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For BusinessTutor: Question 19 Firms U and L each have

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For BusinessTutor:

Question 19

Firms U and L each have the same amount of assets, and both have a basic earning power ratio of 20%. 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?
Answer
The two companies have the same times interest earned (TIE) ratio.
Firm L has a lower ROA than Firm U.
Firm L has a lower ROE than Firm U.
Firm L has the higher times interest earned (TIE) ratio.
Firm L has a higher EBIT than Firm U.

2 points
Question 20

Companies HD and LD have identical tax rates, total assets, and basic earning power ratios, and their basic earning power exceeds their before-tax cost of debt, rd. However, Company HD has a higher debt ratio and thus more interest expense than Company LD. Which of the following statements is CORRECT?
Answer
Company HD has a higher net income than Company LD.
Company HD has a lower ROA than Company LD.
Company HD has a lower ROE than Company LD.
The two companies have the same ROA.
The two companies have the same ROE.

2 points
Question 21

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?
Answer
Its sales become less stable over time.
The costs that would be incurred in the event of bankruptcy increase.
Management believes that the firm’s stock has become overvalued.
Its degree of operating leverage increases.
The corporate tax rate increases.
2 points
Question 22

If debt financing is used, which of the following is CORRECT?
Answer
The percentage change in net operating income will be greater than a given percentage change in net income.
The percentage change in net operating income will be equal to a given percentage change in net income.
The percentage change in net income relative to the percentage change in net operating income will depend on the interest rate charged on debt.
The percentage change in net income will be greater than the percentage change in net operating income.
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.
2 points
Question 23

The firm’s target capital structure should be consistent with which of the following statements?
Answer
Maximize the earnings per share (EPS).
Minimize the cost of debt (rd).
Obtain the highest possible bond rating.
Minimize the cost of equity (rs).
Minimize the weighted average cost of capital (WACC).


2 points
Question 24

Companies HD and LD have the same total assets, operating income (EBIT), tax rate, and business risk. Company HD, however, has a much higher debt ratio than LD. Also HD’s basic earning power (BEP) exceeds its cost of debt (rd). Which of the following statements is CORRECT?
Answer
HD should have a higher return on assets (ROA) than LD.
HD should have a higher times interest earned (TIE) ratio than LD.
HD should have a higher return on equity (ROE) than LD, but its risk, as measured by the standard deviation of ROE, should also be higher than LD's.
Given that BEP > rd, HD's stock price must exceed that of LD.
Given that BEP > rd, LD's stock price must exceed that of HD.


2 points
Question 25

Which of the following statements is CORRECT?
Answer
Since debt financing raises the firm's financial risk, increasing a company’s debt ratio will always increase its WACC.
Since debt financing is cheaper than equity financing, raising a company’s debt ratio will always reduce its WACC.
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.
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.
Since a firm's beta coefficient it not affected by its use of financial leverage, leverage does not affect the cost of equity.
Submitted: 4 years ago.
Category: Finance
Expert:  Manal Elkhoshkhany replied 4 years ago.
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