equity and debt both increase

the current earnings multiplier
November 7, 2019
pricing and financial information
November 7, 2019

equity and debt both increase

Which of the following statements is CORRECT?

When a company increases its debt ratio, the costs of equity and debt both increase. Therefore, the WACC must also increase.

The capital structure that maximizes the stock price is generally the capital structure that also maximizes earnings per share.

All else equal, an increase in the corporate tax rate would tend to encourage a company to increase its debt ratio.

Since debt financing raises the firm’s financial risk, increasing a company’s debt ratio will always increase its WACC.

Since debt is cheaper than equity, increasing a company’s debt ratio will always reduce its WACC.

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Which of the following statements is CORRECT?

If a firm repurchases some of its stock in the open market, then shareholders who sell their stock for more than they paid for it will be subject to capital gains taxes.

An open-market dividend reinvestment plan will be most attractive to companies that need new equity and would otherwise have to issue additional shares of common stock through investment bankers.

Stock repurchases tend to reduce financial leverage.

If a company declares a 2-for-1 stock split, its stock price should roughly double.

One advantage of adopting the residual dividend policy is that this makes it easier for corporations to meet the requirements of Modigliani and Miller’s dividend clientele theory.

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Which of the following statements is CORRECT, holding other things constant?

Firms whose assets are relatively liquid tend to have relatively low bankruptcy costs, hence they tend to use relatively little debt.

An increase in the personal tax rate is likely to increase the debt ratio of the average corporation.

If changes in the bankruptcy code make bankruptcy less costly to corporations, then this would likely reduce the debt ratio of the average corporation.

An increase in the company’s degree of operating leverage is likely to encourage a company to use more debt in its capital structure.

An increase in the corporate tax rate is likely to encourage a company to use more debt in its capital structure.

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Stephens Electronics is considering a change in its target capital structure, which currently consists of 25% debt and 75% equity. The CFO believes the firm should use more debt, but the CEO is reluctant to increase the debt ratio. The risk-free rate, rRF, is 5.0%, the market risk premium, RPM, is 6.0%, and the firm’s tax rate is 40%. Currently, the cost of equity, rs, is 11.5% as determined by the CAPM. What would be the estimated cost of equity if the firm used 60% debt? (Hint: You must first find the current beta and then the unlevered beta to solve the problem.)

10.95%

11.91%

12.94%

14.07%

15.29%
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