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Exam 13: Capital Structure and Leverage

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Modigliani and Miller (MM)won Nobel Prizes for their work on capital structure theory.

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If a firm utilizes debt financing,a 10% decline in earnings before interest and taxes (EBIT)will result in a decline in earnings per share that is larger than 10%,and the higher the debt ratio,the larger this difference will be.

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Other things held constant,an increase in financial leverage will increase a firm's market (or systematic)risk as measured by its beta coefficient.

The trade-off theory states that capital structure decisions involve a tradeoff between the costs and benefits of debt financing.

The Modigliani and Miller (MM)articles implicitly assumed that bankruptcy did not exist.That led to the development of the "trade-off" model,where the firm's value first rises with the use of debt due to the tax shelter of debt,but later falls as more debt is added because the potential costs of bankruptcy begin to more than offset the tax shelter benefits.Under the trade-off theory,an optimal capital structure exists.

As the text indicates,a firm's financial risk can and should be divided into separate market and diversifiable risk components.

Which of the following statements is CORRECT? As a firm increases the operating leverage used to produce a given quantity of output,this

Which of the following statements is CORRECT?

You work for the CEO of a new company that plans to manufacture and sell a new type of laptop computer.The issue now is how to finance the company,with only equity or with a mix of debt and equity.Expected operating income is $600,000.Other data for the firm are shown below.How much higher or lower will the firm's expected EPS be if it uses some debt rather than only equity,i.e. ,what is EPS_L - EPS_U? ​

Your firm's debt ratio is only 5.00%,but the new CFO thinks that more debt should be employed.She wants to sell bonds and use the proceeds to buy back and retire common shares so the percentage of common equity in the capital structure (w_c) = 1 - w_d.Other things held constant,and based on the data below,if the firm increases the percentage of debt in its capital structure (w_d) to 60.0%,by how much would the ROE change,i.e. ,what is ROE_New - ROE_Old? Do not round your intermediate calculations. ​

Companies HD and LD have the same total assets,total investor-supplied capital,operating income (EBIT) ,tax rate,and business risk.Company HD,however,has a much higher debt ratio than LD.Also,both companies' returns on investors' capital (ROIC) exceed their after-tax costs of debt,r_d(1 - T) .Which of the following statements is CORRECT?

According to Modigliani and Miller (MM),in a world without taxes the optimal capital structure for a firm is approximately 100% debt financing.

The Modigliani and Miller (MM)articles implicitly assumed,among other things,that outside stockholders have the same information about a firm's future prospects as its managers.That was called "symmetric information," and it is questionable.The introduction of "asymmetric information" led to the development of the "signaling" theory of capital structure,which postulated that firms are reluctant to issue new stock because investors will interpret such an act as a signal that the firm's managers are worried about its future.Other actions give off different signals,and the end result is that capital structure is affected by managers' perceptions about how their financing decisions will affect investors' views of the firm and thus its value.

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

A firm's business risk is largely determined by the financial characteristics of its industry,especially by the amount of debt the average firm in the industry uses.

Based on the information below,what is the firm's optimal capital structure?

The Miller model begins with the Modigliani and Miller (MM)model with corporate taxes and then adds personal taxes.

Modigliani and Miller (MM),in their second article,took account of taxes,bankruptcy,and other factors that were assumed away in their original article.Once they took account of all these assumptions,they concluded that every firm has a unique optimal capital structure.Moreover,a manager can use the second MM model to determine his or her firm's optimal debt ratio.

As a consultant to First Responder Inc. ,you have obtained the following data (dollars in millions) .The company plans to pay out all of its earnings as dividends,hence g = 0.Also,no net new investment in operating capital is needed because growth is zero.The CFO believes that a move from zero debt to 80.0% debt would cause the cost of equity to increase from 10.0% to 12.0%,and the interest rate on the new debt would be 9.0%.What would the firm's total market value be if it makes this change? Hints: Find the FCF,which is equal to NOPAT = EBIT(1 - T) because no new operating capital is needed,and then divide by (WACC - g) .Do not round your intermediate calculations. ​