4.   If a firm takes on debt, which of the following statements would be TRUE?

A.  Its expected return on equity would be higher and also riskier.

B.   Its expected return on equity would be lower and riskier.

C.   Its expected return on equity would be higher but safer.

D.  Its borrowing rate is not likely to change with debt.

The following data applies to questions 5 through 11.

Pacific Airlines (PA) has annual sales of $850 million, variable costs of 70% of sales and fixed costs of $125 million. It has $1.5 billion in debt, carrying an interest rate of 6%. PA is in the 35% tax bracket and has 50 million shares outstanding. The airline is worried about the impact of a sales drop of 2% on its financials.

5.   How much would PA’s operating profit change by? What is PA’s degree of operating leverage?

A.  2.00% and 1.00 respectively.

B.   2.00% and 2.00 respectively.

C.   5.00% and 1.96 respectively.

D.  3.92% and 1.96 respectively.

6.   How much would its EPS change by? (do not round, use spreadsheet values, or store in calculator)

A.  –20.50%

B.   –18.95%

C.   –12.77%

D.  +12.77%

7.   What is PA’s degree of total leverage?

A.  13.46

B.   6.38

C.   25.54

D.  1.00

8.   What is PA’s degree of financial leverage?

A.  2.00

B.   12.75

C.   6.38

D.  3.25

9.   If PA had a debt of $1.8 billion, how much would its EPS change by for a 2% drop in sales? (do not round)

A.  –23.22%

B.   22.22%

C.   2.00%

D.  12.75%

10. What would be its degree of financial leverage under $1.8 billion debt?

A.  23.22

B.   5.92

C.   2.00

D.  1.96

11. What would be its degree of total leverage under $1.8 billion debt?

A.  1.96

B.   2.00

C.   23.22

D.  11.61

12. Which of the following statements regarding financial leverage is FALSE?

A.  It leads to greater financial risk.

B.   It leads to greater variability of return.

C.   Financial risk can be offset by a lower tax rate.

D.  It leads to possible bankruptcy.

13. Which of the following statements regarding cost of debt and cost equity is FALSE?

A.  As the debt level increases, cost of debt rises.

B.   As the debt level rises, cost of equity rises.

C.   As the debt level falls, after-tax cost of debt rises.

D.  As the debt level rises, beta of the stock increases.

14. As financial leverage increases,

A.  cost of debt and cost of capital increase.

B.   cost of capital falls and then rises.

C.   cost of capital rises and then falls.

D.  after-tax cost of debt stays flat and then declines.

15. Which of the following statements is FALSE?

A.  When the cost of capital is the lowest, value of the firm is the highest.

B.   When the cost of capital is the lowest, bankruptcy cost is balanced against the tax benefit of debt.

C.   When the cost of capital is the lowest, cost of equity is probably rising.

D.  When the cost of capital is the lowest, cost of debt is also the lowest.

16. When the value of the firm is maximized, value of common equity is:

A.  maximized.

B.   minimized.

C.   is still declining.

D.  is still rising.

17. Advantage of financial leverage to a firm is a cost to the:

A.  shareholders.

B.   bondholders.

C.   government.

D.  managers.

The following data applies to questions 21 through 25.

Mainstream Corp. has an EBIT of $5 million. It is currently unlevered (has no debt), and its cost of equity is 8%. It can borrow $30 million at a rate of 5% (risk free). Mainstream has an incremental effective tax rate of 35%.

21. The current cost of capital for Mainstream is,

A.  6.73%

B.   5.98%

C.   8.00%

D.  6.50%

22. If Mainstream borrows $30 million, the value of the firm will,

A.  increase to 51.125 million

B.   decrease to 51.125 million

C.   increase to 70.625 million

D.  increase to 40.625 million

23. After taking on additional debt as stated in the previous question, Mainstream’s equity will have a total value of,

A.  40.625 million

B.   51.125 million

C.   21.125 million

D.  21.625 million

24. The cost of equity for the levered firm will be,

A.  8.00%

B.   11.60%

C.   21.40%

D.  10.77%

25. The weighted cost of capital for the levered firm will be,

A.  7.38%

B.   6.36%

C.   7.01%

D.  5.21%