224GitmanPrinciplesofFinance,EleventhEdition

Chapter12
LeverageandCapitalStructure
.1

Learning Goals

1.

Discussleverage,capitalstructure,breakevenanalysis,theoperatingbreakevenpoint,andtheeffect
ofchangingcostsonit.

2.

Understandoperating,financial,andtotalleverageandtherelationshipsamongthem.

3.

Describethebasictypesofcapital,externalassessmentofcapitalstructure,thecapitalstructureof
nonU.S.firms,andcapitalstructuretheory.

4.

Explaintheoptimalcapitalstructureusingagraphicalviewofthefirmscostofcapitalfunctions
andazerogrowthvaluationmodel.

5.

DiscusstheEBITEPSapproachtocapitalstructure.

6.

Reviewthereturnandriskofalternativecapitalstructures,theirlinkagetomarketvalue,andother
importantconsiderationsrelatedtocapitalstructure.

.2

True/False

1.

Generally,increasesinleverageresultinincreasedreturnandrisk.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:1
Topic:Leverage

2.

Breakevenanalysisisusedbythefirmtodeterminethelevelofoperationsnecessarytocoverall
fixedoperatingcostsandtoevaluatetheprofitabilityassociatedwithvariouslevelsofsales.
Answer: FALSE
LevelofDifficulty:1
LearningGoal:1
Topic:BreakevenAnalysis

3.

Thefirmsoperatingbreakevenpointisthelevelofsalesnecessarytocoverallfixedoperating
costs.
Answer: FALSE
LevelofDifficulty:1
LearningGoal:1

225GitmanPrinciplesofFinance,EleventhEdition

Topic:OperatingBreakevenPoint

Chapter12LeverageandCapitalStructure226

4.

Leverageresultsfromtheuseoffixedcostassetsorfundstomagnifyreturnstothefirmsowners.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:1
Topic:Leverage

5.

Operatingleverageisconcernedwiththerelationshipbetweenthefirmssalesrevenueandits
operatingexpenses.
Answer: FALSE
LevelofDifficulty:1
LearningGoal:1
Topic:OperatingLeverage

6.

Financialleverageisconcernedwiththerelationshipbetweenthefirmsearningsafterinterestand
taxesanditscommonstockearningspershare.
Answer: FALSE
LevelofDifficulty:1
LearningGoal:1
Topic:FinancialLeverage

7.

Totalleverageisconcernedwiththerelationshipbetweenthefirmssalesrevenueanditscommon
stockearningspershare.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:1
Topic:TotalLeverage

8.

Firmscapitalstructureisthemixoftheshorttermdebt,longtermdebt,andequitymaintainedby
thefirm.
Answer: FALSE
LevelofDifficulty:1
LearningGoal:1
Topic:CapitalStructure

9.

Thelevelsoffixedcostassetsandfundsthatmanagementselectsaffectthevariabilityofreturns.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:1
Topic:TotalLeverage

10.

Theamountofleverageinthefirmscapitalstructurethemixoflongtermdebtandequity
maintainedbythefirmcansignificantlyaffectitsvaluebyaffectingreturnandrisk.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:1
Topic:FinancialLeverage

227GitmanPrinciplesofFinance,EleventhEdition

11.

Salescommissionmaybeconsideredasasemivariablecostbecauseitmaybefixedforacertain
volumeofsalesandthenincreasetohigherlevelsforhighervolumes.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:1
Topic:OperatingLeverage

12.

Attheoperatingbreakevenpoint,thesalesrevenueisequaltothesumofthefixedandvariable
operatingcosts.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:1
Topic:OperatingBreakevenPoint

13.

Earningsbeforeinterestandtaxesarepositiveabovetheoperatingbreakevenpoint,andaloss
occursbelowit.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:1
Topic:OperatingBreakevenPoint

14.

Forsaleslevelsbelowtheoperatingbreakevenpoint,salesrevenueexceedstotaloperatingcosts,
andearningsbeforeinterestandtaxesisgreaterthanzero.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:1
Topic:OperatingBreakevenPoint

15.

Anincreaseincost(fixedcostorvariablecost)tendstoincreasetheoperatingbreakevenpoint,
whereasanincreaseinthesalespriceperunitwilldecreasetheoperatingbreakevenpoint.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:1
Topic:OperatingBreakevenPoint

16.

Theuseofadollarbreakevenpointisimportantwhenafirmhasmorethanoneproduct,especially
wheneachproductissellingatadifferentprice.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:1
Topic:DollarBreakevenPoint

17.

Thecontributionmarginisdefinedasthepercentofeachsalesdollarthatremainsaftersatisfying
fixedoperatingcosts.
Answer: FALSE
LevelofDifficulty:4
LearningGoal:1
Topic:ContributionMargin

Chapter12LeverageandCapitalStructure228

18.

Thebreakevenpointindollarscanbecomputedbydividingthecontributionmarginintothefixed
operatingcosts.
Answer: TRUE
LevelofDifficulty:4
LearningGoal:1
Topic:OperatingBreakevenPoint

19.

Duetothedifficultyofallocatingcoststoproductsinamultiproductfirm,thebreakevenmodelmay
failtodeterminebreakevenpointsforeachproductline.
Answer: TRUE
LevelofDifficulty:4
LearningGoal:1
Topic:BreakevenAnalysis

20.

Sincethesalespriceperunitgenerallydecreaseswithvolumeandthecostperunitgenerally
increaseswithvolume,thetruebreakevenpointmaybedifferentfromthoseobtainedusinglinear
revenueandcostfunctionsasassumedinthebreakevenanalysis.
Answer: TRUE
LevelofDifficulty:4
LearningGoal:1
Topic:BreakevenAnalysis

21.

Oneofthelimitationsofbreakevenanalysisisitsshorttermtimehorizon.Alargeoutlayinthe
currentfinancialperiodcouldsignificantlyraisethefirmsbreakevenpoint,whilethebenefitsmay
occuroveraperiodofyears.
Answer: TRUE
LevelofDifficulty:4
LearningGoal:1
Topic:BreakevenAnalysis

22.

Thecashbreakevenpointisusedwhencertainnoncashcharges,suchasdepreciation,constitutean
importantportionofthefirmsfixedoperatingcosts.
Answer: TRUE
LevelofDifficulty:4
LearningGoal:1
Topic:CashOperatingBreakevenPoint

23.

Generally,increasesinleverageresultinincreasedreturnandrisk,whereasdecreasesinleverage
resultindecreasedreturnandrisk.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:2
Topic:Leverage

229GitmanPrinciplesofFinance,EleventhEdition

24.

Totalleveragecanbedefinedasthepotentialuseoffixedcosts,bothoperatingandfinancial,to
magnifytheeffectofchangesinsalesonthefirmsearningspershare.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:2
Topic:TotalLeverage

25.

Therelationshipbetweenoperatingandfinancialleverageisadditiveratherthanmultiplicative.
Answer: FALSE
LevelofDifficulty:1
LearningGoal:2
Topic:TotalLeverage

26.

Operatingleverageresultsfromtheexistenceofoperatingcostsinthefirmsincomestream.
Answer: FALSE
LevelofDifficulty:1
LearningGoal:2
Topic:OperatingLeverage

27.

Thetotalleveragemeasuresthecombinedeffectofoperatingandfinancialleverageonthefirms
risk.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:2
Topic:TotalLeverage

28.

Operatingleveragemaybedefinedasthepotentialuseoffixedoperatingcoststomagnifythe
effectsofchangesinsalesonthefirmsearningsbeforeinterestandtaxes(EBIT).
Answer: TRUE
LevelofDifficulty:2
LearningGoal:2
Topic:OperatingLeverage

29.

Operatingleverageispresentwhenafirmhasfixedoperatingcost.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:2
Topic:OperatingLeverage

30.

Financialleverageresultsfromthepresenceofvariablefinancialcostsinthefirmsincomestream.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:2
Topic:FinancialLeverage

Chapter12LeverageandCapitalStructure230

31.

Financialleveragemaybedefinedasthepotentialuseofvariablefinancialcoststomagnifythe
effectsofchangesinearningsbeforeinterestandtaxes(EBIT)onthefirmsearningspershare
(EPS).
Answer: FALSE
LevelofDifficulty:2
LearningGoal:2
Topic:FinancialLeverage

32.

Wheneverthepercentagechangeinearningsbeforeinterestandtaxesresultingfromagiven
percentagechangeinsalesisgreaterthanthepercentagechangeinsales,operatingleverageexists.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:2
Topic:OperatingLeverage

33.

Theeffectoffinancialleverageissuchthatanincreaseinthefirmsearningsbeforeinterestand
taxes(EBIT)resultsinamorethanproportionalincreaseinthefirmsearningspershare(EPS),
whileadecreaseinthefirmsEBITresultsinalessthanproportionaldecreaseinEPS.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:2
Topic:FinancialLeverage

34.

Wheneverthepercentagechangeinearningspershare(EPS)resultingfromagivenpercentage
changeinsalesisgreaterthanthepercentagechangeinsales,financialleverageexists.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:2
Topic:FinancialLeverage

35.

Totalleverageexistswheneverthepercentagechangeinearningspershare(EPS)resultingfroma
givenpercentagechangeinsalesisgreaterthanthepercentagechangeinsales.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:2
Topic:TotalLeverage

36.

Whenafirmhasfixedoperatingcosts,operatingleverageispresent.Inthatcase,anincreasein
salesresultsinamorethanproportionalincreaseinEBIT,andadecreaseinsalesresultsinamore
thanproportionaldecreaseinEBIT.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:2
Topic:OperatingLeverage

231GitmanPrinciplesofFinance,EleventhEdition

37.

WheneverthepercentagechangeinEBITresultingfromagivenpercentagechangeinsalesis
greaterthanthepercentagechangeinsales,operatingleverageexists.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:2
Topic:OperatingLeverage

38.

Thecloserthebasesaleslevelusedistotheoperatingbreakevenpoint,thesmallertheoperating
leverage.
Answer: FALSE
LevelofDifficulty:3
LearningGoal:2
Topic:OperatingLeverage

39.

ThebaselevelofEBITmustbeheldconstanttocomparethefinancialleverageassociatedwith
differentlevelsoffixedfinancialcosts.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:2
Topic:FinancialLeverage

40.

Thebaselevelofsalesmustbeheldconstanttocomparethetotalleverageassociatedwithdifferent
levelsoffixedcosts.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:2
Topic:TotalLeverage

41.

Thedegreeofoperatingleveragewillincreaseifafirmdecidestocompensateitssales
representativeswithafixedsalaryandbonusratherthanwithapurepercentofsalescommission.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:2
Topic:OperatingLeverage

42.

Comparisonofthedegreeofoperatingleverageoftwofirmsisvalidonlywhenthebaselevelof
salesusedforeachfirmisthesame.
Answer: TRUE
LevelofDifficulty:4
LearningGoal:2
Topic:OperatingLeverage

43.

Thedegreeofoperatingleveragedependsonthebaselevelofsalesusedasapointofreference.The
closerthebasesaleslevelusedistotheoperatingbreakevenpoint,thegreatertheoperating
leverage.
Answer: TRUE
LevelofDifficulty:4
LearningGoal:2
Topic:OperatingLeverage

Chapter12LeverageandCapitalStructure232

44.

Ingeneral,thegreaterthefirmsoperatingleverage,thehigheritsbusinessrisk.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:3
Topic:OperatingLeverage

45.

Theprobabilitythatafirmwillbecomebankruptislargelydependentonitslevelofbothbusiness
riskandfinancialrisk.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:3
Topic:BusinessRiskandFinancialRisk

46.

Thefirmscapitalstructureisthemixofshorttermandlongtermdebtandequitymaintainedbythe
firm.
Answer: FALSE
LevelofDifficulty:1
LearningGoal:3
Topic:CapitalStructureBasics

47.

Thefirmscapitalstructurecansignificantlyaffectthefirmsvaluebyaffectingitsriskandreturn.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:3
Topic:CapitalStructureBasics

48.

Allitemsontherighthandsideofthefirmsbalancesheet,excludingcurrentliabilitiesarecalled
capital.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:3
Topic:CapitalStructureBasics

49.

Ingeneral,lowdebtpaymentratiosareassociatedwithhighdegreesoffinancialleverage.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:3
Topic:FinancialLeverage

50.

Themorefixedcostfinancingafirmhasinitscapitalstructure,thegreateritsfinancialleverageand
risk.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:3
Topic:FinancialLeverage

233GitmanPrinciplesofFinance,EleventhEdition

51.

Symmetricinformationresultswhenmanagersofafirmhavemoreinformationaboutoperations
andfutureprospectsthandoinvestors.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:3
Topic:AsymmetricInformation

52.

Ingeneral,nonU.S.companieshavemuchhigherdebtratiosthandotheirU.S.counterparts
becausefinancialmarketsaremuchmoredevelopedintheUnitedStatesthanelsewhereandhave
playedamuchgreaterroleincorporatefinancingthanhasbeenthecaseinothercountries.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:3
Topic:InternationalAspectsofCapitalStructure

53.

Effectivecapitalstructuredecisionscanlowerthecostofcapital,resultinginhigherNPVsandmore
acceptableprojects,therebyincreasingthevalueofthefirm.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:3
Topic:CapitalStructureBasics

54.

Peckingorderisahierarchyoffinancingbeginningwithretainedearningsfollowedbydebt
financingandfinallyexternalequityfinancing.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:3
Topic:PeckingOrderTheory

55.

Therelativeinexpensivenessofdebtcapitalisduetothefactthatthelenderstaketheleastriskof
anylongtermcontributorsofcapital.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:3
Topic:CapitalStructureBasics

56.

Poorcapitalstructuredecisionscanresultinahighcostofcapital,therebymakingsome
unacceptableinvestmentsacceptable.
Answer: FALSE
LevelofDifficulty:3
LearningGoal:3
Topic:CapitalStructureBasics

57.

Thedebtcapitalhasalowerriskbecausethelendershaveafarstrongerlegalpressureagainstthe
companytomakepaymentthandopreferredorcommonstockholders.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:3
Topic:CapitalStructureBasics

Chapter12LeverageandCapitalStructure234

58.

Duetoitssecondarypositionrelativetoequity,suppliersofdebtcapitaltakegreaterriskand
thereforemustbecompensatedwithhigherexpectedreturnsthansuppliersofequitycapital.
Answer: FALSE
LevelofDifficulty:3
LearningGoal:3
Topic:CapitalStructureBasics

59.

Indefault,debtholdersandpreferredstockholdersmayreceiveavoiceinmanagement;otherwise,
onlycommonstockholdershavevotingrights.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:3
Topic:CapitalStructureBasics

60.

Ashifttowardmorefixedcostsincreasesbusinessrisk,whichinturncausesearningsbeforeinterest
andtaxestoincreasebylessforagivenincreaseinsales.
Answer: FALSE
LevelofDifficulty:4
LearningGoal:3
Topic:BusinessRisk

61.

Whenconsideringfixedoperatingcostincreases,thefinancialmanagermustweightheincreased
financialriskassociatedwithgreateroperatingleverageagainsttheexpectedincreaseinreturns.
Answer: FALSE
LevelofDifficulty:4
LearningGoal:3
Topic:BusinessRiskandFinancialRisk

62.

Businessriskistherisktothefirmofbeingunabletocoveroperatingcosts.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:4
Topic:BusinessRisk

63.

Minimizingtheweightedaveragecostofcapitalallowsmanagementtoundertakealargernumber
ofprofitableprojects,therebyfurtherincreasingthevalueofthefirm.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:4
Topic:OptimalCapitalStructure

64.

Optimalcapitalstructureisthecapitalstructureatwhichtheweightedaveragecostofcapitalis
minimized,therebymaximizingthefirmsvalue.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:4
Topic:OptimalCapitalStructure

235GitmanPrinciplesofFinance,EleventhEdition

65.

Withincreasingcosts,especiallyfixedoperatingandfinancialcostcomesincreasingrisk,since
thefirmwillhavetoachieveahigherlevelofsalesjusttobreakeven.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:4
Topic:BusinessRiskandFinancialRisk

66.

Thecostofequityisgreaterthanthecostofdebtandincreaseswithincreasingfinancialleverage,
butgenerallylessrapidlythanthecostofdebt.
Answer: FALSE
LevelofDifficulty:3
LearningGoal:4
Topic:CostofEquityandFinancialLeverage

67.

Thecostofequityincreaseswithincreasingfinancialleverageinordertocompensatethe
stockholdersforthehigherdegreeoffinancialrisk.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:4
Topic:CostofEquityandFinancialLeverage

68.

Asfinancialleverageincreases,thecostofdebtremainsconstantandthenrises,whilethecostof
equityalwaysrises.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:4
Topic:CostofDebtandFinancialLeverage

69.

IfweassumethatEBITisconstant,thevalueofthefirmismaximizedbyminimizingtheweighted
averagecostofcapital.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:4
Topic:CapitalStructureandFirmValue

70.

TheEBITEPSapproachtocapitalstructureinvolvesselectingthecapitalstructurethatmaximizes
earningsbeforeinterestandtaxes(EBIT)overtheexpectedrangeofearningspershare(EPS).
Answer: FALSE
LevelofDifficulty:2
LearningGoal:5
Topic:EBITEPSApproach

71.

TheEBITEPSanalysistendstoconcentrateonmaximizationofearningsratherthanmaximization
ofownerswealth.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:5
Topic:EBITEPSApproach

Chapter12LeverageandCapitalStructure236

72.

Thehigherthefinancialbreakevenpointandthesteepertheslopeofthecapitalstructureline,the
greaterthefinancialrisk.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:5
Topic:EBITEPSApproach

73.

Becauseriskpremiumsincreasewithincreasesinfinancialleverage,themaximizationofEPSdoes
notassureownerswealthmaximization.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:5
Topic:EBITEPSApproach

74.

Thehigherthedegreeoffinancialleverage(DFL),thegreatertheleverageaplanhas,andthe
steeperitsslopewhenplottedonEBITEPSaxes.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:5
Topic:EBITEPSApproach

75.

ThesteepertheslopeoftheEBITEPScapitalstructureline,thelowerthefinancialrisk.
Answer: FALSE
LevelofDifficulty:3
LearningGoal:5
Topic:EBITEPSApproach

76.

Financialbreakevenpointrepresentsthelevelofearningsbeforeinterestandtaxesnecessaryforthe
firmtocoveritsfixedoperatingandfinancialchangesthatis,thepointatwhichearningspershare
(EPS)isequaltozero.
Answer: FALSE
LevelofDifficulty:3
LearningGoal:5
Topic:EBITEPSApproach

77.

Firmshavingstableandpredictablerevenuescanmoresafelyundertakehighlyleveragedcapital
structuresthancanfirmswithvolatilepatternsofsalesrevenue.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:6
Topic:BusinessRiskandCapitalStructure

78.

Theoperatingbreakevenpointcanbefoundbysolvingforthesaleslevelthatjustcoverstotalfixed
andvariablecosts.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:1
Topic:OperatingBreakevenpoint

237GitmanPrinciplesofFinance,EleventhEdition

79.

Bothoperatingandfinancialleverageresultinthemagnificationofreturnaswellasrisk.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:1
Topic:OperatingandFinancialLeverage

80.

Whileoperatingleverageresultsonlyinamagnificationofreturns,financialleverageresultsonlyin
amagnificationofrisk.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:1
Topic:OperatingandFinancialLeverage

81.

Thedollarbreakevensaleslevelcanbesolvedforbydividingfixedcostsbythecontributionmargin
ratio.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:1
Topic:OperatingBreakevenpoint

82.

Thedollarbreakevensaleslevelcanbesolvedforbydividingfixedcostsbythedollarcontribution
margin.
Answer: FALSE
LevelofDifficulty:3
LearningGoal:1
Topic:OperatingBreakevenpoint

83.

Holdingallotherfactorsconstant,afirmthatissubjecttoagreaterlevelofbusinessriskshould
employlessoperatingleveragethananotherwiseequivalentfirmthatissubjecttoalesserlevelof
businessrisk.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:2
Topic:BusinessRiskandOperatingLeverage

84.

Holdingallotherfactorsconstant,afirmthatissubjecttoagreaterlevelofbusinessriskshould
employmoreoperatingleveragethananotherwiseequivalentfirmthatissubjecttoalesserlevelof
businessrisk.
Answer: FALSE
LevelofDifficulty:3
LearningGoal:2
Topic:BusinessRiskandOperatingLeverage

85.

Holdingallotherfactorsconstant,afirmthatissubjecttoagreaterlevelofbusinessriskshould
employlessfinancialleveragethananotherwiseequivalentfirmthatissubjecttoalesserlevelof
businessrisk.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:2
Topic:BusinessRiskandFinancialLeverage

Chapter12LeverageandCapitalStructure238

86.

Holdingallotherfactorsconstant,afirmthatissubjecttoagreaterlevelofbusinessriskshould
employmorefinancialleveragethananotherwiseequivalentfirmthatissubjecttoalesserlevelof
businessrisk.
Answer: FALSE
LevelofDifficulty:3
LearningGoal:2
Topic:BusinessRiskandFinancialLeverage

87.

Holdingallotherfactorsconstant,afirmthatissubjecttoagreaterlevelofbusinessriskshould
employlesstotalleveragethananotherwiseequivalentfirmthatissubjecttoalesserlevelof
businessrisk.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:2
Topic:BusinessRiskandTotalLeverage

88.

Holdingallotherfactorsconstant,afirmthatissubjecttoagreaterlevelofbusinessriskshould
employmoretotalleveragethananotherwiseequivalentfirmthatissubjecttoalesserlevelof
businessrisk.
Answer: FALSE
LevelofDifficulty:3
LearningGoal:2
Topic:BusinessRiskandTotalLeverage

89.

Becauseoftheextensiveresearchconductedinrecentyearsintheareaofcapitalstructuretheory,it
isnowpossibleforfinancialmanagerstopinpointwithgreataccuracyafirmsoptimalcapital
structure.
Answer: FALSE
LevelofDifficulty:3
LearningGoal:3
Topic:CapitalStructureTheory

90.

Despitetheextensiveresearchconductedinrecentyearsintheareaofcapitalstructuretheory,itis
notyetpossibletoprovidefinancialmanagerswithaspecifiedmethodologyforuseindetermininga
firmsoptimalcapitalstructure.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:3
Topic:CapitalStructureTheory

91.

Ingeneral,afirmstheoreticaloptimalcapitalstructureisthatwhichbalancesthetaxbenefitsof
debtfinancingagainsttheincreaseprobabilityofbankruptcythatresultfromitsuse.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:3
Topic:CapitalStructureTheory

239GitmanPrinciplesofFinance,EleventhEdition

92.

Ingeneral,afirmstheoreticaloptimalcapitalstructureisthatwhichbalancesthetaxdisadvantage
ofdebtfinancingagainsttheincreaseprobabilityofbankruptcythatresultsfromitsuse.
Answer: FALSE
LevelofDifficulty:3
LearningGoal:3
Topic:CapitalStructureTheory

93.

Thepeckingorderexplanationofcapitalstructurestatesthatahierarchyoffinancingexistsforfirms
inwhichretainedearningsareemployedfirst,followedbydebtfinancingandfinallybyexternal
equityfinancing.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:3
Topic:PeckingOrderTheory

94.

Thepeckingorderexplanationofcapitalstructurestatesthatahierarchyoffinancingexistsforfirms
inwhichnewexternaldebtfinancingisemployedfirst,followedbyretainedearningsandfinallyby
externalequityfinancing.
Answer: FALSE
LevelofDifficulty:3
LearningGoal:3
Topic:PeckingOrderTheory

95.

Theasymmetricinformationexplanationofcapitalstructuresuggeststhatfirmswillissuenew
equityonlywhenthemanagersbelievethefirmsstockisovervalued;asaresult,issuingnewequity
isconsideredanegativesignalthatwillresultinadeclineinshareprice.
Answer: TRUE
LevelofDifficulty:4
LearningGoal:3
Topic:AsymmetricInformation

96.

Theasymmetricinformationexplanationofcapitalstructuresuggeststhatfirmswillissuenewdebt
onlywhenthemanagersbelievethefirmsstockisovervalued;asaresult,issuingnewdebtis
consideredanegativesignalthatwillresultinadeclineinshareprice.
Answer: FALSE
LevelofDifficulty:4
LearningGoal:3
Topic:AsymmetricInformation

97.

Intheory,afirmsoptimalcapitalstructureisthatwhichminimizedthefirmsoverallcostofcapital
resultinginamaximizationofthemarketvalueofthefirm.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:4
Topic:OptimalCapitalStructure

Chapter12LeverageandCapitalStructure240

98.

ThebasicshortcomingofEBITEPSanalysisisthatthismodelfocusesonthemaximizationof
earningsratherthanonthemaximizationofshareprice.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:5
Topic:EBITEPSAnalysis

99.

ThebasicshortcomingofEBITEPSanalysisisthatthismodelfocusesonthemaximizationof
stockreturnsratherthanonthemaximizationofshareprice.
Answer: FALSE
LevelofDifficulty:3
LearningGoal:5
Topic:EBITEPSAnalysis

100. Theoverridingobjectiveofthecapitalstructuredecisionshouldbetochoosethelevelofdebtthat
resultsinthelargestpossibleshareprice.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:4
Topic:OptimalCapitalStructure

.3

Multiple Choice Questions

1.

_________analysisisatechniqueusedtoassessthereturnsassociatedwithvariouscoststructures
andlevelsofsales.
(a) Timeseries
(b) Marginal
(c) Breakeven
(d) Ratio
Answer: C
LevelofDifficulty:1
LearningGoal:1
Topic:BreakevenAnalysis

2.

Earningsbeforeinterestandtaxes(EBIT)isadescriptivelabelfor
(a) operatingprofits.
(b) netprofitsbeforetaxes.
(c) earningspershare.
(d) grossprofits.
Answer: A
LevelofDifficulty:1
LearningGoal:1
Topic:EBITEPSAnalysis

241GitmanPrinciplesofFinance,EleventhEdition

3.

_________costsareafunctionoftime,notsales,andaretypicallycontractual.
(a) Fixed
(b) Semivariable
(c) Variable
(d) Operating
Answer: A
LevelofDifficulty:1
LearningGoal:1
Topic:OperatingLeverage

4.

_________costsareafunctionofvolume,nottime.
(a) Fixedoperating
(b) Semivariable
(c) Variable
(d) Fixedfinancial
Answer: C
LevelofDifficulty:1
LearningGoal:1
Topic:OperatingLeverage

5.

Thefirms_________isthelevelofsalesnecessarytocoveralloperatingcosts,i.e.,thepointat
whichEBIT$0.
(a) cashbreakevenpoint
(b) financialbreakevenpoint
(c) operatingbreakevenpoint
(d) totalbreakevenpoint
Answer: C
LevelofDifficulty:1
LearningGoal:1
Topic:OperatingBreakevenPoint

6.

WhichofthefollowingisNOTavariablecost?
(a) Materialsused.
(b) Rent.
(c) Deliverycosts.
(d) Directlabor.
Answer: B
LevelofDifficulty:1
LearningGoal:1
Topic:OperatingLeverage

Chapter12LeverageandCapitalStructure242

7.

_________costsrequirethepaymentofaspecifiedamountineachaccountingperiod.
(a) Operating
(b) Variable
(c) Semivariable
(d) Fixed
Answer: D
LevelofDifficulty:1
LearningGoal:1
Topic:OperatingLeverage

8.

Attheoperatingbreakevenpoint,_________equalszero.
(a) salesrevenue
(b) fixedoperatingcosts
(c) variableoperatingcosts
(d) earningsbeforeinterestandtaxes
Answer: D
LevelofDifficulty:1
LearningGoal:1
Topic:OperatingBreakevenPoint

9.

AfirmsoperatingbreakevenpointissensitivetoallofthefollowingvariablesEXCEPT
(a) fixedoperatingcosts.
(b) salespriceperunit.
(c) interestpayment.
(d) variableoperatingcostperunit.
Answer: C
LevelofDifficulty:1
LearningGoal:1
Topic:OperatingBreakevenPoint

10.

Breakevenanalysisisusedbythefirm
(a) todeterminethelevelofoperationsnecessarytocoveralloperatingcosts.
(b) toevaluatetheprofitabilityassociatedwithvariouslevelsofsales.
(c) Both(a)and(b).
(d) noneoftheabove.
Answer: C
LevelofDifficulty:2
LearningGoal:1
Topic:BreakevenAnalysis

243GitmanPrinciplesofFinance,EleventhEdition

11.

Ifafirmsfixedoperatingcostsdecrease,thefirmsoperatingbreakevenpointwill
(a) decrease.
(b) increase.
(c) remainunchanged.
(d) changeinanundetermineddirection.
Answer: A
LevelofDifficulty:2
LearningGoal:1
Topic:OperatingBreakevenPoint

12.

Ifafirmsvariablecostsperunitincrease,thefirmsoperatingbreakevenpointwill
(a) decrease.
(b) increase.
(c) remainunchanged.
(d) changeinanundetermineddirection.
Answer: B
LevelofDifficulty:2
LearningGoal:1
Topic:OperatingBreakevenPoint

13.

Ifafirmssalepriceperunitdecreases,thefirmsoperatingbreakevenpointwill
(a) decrease.
(b) increase.
(c) remainunchanged.
(d) changeinanundetermineddirection.
Answer: B
LevelofDifficulty:2
LearningGoal:1
Topic:OperatingBreakevenPoint

14.

Ifafirmsfixedfinancialcostsdecrease,thefirmsoperatingbreakevenpointwill
(a) decrease.
(b) increase.
(c) remainunchanged.
(d) changeinanundetermineddirection.
Answer: C
LevelofDifficulty:2
LearningGoal:1
Topic:OperatingBreakevenPoint

Chapter12LeverageandCapitalStructure244

15.

Thefirmsoperatingbreakevenpointisthepointatwhich
(a) totaloperatingcostsequaltotalfixedcosts.
(b) totaloperatingcostsarezero.
(c) EBITislessthansales.
(d) EBITiszero.
Answer: D
LevelofDifficulty:2
LearningGoal:1
Topic:OperatingBreakevenPoint

16.

Noncashchargessuchasdepreciationandamortization_________thefirmsbreakevenpoint.
(a) donotaffect
(b) overstate
(c) understate
(d) decrease
Answer: B
LevelofDifficulty:4
LearningGoal:1
Topic:OperatingBreakevenPoint

17.

Afirmhasfixedoperatingcostsof$525,000,ofwhich$125,000isdepreciationexpense.Thefirms
salespriceperunitis$35anditsvariablecostperunitis$22.50.Thefirmscashoperating
breakevenpointinunitsis
(a) 23,330.
(b) 32,000.
(c) 42,000.
(d) 52,000.
Answer: B
LevelofDifficulty:4
LearningGoal:1
Topic:CashOperatingBreakevenPoint(Equation12.1,Equation12.2andEquation12.3)

18.

Whichoneofthefollowingis(are)consideredaslimitationsofbreakevenanalysis?
(a) Itassumesthatthefirmfaceslinear,ornonvarying,salesrevenueandtotaloperatingcost
functions.
(b) Itisdifficulttobreaksemivariablecostsintofixedandvariablecomponents.
(c) Ithasashorttermtimehorizon.
(d) Alloftheabove.
Answer: D
LevelofDifficulty:4
LearningGoal:1
Topic:LimitationsofBreakevenAnalysis

245GitmanPrinciplesofFinance,EleventhEdition

19.

Amajorassumptionofbreakevenanalysisandonewhichcausesseverelimitationsinitsuseisthat
(a) fixedcostsreallyarefixed.
(b) totalrevenueisnonlinear.
(c) revenuesandoperatingcostsarelinear.
(d) allcostsarereallysemivariable.
Answer: C
LevelofDifficulty:4
LearningGoal:1
Topic:LimitationsofBreakevenAnalysis

20.

Theperdollarcontributiontowardfixedoperatingcostsandprofitsprovidedbyeachdollarofsales
isthe
(a) profitmargin.
(b) contributionmargin.
(c) expenseratio.
(d) fixedcoverageratio.
Answer: B
LevelofDifficulty:4
LearningGoal:1
Topic:ContributionMargin

21.

Afirmhasfixedoperatingcostsof$10,000,thesalepriceperunitofitsproductis$25,andits
variablecostperunitis$15.Thefirmsoperatingbreakevenpointinunitsis_________andits
breakevenpointindollarsis_________.
(a) 250;$6,250
(b) 400;$10,000
(c) 667;$16,675
(d) 1,000;$25,000
Answer: D
LevelofDifficulty:4
LearningGoal:1
Topic:OperatingBreakevenPoint(Equation12.1,Equation12.2andEquation12.3)

22.

Afirmhasfixedoperatingcostsof$150,000,totalsalesof$1,500,000,andtotalvariablecostsof
$1,275,000.Thefirmsoperatingbreakevenpointindollarsis
(a) $150,000.
(b) $176,471.
(c) $1,000,000.
(d) $1,425,000.
Answer: C
LevelofDifficulty:4
LearningGoal:1
Topic:DollarOperatingBreakevenPoint(Equation12.1,Equation12.2andEquation12.3)

Chapter12LeverageandCapitalStructure246

23.

Afirmhasfixedoperatingcostsof$253,750,asalespriceperunitof$100,andavariablecostper
unitof$65.Thefirmsoperatingbreakevenpointindollarsis
(a) $725,000.
(b) $700,000.
(c) $906,250.
(d) $390,385.
Answer: A
LevelofDifficulty:4
LearningGoal:1
Topic:DollarOperatingBreakevenPoint(Equation12.1,Equation12.2andEquation12.3)

24.

Onefunctionofbreakevenanalysisisto
(a) createprofits.
(b) describeleverage.
(c) evaluatetheprofitabilityofvarioussaleslevels.
(d) determinetheamountoffinancingneededbythefirm.
Answer: C
LevelofDifficulty:4
LearningGoal:1
Topic:BreakevenAnalysis

25.

Thepreferredapproachtobreakevenanalysisforthemultiproductfirmisthe
(a) breakevenpointexpressedinunits.
(b) breakevenpointexpressedindollars.
(c) cashbreakevenpoint.
(d) overallbreakevenpoint.
Answer: B
LevelofDifficulty:4
LearningGoal:1
Topic:DollarOperatingBreakevenPoint

26.

Afirmhasfixedoperatingcostsof$25,000,aperunitsalespriceof$5,andavariablecostperunit
of$3.Whatisitsoperatingbreakevenpointifitdesiresnetoperatingincomeof$10,000,not$0
(zero)?
(a) 12,500units.
(b) 15,000units.
(c) 17,500units.
(d) 25,000units.
Answer: C
LevelofDifficulty:4
LearningGoal:1
Topic:OperatingBreakevenPoint(Equation12.1,Equation12.2andEquation12.3)

247GitmanPrinciplesofFinance,EleventhEdition

27.

Thelongtermfundsofthefirmarecalled
(a) debt.
(b) assets.
(c) capital.
(d) equity.
Answer: C
LevelofDifficulty:1
LearningGoal:2
Topic:CapitalStructureBasics

28.

_________resultsfromtheuseoffixedcostassetsorfundstomagnifyreturnstothefirmsowners.
(a) Longtermdebt
(b) Equity
(c) Leverage
(d) Capitalstructure
Answer: C
LevelofDifficulty:1
LearningGoal:2
Topic:CapitalStructureBasics

29.

_________leverageisconcernedwiththerelationshipbetweensalesrevenuesandearningsbefore
interestandtaxes.
(a) Financial
(b) Operating
(c) Variable
(d) Total
Answer: B
LevelofDifficulty:1
LearningGoal:2
Topic:OperatingLeverage

30.

_________leverageisconcernedwiththerelationshipbetweensalesrevenueandearningsper
share.
(a) Financial
(b) Operating
(c) Variable
(d) Total
Answer: D
LevelofDifficulty:1
LearningGoal:2
Topic:TotalLeverage

Chapter12LeverageandCapitalStructure248

31.

_________leverageisconcernedwiththerelationshipbetweenearningsbeforeinterestandtaxes
andearningspershare.
(a) Financial
(b) Operating
(c) Variable
(d) Total
Answer: A
LevelofDifficulty:1
LearningGoal:2
Topic:FinancialLeverage

32.

_________isthepotentialuseoffixedoperatingcoststomagnifytheeffectsofchangesinsaleson
earningsbeforeinterestandtaxes.
(a) Financialleverage
(b) Operatingleverage
(c) Totalleverage
(d) Ratioanalysis
Answer: B
LevelofDifficulty:1
LearningGoal:2
Topic:OperatingLeverage

33.

_________isthepotentialuseoffixedfinancialchargestomagnifytheeffectsofchangesin
earningsbeforeinterestandtaxesonthefirmsearningspershare.
(a) Financialleverage
(b) Operatingleverage
(c) Totalleverage
(d) Debtservice
Answer: A
LevelofDifficulty:1
LearningGoal:2
Topic:FinancialLeverage

34.

Fixedfinancialchargesinclude
(a) commonstockdividendsandbondinterestexpense.
(b) commonstockdividendsandpreferredstockdividends.
(c) bondinterestexpenseandpreferredstockdividends.
(d) stockrepurchaseexpense.
Answer: C
LevelofDifficulty:1
LearningGoal:2
Topic:FinancialLeverage

249GitmanPrinciplesofFinance,EleventhEdition

35.

Adecreaseinfixedfinancialcostswillresultin_________infinancialrisk.
(a) anincrease
(b) adecrease
(c) nochange
(d) anundeterminedchange
Answer: B
LevelofDifficulty:1
LearningGoal:2
Topic:FinancialLeverage

36.

Thethreebasictypesofleverageare
(a) operating,production,andfinancial.
(b) operating,production,andtotal.
(c) production,financial,andtotal.
(d) operating,financial,andtotal.
Answer: D
LevelofDifficulty:1
LearningGoal:2
Topic:TypesofLeverage

37.

Thehigherfinancialleveragecauses_________toincreasemoreforagivenincreasein_________.
(a) EBIT;sales
(b) EPS;sales
(c) EPS;EBIT
(d) EBIT;EPS
Answer: C
LevelofDifficulty:1
LearningGoal:2
Topic:FinancialLeverage

38.

_________isthepotentialuseoffixedcosts,bothoperatingandfinancial,tomagnifytheeffectof
changesinsalesonthefirmsearningspershare.
(a) Debtservice
(b) Totalleverage
(c) Operatingleverage
(d) Financialleverage
Answer: B
LevelofDifficulty:2
LearningGoal:2
Topic:TotalLeverage

Chapter12LeverageandCapitalStructure250

39.

Asfixedoperatingcostsincreaseandallotherfactorsareheldconstant,thedegreeofoperating
leveragewill
(a) increase.
(b) decrease.
(c) remainunchanged.
(d) changeinanundetermineddirection.
Answer: A
LevelofDifficulty:2
LearningGoal:2
Topic:OperatingLeverage

40.

Throughtheeffectsoffinancialleverage,whenEBITincreases,earningspersharewill
(a) increase.
(b) decrease.
(c) remainunchanged.
(d) changeinanundetermineddirection.
Answer: A
LevelofDifficulty:2
LearningGoal:2
Topic:FinancialLeverage

41.

Withtheexistenceoffixedoperatingcosts,adecreaseinsaleswillresultin_________inEBIT.
(a) aproportionalincrease
(b) anequalincrease
(c) alessthanproportionaldecrease
(d) amorethanproportionaldecrease
Answer: D
LevelofDifficulty:3
LearningGoal:2
Topic:OperatingLeverage

42.

Anincreaseinfixedoperatingcostswillresultin_________inthedegreeofoperatingleverage.
(a) adecrease
(b) anincrease
(c) nochange
(d) anundeterminedchange
Answer: B
LevelofDifficulty:3
LearningGoal:2
Topic:OperatingLeverage

251GitmanPrinciplesofFinance,EleventhEdition

43.

Afirmhasfixedoperatingcostsof$650,000,asalespriceperunitof$20,andavariablecost
perunitof$13.Atabasesaleslevelof500,000units,thefirmsdegreeofoperatingleverage
is_________.
(a) 1.07
(b) 1.11
(c) 1.18
(d) 1.23
Answer: D
LevelofDifficulty:3
LearningGoal:2
Topic:DegreeofOperatingLeverage(Equation12.4andEquation12.5)

44.

Afirmhasfixedoperatingcostsof$175,000,totalsalesrevenueof$3,000,000andtotalvariable
costsof$2,250,000.Thefirmsdegreeofoperatingleverageis_________.
(a) 0.77
(b) 1.30
(c) 0.81
(d) 4.29
Answer: B
LevelofDifficulty:3
LearningGoal:2
Topic:DegreeofOperatingLeverage(Equation12.4andEquation12.5)

45.

AfirmhasEBITof$375,000,interestexpenseof$75,000,preferreddividendsof$6,000anda
taxrateof40percent.ThefirmsdegreeoffinancialleverageatabaseEBITlevelof$375,000
is_________.
(a) 0.97
(b) 1.29
(c) 1.27
(d) 1.09
Answer: B
LevelofDifficulty:3
LearningGoal:2
Topic:DegreeofFinancialLeverage(Equation12.6and12.7)

46.

Adecreaseinfixedoperatingcostswillresultin_________inthedegreeoffinancialleverage.
(a) adecrease
(b) anincrease
(c) nochange
(d) anundeterminedchange
Answer: D
LevelofDifficulty:3
LearningGoal:2
Topic:DegreeofFinancialLeverage

Chapter12LeverageandCapitalStructure252

47.

Atabasesaleslevelof$400,000,afirmhasadegreeofoperatingleverageof2andadegreeof
financialleverageof1.5.Thefirmsdegreeoftotalleverageis_________.
(a) 3.5
(b) 3.0
(c) 0.5
(d) 1.3
Answer: B
LevelofDifficulty:3
LearningGoal:2
Topic:DegreeofTotalLeverage(Equation12.4andEquation12.5)

48.

Generally,_________inleverageresultin_________returnand_________risk.
(a) increases;decreased;increased
(b) increases;decreased;decreased
(c) increases;increased;increased
(d) decreases;increased;decreased
Answer: C
LevelofDifficulty:3
LearningGoal:2
Topic:Leverage,ReturnandRisk

49.

Withtheexistenceoffixedoperatingcosts,anincreaseinsaleswillresultin_________increasein
EBIT.
(a) aproportional
(b) anequal
(c) alessthanproportional
(d) amorethanproportional
Answer: D
LevelofDifficulty:3
LearningGoal:2
Topic:OperatingLeverage

50.

Afirmhasinterestexpenseof$145,000,preferreddividendsof$25,000,andataxrateof
40percent.Thefirmsfinancialbreakevenpointis
(a) $25,000.
(b) $170,000.
(c) $186,667.
(d) $145,000.
Answer: C
LevelofDifficulty:3
LearningGoal:2
Topic:FinancialBreakevenPoint

253GitmanPrinciplesofFinance,EleventhEdition

51.

Becausethedegreeoftotalleverageismultiplicativeandnotadditive,whenafirmhasveryhigh
operatingleverageitcanmoderateitstotalriskby
(a) increasingsales.
(b) usingmorefinancialleverage.
(c) increasingEBIT.
(d) usingalowerleveloffinancialleverage.
Answer: D
LevelofDifficulty:3
LearningGoal:2
Topic:DegreeofTotalLeverage

52.

Thefirms_________isthemixoflongtermdebtandequityutilizedbythefirm,whichmay
significantlyaffectitsvaluebyaffectingreturnandrisk.
(a) dividendpolicy
(b) capitalbudget
(c) capitalstructure
(d) workingcapital
Answer: C
LevelofDifficulty:1
LearningGoal:3
Topic:CapitalStructureBasics

53.

ThebasicsourcesofcapitalforafirmincludeallofthefollowingEXCEPT
(a) longtermdebt.
(b) preferredstock.
(c) currentliabilities.
(d) commonstock.
Answer: C
LevelofDifficulty:1
LearningGoal:3
Topic:CapitalStructureBasics

54.

Intheory,thefirmshouldmaintainfinancialleverageconsistentwithacapitalstructurethat
(a) meetstheindustrystandard.
(b) maximizestheearningspershare.
(c) maximizestheownerswealth.
(d) maximizesdividends.
Answer: C
LevelofDifficulty:1
LearningGoal:3
Topic:CapitalStructureBasics

Chapter12LeverageandCapitalStructure254

55.

_________riskistheriskofbeingunabletocoveroperatingcosts.
(a) Business
(b) Financial
(c) Leverage
(d) Total
Answer: A
LevelofDifficulty:1
LearningGoal:3
Topic:BusinessRisk

56.

BusinessriskisaffectedbyallofthefollowingEXCEPT
(a) revenuestability.
(b) coststability.
(c) operatingleverage.
(d) earningspershare.
Answer: D
LevelofDifficulty:1
LearningGoal:3
Topic:BusinessRisk

57.

AllofthefollowingaffectbusinessriskEXCEPT
(a) operatingleverage.
(b) interestratestability.
(c) coststability.
(d) revenuestability.
Answer: B
LevelofDifficulty:1
LearningGoal:3
Topic:BusinessRisk

58.

_________riskistheriskofbeingunabletocoverfinancialcosts.
(a) Business
(b) Financial
(c) Total
(d) Leverage
Answer: B
LevelofDifficulty:1
LearningGoal:3
Topic:FinancialRisk

255GitmanPrinciplesofFinance,EleventhEdition

59.

Aftersatisfyingobligationstocreditors,thegovernment,andpreferredstockholders,anyremaining
earningswillmostlikelybeallocatedtoanyofthefollowingEXCEPT
(a) commonshareholdersascashdividends.
(b) commonshareholdersasstockdividends.
(c) retainedbythefirmforfutureinvestment.
(d) acombinationofretainedearningsandcashdividends.
Answer: B
LevelofDifficulty:2
LearningGoal:3
Topic:ConceptofCapitalStructure

60.

Thelowerrisknatureoflongtermdebtinafirmscapitalstructureisduetothefactthat
(a) theequityholdersarethetrueownersofthefirm.
(b) equitycapitalhasafixedreturn.
(c) creditorshaveahigherpositioninthepriorityofclaims.
(d) dividendpaymentsaretaxdeductible.
Answer: C
LevelofDifficulty:2
LearningGoal:3
Topic:ConceptofCapitalStructure

61.

WhichofthefollowingisNOTareasonwhydebtcapitalisconsideredtobetheleastriskysource
ofcapital?
(a) Ithasahighpriorityclaimagainstassetsandearnings.
(b) Ithasastronglegalposition.
(c) Itisalowcostsourceofcapitalbecauseinterestpaymentsaretaxdeductible.
(d) Itdoesnotnormallyhavetoberepaidataspecificfuturedate.
Answer: D
LevelofDifficulty:2
LearningGoal:3
Topic:ConceptofCapitalStructure

62.

Probabilityofbankruptcyisdeterminedby
(a) financialrisk.
(b) totalrisk.
(c) businessrisk.
(d) interestraterisk.
Answer: B
LevelofDifficulty:2
LearningGoal:3
Topic:FinancialRisk

Chapter12LeverageandCapitalStructure256

63.

Theinexpensivenatureoflongtermdebtinafirmscapitalstructureisduetothefactthat
(a) theequityholdersarethetrueownersofthefirm.
(b) equitycapitalhasafixedreturn.
(c) creditorshaveahigherpositioninthepriorityofclaims.
(d) dividendpaymentsaretaxdeductible.
Answer: C
LevelofDifficulty:2
LearningGoal:3
Topic:ConceptofCapitalStructure

64.

Theinexpensivenatureoflongtermdebtinafirmscapitalstructureisduetothefactthat
(a) theequityholdersarethetrueownersofthefirm.
(b) equitycapitalhasafixedreturn.
(c) interestpaymentsaretaxdeductible.
(d) equityholdershaveahigherpositioninthepriorityofclaims.
Answer: C
LevelofDifficulty:2
LearningGoal:3
Topic:ConceptofCapitalStructure

65.

ThekeydifferencesbetweendebtandequitycapitalincludeallofthefollowingEXCEPT
(a) voiceinmanagement.
(b) maturity.
(c) taxtreatment.
(d) effectonoperatingleverage.
Answer: D
LevelofDifficulty:2
LearningGoal:3
Topic:ConceptofCapitalStructure

66.

Thecostofdebtfinancingresultsfrom
(a) theincreasedprofitabilityofbankruptcycausedbydebtobligations.
(b) theagencycostsofthelendersmonitoringandcontrollingthefirmsactions.
(c) thecostsassociatedwithmanagershavingmoreinformationaboutthefirmsprospectsthando
investors.
(d) Alloftheabove.
Answer: D
LevelofDifficulty:3
LearningGoal:3
Topic:CostofDebtFinancing

257GitmanPrinciplesofFinance,EleventhEdition

67.

Acorporationborrows$1,000,000at10percentannualrateofinterest.Thefirmhasa40percent
taxrate.Theyearly,aftertaxcostofthisdebtis
(a) $40,000.
(b) $60,000.
(c) $100,000.
(d) $166,667.
Answer: B
LevelofDifficulty:3
LearningGoal:3
Topic:CostofDebtFinancing

68.

Acorporationhas$5,000,000of8percentpreferredstockoutstandinganda40percenttaxrate.The
aftertaxcostofthepreferredstockis
(a) $400,000.
(b) $240,000.
(c) $666,667.
(d) $160,000.
Answer: A
LevelofDifficulty:3
LearningGoal:3
Topic:CostofPreferredStockFinancing

69.

Acorporationhas$10,000,000of10percentpreferredstockoutstandinganda40percenttaxrate.
Theamountofearningsbeforeinterestandtaxes(EBIT)requiredtopaythepreferreddividendsis
(a) $1,000,000.
(b) $400,000.
(c) $600,000.
(d) $1,666,667.
Answer: D
LevelofDifficulty:3
LearningGoal:3
Topic:CostofPreferredStockFinancing

70.

Acorporationhas$5,000,000of10percentbondsand$3,000,000of12percentpreferredstock
outstanding.Thefirmsfinancialbreakeven(assuminga40percenttaxrate)is
(a) $860,000.
(b) $716,000.
(c) $1,100,000.
(d) $1,400,000
Answer: C
LevelofDifficulty:3
LearningGoal:3
Topic:FinancialBreakevenPoint

Chapter12LeverageandCapitalStructure258

71.

Theconflictresultingfromamanagersdesiretoincreasethefirmsriskwithoutincreasingcurrent
borrowingcostsandlendersdesiretolimitlendingisoneeffectofthe_________problem.
(a) agency
(b) leverage
(c) capital
(d) variablecost
Answer: A
LevelofDifficulty:3
LearningGoal:3
Topic:OptimalCapitalStructure

72.

Operatingandfinancialconstraintsplacedonacorporationbyloanprovisionare
(a) agencycoststothelender.
(b) agencycoststothefirm.
(c) interestratecoststothefirm.
(d) necessarytocontroltheriskofthefirm.
Answer: B
LevelofDifficulty:3
LearningGoal:3
Topic:AgencyCostsandCapitalStructure

73.

Theriskofthedebtcapitalislessthanthatofotherlongtermcontributorsofcapitalbecause
(a) theyhaveahigherpriorityofclaimagainstanyearningsorassetsavailableforpayment.
(b) theyhaveafarstrongerlegalpressureagainstthecompanytomakepaymentthandopreferred
andcommonstockholders.
(c) thetaxdeductibilityofinterestpaymentslowersthedebtcosttothefirmsubstantially.
(d) alloftheabove.
Answer: D
LevelofDifficulty:3
LearningGoal:3
Topic:CostofDebtFinancing

74.

Managementhasjustdiscoveredanexcellentinvestmentforwhichitneedsadditionalfunding.
Relativetothediscussiononasymmetricinformationthefirmshould
(a) financewithnewcommonstockifmanagementbelievesthefirmisundervalued.
(b) financewithdebtifmanagementbelievesthefirmisundervalued.
(c) financewithdebtifmanagementbelievesthefirmisovervalued.
(d) financewithpreferredstockifthefirmisatvalue.
Answer: B
LevelofDifficulty:4
LearningGoal:3
Topic:AsymmetricInformationandCapitalStructure

259GitmanPrinciplesofFinance,EleventhEdition

75.

Inordertoenhancethewealthofstockholdersandtosendpositivesignalstothemarket,
corporationsgenerallyraisefundsusingthefollowingorder.
(a) Retainedearnings,equity,debt.
(b) Retainedearnings,debt,equity.
(c) Debt,retainedearnings,equity.
(d) Equity,retainedearnings,debt.
Answer: B
LevelofDifficulty:3
LearningGoal:4
Topic:AsymmetricInformationandCapitalStructure

76.

Theoptimalcapitalstructureistheonethatbalances
(a) returnandriskfactorsinordertomaximizeprofits.
(b) returnandriskfactorsinordertomaximizeearningspershare.
(c) returnandriskfactorsinordertomaximizemarketvalue.
(d) returnandriskfactorsinordertomaximizedividends.
Answer: C
LevelofDifficulty:3
LearningGoal:4
Topic:OptimalCapitalStructure

77.

Asdebtissubstitutedforequityinthecapitalstructureandthedebtratioincreases,allofthe
followingstatementsaboutthecomponentcostsofcapitalaretrueEXCEPT
(a) thecostofequitycontinuallyincreases.
(b) thecostofdebtcontinuallyincreases.
(c) theoverallcostofcapitalfirstdeclines,reachesaminimum,andthenrisesagain.
(d) theoverallcostofcapitalcontinuallyincreases.
Answer: D
LevelofDifficulty:3
LearningGoal:4
Topic:OptimalCapitalStructure

78.

Poorcapitalstructuredecisionscanresultin_________thecostofcapital,resultingin_________
acceptableinvestments.Effectivecapitalstructuredecisionscan_________thecostofcapital,
resultingin_________acceptableinvestments.
(a) increasing;fewer;lower;more
(b) decreasing;more;higher;fewer
(c) increasing;more;lower,fewer
(d) decreasing;fewer;higher;more
Answer: A
LevelofDifficulty:3
LearningGoal:4
Topic:OptimalCapitalStructure

Chapter12LeverageandCapitalStructure260

79.

Accordingtothetraditionalapproachtocapitalstructure,thevalueofthefirmwillbemaximized
when
(a) thefinancialleverageismaximized.
(b) thecostofdebtisminimized.
(c) theweightedaveragecostofcapitalisminimized.
(d) thedividendpayoutismaximized.
Answer: C
LevelofDifficulty:3
LearningGoal:4
Topic:TraditionalApproachtoCapitalStructure

80.

Inthetraditionalapproachtocapitalstructure,astheamountofdebtincreasesinafirmscapital
structure,
(a) thecostofequityrisesfasterthanthecostofdebt.
(b) thecostofdebtrisesfasterthanthecostofequity.
(c) debtbecomeslessrisky.
(d) equitycostisunaffected.
Answer: A
LevelofDifficulty:3
LearningGoal:4
Topic:TraditionalApproachtoCapitalStructure

81.

Asdebtissubstitutedforequityinthecapitalstructureandthedebtratioincreases,thebehaviorof
theoverallcostofcapitalispartiallyexplainedby
(a) thetaxdeductibilityofinterestpayments.
(b) theincreaseinthenumberofcommonsharesoutstanding.
(c) thereductioninriskasperceivedbythecommonshareholders.
(d) thedecreaseinthecostofequity.
Answer: A
LevelofDifficulty:3
LearningGoal:4
Topic:TraditionalApproachtoCapitalStructure

82.

Thecontroversyovertheexistenceofanoptimalcapitalstructureisdebatedbetweenthose
_________whobelieveatraditionalapproachexistsandthose_________,whodonotbelieveone
exists.Inthe_________approachtocapitalstructure,theoptimalcapitalstructureoccurswherethe
_________isminimized.
(a) supportersofModiglianiandMiller;traditionalists;ModiglianiandMiller;degreeoffinancial
leverage.
(b) traditionalists;supportersofModiglianiandMiller;traditional;costofcapital
(c) supportersofModiglianiandMiller;traditionalists;ModiglianiandMiller;costofcapital
(d) traditionalists;supportersofModiglianiandMiller;traditional;degreeoffinancialleverage
Answer: B
LevelofDifficulty:4
LearningGoal:4
Topic:TraditionalApproachversusMMApproachtoCapitalStructure

261GitmanPrinciplesofFinance,EleventhEdition

83.

Afirmhasanoperatingprofitof$300,000,interestof$35,000,andataxrateof40percent.The
firmhasanaftertaxcostofdebtof5percentandacostofequityof15percent.Thefirmstarget
capitalstructureissetatamixof40percentdebtand60percentequity.Accordingtothetraditional
approachtocapitalstructure,thevalueofthefirmis
(a) $1.4million.
(b) $2.0million.
(c) $2.7million.
(d) $6.0million.
Answer: C
LevelofDifficulty:4
LearningGoal:4
Topic:TraditionalApproachtoCapitalStructure

84.

IntheEBITEPSapproachtocapitalstructure,riskisrepresentedby
(a) shiftsinthecostofequitycapital.
(b) shiftsinthecostofdebtcapital.
(c) theslopeofthecapitalstructureline.
(d) shiftsinthetimesinterestearnedratio.
Answer: C
LevelofDifficulty:2
LearningGoal:5
Topic:EBITEPSApproachtoCapitalStructure

85.

IntheEBITEPSapproachtocapitalstructure,aconstantlevelofEBITisassumed
(a) toeasethecalculationsofownersequity.
(b) toisolatetheimpactonreturnsofthefinancingcostsassociatedwithalternativecapital
structures.
(c) toemphasizetherelationshipbetweeninterestexpensesandtaxes.
(d) toconcentrateontheeffectofrevenueandexpenseoncapitalstructuredecisions.
Answer: B
LevelofDifficulty:3
LearningGoal:5
Topic:EBITEPSApproachtoCapitalStructure

86.

Afirmhasacurrentcapitalstructureconsistingof$400,000of12percentannualinterestdebtand
50,000sharesofcommonstock.Thefirmstaxrateis40percentonordinaryincome.IftheEBITis
expectedtobe$200,000,thefirmsearningspersharewillbe_________.
(a) $2.40
(b) $3.04
(c) $7.04
(d) $1.82
Answer: D
LevelofDifficulty:3
LearningGoal:5
Topic:EBITEPSApproachtoCapitalStructure

Chapter12LeverageandCapitalStructure262

87.

ThemajorshortcomingoftheEBITEPSapproachtocapitalstructureisthat
(a) thetechniquedoesnotpromotethemaximizationofshareholderwealth.
(b) thetechniquedoesnotconsiderthecostofcapital.
(c) thetechniqueonlyconsidersleveragerelatedrisk.
(d) thetechniquedoesnotmaximizeearningspershare.
Answer: A
LevelofDifficulty:3
LearningGoal:5
Topic:EBITEPSApproachtoCapitalStructure

88.

The_________approachtocapitalstructureproposesthatanoptimalcapitalstructurebeselected
which_________.
(a) MandM;maximizestheweightedaveragecostofcapital
(b) traditional;minimizesthecostofdebt
(c) EBITEPS;maximizestheEPS
(d) residualtheory;minimizesdividends
Answer: C
LevelofDifficulty:3
LearningGoal:5
Topic:EBITEPSApproachtoCapitalStructure

89.

Afirmhasacurrentcapitalstructureconsistingof$400,000of12percentannualinterestdebtand
50,000sharesofcommonstock.Thefirmstaxrateis40percentonordinaryincome.IftheEBITis
expectedtobe$200,000,twoEBITEPScoordinatesforthefirmsexistingcapitalstructureare
(a) ($36,000,$0)and($200,000,$3.04).
(b) ($48,000,$0)and($200,000,$1.82).
(c) ($0,$48,000)and($200,000,$1.82).
(d) ($152,000,$3.50)and($150,000,$1.82).
Answer: B
LevelofDifficulty:3
LearningGoal:5
Topic:EBITEPSApproachtoCapitalStructure

90.

ThebasicshortcomingoftheEBITEPSapproachtocapitalstructureis
(a) thattheoptimalcapitalstructureisdifficulttocompute.
(b) itsdisregardforthepresenceofpreferredstockinthecapitalstructure.
(c) itsdisregardforthefirmsdividendpolicy.
(d) thatitconcentratesonthemaximizationofEPSratherthanthemaximizationofownerswealth.
Answer: D
LevelofDifficulty:3
LearningGoal:5
Topic:EBITEPSApproachtoCapitalStructure

263GitmanPrinciplesofFinance,EleventhEdition

91.

Afirmisanalyzingtwopossiblecapitalstructures30and50percentdebtratios.Thefirmhastotal
assetsof$5,000,000andcommonstockvaluedat$50pershare.Thefirmhasamarginaltaxrateof
40percentonordinaryincome.Thenumberofcommonsharesoutstandingforeachofthecapital
structureswouldbe
(a) 30percentdebtratio:30,000sharesand50percentdebtratio:50,000shares.
(b) 30percentdebtratio:50,000sharesand50percentdebtratio:70,000shares.
(c) 30percentdebtratio:70,000sharesand50percentdebtratio:100,000shares.
(d) 30percentdebtratio:70,000sharesand50percentdebtratio:50,000shares.
Answer: D
LevelofDifficulty:4
LearningGoal:5
Topic:CapitalStructureAnalysis

92.

Afirmisanalyzingtwopossiblecapitalstructures30and50percentdebtratios.Thefirmhastotal
assetsof$5,000,000andcommonstockvaluedat$50pershare.Thefirmhasamarginaltaxrateof
40percentonordinaryincome.Iftheinterestrateondebtis7percentand9percentforthe30
percentandthe50percentdebtratios,respectively,theamountofinterestonthedebtundereachof
thecapitalstructuresbeingconsideredwouldbe
(a) 30percentdebtratio:$105,000and50percentdebtratio:$225,000.
(b) 30percentdebtratio:$245,000and50percentdebtratio:$225,000.
(c) 30percentdebtratio:$105,000and50percentdebtratio:$250,000.
(d) 30percentdebtratio:$135,000and50percentdebtratio:$175,000.
Answer: A
LevelofDifficulty:4
LearningGoal:5
Topic:CapitalStructureAnalysis

93.

Financialleveragemeasurestheeffectoffixedfinancingcostsontherelationshipbetween
(a) SalesandEBIT.
(b) SalesandEPS.
(c) EBITandEPS.
(d) noneoftheabove.
Answer: C
LevelofDifficulty:2
LearningGoal:2
Topic:FinancialLeverage

94.

Operatingleveragemeasurestheeffectoffixedfinancingcostsontherelationshipbetween
(a) SalesandEBIT.
(b) SalesandEPS.
(c) EBITandEPS.
(d) noneoftheabove.
Answer: D
LevelofDifficulty:3
LearningGoal:2
Topic:OperatingLeverage

Chapter12LeverageandCapitalStructure264

95.

Operatingleveragemeasurestheeffectoffixedoperatingcostsontherelationshipbetween
(a) SalesandEBIT.
(b) SalesandEPS.
(c) EBITandEPS.
(d) noneoftheabove.
Answer: A
LevelofDifficulty:2
LearningGoal:2
Topic:OperatingLeverage

96.

Financialleveragemeasurestheeffectoffixedoperatingcostsontherelationshipbetween
(a) SalesandEBIT.
(b) SalesandEPS.
(c) EBITandEPS.
(d) noneoftheabove.
Answer: D
LevelofDifficulty:3
LearningGoal:2
Topic:FinancialLeverage

97.

Totalleveragemeasurestheeffectoffixedcostsontherelationshipbetween
(a) SalesandEBIT.
(b) SalesandEPS.
(c) EBITandEPS.
(d) noneoftheabove.
Answer: B
LevelofDifficulty:2
LearningGoal:2
Topic:TotalLeverage

98.

TonysBeachTShirtshasfixedannualoperatingcostsof$75,000.TonyretailshisTshirtsfor
$14.99eachandthevariablecostperTshirtis$4.99.Basedonthisinformation,thebreakevensales
levelindollarsis
(a) $125,495.
(b) $112,425.
(c) $108,995.
(d) noneoftheabove.
Answer: B
LevelofDifficulty:3
LearningGoal:1
Topic:DollarOperatingBreakevenPoint(Equation12.1,Equation12.2andEquation12.3)

265GitmanPrinciplesofFinance,EleventhEdition

99.

TonysBeachTShirtshasfixedannualoperatingcostsof$75,000.TonyretailshisTshirtsfor
$14.99eachandthevariablecostperTshirtis$4.99.Basedonthisinformation,thebreakevensales
levelinunitsis
(a) 7,500.
(b) 15,030.
(c) 5,003.
(d) noneoftheabove.
Answer: A
LevelofDifficulty:2
LearningGoal:1
Topic:OperatingBreakevenPoint(Equation12.1,Equation12.2andEquation12.3)

100. NicoTradingCompanymustchooseitsoptimalcapitalstructure.Currently,thefirmhasa20
percentdebtratioandthefirmexpectstogenerateadividendnextyearof$5.44pershare.
Dividendsareexpectedtoremainatthislevelindefinitely.Stockholderscurrentlyrequirea
12.1percentreturnontheirinvestment.Nicoisconsideringchangingitscapitalstructureifitwould
benefitshareholders.Thefirmestimatesthatifitincreasesthedebtratioto30percent,itwill
increaseitsexpecteddividendto$5.82pershare.Again,dividendsareexpectedtoremainatthis
newlevelindefinitely.However,becauseoftheaddedrisk,therequiredreturndemandedby
stockholderswillincreaseto12.6percent.Basedonthisinformation,shouldNicomakethechange?
(a) Yes.
(b) No.
(c) Itsirrelevant.
(d) Notenoughinformation.
Answer: A
LevelofDifficulty:4
LearningGoal:6
Topic:OptimalCapitalStructureandShareholderWealthMaximization(Equation12.12)

.4

Essay Questions

1.

TheMajesticBlindCo.sellsitsfinishedproductforanaverageof$35perunitwithavariablecost
perunitof$21.Thecompanyhasfixedoperatingcostsof$1,050,000.
(a) Calculatethefirmsoperatingbreakevenpointinunits.
(b) Calculatethefirmsoperatingbreakevenpointindollars.
(c) Using100,000unitsasabase,whatisthefirmsdegreeofoperatingleverage?

Chapter12LeverageandCapitalStructure266

Answers:
FC
$1,050,000

75,000 units
P VC $35 $21
FC
$1,050,000

$2,625,000
(b) D
(1 TVC/TR) (1 $21/35)
Q(P VC)
(c) DOLatbasesaleslevelof100,000units.
Q(P VC) FC
(a) Q

100,000($35 $21)
100,000($35 21) $1,050,000
4.0

LevelofDifficulty:3
LearningGoal:2
Topic:OperatingBreakevenAnalysis(Equation12.1,Equation12.2andEquation12.3)
2.

RMM,Inc.isconsideringpurchasingasmallfirminthesamelineofbusiness.Thepurchasewould
befinancedbythesaleofcommonstockorabondissue.Thefinancialmanagerneedstoevaluate
howthetwoalternativefinancingplanswillaffecttheearningspotentialofthefirm.Totalfinancing
requiredis$4.5million.Thefirmcurrentlyhas$20,000,000of12percentbondsand600,000
commonsharesoutstanding.Thefirmcanarrangefinancingofthe$4.5millionthrougha14percent
bondissueorthesaleof100,000sharesofcommonstock.Thefirmhasa40percenttaxrate.
(a) Whatisthedegreeoffinancialleverageforeachplanat$7,000,000ofEBIT?
(b) Whatisthefinancialbreakevenpointforeachplan?
Answers:
7,000,000
1.76
7,000,000 3,030,000
7,000,000
DFLatbaselevelEBIT(stockIssue)
1.52
7,000,000 2,400,000
(b) FinancialBreakevenPoint(BondIssue)$3,030,000
FinancialBreakevenPoint(StockIssue)$2,400,000
(a) DFLatbaselevelEBIT(BondIssue)

LevelofDifficulty:3
LearningGoal:2
Topic:FinancialLeverageandFinancialBreakeven(Equation12.6andEquation12.7)
3.

LittleLAM,Inc.hasdecidedtoinvest$10,000,000inanewheadquartersandneedstodetermine
thebestwaytofinancetheconstruction.Thefirmcurrentlyhas$50,000,000of10percentbonds
and4,000,000commonsharesoutstanding.Thefirmcanobtainthe$10,000,000offinancing
througha10percentbondissueorthesaleof1,000,000sharesofcommonstock.Thefirmhasa
40percenttaxrate.
(a) Whatisthedegreeoffinancialleverageforeachplanat$25,000,000ofEBIT?
(b) Whatisthefinancialbreakevenpointforeachplan?

267GitmanPrinciplesofFinance,EleventhEdition

Answers:
(a) Bondissueinterest10,000,000(0.10)$1,000,000
5,000,000
Currentinterest50,000,000(0.10)
$6,000,000
25,000,000
1.32
25,000,000 6,000,000
25,000,000
DFLatbaselevelEBIT(stockIssue)
1.25
25,000,000 5,000,000
DFLatbaselevelEBIT(BondIssue)

(b) FinancialBreakevenPoint(BondIssue)$6,000,000
FinancialBreakevenPoint(StockIssue)$5,000,000
LevelofDifficulty:3
LearningGoal:2
Topic:FinancialLeverageandFinancialBreakeven(Equation12.6andEquation12.7)
4.

TriStarProductions,Inc.isevaluatingtwodifferentoperatingstructureswhicharedescribedbelow.
Thefirmhasannualinterestexpenseof$250,commonsharesoutstandingof1,000,andataxrateof
40percent.

operatingstructure1:
operatingstructure2:

Fixed
Costs
$500
$1,200

Price VariableCost
perUnit
perUnit
$1
$0.75
$1
$0.70

(a) Foreachoperatingstructure,calculate
(a1) EBITandEPSat10,000,20,000,and30,000units.
(a2) thedegreeofoperatingleverage(DOL)anddegreeoftotalleverage(DTL)using20,000
unitsasabasesaleslevel.
(a3) theoperatingbreakevenpointinunits.
(b) Whichoperatingstructurehasgreateroperatingleverageandbusinessrisk?
(c) IfTriStarProductions,Inc.projectssalesof20,000units,whichoperatingstructureis
recommended?
Answers:

(a1)
EBIT
Operating
Structure
#1
#2

10,000
$2,000
1,800

20,000
$4,500
4,800

EPS
30,000
$7,000
7,800

10,000
$1.05
0.93

(a2)and(a3)
Operating
Structure
#1
#2

DOL
1.11
1.25

DTL
1.18
1.32

OperatingBreakeven
PointinUnits
2,000units
4,000units

20,000
$2.55
2.73

30,000
$4.05
4.53

Chapter12LeverageandCapitalStructure268

(b) Operatingstructure2hasgreaterfixedcosts,greateroperatingleverage,andgreater
businessriskthanoperatingstructure1.
(c) Ifsalesareprojectedat20,000units,TriStarProduction,Inc.shouldchoose
operatingstructure2becauseitresultsinahigherEBITandEPSforthefirm.
Operatingstructure2hasahigheroperatingbreakevenpoint,butwithsalesestimated
at20,000unitsversusabreakevenpointof4,000units,thefirmshouldtake
advantageoftheaddedleverage.
LevelofDifficulty:4
LearningGoal:2
Topic:Leverage,Return,andRisk(Equation12.1,Equation12.2,Equation12.3,Equation12.4,
Equation12.5,Equation12.8,Equation12.9,andEquation12.10)
Table12.1
InterestExpense
PreferredDividend
CommonSharesOutstanding
5.

Plan1
$25,000
$3,000
200,000

Plan2
$50,000
$1,500
100,000

Assuminga40percenttaxrate,whatisthefinancialbreakevenpointforeachplan?(See
Table12.1.)
Answer: Financialbreakevenpoint$InterestPreferredDividends/(1t)
FinancingPlan1:FBP$25,0003,000/(10.40)$30,000
FinancingPlan2:FBP$50,0001,500/(10.40)$52,500
LevelofDifficulty:3
LearningGoal:5
Topic:FinancialBreakevenPoint

6.

WhatisthedegreeoffinancialleverageatabaselevelEBITof$120,000forbothfinancingplans?
Thefirmhasa40percenttaxrate.(SeeTable12.1.)
Answer: DegreeoffinancialleverageforPlan1atbaselevelofEBIT

$120,000
1.33
$120,000 $25,000 $3,000 /(1 0.40)

DegreeoffinancialleverageforPlan2atbaselevelofEBIT

$120,000
1.78
$120,000 $50,000 $1,500 /(1 0.40)

LevelofDifficulty:3
LearningGoal:5
Topic:DegreeofFinancialLeverage(Equation12.6andEquation12.7)

269GitmanPrinciplesofFinance,EleventhEdition

7.

WhatistheEPSunderFinancingPlan1,ifthefirmprojectsEBITof$200,000andhasataxrateof
40percent?(SeeTable12.1.)
Answer: CalculatetheEPSwiththeformula:
(EBIT Interest)(1 taxrate) PD
#ofcommonsharesoutstanding
($200,000 $25,000)(1 0.40) $3,000
EPS
0.51
200,000
EPS

LevelofDifficulty:3
LearningGoal:5
Topic:FinancialBreakeven
8.

AtaboutwhatEBITlevelshouldthefinancialmanagerbeindifferenttoeitherplan?(See
Table12.1.)
Answer:

(EBIT 25,000)(1 0.40) 3,000 (EBIT 50,000)(1 0.40) 1,500

200,000
100,000
AtEBIT$75,000.

LevelofDifficulty:3
LearningGoal:5
Topic:FinancialBreakeven
9.

Whichplanhasahigherdegreeoffinancialleverageandfinancialrisk?(SeeTable12.1.)
Answer: FinancingPlan2
LevelofDifficulty:3
LearningGoal:5
Topic:FinancialLeverageandFinancialRisk(Equation12.6andEquation12.7)

10.

FranklineCoin,Inc.isconsideringtwocapitalstructures.Thekeyinformationfollows.Assumea
40percenttaxrateandexpectedEBITof$50,000.
SourceofCapital
Longtermdebt
Commonstock

Structure1
$500,000@8%
10,000shares

Structure2
$350,000@7%
20,000shares

(a) CalculatetwoEBITEPScoordinatesforeachofthestructures.
(b) IndicateoverwhatEBITrange,ifany,eachstructureispreferred.

Chapter12LeverageandCapitalStructure270

Answers:
(a)

Coordinates

Structure1
EBIT
EPS
40,000;
0
50,000;
0.60
60,000;
1.20

Structure2
EBIT
EPS
24,500;
0
50,000;
0.77
60,000;
1.07

(b) Calculationofindifferencepoint
EPS(Structure1)EPS(Structure2)
(EBIT$40,000)(10.40)/10,000(EBIT$24,500)(10.40)/20,000
IfEBITisexpectedtobelessthan$55,500,structure2willmaximizeEPS.IfEBIT
isexpectedtobegreaterthan$55,500,Structure1willmaximizeEPS.
LevelofDifficulty:4
LearningGoal:5
Topic:EBITEPSApproachtoCapitalStructure
11.

TangshanMiningCompanymustchooseitsoptimalcapitalstructure.Currently,thefirmhasa40
percentdebtratioandthefirmexpectstogenerateadividendnextyearof$4.89pershareand
dividendsareexpectedtogrowataconstantrateof5percentfortheforeseeablefuture.
Stockholderscurrentlyrequirea10.89percentreturnontheirinvestment.TangshanMiningis
consideringchangingitscapitalstructureifitwouldbenefitshareholders.Thefirmestimatesthatif
itincreasesthedebtratioto50percent,itwillincreaseitsexpecteddividendto$5.24pershare.
Becauseoftheadditionalleverage,dividendgrowthisexpectedtoincreaseto6percentandthis
growthwillbesustainedindefinitely.However,becauseoftheaddedrisk,therequiredreturn
demandedbystockholderswillincreaseto11.34percent.
(a) WhatisthevaluepershareforTangshanMiningunderthecurrentcapitalstructure?
(b) WhatisthevaluepershareforTangshanMiningundertheproposedcapitalstructure?
(c) ShouldTangshanMiningmakethecapitalstructurechange?Explain.
Answers:
(a) ThecurrentpriceofTangshanMiningstockis:
P$4.89/(0.10890.05)$83.02
(b) ThepriceofTangshanMiningstockifthecapitalstructurechangeismadeis
expectedtobe:
P$5.24/(0.11340.065)$108.26
(c) Yes.TangshanMiningshouldmakethechangebecauseitwillmaximizeshareprice.
LevelofDifficulty:4
LearningGoal:6
Topic:OptimalCapitalStructureandShareholderWealthMaximization(Equation12.12)