us how much pre-tax profit increases for a given increase in EBIT. (t/f)
false
Castanias (1983) presents evidence that when firms face higher bankruptcy risk, they will not carry lower levels of debt. (t/f)
false Castanias (1983) found that firms are aware of costs associated with bankruptcy and rationally choose to carry less debt in order to avoid such costs.
Business risk is the risk associated with having high debt levels. (t/f)
false Business risk is operating risk and as mentioned in the video is associated with high fixed operating costs, not debt levels. (The next section will talk about financial risk that is associated with a company's debt level).
When a firm issues new debt to purchase some of its existing shares it is called a leveraged buyout. (t/f)
false Leverage recapitalization occurs when a firm issues new debt and takes the proceeds from the debt issuance to buy back some of the shares outstanding.
As depreciation increases, a firm's financial risk increases. (tf)
fasle
Using debt is less costly than using equity to finance a capital investment project. (t/f)
true
On an income statement, interest payments are deducted before taxes are calculated. (t/f)
nswer: True Found in the following section(s) of the text:
A firm may choose to recapitalize by issuing new debt to buy back some existing shares. (t/f)
true
An example of nationalization is the U.S. government purchase of the majority equity stake in U.S. automakers. (t/f)
true
Castanias (1983) found that firms are aware of costs associated with bankruptcy and rationally choose to carry less debt in order to avoid such costs. (t/f)
true
Castanias (1983) shows that industries with more firm bankruptcies generally have firms that have lower debt-to-equity ratios. (t/f)
true
During a leveraged buyout, the acquiring firm might use the assets of the target firm as collateral on the new debt issue. (t/f)
true
If sales were to increase 1%, then operating income will increase in proportion to the degree of operating leverage. (t/f)
true
Jensen and Meckling (1976) suggest that agency costs can affect the value of the firm. (t/f)
true
Leveraged recapitalizing generally increases the debt-to-equity ratios. (t/f)
true
Masulis (1980) finds empirical evidence that stocks prices change around the changes in capital structure suggesting that market value is affected by capital structure. (t/F0
true
Masulis (1980) finds that tax shields affect the change in stock prices surrounding changes in capital structure. (t/f)
true
Myers and Majluf (1984) combined the investment and financing decision and show that a firm's capital structure can affect the value of that firm. (t/f)
true
One of the assumptions of the Modigliani and Miller (1958, 1963) research is that firms do not face bankruptcy costs. (t/f)
true
One possible way for a firm to find its optimal debt-to-equity ratio is to estimate a concave function using regression analysis and find the optimal point on that function. (t/f)
true
The degree of combined leverage is calculated by multiplying the degree of operating leverage and the degree of financial leverage. (t/f)
true
The degree of combined leverage tells us how much pre-tax profit increases for a given increase in Sales. (t/f)
true
The process of recapitalization generally affects the capital structure of firms. (t/F0
true
