CAPITAL STRUCTURE DECISIONS and MERGERS, LBOS, AND HOLDING COMPANIES 1. Which of the following statements is CORRECT?

a. The capital structure that maximizes expected EPS also maximizes the price per
share of common stock.
True or False
b. The capital structure that minimizes the interest rate on debt also maximizes the
1. Financial risk refers to the extra risk stockholders bear as a result of using debt as
expected EPS.
compared with the risk they would bear if no debt were used. True
c. The capital structure that minimizes the WACC also maximizes the price per
2. Two firms, although they operate in different industries, have the same expected
share of common stock.
earnings per share and the same standard deviation of expected EPS. Thus, the two
firms must have the same business risk. False d. The capital structure that gives the firm the best credit rating also maximizes the
stock price.
3. A firm’s capital structure does not affect its calculated free cash flows, because FCF
reflects only operating cash flows. True

4. In a merger with true synergies, the post-merger value exceeds the sum of the 2. Based on the information below, what is Ezzel Enterprises' optimal capital
separate companies' pre-merger values. True structure?

5. Provided a firm does not use an extreme amount of debt, financial leverage a. Debt = 40%; Equity = 60%; EPS = $2.95; Stock price = $26.50.
typically affects both EPS and EBIT, while operating leverage only affects EBIT.False
b. Debt = 50%; Equity = 50%; EPS = $3.05; Stock price = $28.90.
6. Merger activity is likely to heat up when interest rates are high because target
c. Debt = 60%; Equity = 40%; EPS = $3.18; Stock price = $31.20.
firms can expect to receive an especially high premium over the pre-announcement
stock price. False d. Debt = 80%; Equity = 20%; EPS = $3.42; Stock price = $30.40.
7. Post-merger control and the negotiated price paid by the acquirer are 2 of the
most important issues in agreeing on the terms of a merger. True
3. Which of the following statements is CORRECT? As a firm increases the operating
8. The purchase of assets at below their replacement cost and tax considerations are leverage used to produce a given quantity of output, this will
two factors that motivate mergers. True

9. The distribution of synergistic gains between the stockholders of 2 merged firms is a. normally lead to an increase in its fixed assets turnover ratio.
almost always based strictly on their respective market values before the
announcement of the merger. False b. normally lead to a decrease in the standard deviation of its expected EBIT.

10. In a financial merger, the relevant post-merger cash flows are simply the sum of c. normally lead to a decrease in the variability of its expected EPS.
the expected cash flows of the 2 companies, measured as if they were operated
d. normally lead to a reduction in its fixed assets turnover ratio.
independently. True

5. Companies HD and LD have identical tax rates, total assets, and basic earning
Multiple choice
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?
a. Company HD has a lower ROA than Company LD.
b. Company HD has a lower ROE than Company LD.
c. The two companies have the same ROA.
d. The two companies have the same ROE.
4. Which of the following statements is most CORRECT?
a. A conglomerate merger is one where a firm combines with another firm in the
same industry.
b. Regulations in the United States prohibit acquiring firms from using common
stock to purchase another firm.
c. Defensive mergers are designed to make a company less vulnerable to a
takeover.
d. In a tender offer, the target firm’s management always remain after the merger
is completed.
5. Which of the following statements about valuing a firm using the APV approach is
most CORRECT?
a. The horizon value is calculated by discounting the free cash flows beyond the
horizon date and any tax savings at the levered cost of equity.
b. The horizon value is calculated by discounting the free cash flows beyond the
horizon date and any tax savings at the cost of debt.
c. The horizon value is calculated by discounting the expected earnings at the
WACC.
d. The horizon value is calculated by discounting the free cash flows beyond the
horizon date and any tax savings at the WACC.
Computation
1. Elephant Books sells paperback books 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? 44. $200,000
2. Ang Enterprises has a levered beta of 1.10, its capital structure consists of 40%
debt and 60% equity, and its tax rate is 40%. What would Ang's beta be if it used no
debt, i.e., what is its unlevered beta? 49. 0.79
3. Michaely Inc. is an all-equity firm with 200,000 shares outstanding. It has
$2,000,000 of EBIT, which is expected to remain constant in the future. The company
pays out all of its earnings, so earnings per share (EPS) equal dividends per shares
(DPS). Its tax rate is 40%.
The company is considering issuing $5,000,000 of 10.0% bonds and using the
proceeds to repurchase stock. The risk-free rate is 6.5%, the market risk premium is
5.0%, and the beta is currently 0.90, but the CFO believes beta would rise to 1.10 if
the recapitalization occurs.
Assuming that the shares can be repurchased at the price that existed prior to the
recapitalization, what would the price be following the recapitalization?
56. $69.23
4. Simon Software Co. is trying to estimate its optimal capital structure. Right now,
Simon has a capital structure that consists of 20% debt and 80% equity, based on
market values. (Its D/S ratio is 0.25.) The risk-free rate is 6% and the market risk
premium, rM – rRF, is 5%. Currently the company’s cost of equity, which is based on
the CAPM, is 12% and its tax rate is 40%. What would be Simon’s estimated cost of
equity if it were to change its capital structure to 50% debt and 50% equity?
58. 14.35%
5. Great Subs Inc., a regional sandwich chain, is considering purchasing a smaller
chain, Eastern Pizza, which is currently financed using 20% debt at a cost of 8%.
Great Subs’ analysts project that the merger will result in incremental free cash flows
and interest tax savings of $2 million in Year 1, $4 million in Year 2, $5 million in Year
3, and $117 million in Year 4. (The Year 4 cash flow includes a horizon value of $107
million.) The acquisition would be made immediately, if it is to be undertaken.
Eastern's pre-merger beta is 2.0, and its post-merger tax rate would be 34%. The
risk-free rate is 8%, and the market risk premium is 4%. What is the appropriate rate
for use in discounting the free cash flows and the interest tax savings?
45. 14.4%