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Exam 12: Capital Structure Decisions

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Question 31

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Which statement best describes the optimal capital structure?

A) The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company's earnings per share (EPS) .
B) The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company's stock price.
C) The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company's cost of equity.
D) The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company's cost of debt.

E) All of the above
F) B) and C)

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Question 32

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The presence of personal taxes completely eliminates the benefits of debt financing.

A) True
B) False

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Question 33

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Assume that the firm's gain from leverage according to the Miller model is $126,667. If the effective personal tax rate on stock income is T_S = 20%, what is the implied personal tax rate on debt income?

MM shows that in a world without taxes, a firm's value is not affected by its capital structure.

The Miller model begins with the MM model without corporate taxes and then adds personal taxes.

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

During a recession, companies with a significant portion of their capital structure in the form of common share equity (i.e., low leverage) often struggle to provide a continuous stream of dividend income to their shareholders.

Suppose the corporate tax rate is 34%, personal tax rate on interest income is 10%, and personal tax rate on equity income is 50%. How much value will leverage add to the unlevered firm per dollar of debt?

It is possible that two firms could have identical financial and operating leverage yet have different degrees of risk as measured by the variability of EPS.

A firm's capital structure does not affect its calculated free cash flows, because FCF reflects only operating cash flows.

The benefit of an interest tax shield is captured by the equity holders, not the debtholders.

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?

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

If debt financing is used, which of the following is correct?

Firms having positive prospects try to raise new equity capital by selling new stocks.

A firm's financial policy drives its equity beta.

The Congress Company has identified two methods for producing playing cards. 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 with greater variable costs ($1.50 per deck of cards) . If the selling price per deck of cards is the same under each method, at what level of output will the two methods produce the same net operating income (EBIT) ?

ABC Co. has an asset beta of 1.05 and a debt beta of 0.8. Target debt-to-equity (D/E) ratio is 0.6. With no taxes, what is the equity beta?

Which of the following statements is correct?

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