optimal capital structure
Question 1. Your consultant firm has been hired by Eco Brothers Inc. to help them estimate the cost of common equity. The yield on the firm’s bonds is 8.75%, and your firm’s economists believe that the cost of common can be estimated using a risk premium of 3.85% over a firm’s own cost of debt. What is an estimate of the firm’s cost of common from reinvested earnings?
Question 2. Which of the following statements best describes the optimal capital structure?
The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company’s ____.
cost of equity
cost of debt
earnings per share (EPS)
Other things held constant, which of the following events is most likely to encourage a firm to increase the amount of debt in its capital structure?
Its sales become less stable over time.
The costs that would be incurred in the event of bankruptcy increase.
Management believes that the firm’s stock has become overvalued.
Its degree of operating leverage increases.
The corporate tax rate increases.
Question 3. Reynolds Paper Products Corporation follows a strict residual dividend policy. All else equal, which of the following factors would be most likely to lead to an increase in the firm’s dividend per share?
The firm’s net income increases.
The company increases the percentage of equity in its target capital structure.
The number of profitable potential projects increases.
Congress lowers the tax rate on capital gains. The remainder of the tax code is not changed.
Earnings are unchanged, but the firm issues new shares of common stock.
Question 4. Burnham Brothers Inc. has no retained earnings since it has always paid out all of its earnings as dividends. This same situation is expected to persist in the future. The company uses the CAPM to calculate its cost of equity, and its target capital structure consists of common stock, preferred stock, and debt. Which of the following events would REDUCE its WACC?
The flotation costs associated with issuing new common stock increase.
The company’s beta increases.
Expected inflation increases.
The flotation costs associated with issuing preferred stock increase.
The market risk premium declines.
Question 5. Based on the corporate valuation model, the value of Weidner Co.’s operations is $1,200 million. The company’s balance sheet shows $80 million in accounts receivable, $60 million in inventory, and $100 million in short-term investments that are unrelated to operations. The balance sheet also shows $90 million in accounts payable, $120 million in notes payable, $300 million in long-term debt, $50 million in preferred stock, $180 million in retained earnings, and $800 million in total common equity. If Weidner has 30 million shares of stock outstanding, what is the best estimate of the stock’s price per share?
Question 6. The world-famous discounter, Fernwood Booksellers, specializes in selling paperbacks for $7 each. The variable cost per book is $5. At current annual sales of 200,000 books, the publisher is just breaking even. It is estimated that if the authors’ royalties are reduced, the variable cost per book will drop by $1. Assume authors’ royalties are reduced and sales remain constant; how much more money can the publisher put into advertising (a fixed cost) and still break even?
Question 7. The term “additional funds needed (AFN)” is generally defined as follows:
Funds that are obtained automatically from routine business transactions.
Funds that a firm must raise externally from non-spontaneous sources, i.e., by borrowing or by selling new stock to support operations.
The amount of assets required per dollar of sales. The amount of internally generated cash in a given year minus the amount of cash needed to acquire the new assets needed to support growth.
A forecasting approach in which the forecasted percentage of sales for each balance sheet account is held constant.
Question 8. 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.
The Federal Reserve tightens interest rates in an effort to fight inflation.
The company’s stock price hits a new high.
Question 9. Poff Industries’ stock currently sells for $120 a share. You own 100 shares of the stock. The company is contemplating a 2-for-1 stock split. Which of the following best describes what your position will be after such a split takes place?
You will have 200 shares of stock, and the stock will trade at or near $120 a share.
You will have 200 shares of stock, and the stock will trade at or near $60 a share.
You will have 100 shares of stock, and the stock will trade at or near $60 a share.
You will have 50 shares of stock, and the stock will trade at or near $120 a share.
You will have 50 shares of stock, and the stock will trade at or near $60 a share
Question 10. Which of the following would be most likely to lead to a decrease in a firm’s dividend payout ratio?
Its earnings become more stable.
Its access to the capital markets increases.
Its R&D efforts pay off, and it now has more high-return investment opportunities.
Its accounts receivable decrease due to a change in its credit policy.
Its stock price has increased over the last year by a greater percentage than the increase in the broad stock market averages.
Question 11. F. Marston, Inc. has developed a forecasting model to estimate its AFN for the upcoming year. All else being equal, which of the following factors is most likely to lead to an increase of the additional funds needed (AFN)?
A sharp increase in its forecasted sales.
A switch to a just-in-time inventory system and outsourcing production.
The company reduces its dividend payout ratio.
The company switches its materials purchases to a supplier that sells on terms of 1/5, net 90, from a supplier whose terms are 3/15, net 35.
The company discovers that it has excess capacity in its fixed assets.
Question 12. Which of the following assumptions is embodied in the AFN equation?
None of the firm’s ratios will change.
Accounts payable and accruals are tied directly to sales.
Common stock and long-term debt are tied directly to sales.
Fixed assets, but not current assets, are tied directly to sales.
Last year’s total assets were not optimal for last year’s sales.
Question 13. Perpetual preferred stock from Franklin Inc. sells for $97.50 per share, and it pays an $8.50 annual dividend. If the company were to sell a new preferred issue, it would incur a flotation cost of 4.00% of the price paid by investors. What is the company’s cost of preferred stock for use in calculating the WACC?
Question 14. Myron Gordon and John Lintner believe that the required return on equity increases as the dividend payout ratio is decreased. Their argument is based on the assumption that
investors are indifferent between dividends and capital gains.
investors require that the dividend yield and capital gains yield equal a constant.
capital gains are taxed at a higher rate than dividends.
investors view dividends as being less risky than potential future capital gains.
investors value a dollar of expected capital gains more highly than a dollar of expected dividends because of the lower tax rate on capital gains.
Question 15. Krackle Korn Inc. had credit sales of $3,500,000 last year and its days sales outstanding was DSO = 35 days. What was its average receivables balance, based on a 365-day year?
Question 16. Trahern Baking Co. common stock sells for $32.50 per share. It expects to earn $3.50 per share during the current year, its expected dividend payout ratio is 65%, and its expected constant dividend growth rate is 6.0%. New stock can be sold to the public at the current price, but a flotation cost of 5% would be incurred. What would be the cost of equity from new common stock?
Question 17. The capital intensity ratio is generally defined as follows:
Sales divided by total assets, i.e., the total assets turnover ratio.
The percentage of liabilities that increase spontaneously as a percentage of sales.
The ratio of sales to current assets.
The ratio of current assets to sales.
The amount of assets required per dollar of sales, or A0*/S0.
Question 18. Suppose Acme Industries correctly estimates its WACC at a given point in time and then uses that same cost of capital to evaluate all projects for the next 10 years, then the firm will most likely
become riskier over time, but its intrinsic value will be maximized.
become less risky over time, and this will maximize its intrinsic value.
accept too many low-risk projects and too few high-risk projects.
become more risky and also have an increasing WACC.
Its intrinsic value will not be maximized.
continue as before, because there is no reason to expect its risk position or value to change over time as a result of its use of a single cost of capital.
Question 19. A lockbox plan is most beneficial to firms that
have suppliers who operate in many different parts of the country.
have widely dispersed manufacturing facilities.
have a large marketable securities portfolio and cash to protect.
receive payments in the form of currency, such as fast food restaurants, rather than in the form of checks.
have customers who operate in many different parts of the country.
Question 20. The value of Broadway-Brooks Inc.’s operations is $900 million, based on the corporate valuation model. Its balance sheet shows $70 million in accounts receivable, $50 million in inventory, $30 million in short-term investments that are unrelated to operations, $20 million in accounts payable, $110 million in notes payable, $90 million in long-term debt, $20 million in preferred stock, $140 million in retained earnings, and $280 million in total common equity. If the company has 25 million shares of stock outstanding, what is the best estimate of the stock’s price per share?
Question 21. If a firm adheres strictly to the residual dividend policy, the issuance of new common stock would suggest that
the dividend payout ratio has remained constant.
the dividend payout ratio is increasing.
no dividends were paid during the year.
the dividend payout ratio is decreasing.
the dollar amount of investments has decreased.
Question 22. Which of these items will not generally be affected by an increase in the debt ratio?
The firm’s beta.
Question 23. Last year National Aeronautics had a FA/Sales ratio of 40%, comprised of $250 million of sales and $100 million of fixed assets. However, its fixed assets were used at only 75% of capacity. Now the company is developing its financial forecast for the coming year. As part of that process, the company wants to set its target Fixed Assets/Sales ratio at the level it would have had had it been operating at full capacity. What target FA/Sales ratio should the company set?
Question 24. Spontaneous funds are generally defined as follows:
Assets required per dollar of sales.
A forecasting approach in which the forecasted percentage of sales for each item is held constant.
Funds that a firm must raise externally through short-term or long-term borrowing and/or by selling new common or preferred stock.
Funds that arise out of normal business operations from its suppliers, employees, and the government, and they include immediate increases in accounts payable, accrued wages, and accrued taxes.
The amount of cash raised in a given year minus the amount of cash needed to finance the additional capital expenditures and working capital needed to support the firm’s growth.
Question 25. Mark’s Manufacturing’s average age of accounts receivable is 45 days, the average age of accounts payable is 40 days, and the average age of inventory is 69 days. Assuming a 365-day year, what is the length of its cash conversion cycle?
Question 26. The Besnier Company had $250 million of sales last year, and it had $75 million of fixed assets that were being operated at 80% of capacity. In millions, how large could sales have been if the company had operated at full capacity?
Question 27. Which of the following statements is NOT CORRECT?
The corporate valuation model discounts free cash flows by the required return on equity.
The corporate valuation model can be used to find the value of a division.
An important step in applying the corporate valuation model is forecasting the firm’s pro forma financial statements.
Free cash flows are assumed to grow at a constant rate beyond a specified date in order to find the horizon, or terminal, value.
The corporate valuation model can be used both for companies that pay dividends and those that do not pay dividends.
Question 28. Last year Baron Enterprises had $350 million of sales, and it had $270 million of fixed assets that were used at 65% of capacity last year. In millions, by how much could Baron’s sales increase before it is required to increase its fixed assets?