Leverage and Capital Structure

 Multiple Choice Questions

1. _________ analysis is a technique used to assess the returns associated with various cost structures and
levels of sales.
(a) Time-series
(b) Marginal
(c) Breakeven
(d) Ratio
Answer: C

2. Earnings before interest and taxes (EBIT) is a descriptive label for

(a) operating profits.
(b) net profits before taxes.
(c) earnings per share.
(d) gross profits.
Answer: A

3. _________ costs are a function of time, not sales, and are typically contractual.
(a) Fixed
(b) Semi-variable
(c) Variable
(d) Operating
 Answer: A

4. _________ costs are a function of volume, not time.

(a) Fixed operating
(b) Semi-variable
(c) Variable
(d) Fixed financial
Answer: C

5. The firm’s _________ is the level of sales necessary to cover all operating costs, i.e., the point at which
EBIT  $0.
(a) cash breakeven point
(b) financial breakeven point
(c) operating breakeven point
(d) total breakeven point
Answer: C

6. Which of the following is NOT a variable cost?

(a) Materials used.
(b) Rent.
(c) Delivery costs.
(d) Direct labor.
Answer: B
7. _________ costs require the payment of a specified amount in each accounting period.
(a) Operating
 (b) Variable
(c) Semi-variable
(d) Fixed
Answer: D

8. At the operating breakeven point, _________ equals zero.

(a) sales revenue
(b) fixed operating costs
(c) variable operating costs
(d) earnings before interest and taxes
Answer: D

9. A firm’s operating breakeven point is sensitive to all of the following variables EXCEPT
(a) fixed operating costs.
(b) sales price per unit.
(c) interest payment.
(d) variable operating cost per unit.
Answer: C

10. Breakeven analysis is used by the firm

(a) to determine the level of operations necessary to cover all operating costs.
(b) to evaluate the profitability associated with various levels of sales.
(c) Both (a) and (b).
(d) none of the above.
 Answer: C

11. If a firm’s fixed operating costs decrease, the firm’s operating breakeven point will
(a) decrease.
(b) increase.
(c) remain unchanged.
(d) change in an undetermined direction.
Answer: A

12. If a firm’s variable costs per unit increase, the firm’s operating breakeven point will
(a) decrease.
(b) increase.
(c) remain unchanged.
(d) change in an undetermined direction.
Answer: B

13. If a firm’s sale price per unit decreases, the firm’s operating breakeven point will
(a) decrease.
(b) increase.
(c) remain unchanged.
(d) change in an undetermined direction.
Answer: B

14. If a firm’s fixed financial costs decrease, the firm’s operating breakeven point will
 (a) decrease.
(b) increase.
(c) remain unchanged.
(d) change in an undetermined direction.
Answer: C

15. The firm’s operating breakeven point is the point at which

(a) total operating costs equal total fixed costs.
(b) total operating costs are zero.
(c) EBIT is less than sales.
(d) EBIT is zero.
Answer: D

16. Noncash charges such as depreciation and amortization _________ the firm’s breakeven point.
(a) do not affect
(b) overstate
(c) understate
(d) decrease
Answer: B

17. A firm has fixed operating costs of $525,000, of which $125,000 is depreciation expense. The firm’s
sales price per unit is $35 and its variable cost per unit is $22.50. The firm’s cash operating breakeven
point in units is
(a) 23,330.
(b) 32,000.
 (c) 42,000.
(d) 52,000.
Answer: B

18. Which one of the following is (are) considered as limitations of breakeven analysis?
(a) It assumes that the firm faces linear, or nonvarying, sales revenue and total operating cost functions.
(b) It is difficult to break semivariable costs into fixed and variable components.
(c) It has a short-term time horizon.
(d) All of the above.
Answer: D

19. A major assumption of breakeven analysis and one which causes severe limitations in its use is that
(a) fixed costs really are fixed.
(b) total revenue is nonlinear.
(c) revenues and operating costs are linear.
(d) all costs are really semi-variable.
Answer: C

20. The per dollar contribution toward fixed operating costs and profits provided by each dollar of sales is
the
(a) profit margin.
(b) contribution margin.
(c) expense ratio.
(d) fixed coverage ratio.
 Answer: B

21. A firm has fixed operating costs of $10,000, the sale price per unit of its product is $25, and its variable
cost per unit is $15. The firm’s operating breakeven point in units is _________ and its breakeven point
in dollars is _________.
(a) 250; $ 6,250
(b) 400; $10,000
(c) 667; $16,675
(d) 1,000; $25,000
Answer: D

22. A firm has fixed operating costs of $150,000, total sales of $1,500,000, and total variable costs of
$1,275,000. The firm’s operating breakeven point in dollars is
(a) $150,000.
(b) $176,471.
(c) $1,000,000.
(d) $1,425,000.
Answer: C

23. A firm has fixed operating costs of $253,750, a sales price per unit of $100, and a variable cost per unit
of $65. The firm’s operating breakeven point in dollars is
(a) $725,000.
(b) $700,000.
(c) $906,250.
(d) $390,385.
Answer: A

24. One function of breakeven analysis is to

 (a) create profits.
(b) describe leverage.
(c) evaluate the profitability of various sales levels.
(d) determine the amount of financing needed by the firm.
Answer: C

25. The preferred approach to breakeven analysis for the multiproduct firm is the
(a) breakeven point expressed in units.
(b) breakeven point expressed in dollars.
(c) cash breakeven point.
(d) overall breakeven point.
Answer: B

26. A firm has fixed operating costs of $25,000, a per unit sales price of $5, and a variable cost per unit of
$3. What is its operating breakeven point if it desires net operating income of $10,000, not $0 (zero)?
(a) 12,500 units.
(b) 15,000 units.
(c) 17,500 units.
(d) 25,000 units.
Answer: C

27. The long-term funds of the firm are called

(a) debt.
(b) assets.
 (c) capital.
(d) equity.
Answer: C

28. _________ results from the use of fixed-cost assets or funds to magnify returns to the firm’s owners.
(a) Long-term debt
(b) Equity
(c) Leverage
(d) Capital structure
Answer: C

29. _________ leverage is concerned with the relationship between sales revenues and earnings before
interest and taxes.
(a) Financial
(b) Operating
(c) Variable
(d) Total
Answer: B

30. _________ leverage is concerned with the relationship between sales revenue and earnings per share.
(a) Financial
(b) Operating
(c) Variable
(d) Total
Answer: D
31. _________ leverage is concerned with the relationship between earnings before interest and taxes and
earnings per share.
(a) Financial
(b) Operating
(c) Variable
(d) Total
Answer: A

32. _________ is the potential use of fixed operating costs to magnify the effects of changes in sales on
earnings before interest and taxes.
(a) Financial leverage
(b) Operating leverage
(c) Total leverage
(d) Ratio analysis
Answer: B

33. _________ is the potential use of fixed financial charges to magnify the effects of changes in earnings
before interest and taxes on the firm’s earnings per share.
(a) Financial leverage
(b) Operating leverage
(c) Total leverage
(d) Debt service
Answer: A

34. Fixed financial charges include

(a) common stock dividends and bond interest expense.
 (b) common stock dividends and preferred stock dividends.
(c) bond interest expense and preferred stock dividends.
(d) stock repurchase expense.
Answer: C

35. A decrease in fixed financial costs will result in _________ in financial risk.
(a) an increase
(b) a decrease
(c) no change
(d) an undetermined change
Answer: B

36. The three basic types of leverage are

(a) operating, production, and financial.
(b) operating, production, and total.
(c) production, financial, and total.
(d) operating, financial, and total.
Answer: D

37. The higher financial leverage causes _________ to increase more for a given increase in _________.
(a) EBIT; sales
(b) EPS; sales
(c) EPS; EBIT
 (d) EBIT; EPS
Answer: C

38. _________ is the potential use of fixed costs, both operating and financial, to magnify the effect of
changes in sales on the firm’s earnings per share.
(a) Debt service
(b) Total leverage
(c) Operating leverage
(d) Financial leverage
Answer: B

39. As fixed operating costs increase and all other factors are held constant, the degree of operating leverage
will
(a) increase.
(b) decrease.
(c) remain unchanged.
(d) change in an undetermined direction.
Answer: A

40. Through the effects of financial leverage, when EBIT increases, earnings per share will
(a) increase.
(b) decrease.
(c) remain unchanged.
(d) change in an undetermined direction.
 Answer: A

41. With the existence of fixed operating costs, a decrease in sales will result in _________ in EBIT.
(a) a proportional increase
(b) an equal increase
(c) a less than proportional decrease
(d) a more than proportional decrease
Answer: D

42. An increase in fixed operating costs will result in _________ in the degree of operating leverage.
(a) a decrease
(b) an increase
(c) no change
(d) an undetermined change
Answer: B

43. A firm has fixed operating costs of $650,000, a sales price per unit of $20, and a variable cost
per unit of $13. At a base sales level of 500,000 units, the firm’s degree of operating leverage
is _________.
(a) 1.07
(b) 1.11
(c) 1.18
(d) 1.23
Answer: D

44. A firm has fixed operating costs of $175,000, total sales revenue of $3,000,000 and total variable costs
of $2,250,000. The firm’s degree of operating leverage is _________.
 (a) 0.77
(b) 1.30
(c) 0.81
(d) 4.29
Answer: B

45. A firm has EBIT of $375,000, interest expense of $75,000, preferred dividends of $6,000 and a
tax rate of 40 percent. The firm’s degree of financial leverage at a base EBIT level of $375,000
is _________.
(a) 0.97
(b) 1.29
(c) 1.27
(d) 1.09
Answer: B

46. A decrease in fixed operating costs will result in _________ in the degree of financial leverage.
(a) a decrease
(b) an increase
(c) no change
(d) an undetermined change
Answer: D

47. At a base sales level of $400,000, a firm has a degree of operating leverage of 2 and a degree of financial
leverage of 1.5. The firm’s degree of total leverage is _________.
(a) 3.5
(b) 3.0
 (c) 0.5
(d) 1.3
Answer: B

48. Generally, _________ in leverage result in _________ return and _________ risk.
(a) increases; decreased; increased
(b) increases; decreased; decreased
(c) increases; increased; increased
(d) decreases; increased; decreased
Answer: C

49. With the existence of fixed operating costs, an increase in sales will result in _________ increase in
EBIT.
(a) a proportional
(b) an equal
(c) a less than proportional
(d) a more than proportional
Answer: D

50. A firm has interest expense of $145,000, preferred dividends of $25,000, and a tax rate of
40 percent. The firm’s financial breakeven point is
(a) $ 25,000.
(b) $170,000.
(c) $186,667.
(d) $145,000.
Answer: C
51. Because the degree of total leverage is multiplicative and not additive, when a firm has very high
operating leverage it can moderate its total risk by
(a) increasing sales.
(b) using more financial leverage.
(c) increasing EBIT.
(d) using a lower level of financial leverage.
Answer: D

52. The firm’s _________ is the mix of long-term debt and equity utilized by the firm, which may
significantly affect its value by affecting return and risk.
(a) dividend policy
(b) capital budget
(c) capital structure
(d) working capital
Answer: C

53. The basic sources of capital for a firm include all of the following EXCEPT
(a) long-term debt.
(b) preferred stock.
(c) current liabilities.
(d) common stock.
Answer: C

54. In theory, the firm should maintain financial leverage consistent with a capital structure that
(a) meets the industry standard.
 (b) maximizes the earnings per share.
(c) maximizes the owner’s wealth.
(d) maximizes dividends.
Answer: C

55. _________ risk is the risk of being unable to cover operating costs.
(a) Business
(b) Financial
(c) Leverage
(d) Total
Answer: A

56. Business risk is affected by all of the following EXCEPT

(a) revenue stability.
(b) cost stability.
(c) operating leverage.
(d) earnings per share.
Answer: D

57. All of the following affect business risk EXCEPT

(a) operating leverage.
(b) interest rate stability.
 (c) cost stability.
(d) revenue stability.
Answer: B

58. _________ risk is the risk of being unable to cover financial costs.
(a) Business
(b) Financial
(c) Total
(d) Leverage
Answer: B

59. After satisfying obligations to creditors, the government, and preferred stockholders, any remaining
earnings will most likely be allocated to any of the following EXCEPT
(a) common shareholders as cash dividends.
(b) common shareholders as stock dividends.
(c) retained by the firm for future investment.
(d) a combination of retained earnings and cash dividends.
Answer: B

60. The lower risk nature of long-term debt in a firm’s capital structure is due to the fact that
(a) the equity holders are the true owners of the firm.
(b) equity capital has a fixed return.
(c) creditors have a higher position in the priority of claims.
(d) dividend payments are tax-deductible.
 Answer: C

61. Which of the following is NOT a reason why debt capital is considered to be the least risky source of
capital?
(a) It has a high priority claim against assets and earnings.
(b) It has a strong legal position.
(c) It is a low cost source of capital because interest payments are tax deductible.
(d) It does not normally have to be repaid at a specific future date.
Answer: D

62. Probability of bankruptcy is determined by

(a) financial risk.
(b) total risk.
(c) business risk.
(d) interest rate risk.
Answer: B

63. The inexpensive nature of long-term debt in a firm’s capital structure is due to the fact that
(a) the equity holders are the true owners of the firm.
(b) equity capital has a fixed return.
(c) creditors have a higher position in the priority of claims.
(d) dividend payments are tax-deductible.
 Answer: C

64. The inexpensive nature of long-term debt in a firm’s capital structure is due to the fact that
(a) the equity holders are the true owners of the firm.
(b) equity capital has a fixed return.
(c) interest payments are tax-deductible.
(d) equity holders have a higher position in the priority of claims.
Answer: C

65. The key differences between debt and equity capital include all of the following EXCEPT
(a) voice in management.
(b) maturity.
(c) tax treatment.
(d) effect on operating leverage.
Answer: D

66. The cost of debt financing results from

(a) the increased profitability of bankruptcy caused by debt obligations.
(b) the agency costs of the lender’s monitoring and controlling the firm’s actions.
(c) the costs associated with managers having more information about the firm’s prospects than do
investors.
(d) All of the above.
Answer: D

67. A corporation borrows $1,000,000 at 10 percent annual rate of interest. The firm has a 40 percent tax
rate. The yearly, after-tax cost of this debt is
 (a) $ 40,000.
(b) $ 60,000.
(c) $100,000.
(d) $166,667.
Answer: B

68. A corporation has $5,000,000 of 8 percent preferred stock outstanding and a 40 percent tax rate. The
after-tax cost of the preferred stock is
(a) $400,000.
(b) $240,000.
(c) $666,667.
(d) $160,000.
Answer: A

69. A corporation has $10,000,000 of 10 percent preferred stock outstanding and a 40 percent tax rate. The
amount of earnings before interest and taxes (EBIT) required to pay the preferred dividends is
(a) $1,000,000.
(b) $ 400,000.
(c) $ 600,000.
(d) $1,666,667.
Answer: D

70. A corporation has $5,000,000 of 10 percent bonds and $3,000,000 of 12 percent preferred stock
outstanding. The firm’s financial breakeven (assuming a 40 percent tax rate) is
(a) $860,000.
(b) $716,000.
 (c) $1,100,000.
(d) $1,400,000
Answer: C

71. The conflict resulting from a manager’s desire to increase the firm’s risk without increasing current
borrowing costs and lenders’ desire to limit lending is one effect of the _________ problem.
(a) agency
(b) leverage
(c) capital
(d) variable cost
Answer: A

72. Operating and financial constraints placed on a corporation by loan provision are
(a) agency costs to the lender.
(b) agency costs to the firm.
(c) interest rate costs to the firm.
(d) necessary to control the risk of the firm.
Answer: B

73. The risk of the debt capital is less than that of other long-term contributors of capital because
(a) they have a higher priority of claim against any earnings or assets available for payment.
(b) they have a far stronger legal pressure against the company to make payment than do preferred and
common stockholders.
(c) the tax-deductibility of interest payments lowers the debt cost to the firm substantially.
(d) all of the above.
 Answer: D

74. Management has just discovered an excellent investment for which it needs additional funding. Relative
to the discussion on asymmetric information the firm should
(a) finance with new common stock if management believes the firm is undervalued.
(b) finance with debt if management believes the firm is undervalued.
(c) finance with debt if management believes the firm is overvalued.
(d) finance with preferred stock if the firm is at value.
Answer: B

75. In order to enhance the wealth of stockholders and to send positive signals to the market, corporations
generally raise funds using the following order.
(a) Retained earnings, equity, debt.
(b) Retained earnings, debt, equity.
(c) Debt, retained earnings, equity.
(d) Equity, retained earnings, debt.
Answer: B

76. The optimal capital structure is the one that balances

(a) return and risk factors in order to maximize profits.
(b) return and risk factors in order to maximize earnings per share.
(c) return and risk factors in order to maximize market value.
(d) return and risk factors in order to maximize dividends.
Answer: C

77. As debt is substituted for equity in the capital structure and the debt ratio increases, all of the following
statements about the component costs of capital are true EXCEPT
 (a) the cost of equity continually increases.
(b) the cost of debt continually increases.
(c) the overall cost of capital first declines, reaches a minimum, and then rises again.
(d) the overall cost of capital continually increases.
Answer: D

78. Poor capital structure decisions can result in _________ the cost of capital, resulting in _________
acceptable investments. Effective capital structure decisions can _________ the cost of capital, resulting
in _________ acceptable investments.
(a) increasing; fewer; lower; more
(b) decreasing; more; higher; fewer
(c) increasing; more; lower, fewer
(d) decreasing; fewer; higher; more
Answer: A

79. According to the traditional approach to capital structure, the value of the firm will be maximized when
(a) the financial leverage is maximized.
(b) the cost of debt is minimized.
(c) the weighted average cost of capital is minimized.
(d) the dividend payout is maximized.
Answer: C

80. In the traditional approach to capital structure, as the amount of debt increases in a firm’s capital
structure,
(a) the cost of equity rises faster than the cost of debt.
(b) the cost of debt rises faster than the cost of equity.
 (c) debt becomes less risky.
(d) equity cost is unaffected.
Answer: A

81. As debt is substituted for equity in the capital structure and the debt ratio increases, the behavior of the
overall cost of capital is partially explained by
(a) the tax-deductibility of interest payments.
(b) the increase in the number of common shares outstanding.
(c) the reduction in risk as perceived by the common shareholders.
(d) the decrease in the cost of equity.
Answer: A

82. The controversy over the existence of an optimal capital structure is debated between those _________
who believe a traditional approach exists and those _________, who do not believe one exists. In the
_________ approach to capital structure, the optimal capital structure occurs where the _________ is
minimized.
(a) supporters of Modigliani and Miller; traditionalists; Modigliani and Miller; degree of financial
leverage.
(b) traditionalists; supporters of Modigliani and Miller; traditional; cost of capital
(c) supporters of Modigliani and Miller; traditionalists; Modigliani and Miller; cost of capital
(d) traditionalists; supporters of Modigliani and Miller; traditional; degree of financial leverage
Answer: B

83. A firm has an operating profit of $300,000, interest of $35,000, and a tax rate of 40 percent. The firm
has an after-tax cost of debt of 5 percent and a cost of equity of 15 percent. The firm’s target capital
structure is set at a mix of 40 percent debt and 60 percent equity. According to the traditional approach
to capital structure, the value of the firm is
(a) $1.4 million.
(b) $2.0 million.
(c) $2.7 million.
(d) $6.0 million.
 Answer: C

84. In the EBIT-EPS approach to capital structure, risk is represented by

(a) shifts in the cost of equity capital.
(b) shifts in the cost of debt capital.
(c) the slope of the capital structure line.
(d) shifts in the times-interest-earned ratio.
Answer: C

85. In the EBIT-EPS approach to capital structure, a constant level of EBIT is assumed
(a) to ease the calculations of owners’ equity.
(b) to isolate the impact on returns of the financing costs associated with alternative capital structures.
(c) to emphasize the relationship between interest expenses and taxes.
(d) to concentrate on the effect of revenue and expense on capital structure decisions.
Answer: B

86. A firm has a current capital structure consisting of $400,000 of 12 percent annual interest debt and
50,000 shares of common stock. The firm’s tax rate is 40 percent on ordinary income. If the EBIT is
expected to be $200,000, the firm’s earnings per share will be _________.
(a) $2.40
(b) $3.04
(c) $7.04
(d) $1.82
Answer: D

87. The major shortcoming of the EBIT-EPS approach to capital structure is that
 (a) the technique does not promote the maximization of shareholder wealth.
(b) the technique does not consider the cost of capital.
(c) the technique only considers leverage-related risk.
(d) the technique does not maximize earnings per share.
Answer: A

88. The _________ approach to capital structure proposes that an optimal capital structure be selected which
_________.
(a) M and M; maximizes the weighted average cost of capital
(b) traditional; minimizes the cost of debt
(c) EBIT-EPS; maximizes the EPS
(d) residual theory; minimizes dividends
Answer: C

89. A firm has a current capital structure consisting of $400,000 of 12 percent annual interest debt and
50,000 shares of common stock. The firm’s tax rate is 40 percent on ordinary income. If the EBIT is
expected to be $200,000, two EBIT-EPS coordinates for the firm’s existing capital structure are
(a) ($36,000, $0) and ($200,000, $3.04).
(b) ($48,000, $0) and ($200,000, $1.82).
(c) ($0, $48,000) and ($200,000, $1.82).
(d) ($152,000, $3.50) and ($150,000, $1.82).
Answer: B

90. The basic shortcoming of the EBIT-EPS approach to capital structure is

(a) that the optimal capital structure is difficult to compute.
(b) its disregard for the presence of preferred stock in the capital structure.
(c) its disregard for the firm’s dividend policy.
 (d) that it concentrates on the maximization of EPS rather than the maximization of owner’s wealth.
Answer: D

91. A firm is analyzing two possible capital structures—30 and 50 percent debt ratios. The firm has total
assets of $5,000,000 and common stock valued at $50 per share. The firm has a marginal tax rate of 40
percent on ordinary income. The number of common shares outstanding for each of the capital structures
would be
(a) 30 percent debt ratio: 30,000 shares and 50 percent debt ratio: 50,000 shares.
(b) 30 percent debt ratio: 50,000 shares and 50 percent debt ratio: 70,000 shares.
(c) 30 percent debt ratio: 70,000 shares and 50 percent debt ratio: 100,000 shares.
(d) 30 percent debt ratio: 70,000 shares and 50 percent debt ratio: 50,000 shares.
Answer: D

92. A firm is analyzing two possible capital structures—30 and 50 percent debt ratios. The firm has total
assets of $5,000,000 and common stock valued at $50 per share. The firm has a marginal tax rate of 40
percent on ordinary income. If the interest rate on debt is 7 percent and 9 percent for the 30 percent and
the 50 percent debt ratios, respectively, the amount of interest on the debt under each of the capital
structures being considered would be
(a) 30 percent debt ratio: $105,000 and 50 percent debt ratio: $225,000.
(b) 30 percent debt ratio: $245,000 and 50 percent debt ratio: $225,000.
(c) 30 percent debt ratio: $105,000 and 50 percent debt ratio: $250,000.
(d) 30 percent debt ratio: $135,000 and 50 percent debt ratio: $175,000.
Answer: A

93. Financial leverage measures the effect of fixed financing costs on the relationship between
(a) Sales and EBIT.
(b) Sales and EPS.
(c) EBIT and EPS.
(d) none of the above.
Answer: C
94. Operating leverage measures the effect of fixed financing costs on the relationship between
(a) Sales and EBIT.
(b) Sales and EPS.
(c) EBIT and EPS.
(d) none of the above.
Answer: D

95. Operating leverage measures the effect of fixed operating costs on the relationship between
(a) Sales and EBIT.
(b) Sales and EPS.
(c) EBIT and EPS.
(d) none of the above.
Answer: A

96. Financial leverage measures the effect of fixed operating costs on the relationship between
(a) Sales and EBIT.
(b) Sales and EPS.
(c) EBIT and EPS.
(d) none of the above.
Answer: D

97. Total leverage measures the effect of fixed costs on the relationship between
(a) Sales and EBIT.
(b) Sales and EPS.
(c) EBIT and EPS.
(d) none of the above.
Answer: B
98. Tony’s Beach T-Shirts has fixed annual operating costs of $75,000. Tony retails his T-shirts for $14.99
each and the variable cost per T-shirt is $4.99. Based on this information, the breakeven sales level in
dollars is
(a) $125,495.
(b) $112,425.
(c) $108,995.
(d) none of the above.
Answer: B

99. Tony’s Beach T-Shirts has fixed annual operating costs of $75,000. Tony retails his T-shirts for $14.99
each and the variable cost per T-shirt is $4.99. Based on this information, the breakeven sales level in
units is
(a) 7,500.
(b) 15,030.
(c) 5,003.
(d) none of the above.
Answer: A

100. Nico Trading Company must choose its optimal capital structure. Currently, the firm has a 20 percent
debt ratio and the firm expects to generate a dividend next year of $5.44 per share. Dividends are
expected to remain at this level indefinitely. Stockholders currently require a
12.1 percent return on their investment. Nico is considering changing its capital structure if it would
benefit shareholders. The firm estimates that if it increases the debt ratio to 30 percent, it will increase its
expected dividend to $5.82 per share. Again, dividends are expected to remain at this new level
indefinitely. However, because of the added risk, the required return demanded by stockholders will
increase to 12.6 percent. Based on this information, should Nico make the change?
(a) Yes.
(b) No.
(c) It’s irrelevant.
(d) Not enough information.
Answer: A