Problem Review Set Capital Structure and Leverage

5 May 2017

Managerial Finance – Problem Review Set – Capital Structure and Leverage If a firm utilizes debt financing, an X% decline in earnings before interest and taxes (EBIT) will result in a decline in earnings per share that is larger than X. True b. False 2) Firm A has a higher degree of business risk than Firm B. Firm A can offset this by using less financial leverage. Therefore, the variability of both firms’ expected EBITs could actually be identical. 3) It is possible that two firms could have identical financial and operating leverage, yet ave different degrees of risk as measured by the variability of EPS. ) Which of the following events is likely to encourage a company to raise its target debt ratio, other things held constant? An increase in the corporate tax rate. An increase in the personal tax rate. An increase in the company’s operating leverage. d. The Federal Reserve tightens interest rates in an effort to fight inflation.

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e. The company’s stock price hits a new high. 5) The firm’s target capital structure should be consistent with which of the following statements? 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). 6) Which of the following statements isAs a firm increases the operating leverage used to produce a given quantity of output, this will normally lead to an increase in its fixed assets turnover ratio. b. normally lead toa decrease in its business risk. normally lead to a decrease in the standard deviation of its expected EBIT. d. ormally lead to a decrease in the variability of its expected EPS. e. ormally lead to a reduction in its fixed assets turnover ratio. 7) Reynolds Resorts is currently 100% equity financed. The CFO is considering a recapitalization plan under which the firm would issue long-term debt with a yield of 9% and use the proceeds to repurchase common stock. The recapitalization would not change the company’s total assets, nor would it affect the firm’s basic earning power, which is currently 15%. The CFO believes that this recapitalization would ikely to occur if the company goes ahead with the recapitalization plan?

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