Capital Structure and Leverage:
The Effect of Financial Leverage:
problem 1: Biddle publishing currently is financed with 10% debt and 90% equity. Though, Biddle’s CFO has proposed that the firm issue new long-term debt and repurchase some of the firm’s common stock. Biddle’s advisors believe the long-term debt would need a before-tax yield of 10%, while the firm’s basic earning power (BEP) is 14%. The firm’s operating income and total assets will not be affected. The CFO has told the rest of the management team that he believes this move will raise the firm’s stock price. If Biddle proceeds with recapitalization, which of the given items is as well likely to rise?
a) Cost of Debt.
b) Net Income.
c) Return on Assets.
d) Cost of Equity.
e) Basic Earning Power.
problem 2: The CFO’s proposal has opened up a dialogue among the company’s management team regarding the effects of debt financing. In specific, one manager notes that debt financing is cheaper than equity financing. He proposes that by using more debt always will reduce the firm’s weighted average cost of capital. Is this true?
Optimal Capital Structure:
Rosewood Fabrics and Taggart Security Systems are two firms trying to spot their optimal capital structure. Rosewood’s CFO has gathered the given financial information to help with the analysis.
Debt Ratio Equity Ratio EPS DPS Stock Price
30% 70% 1.25 .55 36.25
40% 60% 1.40 .60 37.75
50% 50% 1.60 .65 39.50
60% 40% 1.85 .75 38.75
70% 30% 1.75 .70 38.25
problem 3: What capital structure describeed above is Rosewood’s optimal capital structure?
a) Debt Ratio = 70% equity ratio = 30%
b) Debt Ratio = 40% equity ratio = 60%
c) Debt Ratio = 50% equity ratio = 50%
d) Debt Ratio = 60% equity ratio = 40%
e) Debt Ratio = 30% equity ratio = 70%
Taggart’s CFO as well has collected financial information regarding the firm’s capital structure, show in the given table.
Debt Ratio Equity Ratio Rd Rs WACC
30% 70% 7.00% 10.50% 8.61%
40% 60% 7.20% 10.80% 8.21%
50% 50% 7.70% 11.40% 8.01%
60% 40% 8.90% 12.20% 8.08%
70% 30% 10.30% 13.50% 8.38%
problem 4: Which capital structure describeed above is Taggart’s optimal capital structure?
a) Debt ratio = 50% equity ratio = 50%
b) Debt ratio = 70% equity ratio = 30%
c) Debt ratio = 40% equity ratio = 60%
d) Debt ratio = 30% equity ratio = 70%
e) Debt ratio = 60% equity ratio = 40%
problem 5: Would a raise in the corporate tax rate tend to encourage firms to raise or reduce their debt ratio?
Leverage effects on beta:
Maitland INC currently has a capital structure comprising of 30% debt and 70% equity. Though, Maitland’s CFO has suggested that the firm’s raise its debt ratio to 50%. The current risk-free rate is 6% and the market risk premium is 5%, while Maitland’s beta is 1.30. If the firm’s tax rate is 40%, what would the beta of an all –equity firm be if its operations were precisely the dame?
problem 6: If Maitland increased its debt ratio to 50% how much would its cost of equity change?
problem 7: Which of the given statement is correct?
a) If the company has no debt outstanding then its degree of total leverage equivalents its degree of financial leverage
b) The increase in fixed costs (holding sale and variable costs constant) will decrease the company’s degree of operating leverage
c) If a firm’s degree of operating leverage rises, its degree of financial leverage must as well have increase.
d) If the company has no debt outstanding, then its degree of total leverage equivalents its degree of operating leverage
e) The increase in interest expense will reduce the company’s degree of financial leverage
problem 8: The use of financial leverage by the firm has potential impact on which of the following?
(1) The risk related with the firm.
(2) The return experienced by the shareholder.
(3) The variability of net income.
(4) The degree of operating leverage.
(5) The degree of financial leverage.
problem 9: Which of the given statements is correct?
a) If a firm’s after tax cost of equity surpasses its after-tax cost of debt, it can always decrease its WACC by raising its use of debt
b) There is no reason to think which changes in the personal tax rate would affect firm’s capital structure decisions
c) In general, a firm with low operating leverage also has a small proportion of its net costs in the form of fixed costs
d) Assume a firm has less than its optimal amount of debt. Increasing its use of debt to the point where it is at its optimal capital structure will reduce the costs of both debt and equity
e) The firm with a relatively high business risk is more likely to raise its use of financial leverage than a firm with low business risk, supposing all else equivalent.
problem 10: Companies HD and LD have identical amounts of assets, operating income (EBIT), tax rates, and business risk. Company HD, though has a higher debt ratio than LD. Company HD’s basic earning power ratio (BEP) surpasses its cost of debt (rd) which of the given statements is correct?
a) Company HD has a higher return on equity (ROE) than Company LD, and its risk as measured by the standard deviation of ROE is also higher than LD’s.
b) The two companies have similar ROE.
c) Company HD has a higher return on assets (ROA) than the Company LD.
d) Company HD’s ROE would be higher if it had no debt.
e) Company HD has a higher times interest earned (TIE) ratio than the Company LD.
problem 11: Which of the given statements is correct?
a) When a company raises its debt ratio, the costs of equity and debt both raise. Thus, the WACC must also rise.
b) Since debt financing raises the firm’s financial risk, increasing a company’s debt ratio will always increase its WACC
c) All else equal, a raise in the corporate tax rate would tend to encourage companies to raise their debt ratios.
d) The capital structure which maximizes the stock price is usually the capital structure which as well maximizes earnings per share.
e) As the cost of debt is usually fixed, increasing the debt ratio tends to stabilize net income
Cash Conversion Cycle:
problem 12: Kahane Co. has an inventory conversion period of 48.00 days, an average collection period (ACP) of 42.75 days, and a payable deferral period of 26.25 days. Determine Kahane’s cash conversion cycle?
a) 65.00 days
b) 64.50 days
c) 65.25 days
d) 65.50 days
e) 64.75 days
problem 13: The review of Kahane’s balance sheet pointed out that it has accounts receivable for $77,134.00 If Kahane’s COGS is 80% of annual sales, determine the firm’s inventory turnover?
Financing Current Assets:
problem 14: Assume that a firm wants to take benefit of an upward slopping yield curve. If the firm believes that interest rates will stay constant and wants to use the current yield curve to bolster profits, which approach must the firm follow?
a) Conservative approach.
b) Maturity matching approach.
c) Aggressive approach.
problem 15: Assume that a firm occasionally faces demand for short-term credit but usually has an excess of short-term capital to finance current assets. Which approach is the firm following?
a) Conservative approach.
b) Maturity matching approach.
c) Aggressive approach.
problem 16: Which generally costs less?
a) Long-Term Debt
b) Short-Term Debt
problem 17: Which is generally riskier to the borrowing firm if it is most concerned with rising interest rates?
a) Long-Term Debt.
b) Short-Term Debt.
Cost of Trade Credit:
problem 18: Standish incorporated buys on terms of 1/5, net 40 from its chief supplier. Find out the nominal annual cost of the trade credit that supplier extends?
problem 19: Assume that Standish doesn’t take the discount and selects to pay its supplier late. On average, Standish pays its supplier on the 50th day after the sale. By how much does Standish decrease its actual nominal cost of trade credit by paying late?
problem 20: What is the effective annual cost of trade credit for Standish if it continues paying on the 50th day after the sale?