Preview

Variable Cost and Capital Structure

Good Essays
Open Document
Open Document
1560 Words
Grammar
Grammar
Plagiarism
Plagiarism
Writing
Writing
Score
Score
Variable Cost and Capital Structure
1. Which of the following would increase the likelihood that a company would increase its debt ratio in its capital structure?
a. An increase in costs incurred when filing for bankruptcy.
b. An increase in the corporate tax rate.
c. An increase in the personal tax rate.
d. None of the statements above is correct.

ANSWER: B An increase in the corporate tax rate would mean that firms would get larger tax breaks for interest payments. Therefore, firms have an incentive to increase interest payments, in order to reduce taxes. Therefore, they will increase their debt ratios.

2. Which of the following events is likely to encourage a company to raise its target debt ratio? a. An increase in the corporate tax rate. b. An increase in the personal tax rate. c. An increase in the company’s operating leverage. d. Statements a and c are correct.

ANSWER: A An increase in the tax rate would lower the after-tax cost of debt relative to equity; therefore, this would encourage a company to raise its target debt ratio.

3. Which of the following statements is most correct?

a. Since debt financing raises the firm 's financial risk, raising a company’s debt ratio will always increase the company’s WACC.
b. Since debt financing is cheaper than equity financing, raising a company’s debt ratio will always reduce the company’s WACC.
c. Increasing a company’s debt ratio will typically reduce the marginal cost of both debt and equity financing; however, it still may raise the company’s WACC. d. None of the statements above is correct.

ANSWER: D

4. Which of the following statements is most correct?
a. As a rule, the optimal capital structure is found by determining the debt-equity mix that maximizes expected EPS.
b. The optimal capital structure simultaneously maximizes EPS and minimizes the WACC.
c. The optimal capital structure simultaneously minimizes the cost of debt, the cost of equity, and the WACC.
d. None of the statements above is

You May Also Find These Documents Helpful

  • Satisfactory Essays

    HW1 solutions

    • 504 Words
    • 3 Pages

    2. Capital structure refers to the mix of a firm’s long-term debt financing and equity financing. Suppose that a firm has $4 billion debt. The market values the firm’s 100 million (equity) shares at $60 per share. Earnings per share is $5. Dividend per share is $1.What is the fraction of equity in the firm’s capital structure?…

    • 504 Words
    • 3 Pages
    Satisfactory Essays
  • Better Essays

    Finance Exam

    • 1661 Words
    • 7 Pages

    7. If the interest rate on debt is higher than the ROA, then a firm's ROE will _________.…

    • 1661 Words
    • 7 Pages
    Better Essays
  • Satisfactory Essays

    Fin 516 Quiz 2

    • 932 Words
    • 4 Pages

    (a) The yield to maturity on the company's outstanding bonds increases due to a weakening of the firm's financial situation.…

    • 932 Words
    • 4 Pages
    Satisfactory Essays
  • Satisfactory Essays

    Employing debt in the business increases the risk of the firm. In such a case though initially debt proves to be cheaper than equity it will ultimately increase the overall cost of capital as…

    • 362 Words
    • 2 Pages
    Satisfactory Essays
  • Powerful Essays

    Glen Mount Furniture Company

    • 5469 Words
    • 33 Pages

    7. The higher the interest rate on new debt, the less attractive financial leverage is to the firm.…

    • 5469 Words
    • 33 Pages
    Powerful Essays
  • Good Essays

    Due to the fact that cost of equity is higher than cost of debt ( you may need to show the calculation ) , Therefore, if the proportion of equity is reduced, it will definitely reduce in WACC.…

    • 714 Words
    • 3 Pages
    Good Essays
  • Satisfactory Essays

    If a firm’s marginal tax rate is increased, this would, lower the cost of debt used to calculate the WACC. TRUE…

    • 393 Words
    • 2 Pages
    Satisfactory Essays
  • Good Essays

    Sp2750 Unit 3 Answers

    • 1989 Words
    • 8 Pages

    (iv) Return on investment- The greater return on investment of a company increases its capacity to utilise more debt capital.…

    • 1989 Words
    • 8 Pages
    Good Essays
  • Satisfactory Essays

    Hrm/531 Week 3 Quiz

    • 328 Words
    • 2 Pages

    e. An increase in a firm’s debt ratio, with no changes in its sales or operating costs, could be expected to lower the profit margin.…

    • 328 Words
    • 2 Pages
    Satisfactory Essays
  • Powerful Essays

    2. What will be the effects of issuing $3 billion of new debt and using the proceeds either to pay a dividend or to repurchase shares on:…

    • 1184 Words
    • 5 Pages
    Powerful Essays
  • Powerful Essays

    case Bed, Bath & Beyond

    • 1189 Words
    • 5 Pages

    -Leverage increases the risk of equity even when there’s no risk that the firm will default. Thus, while debt may be cheaper when considered on its own, it raises the cost of capital for equity.…

    • 1189 Words
    • 5 Pages
    Powerful Essays
  • Powerful Essays

    WACC: as constant debt ratio is the underlying assumption to derive the WACC model, constant debt ratio should be reasonably assumed to be applied by Midland and its three divisions. According to the case, Midland optimizes its debt levels by regularly reevaluations against its energy price and stock price level and each division has its own target debt ratio. Although the actual capital structure sometimes deviates from the target due to factors such as market value of specific collaterals, it is safe to assume that the debt ratio averages out at the target ratio in the long run, given that the target ratios are not adjusted frequently. Therefore, the debt ratio can be viewed as a constant and thus WACC is applicable.…

    • 1333 Words
    • 6 Pages
    Powerful Essays
  • Satisfactory Essays

    a. by changing the distribution of wealth toward the poor, who have a lower demand for money.…

    • 797 Words
    • 4 Pages
    Satisfactory Essays
  • Good Essays

    EC102

    • 512 Words
    • 2 Pages

    g) Use the AD-AS framework to illustrate the effects of an increase in interest rates…

    • 512 Words
    • 2 Pages
    Good Essays
  • Good Essays

    Marketing Managment

    • 585 Words
    • 3 Pages

    d. Suppose the firm can increase its debt so that capital structure has 50 % debt, based on market values (it will issue debt and buy back stock). At this level of debt, its cost of equity rises to 18.5%. Its interest rate on all debt with rise to 12% (it will have to call and refund the old debt). What would be the WACC under this capital structure?…

    • 585 Words
    • 3 Pages
    Good Essays