# Capital Structure and Net Operating Income Study Guide

36. Net operating income

The Congress Company has identified two methods for producing playing cards. One method involves using a machine having a fixed cost of $10,000 and variable costs of $1.00 per deck of cards. The other method would use a less expensive machine (fixed cost = $5,000), but it would require greater variable costs ($1.50 per deck of cards). If the selling price per deck of cards will be the same under each method, at what level of output will the two methods produce the same net operating income?

a. 5,000 decks

b.10,000 decks

c.15,000 decks

d.20,000 decks

e.25,000 decks

36.Answer: b Diff: M

Total costMethod 1 = $1.00(Q) + $10,000.

Total costMethod 2 = $1.50(Q) + $5,000.

Set equal and solve for Q:

Q + $10,000 = $1.50(Q) + $5,000

$5,000 = $0.5(Q)

10,000 = Q.

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41. Capital structure and stock price Answer: c Diff: M

The following information applies to Lott Enterprises:

Operating income (EBIT) $300,000Shares outstanding 120,000 Debt $100,000EPS $1.45 Interest expense $ 10,000Stock price $17.40 Tax rate 40%

The company is considering a recapitalization where it would issue $348,000 worth of new debt and use the proceeds to buy back $348,000 worth of common stock. The buyback will be undertaken at the pre-recapitalization share price ($17.40). The recapitalization is not expected to have an effect on operating income or the tax rate. After the recapitalization, the company’s interest expense will be $50,000.

Assume that the recapitalization has no effect on the company’s price earnings (P/E) ratio. What is the expected price of the company’s stock following the recapitalization?

a.$15.30

b.$17.75

c.$18.00

d.$19.03

e. $20.48

41.Answer: c Diff: M

We can do this problem by using the P/E before and after the recapitalization. Recall that P/E = Price/EPS.

Before the recap. After recap. EBIT $300,000 $300,000

Interest -10,000 -50,000

EBT $290,000 $250,000

Tax (40%) 116,000 100,000

NI $174,000 $150,000

Shares 120,000 100,000*

EPS $174,000/120,000 = $1.45. $150,000/100,000 = $1.50. P/E $17.40/1.45 = 12(.

*120,000 - ($348,000/$17.40)

As P/E = 12 after the recapitalization (recall the question states that it does not change), we know 12 = Price/$1.50; Price = 12 × $1.50 = $18.00.

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44. Optimal capital structure and Hamada equation Answer: d Diff: T N Aaron Athletics is trying to determine its optimal capital structure. The company’s capital structure consists of debt and common stock. In order to estimate the cost of debt, the company has produced the following table:

Debt-to-total-Equity-to-total-Debt-to-equity BondBefore-tax assets ratio (wd)assets ratio (wc) ratio (D/E)ratingcost of debt

0.100.900.10/0.90 = 0.11AA7.0%

0.200.800.20/0.80 = 0.25A7.2

0.300.700.30/0.70 = 0.43A8.0

0.400.600.40/0.60 = 0.67BB8.8

0.500.500.50/0.50 = 1.00B9.6

The company’s tax rate, T, is 40 percent.

The company uses the...

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