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Multiple choice questions on Capital Structure and Leverages.

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1.  Volga Publishing is considering a proposed increase in its debt ratio, which will also increase the company's interest expense. The plan would involve the company issuing new bonds and using the proceeds to buy back shares of its common stock. The company's CFO expects that the plan will not change the company's total assets or operating income. However, the company's CFO does estimate that it will increase the company's earnings per share (EPS). Assuming the CFO's estimates are correct, which of the following statements is most correct?

  1. Since the proposed plan increases Volga's financial risk, the company's stock price still might fall even though its EPS is expected to increase.
  2. If the plan reduces the company's WACC, the company's stock price is also likely to decline.
  3. Since the plan is expected to increase EPS, this implies that net income is also expected to increase.
  4. Statements a and b are correct.
  5. Statements a and c are correct.

2.  Which of the following statements is false? As a firm increases its operating leverage for a given quantity of output, this

  1. changes its operating cost structure.
  2. increases its business risk.
  3. increases the standard deviation of its EBIT.
  4. increases the variability in earnings per share.
  5. decreases its financial leverage.

3.  If debt financing is used, which of the following is true?

  1. The percentage change in net operating income is greater than a given percentage change in net income.
  2. The percentage change in net operating income is equal to a given percentage change in net income.
  3. The percentage change in net income relative to the percentage change in net operating income depends on the interest rate charged on debt.
  4. The percentage change in net operating income is less than the percentage change in net income.
  5. The degree of operating leverage is greater than 1.

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