Questions and Answers of Contemporary Financial Management

Other factors considered by managers in setting capital structure policy in practice P-9687
The use of cash insolvency analysis in deciding capital structure policy P-9687
The EBIT–EPS framework for analyzing capital structure policy P-9687
The meaning and measurement of operating, financial, and combined leverage
Other factors that are considered when establishing a capital structure policy are industry standards, profitability and the need for funds, lender requirements, managerial risk aversion, and the
Cash insolvency analysis can be used to evaluate the impact of a proposed capital structure on the cash position of a firm during a major business downturn. P-9687
EBIT-EPS analysis is an analytical technique that can be used to help determine the circumstances under which a firm should employ financial leverage. The indifference point in EBIT-EPS analysis is
The degree of combined leverage (DCL) is defined as the percentage change in earnings per share resulting from a 1 percent change in sales. It is also equal to the DOL times the DFL. The degree of
The degree of financial leverage (DFL) is defined as the percentage change in earnings per share(EPS) resulting from a 1 percent change in EBIT.a. The degree of financial leverage approaches a
The degree of operating leverage (DOL) is defined as the percentage change in EBIT resulting from a 1 percent change in sales.a. The degree of operating leverage approaches a maximum as the firm
The cost of capital is the rate of return required by investors in the firm’s securities. The cost of capital determines the rate of return that the firm must earn on its new investments (of
The required return on any security consists of a risk-free rate of return plus a premium for the risk of that security.a. The risk-free rate varies over time and is influenced by the expected rate
The weighted cost of capital is equal to the after-tax cost of debt times its proportion in the capital structure, plus the after-tax costs of preferred stock times its proportion in the capital
The weighted cost of capital is appropriate for determining the return required on projects of average risk. LO1
For capital budgeting purposes, the marginal cost of each capital source needs to be calculated.a. The after-tax cost of debt is equal to the pretax cost of new debt times one minus the firm’s
The beta concept can also be used to compute divisional costs of capital for firms with several operating divisions that differ substantially with respect to the risks of investments that are made.
The optimal capital budget can be determined by comparing the expected project returns to the company’s marginal cost of capital schedule. LO1
The cost of depreciation-generated funds is equal to the firm’s weighted (marginal) cost of capital, before considering new stock issuance costs. LO1
The calculation of cost of debt? LO1
The calculation of the cost of preferred stock? LO1
The calculation of the cost of common equity? LO1
The calculation of the weighted average cost of capital? LO1
The difference between the historical and marginal costs of capital? LO1
The difference between book value weights and market value weights in calculating the cost of capital? LO1
A firm’s cost of capital is defined as the rate the firm has to pay for the debt, preferred stock, common stock, and/or retained earnings it uses to finance its new investments in assets. The cost
The higher the risk of a security, the higher is the return required by investors. In general, common stock is more risky than preferred stock; preferred stock is more risky than corporate debt
Firms normally use an after-tax weighted cost of capital to evaluate proposed capital expenditure projects. Each project is presumed to be financed with the same proportion of debt, preferred stock,
A firm’s pretax cost of debt capital, kd, is the rate of return required by investors. The after-tax cost of debt, ki , is calculated as follows:ki ¼ kdð1 T Þ ¼ Coupon interest rate ð1 T
A firm’s cost of preferred stock, kp, is the rate of return required by the preferred stock investors. In the case of perpetual preferred stock, the cost is calculated as follows:kp ¼ Dp Pnet
A firm’s cost of equity capital is defined as the rate of return required by its common stock investors. Equity capital can be raised internally through retained earnings and externally through the
A firm’s cost of internal equity can be determined by the dividend valuation model, the Capital Asset Pricing Model (CAPM), using the security market line (SML), or the risk premium on debt
A firm’s cost of external equity, k0e, is greater than the cost of internal equity because of issuance expenses. LO1
The optimal capital budget maximizes the value of the firm and occurs at the point where the firm’s investment opportunity curve and weighted marginal cost of capital curve intersect.The investment
How do retained earnings differ from other sources of financing? LO1
Why is corporate long-term debt riskier than government long-term debt? LO1
Why do investors generally consider common stock to be riskier than preferred stock? LO1
Should a firm pay cash dividends in a year in which it raises external common equity? LO1
Discuss the meaning of an optimal capital budget. LO1
Evaluate the statement “Depreciation-generated funds have no explicit cost and therefore should be assigned a zero cost in computing a firm’s cost of capital.” LO1
Describe how to derive the break points in the marginal cost of capital schedule. LO1
Discuss the pros and cons of various sources of estimates of future earnings and dividend growth rates for a company. LO1
What factors determine the required rate of return for any security? LO1
What are the similarities and differences in preferred stock and debt as sources of financing for a firm? LO1
Why is the marginal cost of capital the relevant concept for evaluating investment projects, rather than a firm’s actual, historic cost of capital? LO1
Scherr Enterprises has a series of 8 percent coupon bonds outstanding with a$1,000 par value. The bonds mature in 10 years and currently sell for $946. If new bonds are issued, the issuance cost is
Clarke Equipment currently pays a common stock dividend of $3.50 per share.The common stock price is $60. Analysts have forecast that earnings and dividends will grow at an average annual rate of 6.8
Vargo, Inc., has a beta estimated by Value Line of 1.3. The current risk-free rate(short-term) is 7.5 percent and the market risk premium is 8.6 percent. What is the cost of equity capital for Vargo?
Walther Enterprises has a capital structure target of 60 percent common equity, 15 percent preferred stock, and 25 percent long-term debt. Walther’s financial analysts have estimated the marginal,
Penguin Industries, Inc., has a capital structure that currently consists of 40 percent debt and 60 percent common stock, which it considers optimal. Penguin can raise up to $60 million in long-term
Calculate the after-tax cost of a $25 million debt issue that Pullman Manufacturing Corporation (40 percent marginal tax rate) is planning to place privately with a large insurance company. This
St. Joe Trucking has sold an issue of $6 cumulative preferred stock to the public at a price of $60 per share. After issuance costs, St. Joe netted $57 per share. The com- pany has a marginal tax
The stock of Alpha Tool sells for $10.25 per share. Its current dividend rate, Do, is $1 per share. Analysts and investors expect Alpha to increase its dividends at a 10 percent rate for each of the
The Ewing Distribution Company is planning a $100 million expansion of its chain of discount service stations to several neighboring states. This expansion will be financed, in part, with debt issued
Owens Enterprises is in the process of determining its capital budget for the next fiscal year. The firm’s current capital structure, which it considers to be optimal, is contained in the following
Rolodex, Inc., is in the process of determining its capital budget for the next fiscal year. The firm’s current capital structure, which it considers to be optimal, is contained in the following
The Folske Fan Corporation has four divisions:Division Proportion of Firm’s Assets Consumer products 50%Consulting 10 Industrial products 30 Financial services 10 The (leveraged) beta for Folske
Intermountain Resources is a multidivisional company. It has three divisions with the following betas and proportion of the firm’s total assets:Division Beta Proportion of Assets Natural gas
Del Sarto’s Minuteman Novelties, Inc., (DSMN) expects its earnings to grow from a current (time 0) level of $2 per share to $4 per share over the coming year. After that, earnings are expected to
Access the Thomson consensus earnings forecast report for Mylan Laboratories using data available at www.yahoo.com. From the Yahoo main screen, select“Finance.” On the next screen enter the
Gandha’s Pharmaceutical Corporation’s beta is 1.5. The current risk-free rate is 4.5 percent and the market risk premium is 9 percent. Gandha currently (time 0)pays a dividend of $2 per share.
Under these circumstances, would you purchase this stock? What do you believe is a fair market price for the stock? LO1
Calculate the after-tax cost of each component source of capital. LO1
Calculate the marginal cost of capital for the various intervals, or “packages,” of capital the company can raise next year. Plot the marginal cost of capital curve. LO1
Using the marginal cost of capital curve from question 2, and plotting the investment opportunity curve, determine the company’s optimal capital budget for next year. LO1
Should Project G be accepted or rejected? Why? LO1
What factors do you feel might cause Bosworth to recommend a different capital budget than the one obtained in question 3? LO1
Assume that a sudden rise in interest rates has caused the cost of various capital components to increase. The pretax cost of first-mortgage bonds has increased to 11 percent; the pretax cost of
Washington Paper Company has estimated the costs of debt and equity capital (with bankruptcy and agency costs) for various proportions of debt in its capital structure as follows:Debt Ratio [B/(B +
Ohio Quarry, Inc., has $12 million in assets. Its expected operating income (EBIT) is$2 million and its income tax rate is 40 percent. If Ohio Quarry finances 20 percent of its total assets with debt
Arrow Technology, Inc. (ATI) has total assets of $10 million and expected operating income (EBIT) of $2.5 million. If ATI uses debt in its capital structure, the cost of this debt will be 12 percent
Two firms, No Leverage, Inc., and High Leverage, Inc., have equal levels of operating risk and differ only in their capital structure. No Leverage is unlevered and High Leverage has $500,000 of
Referring to Table 13.2, calculate the market value of firm L (without a corporate income tax) if the equity amount in its capital structure decreases to $5,000 and the debt amount increases to
Citizens Electronics has $25 million in assets. Its expected operating income(EBIT) is $4 million, and its marginal tax rate is 40 percent. If Citizens finances 25 percent of its total assets with
Arizona Minerals, Inc. (AMI) estimated the costs of debt and equity capital with bankruptcy and agency costs for various proportions of debt in its capital structure. Its marginal tax rate is 40
Ogden Optical Company has estimated the following costs of debt and equity capital (with bankruptcy and agency costs) for various proportions of debt in its capital structure: L0358
What other factors besides operating leverage can affect a firm’s business risk? L0358
Explain the difference between business risk and financial risk. L0358
What is arbitrage? How is it used in deriving the proposition that the value of a firm is independent of its capital structure? L0358
What role does signaling play in the establishment of a firm’s capital structure? L0358
What assumptions are required in deriving the proposition that a firm’s cost of capital is independent of its capital structure? L0358
Explain why, according to the pecking order theory, firms prefer internal financing to external financing. L0358
According to the pecking order theory, if additional external financing is required, which type of securities should a firm issue first? Last? L0358
What is the asymmetric information concept? What role does this concept play in a company’s decision to change its financial structure or issue new securities? L0358
What is the relationship between the value of a firm and its capital structure, given the existence of a corporate income tax, bankruptcy costs, and agency costs? L0358
What is the relationship between the value of a firm and its capital structure without a corporate income tax? With a corporate income tax? L0358
Explain the research results of Modigliani and Miller in the area of capital structure. L0358
According to the pecking order theory, a firm has no particular optimal capital structure.Companies prefer internal financing to external financing, and, given that external financing is necessary,
Given that managers have access to better information about a firm’s future prospects than do outside investors (asymmetric information), capital structure changes often signal important
Given a corporate income tax, financial distress costs, and agency costs, an optimal capital structure consisting of both debt and equity is shown to exist. Determination of the optimal capital
Modigliani and Miller (MM) showed that the value of the firm is independent of capital structure, given perfect capital markets and no corporate income taxes. MM also show that the optimal capital
The use of financial leverage results in an increase in perceived risk to the suppliers of a firm’s capital.To offset this increased risk, higher returns are required. L0358
The financial risk of a firm is the additional variability of earnings per share and the increased probability of insolvency that arises when a firm uses fixed-cost sources of funds, such as debt and
The business risk of a firm consists of the variability of a firm’s operating income. It is influenced by the variability of sales volumes, prices, and costs over the business cycle. Business risk
Capital structure is defined as the relative amount of permanent short-term debt, long-term debt, preferred stock, and common stock used to finance a firm. The capital structure decision is important
The different theories of capital structure and their implications for optimal capital structure choice? L0358
The meaning of business risk and financial risk, and the factors that contribute to them? L0358
Financial flexibility is the practice of maintaining a debt ratio that is much lower than the optimal debt ratio. L0358
According to the market timing model, managers raise equity capital when the firm’s stock is overvalued. The observed capital structure of the firm is the cumulative result of such equity timing
According to the pecking order theory, companies prefer internal financing to external financing, and, given that external financing is necessary, they prefer to issue debt securities first and
Changes in the capital structure often serve as a signal to outside investors about management’s expectations concerning future earnings prospects for the company. L0358

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