Test Prep Test Prep Certifications BUSINESS-ENVIRONMENT-AND-CONCEPTS Questions & Answers

• Question 91:

  A firm's target or optimal capital structure is consistent with which one of the following?

  A. Minimum cost of debt.

  B. Minimum risk.

  C. Minimum cost of equity.

  D. Minimum weighted average cost of capital.

  Correct Answer: D

  Choice "d" is correct. Minimum weighted average cost of capital is consistent with a firm's target or optimal

  capital structure.

  Choice "a" is incorrect. Minimum cost of debt is a component of minimum weighted average cost of capital.

  Choice "b" is incorrect. Minimum risk results in a cost of capital heavily weighted in equity.

  Choice "c" is incorrect. Minimum cost of equity results in a cost of capital heavily weighted in debt.

• Question 92:

  The three elements needed to estimate the cost of equity capital for use in determining a firm's weighted average cost of capital are:

  A. Current dividends per share, expected growth rate in earnings per share, and current market price per share of common stock.

  B. Current earnings per share, expected growth rate in dividends per share, and current market price per share of common stock.

  C. Current earnings per share, expected growth rate in earnings per share, and current book value per share of common stock.

  D. Current dividends per share, expected growth rate in dividends per share, and current market price per share of common stock.

  Correct Answer: D

  Choice "d" is correct. The three elements needed to estimate the cost of equity capital are:

  1.

  Current dividends per share (D)

  2.

  Expected growth rate in dividends (g) and

  3.

  Current market price per share of common stock (P)

  The question asks the candidate to identify the three elements needed to estimate the cost of equity capital for use in determining a firm's weighted average cost of capital. The cost of equity capital is defined by the following mathematical expression where the cost of capital or return (R) is: R = D/P + g Choice "d" is consistent with our text, the and the Gordon Growth Model. Use of earnings per share, as suggested by choice "a" is sometimes referred to as the constant growth model and assumes that all earnings per share are either ultimately distributed or reinvested for the benefit of the shareholder. Earnings are anticipated to grow to infinity.

• Question 93:

  Datacomp Industries, which has no current debt, has a beta of .95 for its common stock. Management is considering a change in the capital structure to 30% debt and 70% equity. This change would increase the beta on the stock to 1.05, and the after-tax cost of debt will be 7.5%. The expected return on equity is 16%, and the risk-free rate is 6%. Should Datacomp's management proceed with the capital structure change?

  A. No, because the cost of equity capital will increase.

  B. Yes, because the cost of equity capital will decrease.

  C. Yes, because the weighted average cost of capital will decrease.

  D. No, because the weighted average cost of capital will increase.

  Correct Answer: C

  Choice "c" is correct. First, compute Datacomp's current weighted average cost of capital by using the capital asset pricing model (CAPM):

  

  Because there is no debt, the WACC is equal to the CAPM formula for equity or 15.5%. When debt is introduced, the WACC is calculated by first using the CAPM to determine the required return on equity:

  

  Assuming an after tax cost of debt is equal to 7.5%, the WACC becomes:

  (.165 ?(.70)) + (.075 ?(.3)) = 13.8%

  Therefore, Datacomp should change its capital structure because its WACC will decrease (Choice "c").

  Choices "a", "b", and "d" are incorrect, per above.

• Question 94:

  A firm with a higher degree of operating leverage when compared to the industry average implies that the:

  A. Firm has higher variable costs.

  B. Firm's profits are more sensitive to changes in sales volume.

  C. Firm is more profitable.

  D. Firm uses a significant amount of debt financing.

  Correct Answer: B

  Rule: Operating leverage is the presence of fixed costs in operations, which allows a small change in sales to produce a larger relative change in profits. Choice "b" is correct. A firm with a higher degree of operating leverage when compared to the industry average implies that the firm's profits are more sensitive to changes in sales volume.

  Choice "a" is incorrect. Higher variable costs imply a lower degree of operating leverage.

  Choice "c" is incorrect. Profits will depend upon sales.

  Choice "d" is incorrect. A firm using a significant amount of debt financing has a higher degree of "financial

  leverage."

• Question 95:

  Carlisle Company presently sells 400,000 bottles of perfume each year. Each bottle costs $.84 to produce and sells for $1.00. Fixed costs are $28,000 per year. The firm has annual interest expense of $6,000, preferred stock dividends of $2,000 per year, and a 40 percent tax rate. Carlisle uses the following formulas to determine the company's leverage.

  

  If Carlisle Company did not have preferred stock, the degree of total leverage would:

  A. Decrease in proportion to a decrease in financial leverage.

  B. Increase in proportion to an increase in financial leverage.

  C. Decrease but not be proportional to the decrease in financial leverage.

  D. Decrease but not have an effect on financial leverage.

  Correct Answer: A

  Choice "a" is correct. Without preferred stock, the denominator in the total leverage calculation would be larger (because preferred stock is subtracted to arrive at the denominator). The same holds true for financial leverage. Therefore, both financial and total leverage would decrease in proportion. Choices "b", "c", and "d" are incorrect, per above Explanation.

• Question 96:

  Carlisle Company presently sells 400,000 bottles of perfume each year. Each bottle costs $.84 to produce and sells for $1.00. Fixed costs are $28,000 per year. The firm has annual interest expense of $6,000, preferred stock dividends of $2,000 per year, and a 40 percent tax rate. Carlisle uses the following formulas to determine the company's leverage.

  

  The degree of financial leverage for Carlisle Company is:

  A. 2.4

  B. 1.78

  C. 1.35

  D. 2.3

  Correct Answer: C

  Choice "c" is correct. To calculate financial leverage, EBIT must first be calculated:

  

  Choices "a", "b", and "d" are incorrect, per the above calculation.

• Question 97:

  Carlisle Company presently sells 400,000 bottles of perfume each year. Each bottle costs $.84 to produce and sells for $1.00. Fixed costs are $28,000 per year. The firm has annual interest expense of $6,000, preferred stock dividends of $2,000 per year, and a 40 percent tax rate. Carlisle uses the following formulas to determine the company's leverage.

  

  The degree of operating leverage for Carlisle Company is:

  A. 2.4

  B. 1.78

  C. 1.35

  D. 2.3

  Correct Answer: B

  Choice "b" is correct. Calculation of operating leverage is:

  

  Choices "a", "c", and "d" are incorrect, per the above calculation.

• Question 98:

  The principle measure of non-diversifiable risk included in the CAPM formula is the beta coefficient. The beta coefficient measures the volatility or risk inherent in an investment by:

  A. Computing the ratio of changes in earnings per share to changes in sales.

  B. Computing the ratio of stock price to earnings per share.

  C. Computing the ratio of percentage changes in a stock's price to percentage changes in overall market values during the same period.

  D. Computing the ratio of percentage changes in the expected value of alpha equivalents to derivative fluctuations.

  Correct Answer: C

  Choice "c" is correct. The beta coefficient represents the measure of a particular stock's percentage

  change compared to the percentage change in the market over the same period. The equation for the beta

  coefficient is as follows:

  % in Stock Price

  % in Market price

  Choice "a" is incorrect. The percentage change in earnings per share related to a percentage change in

  sales represents the degree of combined leverage.

  Choice "b" is incorrect. The ratio of stock price to earnings per share is the price earnings ratio.

  Choice "d" is incorrect. Choice "d" represents a word salad distracter of nonsense terms.

• Question 99:

  The term underwriting spread refers to the:

  A. Commission percentage an investment banker receives for underwriting a security lease.

  B. Discount investment bankers receive on securities they purchase from the issuing company.

  C. Difference between the price the investment banker pays for a new security issue and the price at which the securities are resold.

  D. Commission a broker receives for either buying or selling a security on behalf of an investor.

  Correct Answer: C

  Choice "c" is correct. Investment bankers are paid their fees partly by being allowed to purchase the new securities they are underwriting for a discount and then reselling those securities on the market. This is known as the underwriting spread. Choices "a" and "d" are incorrect, as both of these describe either fees or commissions and not an underwriting spread. Choice "b" is incorrect. The underwriting spread is the difference between the discount price paid and the resale price.

• Question 100:

  When evaluating capital budgeting analysis techniques, the payback period emphasizes:

  A. Liquidity.

  B. Profitability.

  C. Net income.

  D. The accounting period.

  Correct Answer: A

  Choice "a" is correct. The payback period is the time period required for cash inflows to recover the initial

  investment. The emphasis of the technique is on liquidity (i.e., cash flow).

  Choices "b", "c", and "d" are incorrect, per the above Explanation.