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Leverage And Capital Structure Summer 2019

7. The degree of combined leverage is equal to the

Multiple Choice degree of operating leverage ____ the degree of
financial leverage.
1. When fixed operating costs are incurred by the a. added to
firm, a change in ____ is magnified into a b. divided by
relatively larger change in earnings before c. multiplied by
interest and taxes. d. subtracted from
a. overhead expenses
b. interest charges 8. A firm that employs relatively large amounts of
c. labor costs labor- saving equipment in its operations will have
d. sales revenue a relatively ____ degree of operating leverage.
a. low
2. When fixed capital costs are incurred by the firm, b. constant
a change in ____ is magnified into a larger c. insignificant
change in earnings per share. d. high
a. earnings before interest and taxes
b. overhead expenses 9. A firm that employs a relatively large proportion
c. interest charges of debt and preferred stock in its capital structure
d. preferred dividends will have a relatively ____ degree of financial
leverage.
3. The percentage change in a firm's EBIT that a. low
results in a 1% change in sales or output is b. high
known as the c. insignificant
a. degree of combined leverage d. constant
b. degree of financial leverage
c. degree of operating leverage 10. A firm is considering the purchase of assets that
d. degree of business risk will increase its fixed operating costs. The firm
should decrease the proportion of ____ it employs
4. The total variability of the firm's EPS associated in its capital structure if it wants to maintain its
with a change in sales is an indication of existing degree of combined leverage.
combined leverage and is best measured by a. debt
a. DOL b. warrants
b. DFL c. common stock
c. DOL + DFL d. none of the above
d. DOL x DFL
11. A firm that has a 2.5 DOL (degree of operating
5. In the analysis of financial leverage, all of the leverage) would find that an 8% increase in EBIT
following are referred to as fixed charges except: would result from a ____ increase in sales.
a. bond interest a. 3.2%
b. common stock dividends b. 5.4%
c. bank interest c. 20.0%
d. preferred stock dividends d. 2.0%

6. The degree of combined leverage is defined as the 12. A DFL (degree of financial leverage) of 3.0
percentage change in earnings per share resulting indicates that a 27% increase in EPS is the result
from a given percentage change in of a ____ increase in EBIT.
a. operating costs a. 81%
b. interest charges b. 3%
c. common stock dividends c. 9%
d. sales (or output) d. 6%

13. The use of increasing amounts of combined

leverage ____ the risk of financial distress.

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 a. decreases a. 1.60
b. increases b. 1.875
c. has no effect on c. 3.0
d. creates diversity in d. none of the above

14. All of the following factors influence a firm's
business risk except:
a. degree of operating leverage
b. variability of interest rates
c. variability of operating costs
d. variability of selling prices
15. The use of fixed cost sources of funds, such as
debt and preferred stock affect a firm's ____.
a. financial risk
b. degree of operating leverage
c. market power
d. business risk
16. The use of fixed-cost financing sources is referred
to as the use of
a. operating leverage
b. a leveraged buyout
c. financial leverage
d. combined leverage
17. The increased variability in earnings per share
due to the firm's use of debt is a definition of
____.
a. combined leverage
b. agency risk
c. financial risk
d. operating risk
18. The less a firm's business risk, the ____ the
amount of ____ that will be used in the optimal
capital structure, holding constant all other
relevant factors.
a. less; financial leverage
b. more; financial leverage
c. less; equity capital
d. more; debt capital
19. Illinois Tool Company's (ITC) fixed operating costs
are P1,260,000 and its variable cost ratio (i.e.,
variable costs as a fraction of sales) is 0.70. The
firm has P3,000,000 in bonds outstanding at an
interest rate of 8 percent. ITC has 30,000 shares
of P5 preferred stock and 150,000 shares of
common stock outstanding. ITC is in the 50
percent corporate income tax bracket. Forecasted
sales for next year are P9 million. What is ITC's
degree of operating leverage at a sales level of P9
million?
20. Illinois Tool Company's (ITC) fixed operating costs
are P1,260,000 and its variable cost ratio (i.e.,
variable costs as a fraction of sales) is 0.70. The
firm has P3,000,000 in bonds outstanding at an
interest rate of 8 percent. ITC has 30,000 shares
of P5 preferred stock and 150,000 shares of
common stock outstanding. ITC is in the 50
percent corporate income tax bracket. Forecasted
sales for next year are P9 million. What is ITC's
degree of financial leverage at an EBIT level of
P1,440,000.
a. 1.20
b. 1.875
c. 3.0
d. 1.60
21. Illinois Tool Company's (ITC) fixed operating costs
are P1,260,000 and its variable cost ratio (i.e.,
variable costs as a fraction of sales) is 0.70. The
firm has P3,000,000 in bonds outstanding at an
interest rate of 8 percent. ITC has 30,000 shares
of P5 preferred stock and 150,000 shares of
common stock outstanding. ITC is in the 50
percent corporate income tax bracket. Forecasted
sales for next year are P9 million. What is ITC's
degree of combined leverage at a sales level of
P10 million?
a. 2.00
b. 1.72
c. 2.50
d. none of the above
22. Suppose that ITC's degree of combined leverage
(DCL) is 3.00 at a sales volume of P9 million.
Determine ITC's percentage change in earnings
per share (EPS) if forecasted sales increase by 20
percent to P10,800,000.
a. 60%
b. 50%
c. 32%
d. none of the above

23. The Lincoln Mint produces various types of one ounce silver commemorative medals for sale to collectors. The
cost of producing and selling a given medal is as follows:

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 Fixed costs:
Design and preparation of dies P 8,000
Promotion and selling expenses 25,000
Administrative overhead 7,000
Total P40,000
Variable costs:
Silver blanks P 6.00
Striking medals 0.50
Mailing expenses 3.50
Total P 10.00

Projected selling price: P 14.00

What is the degree of operating leverage at an output level of 15,000 units?

a. 0.0
b. 1.0
c. 3.0
d. cannot be computed from information in problem
24. Last year Avator's operating income (EBIT)
increased by 22 percent while its peso sales
increased by 15%. What is Avator's degree of
operating leverage (DOL)?
a. 0.68
b. 2.0
c. 1.47
d. 0.32
25. Kermit's Hardware's (KH) fixed operating costs
are P20.8 million and its variable cost ratio is
0.30. The firm has P10 million in bonds
outstanding with a coupon interest rate of 9%. KH
has 200,000 shares of common stock
outstanding. The firm has revenues of P32.2
million and its marginal tax rate is 40%. Compute
KH's degree of operating leverage.
a. 14.81
b. 5.19
c. 12.95
d. 4.54
26. Kermit's Hardware's (KH) fixed operating costs
are P20.8 million and its variable cost ratio is
0.30. The firm has P10 million in bonds
outstanding with a coupon interest rate of 9%. KH
has 200,000 shares of common stock
outstanding. The firm has revenues of P32.2
million and its marginal tax rate is 40%. Compute
KH's degree of financial leverage.
a. 1.22
b. 2.07
c. 1.09
d. 1.04
2 degree of financial leverage is 2.91. If sales are
7. Kermit's Hardware's (KH) fixed operating costs
are P20.8 million and its variable cost ratio is
0.30. The firm has P10 million in bonds
outstanding with a coupon interest rate of 9%. KH
has 200,000 shares of common stock
outstanding. The firm has revenues of P32.2
million and its marginal tax rate is 40%. Compute
KH's degree of combined leverage.
a. 26.8
b. 5.5
c. 29.1
d. 4.7
28. Weis Products has fixed operating costs of P20
million and a variable cost ratio of 0.55. Weis has
4 million common shares outstanding and a
marginal tax rate of 45%. What is Weis's degree
of operating leverage at an expected sales level of
P150 million.
a. 1.00
b. 1.74
c. 1.42
d. 1.32
29. Kenzel has an EPS of P4.20 and sales are P9
million. If the firm has a degree of operating
leverage of 4.0 and a degree of financial leverage
of 5.2, forecast EPS if the firm expects a 4% sales
decline.
a. P0.71
b. P3.49
c. P4.03
d. P3.33
30. Archive Storage earned P3.20 a share on sales of
P13.6 million. Archive has determined that its
degree of operating leverage is 1.87 and its
expected to increase 15%, what will be the EPS
forecast?
a. P2.61

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 b. P4.60 d. 1.67
c. P5.81
d. P3.68 32. If a firm sees its EPS increase 27% on a 12%
increase in sales, what is the firm's DOL. During
31. Last year Alpine Growers experienced a 34% the same period the firm saw its EBIT increase
increase in earnings per share on 11% increase in only 8%.
sales. If management knows that Alpine's DOL is a. 1.50
1.5, what is its DFL? b. 3.38
a. 3.09 c. 1.34
b. 2.06 d. 0.67
c. 3.55

33. Given the following financial data for Boston Technology, compute the firm's degree of combined leverage.
Assume a marginal tax rate of 40%.

2004 2005
Sales P700,000 P760,000
Fixed costs 175,000 190,000
Variable costs 406,000 448,000
EBIT 119,000 122,000
Interest 42,000 46,000
Shares outstanding 100,000 102,000

a. 0.29
b. -0.38
c. -0.15
d. 0.38

34. Given the following financial data for Cosmos, compute the firm's degree of combined leverage.

2004 2005
Sales P780,000 P874,000
Fixed costs 195,000 218,500
Variable costs 460,200 524,400
EBIT 124,800 131,100
Interest 46,800 52,400
EPS P0.42 P0.51

a. P0.42
b. 8.37
c. -2.15
d. 1.78

35. Given the following financial data for Cosmos, compute the firm's degree of financial leverage.

Sales P780,000 P874,000

Fixed costs 195,000 218,500
Variable costs 460,200 524,400
EBIT 124,800 131,100
Interest 46,800 52,400
EPS P0.42 P0.51
a. 23.81
b. 4.24
c. 0.42
d. 2.18
36. With an optimal capital structure c. financial leverage is minimized
a. overall capital costs are minimized d. a and b
b. the net present value of new projects is
minimized

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37. Holding all other things equal, as the relative d. reduce the market value of the levered firm
amount of debt in the capital structure of the firm
increases, the cost of equity capital will 43. Protection for debt holders takes the form of
a. increase protective covenants in the bond indenture. These
b. decrease covenants place restrictions on which of the
c. remain unchanged; there is no relationship following activities?
between the two a. the sale of assets
d. initially rise rapidly, then increase slowly b. payment of dividends
beyond some point c. the issuance of additional debt
d. all of the above are typical protective
38. The mix of debt, preferred stock, and common covenants
equity that minimizes the weighted cost of capital
to the firm is known as the 44. Investors' required returns and the cost of equity
a. optimal corporate structure capital ____ as the relative amount of debt used
b. target financial structure to finance the firm ____.
c. optimal capital structure a. increase, increases
d. optimal degree of combined leverage b. increase, decreases
c. remain constant, increases
39. The optimal capital structure is determined by d. remain constant, decreases
several factors including all of the following
except: 45. According to the "pecking order theory," firms
a. corporate capital gains prefer to issue ____ securities first and then issue
b. business risk ____ securities as a last resort.
c. potential bankruptcy risk a. equity, debt
d. agency costs b. debt, convertible debt
c. debt, equity
40. Generally the ____ a firm's business risk, the d. equity, convertible debt
____ the amount of financial leverage that will be
used in the optimal capital structure. 46. ____ refers to the argument that officers and
a. greater, greater managers have access to information about the
b. smaller, less expected future earnings of the firm that is not
c. greater, less available to outside investors.
d. none of the above is correct a. Insider trading
b. Asymmetric information
41. The objective of capital structure management is c. Signaling effect
to find the capital mix that leads to d. Pecking order theory
a. maximization of earnings per share
b. shareholder wealth maximization 47. A survey of Fortune 500 firms indicate that they
c. maximization of net income prefer internal financing (retained earnings) to
d. maximization of the current period's dividends external financing. This preference is known as
____.
42. Agency costs a. financial slack
a. increase as the debt/total assets ratio b. the pecking order theory
decreases c. capital structure theory
b. affect the present value of the tax shield d. asymmetric capital
c. decrease as financial distress increases

48. Two companies, Jefferson and Jackson, are virtually identical in all aspects of their operations except that the
two companies differ in their capital structures, as shown below:

Jefferson Jackson
Debt (10%) P200 million P100 million
Common equity P300 million P400 million
No. shares outstanding 15 million 20 million

Both companies have P500 million in total assets and both have a 40% marginal tax rate. What is the EPS for
Jefferson at an EBIT level of P50 million?
a. P-1.20
b. P 1.20

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 c. P 2.20
d. P 3.33

49. Two companies, Jefferson and Jackson, are virtually identical in all aspects of their operations except that the
two companies differ in their capital structures, as shown below:

Jefferson Jackson
Debt (10%) P200 million P100 million
Common equity P300 million P400 million
No. shares outstanding 15 million 20 million

Both companies have P500 million in total assets and both have a 40% marginal tax rate. What is the EPS for
Jackson at an EBIT level of P50 million?
a. P1.50
b. P1.20
c. P2.00
d. P2.50

50. Knight Moves is considering two alternative financing plans. The firm is expected to operate at the P75 million
EBIT level. Under Plan D (debt financing) EPS is expected to be P2.25, and under Plan E (equity financing) EPS
is expected to be P1.82. If the market is expected to assign a P/E ratio of 12 to the debt plan and 15 to the
equity plan, which plan should Knight pursue?
a. debt
b. equity
c. indifferent between the two alternatives
d. neither is satisfactory

51. Feldspar Inc. is considering the capital structure for a new division. Management has been given the following
cost information:

Debt/assets kd ke
.30 .10 .125
.40 .105 .13
.50 .11 .135
.60 .117 .142
.70 .13 .155

Based on this information, what capital structure (debt/asset ratio) should management accept? Assume the
marginal tax rate is 40%.
a. 40% has lowest cost of capital
b. 50% has lowest cost of capital
c. 60% has lowest cost of capital
d. 70% has lowest cost of capital

52. Seduak has estimated the costs of debt and equity capital for various proportions of debt in its capital
structure:

% of Debt Cost of Debt Cost of Equity

0% - 13.0%
10 5.4% 13.3
20 5.4 13.8
30 5.8 14.4
40 6.3 15.2
50 7.0 16.0
60 8.2 17.0

Based on these estimates, determine Seduak's optimal capital structure.

a. 30% debt
b. 40% debt

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 c. 50% debt
d. 60 % debt

53. Technico has determined that its optimal capital structure is 40% debt, at which point its weighted cost of
capital, ka, is 13.7%. Due to financial problems, the firm has decided to raise the proportion of debt to 50%,
which will increase its weighted cost of capital to 14.4%. What is the effect on the stock price of Technico? The
current dividend is P1.60 and the long-term growth rate of dividends is expected to be 8.5%.
a. Decrease P3.65
b. Decrease P3.96
c. Increase P3.65
d. Increase P3.96

54. Biotec has estimated the costs of debt and equity capital for various proportions of debt in its capital structure:

% of Debt Cost of Debt Cost of Equity

35 5.4% 13.8%
40 5.6 14.0
45 5.9 14.3
50 6.4 14.7

Based on these estimates, determine Biotec's optimal capital structure.

a. 35% debt
b. 40% debt
c. 45% debt
d. 50% debt

55. Biotec has estimated the costs of debt and equity capital for various proportions of debt in its capital structure:

% of Debt Cost of Debt Cost of Equity

35 5.4% 13.8%
40 5.6 14.0
45 5.9 14.3
50 6.4 14.7

If Biotec pays a current dividend of P1.00 and expects dividends to grow at a constant rate of 7%, what is
Biotec's stock price if it obtains its optimal capital structure?
a. P14.66
b. P30.40
c. P30.14
d. P29.40

56. Triad Labs has total assets of P120 million and P40 million of debt in its capital structure. Its current cost of
equity is 13% and its cost of debt is 8.5%. Triad is considering increasing its debt to P70 million and
purchasing its own stock with proceeds from the sale of P30 million in debt with a cost of 9.5%, reducing
equity to P50 million. The cost of equity will increase to 14.5%. Net operating income (EBIT) will remain at P12
million. If Triad has a marginal tax rate of 40%, should the firm increase its debt? Assume that both debt and
EBIT are perpetual.
a. No, the value of the firm decreases P15.9 million
b. No, the value of the firm decreases P30.0 million
c. Yes, the value of the firm increases P14.1 million
d. Yes, the value of the firm increases P30.0 million

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CTDI 12 Leverage And Capital Structure
Answer Section

MULTIPLE CHOICE

1. ANS: D TOP: Measurement of operating and financial leverage

2. ANS: A TOP: Degree of financial leverage
3. ANS: C TOP: Degree of operating leverage
4. ANS: D TOP: Degree of combined leverage
5. ANS: B TOP: Degree of financial leverage
6. ANS: D TOP: Degree of combined leverage
7. ANS: C TOP: Degree of combined leverage
8. ANS: D TOP: Degree of operating leverage
9. ANS: B TOP: Degree of financial leverage
10. ANS: A TOP: Degree of combined leverage
11. ANS: A TOP: DOL
12. ANS: C TOP: DFL
13. ANS: B TOP: DCL
14. ANS: B TOP: Business risk
15. ANS: A TOP: Financial risk and financial leverage
16. ANS: C TOP: Financial risk and financial leverage
17. ANS: C TOP: Financial risk and financial leverage
18. ANS: B TOP: Business risk
19. ANS: B
Solution:
DOL = [(P9,000,000 - 0.7(P9,000,000)]/[P9,000,000 - 0.7(P9,000,000) - P1,260,000]
= 1.875

TOP: Degree of operating leverage calculation

20. ANS: D
Solution:
DFL = P1,440,000/[P1,440,000 - 0.08(P3,000,000) - P150,000/(1 - 0.5)]
= 1.60

TOP: Degree of financial leverage calculation

21. ANS: C
Solution:
DCL = (P10,000,000 - 0.70(P10,000,000)/[(P10,000,000
- 0.7(P10,000,000 - P1,260,000 - 0.08(P3,000,000)
- (P150,000)/(1 - 0.5)]
DCL = 2.50

TOP: Degree of combined leverage calculation

22. ANS: A
Solution:
% change EPS = 3.00(20%) = 60%

TOP: Degree of combined leverage analysis

23. ANS: C
Solution:
DOL = [(P14 - P10)(15,000)]/[(P14 - P10)(15,000) - P40,000] = 3.0

TOP: Degree of operating leverage calculation

24. ANS: C
Solution:
 DOL = 22% / 15% = 1.47

TOP: Degree of operating leverage

25. ANS: C
Solution:
VC = P32.2(0.30) = 9.66
EBIT = P32.2 - P20.8 - P9.66 = P1.74
DOL = (P32.2 - P9.66)/P1.74 = 12.95

TOP: Degree of operating leverage

26. ANS: B
Solution:
EBIT = P32.2 - P20.8 - P9.66 = P1.74
DFL = P1.74/(P1.74 - P0.9) = 2.07

TOP: Degree of financial leverage

27. ANS: A
Solution:
DCL = 12.95 ´ 2.07 = 26.8
Check: DCL = (P32.2 - P9.66)/(P1.74 - P0.9) = 26.83

TOP: Degree of combined leverage

28. ANS: C
Solution:
EBIT = P150 - P20 - 0.55(P150) = P47.5
DOL = (P150 - 0.55(150))/47.5 = 1.42

TOP: Degree of operating leverage

29. ANS: A
Solution:
DCL = 4.0 ´ 5.2 = 20.8
EPS decline = 4%(20.8) = 83.2%
Forecasted EPS = P4.20(1 - 0.832) = P0.7056

TOP: Degree of combined leverage

30. ANS: C
Solution:
DCL = 1.87(2.91) = 5.44
% change in EPS = 5.44(15) = 81.6
Forecasted EPS = 3.20(1.816) = P5.81

TOP: Degree of combined leverage

31. ANS: B
Solution:
DCL = 34/11 = 3.09
DFL = 3.09/1.5 = 2.06

TOP: Degree of financial leverage

32. ANS: D
Solution:
D0L = 8%/12% = 0.67

TOP: Degree of operating leverage

33. ANS: B
Solution:

2004 2005
EBIT P119,000 P122,000
 I 42,000 46,000
EBT 77,000 76,000
T 30,800 30,400
EAT P 46,200 P 45,600
EPS P0.462 P0.447
DCL = [(P0.447 - P0.462)/P0.462]/[(P760,000 - P700,000)/P700,000] = -0.38

TOP: Degree of combined leverage

34. ANS: D
Solution:
DCL = [(P0.51 - P0.42)/P0.42]/[(P874,000 - P780,000)/P780,000]
= 1.78

TOP: Degree of combined leverage

35. ANS: B
Solution:
DFL = [(P0.51 - P0.42)/P0.42]/[(P131,100 - P124,800)/P124,800] = 4.24

TOP: Degree of financial leverage

36. ANS: A TOP: The cost of capital and the optimal capital structure
37. ANS: A TOP: The cost of capital and the optimal capital structure
38. ANS: C TOP: Capital structure decisions & maxim. of shareholder wealth
39. ANS: A TOP: Capital structure decisions & maxim. of shareholder wealth
40. ANS: C TOP: Effect of financial leverage on stockholders returns
41. ANS: B TOP: Effect of financial leverage on stockholder returns and risk
42. ANS: D TOP: Agency costs
43. ANS: D TOP: Agency costs
44. ANS: A TOP: The cost of capital and the optimal capital structure
45. ANS: C TOP: The pecking order theory
46. ANS: B TOP: Signaling effects
47. ANS: B TOP: The pecking order theory
48. ANS: B
Solution:
EBT = P50 - P20 = P30
EAT = P30(1 - 0.4) = P18
EPS = P18,000,000/15,000,000 = P1.20

TOP: Indifference point analysis

49. ANS: B
Solution:
EBT = P50 - P10 = P40
EAT = P40(1 - 0.4) = P24
EPS = P24,000,000/20,000,000 = P1.20

TOP: Indifference point analysis

50. ANS: B
Solution:
Debt Plan Price = 12($2.25) = $27.00
Equity Plan Price = 15($1.82) = $27.30

TOP: Effect of financial leverage on stock prices

51. ANS: C
Solution:

Debt/assets
.30 0.3(0.10)(0.6) + 0.7(0.125) = 0.1055
.40 0.4(0.105)(0.6) + 0.6(0.13) = 0.1032
 .50 0.5(0.11)(0.6) + 0.5(0.135) = 0.1005
.60 0.6(0.117)(0.6) + 0.4(0.142) = 0.0989
.70 0.7(0.13)(0.6) + 0.3(0.155) = 0.1011

TOP: Cost of capital and optimal capital structure

52. ANS: C
Solution:
k10 = 0.10(0.054) + 0.90(0.133) = 0.1251
k20 = 0.20(0.054) + 0.80(0.138) = 0.1212
k30 = 0.30(0.058) + 0.70(0.144) = 0.1182
k40 = 0.40(0.063) + 0.60(0.152) = 0.1164
k50 = 0.50(0.07) + 0.50(0.16) = 0.115
k60 = 0.60(0.082) + 0.40(0.17) = 0.1172

TOP: Cost of capital and capital structure

53. ANS: B
Solution:
P0 = $1.60(1.085)/(0.137 - 0.085) = $33.38
P0 = $1.60(1.085)/(0.144 - 0.085) = $29.42

TOP: Valuation
54. ANS: C
Solution:
k35 = 0.35(0.054) + 0.65(0.138) = 0.1086
k40 = 0.40(0.056) + 0.60(0.140) = 0.1064
k45 = 0.45(0.059) + 0.55(0.143) = 0.1052
k50 = 0.50(0.064) + 0.50(0.147) = 0.1055

TOP: Cost of capital and optimal capital structure

55. ANS: A
Solution:
P0 = 1.00(1.07)/(0.143 - 0.07) = P30.40

TOP: Valuation
56. ANS: C
Solution:
Income available = (12 - 3.4)(.6) = $5.16
Value = $5.16/.13 + 3.4/.085 = $79.7 million
Income available (after new debt) = (12 - 3.4 - 2.85)(.6) = $3.45
Value = 3.45/.145 + 3.4/.085 + 2.85/.095 = $93.8 million

TOP: Valuation and capital structure