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Exhibit 16.2 VanMannen Foundations, Inc. (VF) is a zero-growth company that currently has zero debt, and it has the data shown below. Now the company is considering using some debt, moving to the market value capital structure indicated below. The money raised would be used to repurchase stock. It is estimated that the increase in risk resulting from the additional leverage would cause the required rate of return on equity to rise somewhat, as indicated below.  EBIT =$80,000New Debt / Value =20% Growth =0% New Equity/Value =80% Orig cost of equity, rs=10.0% No. of shares =10,000 New cost of equity =rs=11.0% Price per share =$48.00 Tax rate =40% Interest rate =rd=7.0%\begin{array} { l c } \text { EBIT } = & \$ 80,000 \mathrm { New } \text { Debt } / \text { Value } =&20\% \\\text { Growth } = & 0 \% \text { New Equity/Value } =&80\% \\\text { Orig cost of equity, } r _ { s } = & 10.0 \% \text { No. of shares } =&10,000 \\\text { New cost of equity } = r _ { s } = & 11.0 \% \text { Price per share } =&\$48.00 \\\text { Tax rate } = & 40 \% \text { Interest rate } = r _ { d } =&7.0\%\end{array} -Refer to Exhibit 16.2.Now assume that VF is considering changing from its original zero debt capital structure to a new capital structure with even more debt.This results in changes in the cost of debt and equity,and thus to a new WACC and a new value of operations.Assume VF raises the amount of new debt indicated below and uses the funds to purchase and hold T-bills until it makes the stock repurchase.What is the stock price per share immediately after issuing the debt but prior to the repurchase?  Debt/Value =40% Value of new debt =$213,333 Equity / Value =60%NewWACC=9.0%\begin{array} { l l r } \text { Debt/Value } = & 40 \% \text { Value of new debt } = & \$ 213,333 \\\text { Equity } / \text { Value } = & 60 \% \mathrm { New } \mathrm { WACC } = & 9.0 \%\end{array}


A) $50.67
B) $53.33
C) $56.00
D) $58.80
E) $61.74

F) A) and B)
G) A) and D)

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A venture capital investment group received a proposal from Wireless Solutions to produce a new smart phone.The variable cost per unit is estimated at $250,the sales price would be set at twice the VC/unit,fixed costs are estimated at $750,000,and the investors will put up the funds if the project is likely to have an operating income of $500,000 or more.What sales volume would be required in order to meet this profit goal?


A) 4,513
B) 4,750
C) 5,000
D) 5,250
E) 5,513

F) All of the above
G) D) and E)

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Exhibit 16.4 The Anson Jackson Court Company (AJC) currently has $200,000 market value (and book value) of perpetual debt outstanding carrying a coupon rate of 6%. Its earnings before interest and taxes (EBIT) are $100,000, and it is a zero growth company. AJC's current cost of equity is 8.8%, and its tax rate is 40%. The firm has 10,000 shares of common stock outstanding selling at a price per share of $60.00. -Refer to Exhibit 16.4.Now assume that AJC is considering changing from its original capital structure to a new capital structure with 50% debt and 50% equity.If it makes this change,its resulting market value would be $820,000.What would be its new stock price per share?


A) $58
B) $59
C) $60
D) $61
E) $62

F) A) and C)
G) A) and B)

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Exhibit 16.3 Best Bagels, Inc. (BB) currently has zero debt. Its earnings before interest and taxes (EBIT) are $100,000, and it is a zero growth company. BB's current cost of equity is 13%, and its tax rate is 40%. The firm has 20,000 shares of common stock outstanding selling at a price per share of $23.08. -Refer to Exhibit 16.3.BB is considering moving to a capital structure that is comprised of 20% debt and 80% equity,based on market values.The debt would have an interest rate of 7%.The new funds would be used to repurchase stock.It is estimated that the increase in risk resulting from the additional leverage would cause the required rate of return on equity to rise to 14%.If this plan were carried out,what would BB's new value of operations be?


A) $498,339
B) $512,188
C) $525,237
D) $540,239
E) $590,718

F) A) and C)
G) None of the above

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If debt financing is used,which of the following is CORRECT?


A) The percentage change in net operating income will be equal to a given percentage change in net income.
B) The percentage change in net income relative to the percentage change in net operating income will depend on the interest rate charged on debt.
C) The percentage change in net income will be greater than the percentage change in net operating income.
D) The percentage change in sales will be greater than the percentage change in EBIT, which in turn will be greater than the percentage change in net income.
E) The percentage change in net operating income will be greater than a given percentage change in net income.

F) C) and D)
G) B) and E)

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Merriwether Building has operating income of $20 million,a tax rate of 40%,and no debt.It pays out all of its net income as dividends and has a zero growth rate.The current stock price is $40 per share,and it has 2.5 million shares of stock outstanding.If it moves to a capital structure that has 40% debt and 60% equity (based on market values) ,its investment bankers believe its weighted average cost of capital would be 10%.What would its stock price be if it changes to the new capital structure?


A) $40
B) $48
C) $52
D) $54
E) $60

F) A) and D)
G) B) and E)

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Which of the following is NOT associated with (or does not contribute to) business risk? Recall that business risk is affected by a firm's operations.


A) Sales price variability.
B) The extent to which operating costs are fixed.
C) The extent to which interest rates on the firm's debt fluctuate.
D) Input price variability.
E) Demand variability.

F) B) and C)
G) D) and E)

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The world-famous discounter,Fernwood Booksellers,specializes in selling paperbacks for $7 each.The variable cost per book is $5.At current annual sales of 200,000 books,the publisher is just breaking even.It is estimated that if the authors' royalties are reduced,the variable cost per book will drop by $1.Assume authors' royalties are reduced and sales remain constant; how much more money can the publisher put into advertising (a fixed cost) and still break even?


A) $600,000
B) $466,667
C) $333,333
D) $200,000
E) None of the above

F) C) and D)
G) D) and E)

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Daylight Solutions is considering a recapitalization that would increase its debt ratio and increase its interest expense.The company would issue new bonds and use the proceeds to buy back shares of its common stock.The company's CFO thinks the plan will not change total assets or operating income,but that it will increase earnings per share (EPS) .Assuming the CFO's estimates are correct,which of the following statements is CORRECT?


A) If the plan reduces the WACC, the stock price is also likely to decline.
B) Since the plan is expected to increase EPS, this implies that net income is also expected to increase.
C) If the plan does increase the EPS, the stock price will automatically increase at the same rate.
D) Under the plan there will be more bonds outstanding, and that will increase their liquidity and thus lower the interest rate on the currently outstanding bonds.
E) Since the proposed plan increases Daylight's financial risk, the company's stock price still might fall even if EPS increases.

F) A) and B)
G) A) and C)

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Other things held constant,which of the following events is most likely to encourage a firm to increase the amount of debt in its capital structure?


A) The costs that would be incurred in the event of bankruptcy increase.
B) Management believes that the firm's stock has become overvalued.
C) Its degree of operating leverage increases.
D) The corporate tax rate increases.
E) Its sales become less stable over time.

F) A) and E)
G) A) and C)

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A new company to produce state-of-the-art car stereo systems is being considered by Jagger Enterprises.The sales price would be set at 1.5 times the variable cost per unit; the VC/unit is estimated to be $2.50; and fixed costs are estimated at $120,000.What sales volume would be required in order to break even,i.e.,to have an EBIT of zero for the stereo business?


A) 86,640
B) 91,200
C) 96,000
D) 100,800
E) 105,840

F) A) and C)
G) A) and D)

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Which of these items will not generally be affected by an increase in the debt ratio?


A) Total risk.
B) Financial risk.
C) Market risk.
D) The firm's beta.
E) Business risk.

F) C) and E)
G) D) and E)

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As the text indicates,a firm's financial risk has identifiable market risk and diversifiable risk components.

A) True
B) False

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Exhibit 16.3 Best Bagels, Inc. (BB) currently has zero debt. Its earnings before interest and taxes (EBIT) are $100,000, and it is a zero growth company. BB's current cost of equity is 13%, and its tax rate is 40%. The firm has 20,000 shares of common stock outstanding selling at a price per share of $23.08. -Refer to Exhibit 16.3.Now assume that BB is considering changing from its original capital structure to a new capital structure with 45% debt and 55% equity.This results in a weighted average cost of capital equal to 10.4% and a new value of operations of $576,923.Assume BB raises $259,615 in new debt and purchases T-bills to hold until it makes the stock repurchase.BB then sells the T-bills and uses the proceeds to repurchase stock.How many shares remain after the repurchase,and what is the stock price per share immediately after the repurchase?


A) 11,001; $28.85
B) 12,711; $35.62
C) 13,901; $42.57
D) 15,220; $54.31
E) 17,105; $89.67

F) B) and D)
G) B) and E)

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LeCompte Learning Solutions is considering making a change to its capital structure in hopes of increasing its value.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:  Percent financed  with debt (wdd)  Percent financed  with equity (wc)  Debt-to-equity  ratio (D/S)  B ond  Rating  Before-tax  cost of debt 0.100.900.10/0.90=0.11AAA7.0%0.200.800.20/0.80=0.25AA7.20.300.700.30/0.70=0.43 A8.00.400.600.40/0.60=0.67BBB8.80.500.500.50/0.50=1.00BB9.6\begin{array} { c c c c c } \begin{array} { c } \text { Percent financed } \\\text { with debt } \left( \mathrm { wd } _ { \mathrm { d } } \right) \end{array} & \begin{array} { c } \text { Percent financed } \\\text { with equity } \left( \mathrm { w } _ { \mathrm { c } } \right) \end{array} & \begin{array} { c } \text { Debt-to-equity } \\\text { ratio } ( \mathrm { D } / \mathrm { S } ) \end{array} & \begin{array} { c } \text { B ond } \\\text { Rating }\end{array} & \begin{array} { c } \text { Before-tax } \\\text { cost of debt }\end{array} \\\hline 0.10 & 0.90 & 0.10 / 0.90 = 0.11 & \mathrm { AAA } & 7.0 \% \\0.20 & 0.80 & 0.20 / 0.80 = 0.25 & \mathrm { AA } & 7.2 \\0.30 & 0.70 & 0.30 / 0.70 = 0.43 & \mathrm {~A} & 8.0 \\0.40 & 0.60 & 0.40 / 0.60 = 0.67 & \mathrm { BBB } & 8.8 \\0.50 & 0.50 & 0.50 / 0.50 = 1.00 & \mathrm { BB } & 9.6\end{array} The company uses the CAPM to estimate its cost of common equity,rs.The risk-free rate is 5% and the market risk premium is 6%.LeCompte estimates that if it had no debt its beta would be 1.0.(Its "unlevered beta," bU,equals 1.0.) The company's tax rate,T,is 40%. On the basis of this information,what is LeCompte's optimal capital structure,and what is the firm's cost of capital at this optimal capital structure?


A) wc = 0.9; wd = 0.1; WACC = 14.96%
B) wc = 0.8; wd = 0.2; WACC = 10.96%
C) wc = 0.7; wd = 0.3; WACC = 7.83%
D) wc = 0.6; wd = 0.4; WACC = 10.15%
E) wc = 0.5; wd = 0.5; WACC = 10.18%

F) B) and E)
G) C) and E)

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Which of the following statements best describes the optimal capital structure? The optimal capital structure is the mix of debt,equity,and preferred stock that maximizes the company's ____.


A) stock price.
B) cost of equity.
C) cost of debt.
D) cost of preferred stock.
E) earnings per share (EPS) .

F) A) and D)
G) B) and C)

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Which of the following statements is CORRECT?


A) Since debt financing is cheaper than equity financing, raising a company's debt ratio will always reduce its WACC.
B) Increasing a company's debt ratio will typically reduce the marginal cost of both debt and equity financing. However, this action still may raise the company's WACC.
C) Increasing a company's debt ratio will typically increase the marginal cost of both debt and equity financing. However, this action still may lower the company's WACC.
D) Since a firm's beta coefficient it not affected by its use of financial leverage, leverage does not affect the cost of equity.
E) Since debt financing raises the firm's financial risk, increasing a company's debt ratio will always increase its WACC.

F) All of the above
G) A) and C)

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If Miller and Modigliani had incorporated the costs of bankruptcy into their model,it is unlikely that they would have concluded that 100% debt financing is optimal.

A) True
B) False

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Firms U and L both have a basic earning power ratio of 20% and each has the same amount of assets.Firm U is unleveraged,i.e.,it is 100% equity financed,while Firm L is financed with 50% debt and 50% equity.Firm L's debt has a before-tax cost of 8%.Both firms have positive net income.Which of the following statements is CORRECT?


A) Firm L has a lower ROA than Firm U.
B) Firm L has a lower ROE than Firm U.
C) Firm L has the higher times interest earned (TIE) ratio.
D) Firm L has a higher EBIT than Firm U.
E) The two companies have the same times interest earned (TIE) ratio.

F) C) and E)
G) A) and B)

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Which of the following statements is CORRECT,holding other things constant?


A) An increase in the personal tax rate is likely to increase the debt ratio of the average corporation.
B) If changes in the bankruptcy code make bankruptcy less costly to corporations, then this would likely reduce the debt ratio of the average corporation.
C) An increase in the company's degree of operating leverage is likely to encourage a company to use more debt in its capital structure.
D) An increase in the corporate tax rate is likely to encourage a company to use more debt in its capital structure.
E) Firms whose assets are relatively liquid tend to have relatively low bankruptcy costs, hence they tend to use relatively little debt.

F) C) and E)
G) A) and E)

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