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Exam 15: Capital structure decisions

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Question 21

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After an intensive research and development effort, two methods for producing playing cards have been identified by the Turner Company.One method involves using a machine having a fixed cost of $10, 000 and variable costs of $1.00 per deck of cards.The other method would use a less expensive machine (fixed cost = $5, 000) , but it would require greater variable costs ($1.50 per deck of cards) .If the selling price per deck of cards will be the same under each method, at what level of output will the two methods produce the same net operating income (EBIT) ?

A) 5, 000 decks
B) 10, 000 decks
C) 15, 000 decks
D) 20, 000 decks
E) 25, 000 decks

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Question 22

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

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Question 23

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Barette Consulting currently has no debt in its capital structure, has $500 million of total assets, and its basic earning power is 15%.The CFO is contemplating a recapitalization where it will issue debt at a cost of 10% and use the proceeds to buy back shares of the company's common stock, paying book value.If the company proceeds with the recapitalization, its operating income, total assets, and tax rate will remain unchanged.Which of the following is most likely to occur as a result of the recapitalization?

Which of the following is NOT associated with (or does not contribute to) business risk? Recall that business risk is affected by a firm's operations.

Which of the following statements is CORRECT?

A venture capital investment group received a proposal from Wireless Solutions to produce a new smart phone.The variable cost per unit is estimated at $250, the sales price would be set at twice the VC/unit, fixed costs are estimated at $750, 000, and the investors will put up the funds if the project is likely to have an operating income of $500, 000 or more.What sales volume would be required in order to meet this profit goal?

Cartwright Communications is considering making a change to its capital structure to reduce its cost of capital and increase firm value.Right now, Cartwright has a capital structure that consists of 20% debt and 80% equity, based on market values.(Its D/S ratio is 0.25.) The risk-free rate is 6% and the market risk premium, rM - rRF, is 5%.Currently the company's cost of equity, which is based on the CAPM, is 12% and its tax rate is 40%.What would be Cartwright's estimated cost of equity if it were to change its capital structure to 50% debt and 50% equity?

Refer to Exhibit 15.3.Now assume that BB is considering changing from its original capital structure to a new capital structure with 45% debt and 55% equity.This results in a weighted average cost of capital equal to 10.4% and a new value of operations of $576, 923.Assume BB raises $259, 615 in new debt and purchases T-bills to hold until it makes the stock repurchase.BB then sells the T-bills and uses the proceeds to repurchase stock.How many shares remain after the repurchase, and what is the stock price per share immediately after the repurchase?

Refer to Exhibit 15.1.PP is considering changing its capital structure to one with 30% debt and 70% equity, based on market values.The debt would have an interest rate of 8%.The new funds would be used to repurchase stock.It is estimated that the increase in risk resulting from the added leverage would cause the required rate of return on equity to rise to 12%.If this plan were carried out, what would be PP's new value of operations?

Other things held constant, which of the following events is most likely to encourage a firm to increase the amount of debt in its capital structure?

The world-famous discounter, Fernwood Booksellers, specializes in selling paperbacks for $7 each.The variable cost per book is $5.At current annual sales of 200, 000 books, the publisher is just breaking even.It is estimated that if the authors' royalties are reduced, the variable cost per book will drop by $1.Assume authors' royalties are reduced and sales remain constant; how much more money can the publisher put into advertising (a fixed cost) and still break even?

Bailey and Sons has a levered beta of 1.10, its capital structure consists of 40% debt and 60% equity, and its tax rate is 40%.What would Bailey's beta be if it used no debt, i.e., what is its unlevered beta?

Refer to Exhibit 15.3.BB is considering moving to a capital structure that is comprised of 20% debt and 80% equity, based on market values.The debt would have an interest rate of 7%.The new funds would be used to repurchase stock.It is estimated that the increase in risk resulting from the additional leverage would cause the required rate of return on equity to rise to 14%.If this plan were carried out, what would BB's new value of operations be?

As the text indicates, a firm's financial risk has identifiable market risk and diversifiable risk components.

LeCompte Learning Solutions is considering making a change to its capital structure in hopes of increasing its value.The company's capital structure consists of debt and common stock.In order to estimate the cost of debt, the company has produced the following table: The company uses the CAPM to estimate its cost of common equity, rs.The risk-free rate is 5% and the market risk premium is 6%.LeCompte estimates that if it had no debt its beta would be 1.0.(Its "unlevered beta, " bU, equals 1.0.) The company's tax rate, T, is 40%. On the basis of this information, what is LeCompte's optimal capital structure, and what is the firm's cost of capital at this optimal capital structure?

Laramie Trucking's CEO is considering a change to the company's capital structure, which currently consists of 25% debt and 75% equity.The CFO believes the firm should use more debt, but the CEO is reluctant to increase the debt ratio.The risk-free rate, rRF, is 5.0%, the market risk premium, RPM, is 6.0%, and the firm's tax rate is 40%.Currently, the cost of equity, rs, is 11.5% as determined by the CAPM.What would be the estimated cost of equity if the firm used 60% debt? (Hint: You must first find the current beta and then the unlevered beta to solve the problem.)

An all-equity firm with 200, 000 shares outstanding, Antwerther Inc., has $2, 000, 000 of EBIT, which is expected to remain constant in the future.The company pays out all of its earnings, so earnings per share (EPS) equal dividends per shares (DPS) .Its tax rate is 40%. The company is considering issuing $5, 000, 000 of 10.0% bonds and using the proceeds to repurchase stock.The risk-free rate is 6.5%, the market risk premium is 5.0%, and the beta is currently 0.90, but the CFO believes beta would rise to 1.10 if the recapitalization occurs. Assuming that the shares can be repurchased at the price that existed prior to the recapitalization, what would the price be following the recapitalization?

Which of the following statements is CORRECT?

Refer to Exhibit 15.4.Now assume that AJC is considering changing from its original capital structure to a new capital structure with 50% debt and 50% equity.If it makes this change, its resulting market value would be $820, 000.What would be its new stock price per share?

Refer to Exhibit 15.1.Assume that PP is considering changing from its original capital structure to a new capital structure with 35% debt and 65% equity.This results in a weighted average cost of capital equal to 9.4% and a new value of operations of $510, 638.Assume PP raises $178, 723 in new debt and purchases T-bills to hold until it makes the stock repurchase.PP then sells the T-bills and uses the proceeds to repurchase stock.How many shares remain after the repurchase, and what is the stock price per share immediately after the repurchase?