Exam 15: Capital Structure Decisions

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A) Generally, debt-to-total-assets ratios do not vary much among different industries, although they do vary among firms within a given industry.
B) Electric utilities generally have very high common equity ratios because their revenues are more volatile than those of firms in most other industries.
C) Drug companies (prescription, not illegal!) generally have high debt-to-equity ratios because their earnings are very stable and, thus, they can cover the high interest costs associated with high debt levels.
D) Wide variations in capital structures exist both between industries and among individual firms within given industries. These differences are caused by differing business risks and also managerial attitudes.
E) Since most stocks sell at or very close to their book values, book value capital structures are almost always adequate for use in estimating firms' costs of capital.

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A) Its sales become less stable over time.
B) The costs that would be incurred in the event of bankruptcy increase.
C) Management believes that the firm's stock has become overvalued.
D) Its degree of operating leverage increases.
E) The corporate tax rate increases.

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False

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A) A firm can use retained earnings without paying a flotation cost. Therefore, while the cost of retained earnings is not zero, its cost is generally lower than the after-tax cost of debt.
B) The capital structure that minimizes a firm's weighted average cost of capital is also the capital structure that maximizes its stock price.
C) The capital structure that minimizes the firm's weighted average cost of capital is also the capital structure that maximizes its earnings per share.
D) If a firm finds that the cost of debt is less than the cost of equity, increasing its debt ratio must reduce its WACC.
E) Other things held constant, if corporate tax rates declined, then the Modigliani-Miller tax-adjusted tradeoff theory would suggest that firms should increase their use of debt.

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A) Business risk.
B) Total risk.
C) Financial risk.
D) Market risk.
E) The firm's beta.

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A) As a rule, the optimal capital structure is found by determining the debt-equity mix that maximizes expected EPS.
B) The optimal capital structure simultaneously maximizes EPS and minimizes the WACC.
C) The optimal capital structure minimizes the cost of equity, which is a necessary condition for maximizing the stock price.
D) The optimal capital structure simultaneously minimizes the cost of debt, the cost of equity, and the WACC.
E) The optimal capital structure simultaneously maximizes stock price and minimizes the WACC.

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A) $484,359
B) $487,805
C) $521,173
D) $560,748
E) $584,653

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A) 7.38%; $800,008
B) 7.38%; $813,008
C) 7.50%; $813,008
D) 7.50%; $790,008
E) 7.80%; $790,008

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A) The ROA would increase.
B) The ROA would remain unchanged.
C) The basic earning power ratio would decline.
D) The basic earning power ratio would increase.
E) The ROE would increase.

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A) Demand variability.
B) Sales price variability.
C) The extent to which operating costs are fixed.
D) The extent to which interest rates on the firm's debt fluctuate.
E) Input price variability.

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A) Since debt financing raises the firm's financial risk, increasing a company's debt ratio will always increase its WACC.
B) Since debt financing is cheaper than equity financing, raising a company's debt ratio will always reduce its WACC.
C) Increasing a company's debt ratio will typically reduce the marginal cost of both debt and equity financing. However, this action still may raise the company's WACC.
D) Increasing a company's debt ratio will typically increase the marginal cost of both debt and equity financing. However, this action still may lower the company's WACC.
E) Since a firm's beta coefficient it not affected by its use of financial leverage, leverage does not affect the cost of equity.

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A) If corporate tax rates were decreased while other things were held constant, and if the Modigliani-Miller tax-adjusted tradeoff theory of capital structure were correct, this would tend to cause corporations to decrease their use of debt.
B) A change in the personal tax rate should not affect firms' capital structure decisions.
C) "Business risk" is differentiated from "financial risk" by the fact that financial risk reflects only the use of debt, while business risk reflects both the use of debt and such factors as sales variability, cost variability, and operating leverage.
D) The optimal capital structure is the one that simultaneously (1) maximizes the price of the firm's stock, (2) minimizes its WACC, and (3) maximizes its EPS.
E) If changes in the bankruptcy code make bankruptcy less costly to corporations, then this would likely reduce the debt ratio of the average corporation.

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A) Company HD has a higher net income than Company LD.
B) Company HD has a lower ROA than Company LD.
C) Company HD has a lower ROE than Company LD.
D) The two companies have the same ROA.
E) The two companies have the same ROE.

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False