Chapter 14
Practice Quiz 1-Answer Key
1. Jackson Trucking Company is trying to determine its optimal capital structure. The company’s CFO believes the optimal debt ratio is somewhere between 20 percent and 50 percent. Her staff has compiled the following projections for the company’s EPS and stock price for various debt levels:
Debt Ratio Projected EPS Projected Stock Price
20% $3.20 $35.00
30% $3.45 $36.50
40% $3.75 $36.25
50% $3.50 $35.50
Assuming that the firm uses only debt and common equity, what is Jackson’s optimal capital structure?
A. 20% debt, 80% equity
B. 30% debt, 70% equity-ANSWER
C. 40% debt, 60% equity
D. 50% debt, 50% equity
2. Harley Motors has $10 million in assets, which is financed with $2 million of debt and $8 million in equity. If Harley’s beta is currently 1.2 and its tax rate 40 percent, what is its unlevered beta?
A. 1.01
B. 1.03
C. 1.04-ANSWER
D. 1.05
3. A company currently has assets of $5 million. The firm is 100 percent equity financed. The company currently has net income of $1 million, and it pays out 40 percent of its net income as dividends. Both net income and dividends are expected to grow at a constant rate of 5 percent per year. There are 200,000 shares of stock outstanding, and it is estimated that the current cost of capital is 13.40 percent. The company is considering a recapitalization where it will issue $1 million in debt and use the proceeds to repurchase stock. Investment bankers have estimated that if the company goes through with the recapitalization, its before-tax cost of debt will be 11 percent, and the cost of equity will rise to 14.5 percent. The company has a 40 percent federal-plus-state tax rate. What is the current share price of the stock before the recapitalization?
A. $23.00
B. $24.00
C. $25.00-ANSWER
D. $26.00
4. Using the above information and assuming that the company maintains the same payout ratio, what will be its stock price following the recapitalization?
A. $25.43
B. $25.81-ANSWER
C. $25.91
D. $25.98