FINA 351 – Managerial Finance, Chapter 13, Questions (Ref. 13)
We don’t have much time to thoroughly cover Ch. 13 but we’ll pick up what we need to know by answering the
questions below.
1. According to the introduction:
(A) Debt is a double-edged sword. Why?
(B) T or F: Striking the right balance between too little debt and too much debt is what capital structure is
all about.
2. (A) T or F: Leverage involves borrowing money to lever up the return on equity, which is one reason firms
often take on too much debt (see instructor notes on advantages of debt.)
(B) To illustrate the power of leverage, assume you could afford to pay cash for a new $100,000 house (you
didn’t need to borrow anything). If the home value goes up to $110,000, what return on equity does the
$10,000 increase represent? (Hint: ROE = the amount of increase divided by original equity; the increase
is $10k and your equity in the home is $100k).
(C) Assume instead that you had to borrow $90,000 from the bank in order to buy a new $100,000 home
(you put $10,000 of your own money down). If the home value goes up to $110,000, what return on equity
does the $10,000 increase represent? (Hint: the increase was $10k, and your equity is $10k).
(D) Recalculate return on equity in letters B & C above assuming instead that the value of your home
decreased from $100,000 to $90,000. Note: In the U.S. today, many homes are still underwater, where the
debt is more than the home value. This is not surprising given the 100% financing (i.e. no money down)
available in the mid-2000s.
(E) T or F: Leverage (debt) magnifies gains and losses, making a return on investment more risky.
(F) T or F: The principle of leverage also applies to an Investopedia portfolio that uses margin.
(G) Prior to the financial crisis, many banks loaded up with massive amounts of debt on their balance
sheets. For example, Lehman Brothers (an investment bank) had $33 of debt for every $1 of equity. Why
do you suppose that banks, such as Lehman, did this?
3. Suppose a firm had financed half of its assets with debt financing and the half with equity financing, thus
having a debt equity ratio equal to one (50/50 or 1:1). What actions could the firm take to decrease its
debt/equity ratio to less than one? To increase its debt/equity ratio to greater than one?
4. (A) ZZZ Corp. had an existing balance sheet as follows: Assets = $100,000, Liabilities = $50,000, and
Equity = $50,000. If net income was $5,000 for the year, what was the return on equity for that year?
(B) In the following year, the CFO for ZZZ realized that the goal of the firm should be to return value to
owners, so she decides to increase the return on equity by issuing $25,000 of bonds and with the proceeds
buying back $25,000 of stock. If net income in the new year is also $5,000, what is the return on equity
now?
5. Who are M&M? (see instructor notes)
6. See Figure 13.6 (reproduced in instructor notes, point #5).
(A) What is the conclusion of Case I (no taxes) regarding how much debt a firm should have?
(B) What is the conclusion of Case II (with taxes) regarding how much debt a firm should have?
(C) What is the conclusion of Case III (with taxes and bankruptcy costs) regarding how much debt a firm
should have?
7. See Figure 13.6 (reproduced in instructor notes, point #5)..
(A) T or F: The value of the firm is maximized when the WACC is minimized.
(B) T or F: The optimal or target capital structure is one that minimizes WACC.
(C) T or F: The capital structure determines the weights in the WACC formula.
(D) If debt financing is generally cheaper than equity financing, why don’t corporations use debt financing
exclusively?
8. See Table 13.5 in your text (reproduced in instructor notes, point #7).
(A) Which three industries carry the highest debt levels?
(B) Which three industries carry the lowest debt levels?
(C) Why do you suppose that debt levels vary so much from industry to industry?
9. (A) Regarding the two most common forms of bankruptcy (Chapter 7 and 11), which of these types is
called reorganization and which is called liquidation?
(B) Which of these two types of bankruptcy assumes the company is worth more alive than dead?
Which one assumes the company is worth more dead than alive?
(C) Rank the following parties in order of who got paid first in a bankruptcy of Blockbuster Video:
a) preferred stockholders
b) debenture bond holders
c) common stockholders
d) bank lenders with lien on specific assets
e) court lawyers and judge involved in bankruptcy
f) Internal Revenue Service
g) employees of Blockbuster with wages/benefits owed