2 points Question 16 Which of the following statements is CORRECT? As a firm increases the operating leverage used to produce a given quantity of output, this will

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2 points
Question 16

Which of the following statements is CORRECT?  As a firm increases the operating leverage used to produce a given quantity of output, this will
Answer    normally lead to an increase in its fixed assets turnover ratio.
normally lead to a decrease in its business risk.
normally lead to a decrease in the standard deviation of its expected EBIT.
normally lead to a decrease in the variability of its expected EPS.
normally lead to a reduction in its fixed assets turnover ratio.

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2 points
Question 17

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?
Answer    Its sales become less stable over time.
The costs that would be incurred in the event of bankruptcy increase.
Management believes that the firm’s stock has become overvalued.
Its degree of operating leverage increases.
The corporate tax rate increases.
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2 points
Question 18

Which of the following statements is CORRECT?
Answer    A firm’s business risk is determined solely by the financial characteristics of its industry.
The factors that affect a firm’s business risk are affected by industry characteristics and economic conditions.  Unfortunately, these factors are generally beyond the control of the firm’s management.
One of the benefits to a firm of being at or near its target capital structure is that this eliminates any risk of bankruptcy.
A firm’s financial risk can be minimized by diversification.
The amount of debt in its capital structure can under no circumstances affect a company’s business risk.

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2 points
Question 19

Based on the information below, what is Ezzel Enterprises’ optimal capital structure?
Answer    Debt = 40%; Equity = 60%; EPS = $2.95; Stock price = $26.50.
Debt = 50%; Equity = 50%; EPS = $3.05; Stock price = $28.90.
Debt = 60%; Equity = 40%; EPS = $3.18; Stock price = $31.20.
Debt = 80%; Equity = 20%; EPS = $3.42; Stock price = $30.40.
Debt = 70%; Equity = 30%; EPS = $3.31; Stock price = $30.00.

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2 points
Question 20

Companies HD and LD have the same total assets, operating income (EBIT), tax rate, and business risk.  Company HD, however, has a much higher debt ratio than LD.  Also HD’s basic earning power (BEP) exceeds its cost of debt (rd).  Which of the following statements is CORRECT?
Answer    HD should have a higher return on assets (ROA) than LD.
HD should have a higher times interest earned (TIE) ratio than LD.
HD should have a higher return on equity (ROE) than LD, but its risk, as measured by the standard deviation of ROE, should also be higher than LD’s.
Given that BEP > rd, HD’s stock price must exceed that of LD.
Given that BEP > rd, LD’s stock price must exceed that of HD.

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2 points
Question 21

Firms U and L each have the same amount of assets, and both have a basic earning power ratio of 20%.  Firm U is unleveraged, i.e., it is 100% equity financed, while Firm L is financed with 50% debt and 50% equity.  Firm L’s debt has a before-tax cost of 8%.  Both firms have positive net income.  Which of the following statements is CORRECT?
Answer    The two companies have the same times interest earned (TIE) ratio.
Firm L has a lower ROA than Firm U.
Firm L has a lower ROE than Firm U.
Firm L has the higher times interest earned (TIE) ratio.
Firm L has a higher EBIT than Firm U.

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2 points
Question 22

Which of the following statements is CORRECT?
Answer    Since debt financing raises the firm’s financial risk, increasing a company’s debt ratio will always increase its WACC.
Since debt financing is cheaper than equity financing, raising a company’s debt ratio will always reduce its WACC.
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.
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.
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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2 points
Question 23

Companies HD and LD have identical tax rates, total assets, and basic earning power ratios, and their basic earning power exceeds their before-tax cost of debt, rd.  However, Company HD has a higher debt ratio and thus more interest expense than Company LD.  Which of the following statements is CORRECT?
Answer    Company HD has a higher net income than Company LD.
Company HD has a lower ROA than Company LD.
Company HD has a lower ROE than Company LD.
The two companies have the same ROA.
The two companies have the same ROE.

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2 points
Question 24

Which of the following statements is CORRECT?
Answer    The capital structure that maximizes the stock price is also the capital structure that minimizes the weighted average cost of capital (WACC).
The capital structure that maximizes the stock price is also the capital structure that maximizes earnings per share.
The capital structure that maximizes the stock price is also the capital structure that maximizes the firm’s times interest earned (TIE) ratio.
Increasing a company’s debt ratio will typically reduce the marginal costs of both debt and equity financing; however, this still may raise the company’s WACC.
If Congress were to pass legislation that increases the personal tax rate but decreases the corporate tax rate, this would encourage companies to increase their debt ratios.
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2 points
Question 25

Volga Publishing is considering a proposed increase in its debt ratio, which would also increase the company’s interest expense.  The plan would involve issuing new bonds and using the proceeds to buy back shares of its common stock.  The company’s CFO thinks the plan will not change total assets or operating income, but that it will increase earnings per share (EPS).  Assuming the CFO’s estimates are correct, which of the following statements is CORRECT?
Answer    Since the proposed plan increases Volga’s financial risk, the company’s stock price still might fall even if EPS increases.
If the plan reduces the WACC, the stock price is also likely to decline.
Since the plan is expected to increase EPS, this implies that net income is also expected to increase.
If the plan does increase the EPS, the stock price will automatically increase at the same rate.
Under the plan there will be more bonds outstanding, and that will increase their liquidity and thus lower the interest rate on the currently outstanding bonds.
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2 points
Question 26

Which of the following statements is CORRECT?
Answer    When a company increases its debt ratio, the costs of equity and debt both increase. Therefore, the WACC must also increase.
The capital structure that maximizes the stock price is generally the capital structure that also maximizes earnings per share.
All else equal, an increase in the corporate tax rate would tend to encourage a company to increase its debt ratio.
Since debt financing raises the firm’s financial risk, increasing a company’s debt ratio will always increase its WACC.
Since debt is cheaper than equity, increasing a company’s debt ratio will always reduce its WACC.
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2 points
Question 27

Which of the following statements is CORRECT?
Answer    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.
A change in the personal tax rate should not affect firms’ capital structure decisions.
“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.
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.
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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2 points
Question 28

The firm’s target capital structure should be consistent with which of the following statements?
Answer    Maximize the earnings per share (EPS).
Minimize the cost of debt (rd).
Obtain the highest possible bond rating.
Minimize the cost of equity (rs).
Minimize the weighted average cost of capital (WACC).

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2 points
Question 29

Which of the following events is likely to encourage a company to raise its target debt ratio, other things held constant?
Answer    An increase in the corporate tax rate.
An increase in the personal tax rate.
An increase in the company’s operating leverage.
The Federal Reserve tightens interest rates in an effort to fight inflation.
The company’s stock price hits a new high.

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2 points
Question 30

If debt financing is used, which of the following is CORRECT?
Answer    The percentage change in net operating income will be greater than a given percentage change in net income.
The percentage change in net operating income will be equal to a given percentage change in net income.
The percentage change in net income relative to the percentage change in net operating income will depend on the interest rate charged on debt.
The percentage change in net income will be greater than the percentage change in net operating income.
The percentage change in sales will be greater than the percentage change in EBIT, which in turn will be greater than the percentage change in net income.

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