MOCK EXAM REVIEWER

CAPITAL STRUCTURE AND LEVERAGE

QUESTIONNAIRE

I. True or False: Write true if the statement is true and false if the statement is
false.

1. Due to changing conditions both internal and external to the company, it is

easier to have an exact optimal debt ratio instead of an optimal debt ratio
range.
2. If a firm is not financially flexible, at higher debt levels, and it needs financing,
it will probably issue new shares to new stockholders.
3. Pharmaceutical companies generally have higher business risk compared to
food companies due to higher research and development activities involved in
the former.
4. In computing for the stock value using the corporate valuation model, net
operating profit after tax (NOPAT) is used to get the free cash flows because the
cost of capital used to get the total value of the firm is also after-tax.
5. In computing for the operating break-even, only the fixed operating costs are
considered.
6. The operating leverage is unaffected by the decision to use the proceeds from
the bond issue to repurchase shares.
7. Asymmetric information results when a firm’s managers have more information
about operations and future prospects than do investors wherein this additional
information will generally cause financial managers to raise funds using a
pecking order (a hierarchy of financing beginning with retained earnings,
followed by new debt, and finally, new equity) rather than maintaining a target
capital structure.
8. In the agency problem between managers and shareholders, the firm's
managers, as agents of the owners, have an incentive to “take advantage” of
lenders although lenders have an incentive to protect their own interests, and
can develop monitoring and controlling techniques by means of loan covenants
that limit the firm’s ability to significantly change its risk, specifically financial
risk.
9. The total risk of a firm - business and financial risk combined - determines its
probability of bankruptcy.
10. The operating break-even is the level of sales in which all fixed and variable
operating costs are covered and that earnings before taxes or profit equals zero.
II. Multiple Choice: Write the letter of the best answer.

11. Firms whose products are sold in volatile markets are more exposed to business
risk compared to those firms whose output prices are stable. This is the factor
affecting business risk on
a) demand variability
b) sales price variability
c) competition.
d) input cost variability.

12. Using debt or financial leverage adds risk to the

a) shareholders.
b) firm.
c) both a and b.
d) none of the above.

13. The degree of total leverage is computed as

a) EBT divided by the CM.
b) %Change in Sales divided by %Change in EPS.
c) %Change in EPS divided by %Change in CM.
d) None of the above.

14. The hamada equation shows the effect of the changes in the capital structure to
all of the following EXCEPT
a) firm's WACC.
b) firm's cost of equity.
c) firm's cost beta.
d) firm's EPS.

15. Which of the following statements about operating leverage is most correct?
a) At all times, comparing two firms with the same selling prices and same
sales units, the firm which operates closer to its break-even point is the firm
with the higher degree of operating leverage, assuming that the firms are
currently operating at a profit.
b) At all times, comparing two firms with the same selling prices and same
sales units, the firm with the higher fixed operating cost is the firm with the
higher degree of operating leverage, assuming that the firms are currently
operating at a profit.
c) At all times, comparing two firms with the same selling prices and same
sales units, the firm with the higher fixed finance cost is the firm with the
higher degree of operating leverage, assuming that the firms are currently
operating at a profit.
d) All of the above statements are correct.
16. Which of the following statements about leverage is most correct?
a) Financial risk is the risk that the firm will be unable to cover its operating
costs.
b) Business risk is the risk that the firm will be unable to meet required
financial obligations.
c) The more fixed-cost components in a firm’s capital structure (debt and
preferred stock) the greater its financial leverage and financial risk.
d) The greater the revenue and cost stability, then the higher the business risk.

17. According to the capital structure theories, which of the following statements is
the least correct?
a) The capital structure theory according to Modigliani and Miller states that
capital structure does not affect the firm’s value.
b) According to the effect of taxes, higher corporate taxes encourage the firm to
use more debt while personal taxes, being favorable on shareholders’ income
compared to the creditors’ income, encourages the firm to use more equity.
c) According to the trade-off theory, use of debt has the benefit of tax savings
and the cost of bankruptcy-related cost.
d) According to the debt to constrain managers, using debt will motivate
managers to be more relaxed in their work and to excessively use cash for
non-value adding activities.

18. In which situation will a firm used more debt?

a) Corporate taxes decrease.
b) Bankruptcy costs increase.
c) During normal situation according to the reserved borrowing capacity
concept.
d) If there are good investment opportunities.

19. When a firm uses debt financing after successfully completing an R&D program
and forecasts higher earnings in the feature, this is a factor affecting capital
structure decision on
a) the firm's internal condition.
b) market conditions.
c) sales stability.
d) profitability.

20) The concept of windows of opportunity states that if the firm's stock is
overpriced and it needs financing,
a) it should use more debt.
b) it should use less debt.
c) it should use retained earnings.
d) it should use accounts payable.
III. Problem Solving: Supply the correct answer

Problem A.

Below is the summary of Fara’s EPS for the past 6 years, as follows:

Year EPS Year EPS

2012 P2.00 2015 P2.40
2013 2.10 2016 2.52
2014 2.35 2017 2.72

1) What is the growth rate to be used in computing for the Fara’s cost of equity?
Round-off answers to two percentage places. Answer in this format (e.g. 12%,
12.12%, 0.12%).

Problem B.

Peter’s capital structure consists solely of debt and common equity. The company’s
WACC is 10%. Its interest rate is 6%, tax rate is 30%, and cost of equity is 12%.

2) What is Peter’s equity ratio? Round-off answers to two percentage or decimal

places. Answer in this format (e.g. 45%, 55.56%, 0.45, 0.56)

Problem C.

The Angulo company analysed its EPS based on four possible outcomes

Outcomes EPS Probability

1 P6 15%
2 5 30%
3 4 45%
4 4.5 10%

3) Compute for the expected EPS based on the given probable outcomes. Round-off
final answers to 2 decimal place (e.g. 6.10, 7.87, 10).
4) If Angulo’s coefficient of variation is 0.153957, what is the company’s standard
deviation? Round-final answers to two decimal places (e.g. 1.77, 1.70, 0.77, 0.70)

Problem D.

You are given the following data in determining the Alex firm’s optimal capital
structure. Assume that the firm’s growth rate is 3%.
 Debt Ratio Expected Cost of equity
Dividends per (rs)
share
0% P5.50 10%
25% 6.00 10.50%
40% 6.50 11%
50% 6.75 12%
75% 7.25 13%

5) What is Alex’ optimal debt ratio?

6) What is the stock price at the optimal debt ratio?

Problem E.

Note: For this problem, if you need to round-off in between the computation, round-off
to 4 decimal places.

Green Mango Co. is trying to estimate its optimal capital structure. Right now, Green
Mango has a capital structure that consists of 30% debt and 70% equity. The risk-
free rate is 4% and the market risk premium is 5%. Currently, the company’s cost of
equity, which is based on CAPM is 12% and its tax rate is 40%.

7) What would be Green Mango’s unlevered beta? (Round-off final answer to 4

decimal places)

8) What would be Green Mango’s new cost equity if it decides to change its capital
structure to 50% debt and 50% equity? Round-off final answer to 2 percentage
places (e.g. 12%, 12.12%, 0.12%)

Problem F.

James Company, a satellite launching firm, expects its sales to increase by 25 percent
in the coming year as a result of NASA's recent problems with the space shuttle. The
firm's current EPS is P10. Its degree of operating leverage is 1.5, while its degree of
financial leverage is 3.30.

9) What is the firm's DTL? Round-off final answer to 2 decimal places (e.g. 5.50, 5,
5.55)
10) What is the firm's projected EPS for the coming year using the DTL approach?
Round-off final answer to 2 decimal places (e.g. 5.50, 5, 5.55).
PROBLEM G.

Garnern Inc. is an all-equity firm with 500,000 shares outstanding. It has P2,000,000
of EBIT, and EBIT is expected to remain constant in the future. The company pays
out 100% of its earnings as dividends and it does not intend to increase its dividend
payments in the future. Its tax rate is 40%. The company is considering to issue
bonds for P4,000,000 and use the proceeds to repurchase stock, at its current stock
price. The plan for recapitalization is soon to be done. The interest expense that will
be incurred after 1 year, due to the repurchase, is P200,000. The risk-free rate is
4.5%, the market risk premium is 6.0%, and the firm's beta is currently at 0.50.

11) What will be Garnern’s stock price 1 year after the recapitalization? Round-off
final answer to 2 decimal places (e.g. 5.50, 5, 5.55).

PROBLEM H.

Zeus recently sold 120,000 units at P8.00 each; its variable operating costs are P3.00,
and its fixed operating costs are P200,000. Annual interest charges total P50,000 and
the firm has 5,000 shares at P5 (annual dividend) preferred stock outstanding. It
currently has 15,000 shares of common stock outstanding. Assume that the firm is
subject to 40% tax rate.

12) At what sales level (in units) would the firm break-even on operations (that is EBIT
= 0)? Round-off final answer to 2 decimal places (e.g. 5,000, 5,555.56).
13) Zeus increased its sales units to 150,000 units. Compute for Zeus’ degree of
financial leverage at sales units of 120,000 (meaning use 120,000 units as base
units)? Round-off final answer to 2 decimal places (e.g. 5.50, 5, 5.55).

PROBLEM I.

Bayabas has sales of 10,000 units at a price of P20. The firm incurs fixed operating
costs of P20,000, and variable operating costs of P12 per unit.

14) What is Bayabas’ degree of operating leverage at base level sales of 10,000 units?
Round-off final answer to 2 decimal places (e.g. 5.50, 5, 5.56).

PROBLEM J.

Tony Investments has EBIT of P30,000, interest expense of P4,000, and preferred
dividends of P3,000. It pays taxes at a rate of 40%.
15) What is Tony’s degree of financial leverage at a base level of EBIT of P30,000?
Round-off final answer to 2 decimal places (e.g. 5.50, 5, 5.56).

PROBLEM K.

Copper Industries had sales of 90,000 units at a price of P10 per unit. It faced fixed
operating costs of P200,000, variable operating costs of P6 per unit, and interest
expense of P20,000. The company is subject to 30% tax rate and has a WACC of 8%.
The company’s not expecting any growth rate in the succeeding years.

16) Compute for the total value of the firm (V or firm value or MV of debt plus MV of
Equity). Round-off final answer to 2 decimal places (e.g. 5,000,000,
5,555,555.56).

PROBLEM L.

Gold Cooling Systems, Inc. has a total assets of P10,000,000, EBIT of P2,000,000, and
preferred dividends of P200,000 and is taxed at a rate of 40%. It pays out all its
earnings as dividends.

In an effort to determine the optimal capital structure, the firm has assembled data on
the cost of debt and required return on investment for various levels of indebtedness,
as follows:

Debt Ratio Interest Rate Required Return

(rd) on the Stock (rs)
0% 0% 12%
15% 8% 13%
30% 9% 14%
45% 12% 16%
60% 15% 20%

17) Based on the information above, determine Gold’s optimal debt ratio.
18) Determine the WACC at the optimal debt ratio. Round-off answers to two
percentage places. Answer in this format (e.g. 12%, 12.12%, 0.12%)
PROBLEM M.

Below are the details of LT and JD Companies, as follows

LT JD
SD (if without debt) 10% 15%
Expected ROIC 18% 22%
Beta 2.00 1.80

Currently, both companies use financial leverage (have debt in their capital
structures).

19) Which company has the higher business risk?

20) Which company has the higher financial risk?