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Exam 14: Capital Structure and Dividend Policy Decisions

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Question 61

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The central result from the work of Miller and Modigliani (MM)and subsequent researchers,is that it is now possible to precisely identify a firm's optimal capital structure.

A) True
B) False

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Question 62

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Which of the following statements is correct?

A) Suppose Company A's EPS is expected to experience a larger percentage change in response to a given percentage change in sales than Company B's EPS.Other things held constant,Company A would appear to have more business risk than Company B.
B) Statement a would be correct if the term "EBIT" were substituted for "EPS."
C) Statement a would be correct if the term "EBIT" were substituted for "sales."
D) Statement a would be correct if the words "financial risk" were substituted for "business risk."
E) The above statements are all false.

F) B) and D)
G) C) and D)

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Question 63

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

How a firm splits its income between retained earnings and dividends does not affect its rate of growth,which is determined by the firm's basic earning power.

The mix of debt,preferred stock,and common equity with which the firm plans to support its asset structure is known as the target capital structure.

Howell Enterprises is forecasting EPS of $4.00 per share for next year.The firm has 10,000 shares outstanding,it pays 12 percent interest on its debt,and it faces a 40 percent marginal tax rate.Its estimated fixed costs are $80,000 while its variable costs are estimated at 40 percent of revenue.The firm's target capital structure is 40 percent equity and 60 percent debt and it has total assets of $400,000.On what level of sales is Howell basing its EPS forecast?

You are the president of a small,publicly-traded corporation.Since you believe that your firm's stock price is temporarily depressed,all additional capital funds required during the current year will be raised using debt.Thus,the appropriate marginal cost of capital for the current year is the after-tax cost of debt.

If Miller and Modigliani had considered the cost of bankruptcy,it is unlikely that they would have concluded that 100 percent debt financing is optimal for the firm.

Copybold Corporation Copybold Corporation is a start-up firm considering two alternative capital structures⎯one is conservative and the other aggressive. The conservative capital structure calls for a D/A ratio = 0.25, while the aggressive strategy call for D/A = 0.75. Once the firm selects its target capital structure it envisions two possible scenarios for its operations: Feast or Famine. The Feast scenario has a 60 percent probability of occurring and forecast EBIT in this state is $60,000. The Famine state has a 40 percent chance of occurring and the EBIT is expected to be $20,000. Further, if the firm selects the conservative capital structure its cost of debt will be 10 percent, while with the aggressive capital structure its debt cost will be 12 percent. The firm will have $400,000 in total assets, it will face a 40 percent marginal tax rate, and the book value of equity per share under either scenario is $10.00 per share -Refer to Copybold Corporation.What is the difference between the EPS forecasts for Feast and Famine under the aggressive capital structure?

Generally,as debt is substituted for equity,risk,as measured by the coefficient of variation of EPS,increases.This negative effect works against the positive effect of substituting debt for equity,which is that higher leverage increases expected EPS.

If a firm utilizes debt financing,a decrease in earnings before interest and taxes (EBIT)will result in a more than proportionate decrease in earnings per share.

Flavortech Inc.expects EBIT of $2,000,000 for the coming year.The firm's capital structure consists of 40 percent debt and 60 percent equity,and its marginal tax rate is 40 percent.The cost of equity is 14 percent,and the company pays a 10 percent rate on its $5,000,000 of long-term debt.One million shares of common stock are outstanding.In its next capital budgeting cycle,the firm expects to fund one large positive NPV project costing $1,200,000,and it will fund this project in accordance with its target capital structure.If the firm follows a residual dividend policy and has no other projects,what is its expected dividend payout ratio?

Empirical testing has confirmed the validity of which of the following attitudes concerning dividends?

Van Slyke Inc.has $5,000,000 in assets,and currently has no debt⎯it is financed entirely with 200,000 shares of common stock,each of which trades at $25 per share.The firm's EBIT is expected to be $1,250,000 at year end .The corporate tax rate is 40 percent.Van Slyke expects to pay out a dividend at year end which is 50 percent of its net income.The company estimates that its earnings and dividends grow at a constant rate of 3 percent a year.The company is considering a recapitalization where they would issue $1,000,000 of debt at a before-tax cost of 10 percent.The proceeds from the debt issued would be used to repurchase shares of the company's stock at $25 per share.The company's investment bankers estimate that the cost of equity capital would be 16 percent after the recapitalization.What would you expect the company's stock price to be immediately following the recapitalization? Assume that the dividend has not yet been paid.

Which of the following statements is correct?

Once a target capital structure for a firm is determined the firm ____.

If the information content,or signaling,hypothesis is correct,then changes in dividend policy can be important with respect to firm value and capital costs.

Which of the following statements is correct?

In signaling theory,when a manager has better information than outside investors about the firm,this is called asymmetric information.

Copybold Corporation Copybold Corporation is a start-up firm considering two alternative capital structures⎯one is conservative and the other aggressive. The conservative capital structure calls for a D/A ratio = 0.25, while the aggressive strategy call for D/A = 0.75. Once the firm selects its target capital structure it envisions two possible scenarios for its operations: Feast or Famine. The Feast scenario has a 60 percent probability of occurring and forecast EBIT in this state is $60,000. The Famine state has a 40 percent chance of occurring and the EBIT is expected to be $20,000. Further, if the firm selects the conservative capital structure its cost of debt will be 10 percent, while with the aggressive capital structure its debt cost will be 12 percent. The firm will have $400,000 in total assets, it will face a 40 percent marginal tax rate, and the book value of equity per share under either scenario is $10.00 per share -Refer to Copybold Corporation.What is the coefficient of variation of expected EPS under the conservative capital structure plan?