Reading 32- LOS g ～ Q1－5

1.Jayco, Inc. currently has a D/A ratio of 33.33 percent but feels its optimal D/A ratio should be 16.67 percent. Sales are currently $750,000, and the total assets turnover (Sales/Assets) is 7.5. If Jayco needs to raise $100,000 to expand, how should the expansion be financed so as to produce the desired debt ratio? Finance it with:

A)   all debt.

B)   75% debt, 25% equity.

C)   25% debt, 75% equity.

D)   all equity.

The correct answer was D)

S/A = 7.5 = 750,000/A, so A = $100,000, D/100,000 = 33.33. Therefore, D must be 33,333. You want to change D/A to 16.67, so must double A so the 100,000 must be all equity.

2.Which of the following firms is likely to have a higher debt ratio?

A)   Egg Harbor Furs, which serves as a wholesaler of fine furs and garments.

B)   Bath & Books, which produces toiletries and other consumer staples that are in demand regardless of economic conditions.

C)   Donaldson & Friends, which is under the direction of a very conservative management team.

D)   Critter Care, which has a low debt rating due to the prior financial mismanagement by the chief executive officer.

The correct answer was B)

Bath and Books appears to have relatively little business risk, especially in relation to Egg Harbor Furs, which is likely to be a much more cyclical business. The conservative managers will likely minimize the amount of debt Donaldson & Friends incurs, while creditors will be less willing to lend funds to Critter Care whose managers have shown poor money management skills in the past.

3.Which of the following firms is most likely to utilize additional debt the next time it raises capital? The firm:

A)   that has many new fixed assets.

B)   whose current debt ratio is higher than the industry average.

C)   firm that has experienced significant losses in recent years.

D)   in a high tax bracket.

The correct answer was D)

The value of tax deductibility rises with tax rates. Of course, there are other ways to reduce taxes. Firms with many new assets are probably also benefiting from high levels of depreciation. Firms with above average debt ratios may be limited in terms of financial flexibility and are likely to already have a significant tax write-off from debt outstanding. Finally, firms with recent losses may be avoiding taxes by writing off those losses.

4.hich one of the following statements about a firm's capital structure is most accurate? The optimal capital structure:

A)   maximizes expected EPS, maximizes the price per share of common stock.

B)   minimizes the interest rate on debt, maximizes the expected EPS.

C)   minimizes the required rate on equity, maximizes the stock price.

D)   maximizes the stock price, minimizes the weighted average cost of capital.

The correct answer was D)

The firm's optimal capital structure is the one that balances the influence of risk and return and thus maximizes the firm's stock price. Return - This optimal capital structure will maximize the firm's stock price. Risk - At the optimum level, the cost of capital (as reflected in WACC) is also minimized.

A firm’s target capital structure is the debt to equity ratio that the firm tries to maintain over time. Should the firm’s current debt ratio fall below the target level, new capital needs will be satisfied by issuing debt. On the other hand, if the debt ratio is greater than the target level, the firm will raise new capital by retaining earnings or issuing new equity. When setting its target capital structure, the firm must weigh the tradeoff between risk and return associated with the use of debt. The use of debt increases the risk borne by shareholders. However, using debt leads to higher expected rates of return by shareholders. The higher risk associated with debt will depress stock prices, while the higher expected return will increase stock prices. Thus, the firm’s optimal capital structure is the one that balances the influence of risk and return and thus maximizes the firm’s stock price. The optimal debt ratio will be the firm’s target capital structure.

5.The capital structure that:

A)   minimizes the required rate on equity maximizes the stock price.

B)   maximizes the stock price minimizes the weighted average cost of capital.

C)   minimizes the interest rate on debt also maximizes the expected EPS.

D)   maximizes expected EPS maximizes the price per share of common stock.

The correct answer was B)     

At the optimal capital structure the firm will minimize the WACC, maximize the share price of the stock and maximize the value of the firm.