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Chapter 16

Planning the Firm’s Financing Mix

True/False

1. Financial structure includes long-term and short-term sources of funds.

Difficulty: Easy

Keywords: financial structure

2. Financial structure design determines how permanent financing should be utilized.

Difficulty: Easy

Keywords: financial structure design

3. Real assets should be financed with temporary capital due to the short-term nature of depreciation expense.

Difficulty: Moderate

Keywords: temporary capital, permanent capital

4. The net income theory of capital structure holds that the price of a share is increased by moderate increases in a firm’s use of debt capital.

Difficulty: Moderate

Keywords: net income theory

5. According to the net operating income approach to valuation, the market value of the firm’s common stock is a residual of total market value.

Difficulty: Moderate

Keywords: net operating income approach

6. According to the net operating income approach to valuation, the total cost of debt financing is the coupon rate.

Difficulty: Moderate

Keywords: net operating income approach

7. According to the net income approach to valuation, the cost of capital will be lower the more debt financing is used.

Difficulty: Moderate

Keywords: net income approach

8. According to the dependence hypothesis of debt financing, the cost of common equity is constant regardless of the debt financing level.

Difficulty: Moderate

Keywords: dependence hypothesis

9. Under the net income approach to valuation, the explicit and implicit cost of debt are one and the same.

Difficulty: Moderate

Keywords: net income approach

10. An increase in financial leverage will increase earnings before income and taxes (EBIT).

Difficulty: Moderate

Keywords: financial leverage

11. Because preferred stock dividends are not tax-deductible, they are not a source of financial leverage.

Difficulty: Moderate

Keywords: financial leverage

12. The objective of capital structure management is to maximize the market value of the firm’s equity.

Difficulty: Moderate

Keywords: capital structure management

13. Investors require a higher return on common stock investments if a firm uses less leverage.

Difficulty: Easy

Keywords: stock returns, leverage

14. According to the net operating income theory, a firm does not have an optimal capital structure.

Difficulty: Moderate

Keywords: net operating income theory

15. Uncommitted earnings per share is never greater than earnings per share (EPS).

Difficulty: Moderate

Keywords: uncommitted earnings per share

16. Capital costs, like other costs, potentially reduce the size of the cash dividend that can be paid.

Difficulty: Moderate

Keywords: capital costs

17. According to the independence hypothesis, the cost of debt consists of an explicit return to the bondholder and an implicit cost reflected in the increased return to equity.

Difficulty: Moderate

Keywords: independence hypothesis

18. The independence hypothesis is also known as the net income hypothesis.

Difficulty: Easy

Keywords: independence hypothesis

19. The independence hypothesis suggests that the total market value of the firm’s outstanding securities is unaffected by its capital structure.

Difficulty: Moderate

Keywords: independence hypothesis

20. According to the independence hypothesis, earnings and dividends are expected to fall as financial leverage increases.

Difficulty: Moderate

Keywords: independence hypothesis

21. The major implication of the independence hypothesis is that one capital structure is as good as any other.

Difficulty: Moderate

Keywords: independence hypothesis

22. The dependence hypothesis states that as debt usage increases, a firm’s cost of debt capital increases.

Difficulty: Moderate

Keywords: dependence hypothesis

23. The dependence hypothesis is also called the net income approach to valuation.

Difficulty: Moderate

Keywords: dependence hypothesis

24. The independence hypothesis suggests that the cost of equity decreases as financial leverage increases.

Difficulty: Moderate

Keywords: independence hypothesis

25. The dependence hypothesis suggests that the cost of equity decreases as financial leverage increases.

Difficulty: Moderate

Keywords: dependence hypothesis

26. Other things the same, the use of debt financing reduces the firm’s total tax bill, resulting in a higher total market value.

Difficulty: Moderate

Keywords: debt financing

27. The real cost of debt is the sum of explicit and implicit costs.

Difficulty: Moderate

Keywords: explicit costs, implicit costs

28. One benefit from using fixed cost securities is the reduced variability in the EPS stream.

Difficulty: Moderate

Keywords: fixed cost securities

29. The free cash flow theory of capital structure gives a theoretical solution as to how much financial leverage a firm should have.

Difficulty: Moderate

Keywords: free cash flow theory

30. Because there are no fixed financing costs, a common stock plan line in an EBIT-EPS analysis chart will have a steeper slope than will a bond-plan line.

Difficulty: Moderate

Keywords: EBIT-EPS analysis

31. One danger of EBIT-EPS analysis is that it ignores the implicit cost of debt financing.

Difficulty: Moderate

Keywords: EBIT-EPS analysis

32. The two most common types of leverage ratios are balance sheet leverage ratios and sources and uses leverage ratios.

Difficulty: Moderate

Keywords: leverage ratios

33. The common equity ratios of large retail firms seem to differ statistically from those of major steel producers.

Difficulty: Moderate

Keywords: common equity ratios

34. Debt capacity is the maximum proportion of debt that the firm can include in its capital structure without increasing its tax liability.

Difficulty: Moderate

Keywords: debt capacity

35. Based on the results of a study reviewed in the text, the single most important influence on target debt ratios is the advice of investment bankers.

Difficulty: Moderate

Keywords: target debt ratios

36. According to the pecking order theory of capital structure, when external funding is needed, common stock will be used to raise the funds.

Difficulty: Moderate

Keywords: pecking order theory

37. According to the net operating income approach (with no taxes), the use of a greater degree of financial leverage might result in an increase in earnings and dividends but will have no effect on the firm’s cost of common equity.

Difficulty: Moderate

Keywords: net operating income approach

38. The implicit cost of debt takes into consideration the change in the cost of common equity brought on by using additional debt.

Difficulty: Moderate

Keywords: implicit cost of debt

39. The dependence hypothesis or NI approach (with no taxes) suggests that the greater use of debt financing, in regard to common equity financing, will have an unfavorable effect on the price of the company’s common stock.

Difficulty: Moderate

Keywords: dependence hypothesis

40. The tax shield on interest is calculated by multiplying the interest rate paid on debt by the principal amount of the debt and the firm’s marginal tax rate.

Difficulty: Moderate

Keywords: interest tax shield

41. The EBIT-EPS indifference point, sometimes called the break-even point, identifies the optimal range of financial leverage regardless of the financing plan chosen by the financial manager.

Difficulty: Moderate

Keywords: EBIT-EPS analysis

42. Debt capacity is the minimum proportion of debt the firm can include in its capital structure and still maintain its lowest composite cost of capital.

Difficulty: Moderate

Keywords: debt capacity

43. Monitoring costs are higher for a firm with a high debt-to-equity ratio.

Difficulty: Easy

Keywords: monitoring costs

44. A sinking fund is a real cash reserve that is used to provide for the orderly and early retirement of the principal amount of the bond issue.

Difficulty: Moderate

Keywords: sinking fund

45. Agency costs tend to occur in business organizations when ownership and management control are confined to the same individuals.

Difficulty: Moderate

Keywords: agency costs

46. Comparative leverage ratio analysis does not involve the use of industry norms.

Difficulty: Moderate

Keywords: comparative leverage ratio analysis

47. The firm’s financial structure is the same as its capital structure.

Difficulty: Easy

Keywords: financial structure

48. The static trade-off theory of capital structure takes into account the monitoring and agency costs associated with debt usage.

Difficulty: Moderate

Keywords: static trade-off theory

49. The nature of a firm’s assets has a major influence on the types of financial capital a firm uses.

Difficulty: Easy

Keywords: financial capital

50. The objective of capital-structure management can be viewed as the endeavor to find the financing mix that will minimize the firm’s composite cost of capital.

Difficulty: Moderate

Keywords: capital structure management

51. An integral part of the independence hypothesis of capital structure is that the cost of common equity will increase at precisely the same rate as any increase in earnings and dividends.

Difficulty: Moderate

Keywords: independence hypothesis

52. The net operating income theory of capital structure maintains that debt has a single cost referred to as its explicit cost of capital.

Difficulty: Moderate

Keywords: net operating income theory

53. The net income theory of capital structure indicates that the firm’s composite cost of capital and its common stock price will be affected by the firm’s use of financial leverage, regardless of how little the firm uses debt.

Difficulty: Moderate

Keywords: net income theory

54. The net operating income theory of capital structure maintains that a greater degree of financial leverage might result in higher earnings and dividends.

Difficulty: Moderate

Keywords: net operating income theory

55. The dependence hypothesis of capital structure suggests that the use of more leverage will lower the cost of capital.

Difficulty: Moderate

Keywords: dependence hypothesis, cost of capital, leverage

56. The moderate position of capital structure theory indicates that there is a range of capital structures, rather than a single capital structure, that is optimal.

Difficulty: Moderate

Keywords: moderate position of capital structure

57. Debt capacity is the maximum level of debt that the firm can include in its capital structure and still maintain its minimum composite cost of capital.

Difficulty: Moderate

Keywords: debt capacity

58. The static trade-off theory of capital structure recognizes the tax-shield benefit of debt financing, but also recognizes that the benefit is offset by costs associated with debt financing.

Difficulty: Moderate

Keywords: static trade-off theory

59. The pecking order theory of capital structure indicates that firms prefer to finance investment opportunities with external financial capital first, then with internally generated funds.

Difficulty: Moderate

Keywords: pecking order theory

60. The free cash flow theory of capital structure indicates how debt can be used to control managerial behavior.

Difficulty: Moderate

Keywords: free cash flow theory

61. The indifference level of EBIT based on uncommitted EPS will always be less than that based on EPS.

Difficulty: Moderate

Keywords: indifference level of EBIT

62. High coverage ratios, compared with a standard, imply unused debt capacity.

Difficulty: Easy

Keywords: coverage ratios, debt capacity

63. Empirical evidence indicates that firms use target debt ratios influenced primarily by the firm’s internal management and staff analysts.

Difficulty: Moderate

Keywords: target debt ratios

64. When market conditions change abruptly, company financial policies and decisions must adapt to the new conditions; otherwise, the firm will be faced with a lower level of cash flow generation and increased risk of financial distress.

Difficulty: Moderate

Keywords: market conditions, financial policy

65. Debt capacity is the maximum proportion of debt that the firm can include in its capital structure and still maintain a lower EPS.

Difficulty: Moderate

Keywords: debt capacity

Multiple Choice

66. When the impact of taxes is considered with the net operating income approach to valuation, the value of the firm:

a. increases at a debt-to-total value ratio of 40 percent.

b. decreases by interest expense paid out.

c. increases by the present value of the tax shield.

d. decreases by the future value of cash flows.

Difficulty: Moderate

Keywords: net operating income approach

67. The inclusion of bankruptcy risk in firm valuation:

a. acknowledges that a firm has an upper limit to debt financing.

b. provides a rationale for a linear cost of capital curve.

c. is ignored in both the net operating income and the net income of cost of capital.

d. both a and c.

e. all of the above.

Difficulty: Moderate

Keywords: bankruptcy risk

68. According to the net income approach to valuation, as the use of debt financing increases, the cost of capital _________ while the cost of equity _______________.

a. remains constant; decreases

b. decreases; remains constant

c. remains constant; increases

d. increases; increases

Difficulty: Moderate

Keywords: net income approach

69. According to the net operating income theory of firm valuation, an increase in ____________ will increase the cost of common equity.

a. dividends per share

b. market price per share

c. earnings available to common stockholders

d. both a and c

Difficulty: Moderate

Keywords: net operating income theory

70. The primary objective of capital structure management is to mix the _______ sources of funds obtained by a firm to minimize the cost of the company’s __________.

a. short-term; common stock

b. permanent; common stock

c. short-term; debt

d. permanent; debt

Difficulty: Moderate

Keywords: capital structure management

71. Which of the following is inconsistent with an optimal capital structure policy?

a. Lower the blended cost of debt and equity.

b. Maximize a firm’s common stock price.

c. Minimize the cost of capital.

d. Maximize EPS.

Difficulty: Moderate

Keywords: optimal capital structure

72. Which of the following is part of a firm’s financial structure but not a component of its capital structure?

a. Retained earnings

b. Mortgage bonds

c. Accounts payable

d. Both a and c

Difficulty: Moderate

Keywords: capital structure components

73. The independence theory assumes that a firm’s debt usage does not influence:

a. common stock price.

b. explicit costs.

c. implicit costs.

d. both b and c.

e. all of the above.

Difficulty: Moderate

Keywords: independence theory, common stock price

74. Which theory of capital structure rests upon the net operating income approach to valuation?

a. The independence theory

b. The moderate position theory

c. The dependence theory

d. The capital accumulation theory

Difficulty: Easy

Keywords: independence theory, net operating income

75. Dependence theory assumes that as debt usage increases, _______ increases.

a. explicit costs

b. cost of debt

c. common stock price

d. both b and c

Difficulty: Moderate

Keywords: dependence theory, common stock price

76. The net income approach to valuation relates to what theory on capital structure?

a. The independence theory

b. The moderate position theory

c. The dependence theory

d. The capital accumulation theory

Difficulty: Easy

Keywords: dependence theory, net income approach

77. According to the moderate view of capital costs and financial leverage, as the use of debt financing increases:

a. the cost of capital continuously decreases.

b. the cost of capital remains constant.

c. the cost of capital continuously increases.

d. there is an optimal level of debt financing.

Difficulty: Moderate

Keywords: moderate view of capital costs

78. Financial leverage is distinct from operating leverage since it accounts for the use of:

a. debt.

b. fixed operating costs.

c. preferred stock.

d. both a and c.

e. all of the above.

Difficulty: Moderate

Keywords: financial leverage

79. Fluctuations in EBIT result in:

a. fluctuations in EPS, which might be larger or smaller as financial leverage increases.

b. smaller fluctuations in EPS, the greater the degree of financial leverage.

c. greater fluctuations in EPS, the greater the degree of financial leverage.

d. equal fluctuations in EPS, the greater the degree of financial leverage.

Difficulty: Moderate

Keywords: financial leverage

80. When using an EPS-EBIT chart to evaluate a pure debt financing and pure equity financing plan, the debt financing plan line will have:

a. a steeper slope than the equity financing plan line.

b. a lower level of EBIT at EPS = 0.

c. a smaller slope when less leverage is used.

d. both a and c.

Difficulty: Moderate

Keywords: EPS-EBIT approach

81. When deciding upon how much debt financing to employ, most practitioners would cite which of the following as the most important influence on the level of the debt ratio?

a. Providing a borrowing reserve

b. Maintaining desired bond rating

c. Ability to adequately meet financing charges

d. Exploiting advantages of financial leverage

Difficulty: Moderate

Keywords: debt ratio

82. The Independence Hypothesis states that the use of a greater degree of leverage might result in greater:

a. earnings.

b. dividends.

c. firm cost of common equity.

1. both a & c.
2. all of the above.

Difficulty: Moderate

Keywords: net operating income theory

83. The moderate view of capital structure management assumes:

a. no corporate income taxes.

b. cost of equity remains constant with an increase in financial leverage.

c. firms might fail.

d. none of the above.

Difficulty: Moderate

Keywords: moderate view of capital structure

84. The moderate view of capital structure management says that the cost of capital curve is:

a. a straight line.

b. v-shaped.

c. s-shaped.

d. saucer-shaped.

Difficulty: Moderate

Keywords: moderate view of capital structure

85. The single most important factor that should influence a firm’s financing mix is their:

a. cost of debt.

b. EPS.

c. temporary capital.

d. probability distribution of EBIT.

Difficulty: Moderate

Keywords: financing mix

86. The level of EBIT that will equate EPS between two different financing plans is called the:

a. indifference point.

b. optimal capital plan.

c. break-even point.

d. both a and c.

e. all of the above.

Difficulty: Moderate

Keywords: indifference point

87. Which two ratios would be most helpful in managing a firm’s capital structure?

a. Balance sheet leverage ratios and profitability ratios

b. Leverage ratios and coverage ratios

c. Coverage ratios and liquidity ratios

d. Coverage ratios and profitability ratios

Difficulty: Moderate

Keywords: capital structure

88. The dependence hypothesis (no-tax case) suggests that the use of more debt will:

a. lower the overall cost of capital.

b. have no effect on the firm’s cost of common equity.

c. have a favorable effect on the company’s common stock price.

d. all of the above.

Difficulty: Moderate

Keywords: dependence hypothesis

89. Sinking fund payments are made to the:

a. banks.

b. bond trustee.

c. bondholder.

d. board of directors.

Difficulty: Moderate

Keywords: sinking fund payments

90. The net operating income approach (no-tax case) suggests that a 10% increase in earnings and dividends per share, caused by a change in the financing mix, will:

a. cause the firm’s cost of common equity to fall by some percentage less than 10.

b. cause the firm’s cost of common equity to rise by 10%.

c. cause the firm’s cost of common equity to rise by some percentage less than 10.

d. cause no change in the cost of common equity.

Difficulty: Moderate

Keywords: net operating income approach

91. Optimal capital structure is:

a. the mix of permanent sources of funds used by the firm in a manner that will maximize the company’s common stock price.

b. the mix of all items that appear on the right-hand side of the company’s balance sheet.

c. the mix of funds that will minimize the firm’s beta.

d. the mix of securities that will maximize EPS.

Difficulty: Moderate

Keywords: optimal capital structure

92. Optimal capital structure is:

a. the explicit cost of debt.

b. the implicit cost of debt.

c. the change in the cost of equity caused by the issuance of the debt.

d. all of the above.

Difficulty: Moderate

Keywords: optimal capital structure

93. Basic tools of capital structure management include:

a. EBIT-EPS analysis.

b. comparative profitability ratios.

c. capital budgeting techniques.

d. none of the above.

Difficulty: Moderate

Keywords: capital structure management

94. The EBIT-EPS indifference point:

a. identifies the EBIT level at which the EPS will be the same regardless of the financing plan.

b. identifies the point at which the analysis can use EBIT and EPS interchangeably.

c. identifies the level of earnings at which the management is indifferent about the payments of dividends.

d. none of the above.

Difficulty: Moderate

Keywords: EBIT-EPS approach, indifference point

95. In equation form, the relationship between financial and capital structure can be expressed by:

financial structure - ____________________ = capital structure

a. equity

b. current liabilities

c. long-term debt

d. none of the above

Difficulty: Moderate

Keywords: financial structure, capital structure

96. Which of the following statements is true?

a. The net operating income theory of capital structure maintains that the firm’s composite cost of capital and its common stock price are dependent on the degree to which the firm chooses to use financial leverage.

b. The net income theory of capital structure maintains that the firm’s composite cost of capital and its common stock price are independent of the degree to which the firm chooses to use financial leverage.

c. The dependence hypothesis of capital structure suggests that the explicit and implicit costs of debt are the same.

d. All of the above statements are true.

Difficulty: Moderate

Keywords: dependence hypothesis

97. If a firm chose to increase its debt ratio from 20% to 40%, what is the potential risk?

a. The average cost of capital would most likely rise.

b. The price of the firm’s common stock would definitely decline.

c. If economic forces cause a reduction of sales, the firm’s EPS might decline.

d. The firm’s WACC might decline.

Difficulty: Moderate

Keywords: debt ratio

98. The moderate position of capital structure theory indicates that:

a. the tax shield on debt positively affects firm value, indicating that there is some benefit to financial leverage as opposed to an all-equity capitalization.

b. the higher the firm’s financial leverage, the higher the probability the firm will be unable to meet the financial obligations included in its debt contracts, which could ultimately lead to firm failure.

c. there is a range of capital structures, rather than a single capital structure, that is optimal.

d. all of the above.

Difficulty: Moderate

Keywords: moderate position of capital structure

99. Monitoring costs that arise due to capital structure management:

a. help to reduce the conflict between stockholders and creditors.

b. are ultimately borne by the debt holders.

c. are borne by preferred stockholders.

d. none of the above.

Difficulty: Moderate

Keywords: capital structure management, costs

100. A firm is analyzing two different capital structures for financing a new asset that will cost $100,000. The effects of the two structures on the firm’s balance sheet are described below.

Plan A: finance with 50% debt

New asset $100,000 Debt $50,000

Common equity $50,000

Total $100,000

Plan B: finance with 70% debt

New asset $100,000 Debt $70,000

Common equity $30,000

Total $100,000

Based on the information provided, we can conclude that:

a. if the firm chooses Plan A, then any changes in the firm’s EBIT will lead to larger fluctuations in the firm’s EPS than if the firm chooses Plan B.

b. if the firm chooses Plan B, then any changes in the firm’s EBIT will lead to larger fluctuations in the firm’s EPS than if the firm chooses Plan A.

c. if the firm chooses Plan A, then any changes in the firm’s EBIT will lead to the same fluctuations in the firm’s EPS as will occur if the firm chooses Plan B.

d. if the firm chooses Plan B, then any changes in the firm’s EBIT will lead to smaller fluctuations in the firm’s EPS than if the firm chooses Plan A.

Difficulty: Moderate

Keywords: EBIT-EPS approach

Use the following information to answer questions 101-104. Your firm is trying to determine whether it should finance a project requiring $800,000 with new common stock or with debt. The firm is faced with the following financing alternatives:

I: Issue new common stock. Sale price of the common stock is expected to be $40 per share.

II: Issue new bonds with a coupon rate of 12%.

The firm has a marginal tax rate of 34%, the company currently has 40,000 shares of common stock outstanding, and $90,000 face value of 10% debt outstanding.

101. Total shares outstanding will be:

a. 20,000 under alternative I and zero under alternative II.

b. 40,000 under alternative I and 60,000 under alternative II.

c. 60,000 under alternative I and 40,000 under alternative II.

d. 60,000 under both alternative I and alternative II.

Difficulty: Moderate

Keywords: capital structure

102. The total interest obligation will be:

a. $105,000 under alternative I and $9,000 under alternative II.

b. $9,000 under alternative I and $105,000 under alternative II.

c. zero under alternative I and $96,000 under alternative II.

d. $105,000 under both alternative I and alternative II.

Difficulty: Moderate

Keywords: interest expense

103. The indifference level of EBIT is:

a. $99,000.

b. $66,600.

c. $333,000.

d. $297,000.

Difficulty: Moderate

Keywords: indifference level of EBIT

104. EPS at the indifference level of EBIT is:

a. $3.17.

b. $4.80.

c. $5.27.

d. $5.90.

Difficulty: Moderate

Keywords: indifference level of EBIT

105. Weaknesses of the EBIT-EPS analysis include:

a. that it disregards the implicit costs of debt financing.

b. that it ignores the effect of the specific financing decision on the firm’s cost of common equity capital.

c. that it considers only the level of the earnings stream and ignores the variability inherent in it.

d. all of the above.

Difficulty: Moderate

Keywords: EBIT-EPS approach

106. Typically, Delta, Inc. maintains $1 million in cash and marketable securities. The firm currently is expecting an economic recession and projects that its net cash flows from operations during the period will be $2.5 million. Delta expects annual interest and sinking fund payments will be $3 million during the period. If the recession occurs, Delta’s cash balance at the end of the period will be:

a. $6.5 million.

b. $1 million.

c. $500,000.

d. $3.5 million.

Difficulty: Moderate

Keywords: cash balance

107. An optimal capital structure is achieved:

a. when a firm’s expected profits are maximized.

b. when a firm’s expected EPS are maximized.

c. when a firm’s expected stock price is maximized.

d. when a firm’s break-even point is achieved.

Difficulty: Moderate

Keywords: optimal capital structure

108. The Goreman Corporation has a debt ratio of 33.33%, and it needs to raise $100,000 to expand. Management feels that an optimal debt ratio is 16.67%. Sales are currently $750,000, and the total assets turnover is 7.5. How should the expansion be financed so as to produce the desired debt ratio?

a. Finance it all with debt.

b. Finance it all with equity.

c. Finance 20% with debt and 80% with equity.

d. Finance 40% with debt and 60% with equity.

e. Finance 50% with debt and 50% with equity.

Difficulty: Moderate

Keywords: debt ratio

109. An optimal capital structure is achieved:

a. when a firm’s expected profits are maximized.

b. when a firm’s expected EPS are maximized.

c. when a firm’s break-even point is achieved.

d. when a firm’s weighted average cost of capital is minimized.

Difficulty: Moderate

Keywords: optimal capital structure

110. The inclusion of bankruptcy risk in firm valuation:

a. acknowledges that a firm is insulted from the impact of high debt financing.

b. provides a rationale for a saucer-shaped cost of capital curve.

c. is ignored in the Independence Hypothesis.

d. both b & c.

e. all of the above.

Difficulty: Moderate

Keywords: bankruptcy risk

111. Which of the following is the most typical natural conflict that could lead to agency costs in managing a firm’s capital structure?

a. Potential stockholders versus existing stockholders

b. Stockholders versus bondholders

c. There are no potential conflicts that could lead to agency costs in managing a firm’s capital structure

d. Existing shareholders and the IRS

Difficulty: Moderate

Keywords: agency costs

112. How can bondholders reduce potential conflicts with stockholders as related to capital structure?

a. Pay out higher dividends.

b. Increase management stock options.

c. Require protective covenants in the bond indenture agreement.

d. Require the firm to increase capital spending for new investments.

Difficulty: Moderate

Keywords: bondholder protection

113. Which of the following is not a component of a firm’s capital structure?

a. Preferred stock

b. Bonds

c. Common stock

d. Accounts payable

e. Retained earnings

Difficulty: Moderate

Keywords: capital structure

114. Which of the following is consistent with the moderate view of capital structure theory?

a. The cost of capital continuously decreases as the firm’s debt ratio increases.

b. The cost of capital remains constant as the firm’s debt ratio increases.

c. The cost of capital continuously increases as the firm’s debt ratio increases.

d. There is an optimal level of debt financing.

e. Capital structure does not affect a firm’s cost of capital.

Difficulty: Moderate

Keywords: moderate view of capital structure

115. What is the central feature of the moderate view (theory) of capital structure?

a. A high debt ratio will result in a maximum price of a firm’s common stock.

b. A firm’s common stock price will not be affected by the amount of debt a firm uses.

c. A low debt ratio will result in a maximum price for a firm’s common stock.

d. Modest levels of debt have a more favorable impact on a firm’s average cost of capital and stock price than no debt.

Difficulty: Moderate

Keywords: moderate view of capital structure

116. The moderate position (theory) of capital structure suggests that if a firm moves from zero debt in its capital structure to moderate usage of debt, the result is an increase in a firm’s:

a. stock price.

b. cost of equity.

c. dividend payout.

d. both a & c.

e. all of the above.

Difficulty: Moderate

Keywords: moderate view of capital structure

117. What is the best argument against the dependence theory of capital structure?

a. The tax shield effect of debt will result in a lower cost of equity.

b. Increasing debt too much can result in a greater likelihood of firm failure (financial distress).

c. A firm’s common stock price will not be affected by the amount of debt a firm uses.

d. Too much common equity increases the probability of bankruptcy.

Difficulty: Moderate

Keywords: dependence theory

118. Which of the following is consistent with the independence hypothesis?

a. A firm’s composite cost of capital decreases as financial leverage is used.

b. A firm’s common stock price falls as financial leverage is used.

c. A firm’s composite cost of capital and common stock price are unaffected by the amount of financial leverage used by the firm.

d. A firm’s composite cost of capital increases as operating leverage is used.

e. A firm’s common stock price rises as operating leverage is used.

Difficulty: Moderate

Keywords: independence theory

119. Which of the following is consistent with the dependence hypothesis?

a. Increased usage of financial leverage will increase a firm’s composite cost of capital indefinitely.

b. Increased usage of financial leverage will lower a firm’s composite cost of capital indefinitely.

c. Increased usage of financial leverage will not affect a firm’s composite cost of capital.

d. Increased usage of operating leverage will increase a firm’s composite cost of capital indefinitely.

Difficulty: Moderate

Keywords: dependence hypothesis

120. Which of the following statements is correct?

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 Capital Asset Pricing Model (CAPM).

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. Each of the statements above is false.

Difficulty: Moderate

Keywords: optimal capital structure

121. From the information below, select the optimal capital structure for Mountain High Corp.

a. Debt = 40%; Equity = 60%; EPS = $2.95; Stock price = $26.50

b. Debt = 50%; Equity = 50%; EPS = $3.05; Stock price = $28.90

c. Debt = 60%; Equity = 40%; EPS = $3.18; Stock price = $31.20

d. Debt = 80%; Equity = 20%; EPS = $3.42; Stock price = $30.40

e. Debt = 70%; Equity = 30%; EPS = $3.31; Stock price = $30.00

Difficulty: Moderate

Keywords: optimal capital structure

122. The most acceptable view of capital structure, according to the text, is that the weighted average cost of capital:

a. first falls with moderate levels of leverage and then increases as a firm’s leverage becomes high.

b. does not change with leverage.

c. increases proportionately with increases in leverage.

d. increases with moderate amounts of leverage and then falls.

Difficulty: Moderate

Keywords: weighted average cost of capital

123. An increase in the ____________ is likely to encourage a corporation to increase its debt ratio.

a. corporate tax rate

b. personal tax rate

c. company’s degree of operating leverage

d. expected cost of bankruptcy

Difficulty: Moderate

Keywords: debt ratio

124. As a general rule, the capital structure:

a. maximizes expected EPS and also maximizes the price per share of common stock.

b. minimizes the interest rate on debt and also maximizes the expected EPS.

c. minimizes the required rate on equity and also maximizes the stock price.

d. maximizes the price per share of common stock and also minimizes the weighted average cost of capital.

Difficulty: Moderate

Keywords: capital structure

125. Which of the following statements is correct?

a. Firms whose sales are less sensitive to changes in the business cycle are more likely to rely on debt financing.

b. Firms with large tax loss-carry-forwards are more likely to rely on debt financing.

c. Firms with a low operating leverage are more likely to rely on debt financing.

d. Both a and c are correct.

Difficulty: Moderate

Keywords: debt financing

126. Which of the following statements is correct?

a. Firms whose sales are very stable are more likely to rely on debt financing than firms whose sales are very sensitive to changes in economic circumstances.

b. Firms with large tax loss-carry-forwards are more likely to rely on debt financing.

c. Firms with a high operating leverage are more likely to rely on debt financing.

d. Firms operating in risky industries will have greater leverage.

Difficulty: Moderate

Keywords: debt financing

127. The independence hypothesis assumes which of the following?

a. A firm’s value is determined by capitalizing (discounting) the firm’s expected profits by the firm’s CAPM.

b. A firm’s cost of capital rises as a firm uses more financial leverage.

c. A firm’s value is determined by capitalizing (discounting) the firm’s expected net operating income stream.

d. All of the above.

Difficulty: Moderate

Keywords: independence hypothesis

128. The dependence hypothesis assumes which of the following?

a. A firm’s value is determined by capitalizing (discounting) the firm’s expected operating income by the firm’s CAPM.

b. A firm’s value is determined by capitalizing (discounting) the firm’s expected net income stream.

c. A firm’s cost of capital rises as a firm uses more financial leverage.

d. A firm’s cost of capital decreases as a firm uses more financial leverage.

Difficulty: Moderate

Keywords: dependence hypothesis

129. The moderate view of capital structure theory states that the cost of capital initially ____________ and then ____________ as the firm uses high amounts of debt.

a. increases; remains the same

b. decreases; remains the same

c. remains the same; increases

d. increases; increases

e. decreases; increases

Difficulty: Moderate

Keywords: moderate view of capital structure

130. Which of the following is the most important factor that affects a firm’s financing mix?

a. The amount of EPS

b. The amount of operating income

c. The number of shares that are outstanding

d. Business risk

Difficulty: Moderate

Keywords: financing mix

131. A firm’s capital structure consists of which of the following?

a. The amount of debt that a firm utilizes

b. The amount of debt and preferred stock that a firm utilizes

c. The amount of debt, preferred stock, and common stock that a firm utilizes

d. None of the above

Difficulty: Moderate

Keywords: capital structure

132. Baseline Corporation generated $2 million in operating income from sales of $20 million during the latest fiscal year. The firm’s interest expense was $500,000, and the corporate income tax rate was 40%. Investors require a capitalization rate of 12%. Using the independence hypothesis approach to valuation, what is Baseline’s market value?

a. $18.6 million

b. $17.1 million

c. $16.7 million

d. $15.4 million

e. $14.3 million

Difficulty: Moderate

Keywords: independence hypothesis approach

133. Castle Corp. generated $2 million in operating income from sales of $20 million during the latest fiscal year. The firm’s interest expense was $500,000, and the corporate income tax rate was 40%. Investors require a rate of return of 18%. Using the dependence hypothesis approach to valuation, what is the market value of Castle?

a. $9.6 million

b. $8.3 million

c. $7.2 million

d. $6.5 million

e. $5.1 million

Difficulty: Moderate

Keywords: dependence hypothesis approach

134. Farar, Inc. projects operating income of $4 million next year. The firm’s income tax rate is 40%. Farar presently has 750,000 shares of common stock, no preferred stock, and no debt. The firm is considering the issuance of $6 million of 10% bonds to finance a new product that is not expected to generate an increase in income for two years. If Farar issues the bonds this year, what will projected EPS be next year?

a. $1.53

b. $1.98

c. $2.33

d. $2.72

e. $3.12

Difficulty: Moderate

Keywords: projected earnings per share

135. Zybeck Corp. projects operating income of $4 million next year. The firm’s income tax rate is 40%. Zybeck presently has 750,000 shares of common stock which have a market value of $10 per share, no preferred stock, and no debt. The firm is considering two alternatives to finance a new product: (a) the issuance of $6 million of 10% bonds, or (b) the issuance of 60,000 new shares of common stock. If Zybeck issues common stock this year, what will projected EPS be next year?

a. $2.10

b. $2.96

c. $2.33

d. $1.67

Difficulty: Moderate

Keywords: projected earnings per share

136. Zybeck Corp. projects operating income of $4 million next year. The firm’s income tax rate is 40%. Zybeck presently has 750,000 shares of common stock which have a market value of $10 per share, no preferred stock, and no debt. The firm is considering two alternatives to finance a new product: (a) the issuance of $6 million of 10% bonds, or (b) the issuance of 60,000 new shares of common stock at $10 per share. If Zybeck issues common stock this year, what will the firm’s return on equity be next year?

a. 16.7%

b. 18.2%

c. 22.1%

d. 26.4%

e. 29.6%

Difficulty: Moderate

Keywords: return on equity

137. Lever Brothers has a debt ratio (debt to assets) of 20%. Management is wondering if its current capital structure is too conservative. Lever Brothers’s present EBIT is $3 million, and profits available to common shareholders are $1,680,000, with 457,143 shares of common stock outstanding. If the firm were to instead have a debt ratio of 40%, additional interest expense would cause profits available to stockholders to decline to $1,560,000, but only 342,857 common shares would be outstanding. What is the difference in EPS at a debt ratio of 40% versus 20%?

a. $2.12

b. $1.95

c. $1.16

d. $0.88

Difficulty: Moderate

Keywords: EBIT-EPS approach

138. Lever Brothers has a debt ratio (debt to assets) of 40%. Management is wondering if its current capital structure is too conservative. Lever Brothers’s present EBIT is $3 million, and profits available to common shareholders are $1,560,000, with 342,857 shares of common stock outstanding. If the firm were to instead have a debt ratio of 60%, additional interest expense would cause profits available to stockholders to decline to $1,440,000, but only 228,571 common shares would be outstanding. What is the difference in EPS at a debt ratio of 60% versus 40%?

a. $1.75

b. $2.00

c. $3.25

d. $4.50

Difficulty: Moderate

Keywords: EBIT-EPS approach

139. Lever Brothers has a debt ratio (debt to assets) of 60%. Management is wondering if its current capital structure is too aggressive. Lever Brothers’s present EBIT is $3 million, and profits available to common shareholders are $1,440,000, with 228,571 shares of common stock outstanding. If the firm were to instead have a debt ratio of 20%, reduced interest expense would cause profits available to stockholders to increase to $1,680,000, but 457,143 common shares would be outstanding. What is the difference in EPS at a debt ratio of 20% versus 60%?

a. $-1.76

b. $-2.63

c. $-3.14

d. $-4.37

Difficulty: Moderate

Keywords: EBIT-EPS approach

Short Answer

140. Discuss how currency risk of the multinational firm influences the amount of financial risk that the firm is willing to bear.

Difficulty: Moderate

Keywords: multinational firm, currency risk, financial risk

141. Briefly explain what the empirical evidence suggests about financial managers’ actions as they relate to the moderate view of capital structure theory.

Difficulty: Moderate

Keywords: financial managers, moderate view

142. Roberts, Inc. is trying to decide how best to finance a proposed $10 million capital investment. Under Plan I, the project will be financed entirely with long-term 9% bonds. The firm currently has no debt or preferred stock. Under Plan II, common stock will be sold to net the firm $20 a share; presently, 1 million shares are outstanding. The corporate tax rate for Roberts is 40%.

a. Calculate the indifference level of EBIT associated with the two

financing plans.

b. Prepare an EBIT-EPS analysis chart, showing the intersection of the

two financing plan lines.

c. Which financing plan would you expect to cause the greatest change

in EPS relative to a change in EBIT? Why?

d. If EBIT is expected to be $3.1 million, which plan will result in a

higher EPS?

a. (EBIT)(1 - 0.4)/1,500,000 =

(EBIT - $900,000)(1 - 0.4)/1,000,000

EBIT = $2,700,000.

b. Graph should be drawn by student.

c. The bond plan will magnify changes in EPS since it increases

financial leverage.

d. Since $3.1 million EBIT is above the indifference point of $2.7

million, the bond plan will give a higher EPS.

Difficulty: Moderate

Keywords: EBIT-EPS analysis

143. Young Enterprises is financed entirely with 3 million shares of common stock selling for $20 a share. Capital of $4 million is needed for this year’s capital budget. Additional funds can be raised with new stock (ignore dilution) or with 13% 10-year bonds. Young’s tax rate is 40%.

a. Calculate the financing plan’s EBIT indifference point.

b. The expected level of EBIT is $10,320,000 with a standard deviation

of $2 million. What is the probability that EBIT will be above the

indifference point?

c. Does the "indifference point" calculated in question (a) above

truly represent a point where stockholders are indifferent between

stock and debt financing? Explain your answer.

a. (EBIT - 0)(1 - 0.4)/3,200,000 =

(EBIT - 520,000)(1 - 0.4)/3,000,000

EBIT = $8,320,000.

b. Z = (8.32 - 10.32)/2 = 1.00 to the left of the mean

P(EBIT >= $8.32 million) = 1 - 0.16 = 0.84.

c. No. Financial risk is ignored.

Difficulty: Moderate

Keywords: EBIT-EPS analysis

144. Armstrong, Inc. expects cash inflows next year to be quite low due to the continuing recession. $1 million in cash is expected from sales. Miscellaneous receipts will account for an additional $100,000. Outflows include $300,000 in wages, $400,000 in raw material, and $100,000 in other expenses. Armstrong plans to have a $100,000 average cash balance at the end of the year. The existing cash balance is $150,000. In spite of the recession, Armstrong desires to invest $6 million to renovate its existing plant. What amount of the needed funds can be raised with 7% long-term debt? All current financing is with common stock. Ignore taxes.

$1,000,000 + $100,000 + $50,000 =

$300,000 + $400,000 + $100,000 = FC

FC = $350,000

$350,000/0.07 = $5,000,000

Only $5,000,000 can be financed with the bonds if CBR = $100,000.

Difficulty: Moderate

Keywords: debt ratio

145. The Gibson Co. is financed entirely with 500,000 shares of common stock selling at $40 a share. The firm’s P/E ratio is 8, and all earnings are paid as dividends. Ignore taxes and assume no growth.

a. What is the total market value of the firm?

b. What is the cost of equity?

c. Gibson has decided to retire $5 million of common stock,

replacing it with 10% long-term debt. According to the

net operating income theory of valuation:

(1) What will be the dividend per share after the capital structure change?

(2) By what percent has the dividend per share changed due to the capital structure change?

(3) By what percent has the cost of common equity changed due to the capital structure change?

(4) What will be the composite cost of capital after the capital structure change?

a. Value of firm = (500,000)($40) = $20,000,000

b. kc = 1/8 = 0.125

EPS = $40/8 = $5.00

NET OPERATING INCOME = $5.00 (500,000) = $2,500,000

c.

Market value of debt and equity $20,000,000

Market value of debt 5,000,000

Market value of equity $15,000,000

Net operating income $ 2,500,000

Less interest expense 500,000

Earnings available to common stockholders $ 2,000,000

Note that $5 million of debt retires 125,000 shares of common stock at $40 per share.

Thus 375,000 shares remain.

(1) EPS = $2,000,000/375,000 = $5.33. Dividend per share = $5.33

(2) $0.33/$5.00 = .066 or an increase of 6.6%

(3) kc = $5.33/$40 - 0.1333

(0.1333 - 0.125)/0.125 = .066 or an increase of 6.6%

(4) ko = $2,500,000/$20,000,000 = 0.125

Difficulty: Moderate

Keywords: EBIT-EPS approach

146. Linkous Industries is financed entirely with 1 million shares of common stock priced at $30 a share. The firm pays 100% of its earnings as dividends. EBIT is expected to be $6 million for the foreseeable future. Ignore taxes and assume no growth.

a. What is the total market value of the firm?

b. What is the cost of equity?

c. The board of directors has decided to retire $9 million of common

stock, replacing it with 8% long-term debt. According to the

net income approach to valuation:

(1) What will be the cost of equity after refinancing?

(2) What will be the cost of capital after refinancing?

a. Market value $30 × 1,000,000 = $30,000,000

b. kc = $6/$30 = 0.20

c.

EBIT $6,000,000

Less interest 720,000

Earnings available to common stockholders $5,280,000

At $30 per share, 300,000 shares will be retired leaving 700,000 shares outstanding.

EPS = $5,280,000/700,000 = $7.54

Price = $7.54/0.20 = $37.71

(1) kc = 0.20

(2)

Market value of common stock $37.71 × 700,000 $26,397,000

+ market value of new debt 9,000,000

Total market value of new debt $35,397,000

ko = $6,000,000/$35,397,000 = 0.17 or

ko = 0.20 × ($26,397,000/$35,397,000) + 0.08 ×

($9,000,000/$35,397,000)

ko = 0.17

Difficulty: Moderate

Keywords: market value of the firm

147. The MAX Corporation is planning a $4 million expansion this year. The expansion can be financed by issuing either common stock or bonds. The new common stock can be sold for $60 per share. The bonds can be issued with a 12% coupon rate. The firm’s existing shares of preferred stock pay dividends of $2.00 per share. The company’s corporate income tax rate is 46%. The company’s balance sheet prior to expansion is as follows:

MAX Corporation

Current assets $ 2,000,000

Fixed assets 8,000,000

Total assets $10,000,000

Current liabilities $ 1,500,000

Bonds:

(8%, $1,000 par value) 1,000,000

(10%, $1,000 par value) 4,000,000

Preferred stock:

($100 par value) 500,000

Common stock:

($2 par value) 700,000

Retained earnings 2,300,000

Total liabilities and equity $10,000,000

a. Calculate the indifference level of EBIT between the two plans.

b. If EBIT is expected to be $3 million, which plan will result in higher EPS?

a.

EPS: Stock Plan

[(EBIT - $480,000)(1 - .46) - $10,000]/[(350,000 + 66,667)]

[(EBIT)(.54) - $259,200 - $10,000]/(416,667)

EPS: Bond Plan

[(EBIT - $960,000)(1 - .46) - $10,000]/(350,000)

[(EBIT)(.54) - $518,400 - $10,000]/(350,000)

(350,000)[EBIT(.54) - $269,200] =

(416,667)[EBIT(.54) - $528,400]

(189,000)EBIT - $94,220,000,000 =

(225,000)EBIT - $220,000,000,000

(36,000)EBIT = $125,780,000,000

EBIT = $3,493,889

b.

EPS: Stock Plan

[($3,000,000 - $480,000)(1 - .46) - $10,000]/(350,000 + 66,667) = $1,350,800/416,667 = $3.24

EPS: Bond Plan

[($3,000,000 - $960,000)(1 - .46) - $10,000]/350,000 =

$1,091,600/350,000 = $3.12

Stock plan has higher EPS.

Difficulty: Moderate

Keywords: indifference level of EBIT

148. Dave’s Happy Trails, a motor home manufacturer, is considering a plan to sell $4 million worth of bonds that would mature in 20 years. The bonds would carry a 10% interest rate and have a sinking fund provision requiring that 1/20th of the principal be retired each year. The management of Dave’s Happy Trails feels that next year will be their toughest and that it could be used as a "worst case" scenario. Cash collections for the coming year are expected to be $4.5 million. Miscellaneous cash receipts will be $600,000. Wages and salaries will amount to $1.5 million. Raw material costs will total $2 million. The firm is expecting $800,000 in non-discretionary cash outflows, and all taxes are included in this amount. Dave’s is currently in the 34% marginal tax bracket and always tries to carry an operating cash balance of $800,000.

a. If Dave’s is currently unleveraged, what will be the total fixed

financing charges that the firm must pay next year?

b. If the bonds are issued, what is the expected cash balance at the

end of next year?

c. Should Dave’s issue the bond?

a. FC = interest + sinking fund

FC = $400,000 + $200,000 = $600,000

b. CBr = CBo + NCF - FC

CBo = $800,000

FC = $600,000

NCF = $5,100,000 - $4,300,000 = $800,000

CBr = $800,000 + $800,000 - $600,000

CBr = $1,000,000

c. That analysis of the recessionary cash flows suggests that Dave’s could cover its cash obligations if they issued the bonds.

Difficulty: Moderate

Keywords: cash balance

149. The Fisher Boat Company has $55 million of net operating earnings. In its capital structure, $80 million worth of debt is outstanding, with an interest rate of 11%. The debt is selling in the marketplace at its book value. Parts (a) and (b) below assume that there is no tax on corporate income.

a. According to the net operating income valuation method, compute the total value of the firm and the implied equity-capitalization rate. Assume an implied overall capitalization rate of 20%.

b. Compute the total value of the firm and the implied overall

capitalization rate according to the dependence hypothesis (NI

theory) capitalization model. Assume an equity-capitalization rate,

kc, of 25%.

c. Now allow for the existence of a federal tax on corporate income at

a 45% rate. Calculate the value of the firm’s tax shield.

a.

O = Net operating earnings $ 55,000,000

ko = Overall capitalization rate 0.20

V = Total value of the firm 275,000,000

B = Market value of debt -80,000,000

S = Market value of stock $195,000,000

kc = <O - I>/K = <55,000,000 - 8,800,000>/195,000,000 = 23.69%

where I = interest expense

b.

O = $ 55,000,000

I = 8,800,000

E = 46,200,000

kc = 0.25

S = 184,800,000

B = 80,000,000

V = $104,800,000

ko = O/V = 55,000,000/104,800,000 = 52.48%

c. Tax shield = rd(M)(t) = (0.11)(80,000,000)(0.45) = $3,960,000

Difficulty: Moderate

Keywords: net operating income approach

150. Sunshine Candy Company’s capital structure for the past year of operation is shown below.

First mortgage bonds at 12% $2,000,000

Debentures at 15% 1,500,000

Common stock (1 million shares) 5,000,000

Retained earnings 500,000

Total $9,000,000

The federal tax rate is 50%. Sunshine Candy Company, home-based in Orlando, wants to raise an additional $1 million to open new facilities in Tampa and Miami. The firm can accomplish this via two alternatives: (1) it can sell a new issue of 20-year debentures with 16% interest; or (2) 20,000 new shares of common stock can be sold to the public to net the candy company $50 per share. A recent study, performed by an outside consulting organization, projected Sunshine Candy Company’s long-term EBIT level at approximately $6.8 million. Find the indifference level of EBIT (with regard to EPS) between the suggested financing plans.

[(EBIT - 465,000)(0.5)]/1,020,000 =

[(EBIT - 625,000)(0.5)]/1,000,000

(0.5 EBIT - 232,500)/102 =

<0.5 EBIT - 312,500>/100

50 EBIT - 23,250,000 = 51 EBIT - 31,875,000

EBIT = $8,625,000 indifference level

Difficulty: Moderate

Keywords: net operating income approach

151. Long Lodging, Inc. is financed entirely with $5 million shares of common stock selling for $25 a share. Capital of $7 million is needed for this year’s capital budget. Additional funds can be raised with new stock (ignore dilution) or with 12% 10-year bonds. Long Lodging’s tax rate is 45%.

a. Calculate the financing plan’s EBIT indifference point.

b. The expected level of EBIT is $18,840,000 with a standard deviation of $3 million. What is the probability that EBIT will be above the indifference point?

a. [(EBIT - 0)(1-0.45)]/5,280,000 =

[(EBIT - 840,000)(1 - 0.45)]

(0.55 EBIT)/525 = (0.55 EBIT - 462,000)/500

275 EBIT = 290.4 EBIT - 243,936,000

15.4 EBIT = 243,936,000

EBIT = $15,840,000 indifference level

b. Z = (15.84 - 18.84)/3 = 1.00 to the left of the mean

P (EBIT >= $15.84 million) = 1 - 0.16 = 0.84

Difficulty: Moderate

Keywords: EBIT indifference point

152. Downtown Packages is financed entirely with 500,000 shares of common stock priced at $20 a share. The firm pays 100% of its earnings as dividends. EBIT is expected to be $3 million for the foreseeable future. Ignore taxes and assume no growth.

a. What is the total market value of the firm?

b. What is the cost of equity?

c. The board of directors has decided to retire $4 million in common

stock, replacing it with 10% long-term debt. According to

the net income approach to valuation:

(1) What will be the cost of equity after refinancing?

(2) What will be the cost of capital after refinancing?

a. Market value $20 × 500,000 = $10,000,000

b. kc = $3/$10 = 0.30

c.

EBIT $ 3,000,000

Less interest 400,000

Earnings available to common stockholders $ 2,600,000

At $20 per share, 200,000 shares will be retired leaving 300,000

shares outstanding.

EPS = $2,600,000/300,000 = 8.67

Price = 8.67/0.30 = $28.90

(1) kc = 0.30

(2)

Market value of common stock

$28.90 × 300,000 $ 8,670,000

+ market value of new debt 4,000,000

Total market value of new debt $12,670,000

ko = 3,000,000/12,670,000 = 0.2368 or

ko = 0.30 × (8,670,000/12,670,000)

+ 0.10 × (4,000,000/12,670,000)

ko = 0.2368

Difficulty: Moderate

Keywords: market value of common stock