Deck 18: Capital Structure and the Cost of Capital

Question 1

The ratio of long-term debt to GDP for non-financial U.S. corporations declined drastically during the late 1990s.

Answer 1

False

Question 2

There is no opportunity cost associated with retained earnings.

Answer 2

False

Question 3

Firm value is calculated by adding expected cash flow to the firm's cost of capital under each capital structure.

Answer 3

False

Question 4

The cost of debt represents the minimum acceptable rate of return to a firm on a project of average risk.

Question 5

The minimum required rate of return is a weighted average of the firm's cost of various sources of capital.

Question 6

The ratio of debt to stock market equity has generally been lowest for the largest of U.S. firms.

Question 7

The cost of capital should be estimated from the historical cost of raising debt and equity capital.

Question 8

Firms have three sources of common equity, retained earnings, new stock issues, and new bond issues.

Question 9

Repurchasing common stock decreases a firm's debt to equity ratio.

Question 10

The firm's unadjusted cost of debt financing equals the yield to maturity on new debt issues.

Question 11

A lower weighted average cost of capital gives lower project NPVs.

Question 12

The firm's optimum debt/equity mix maximizes the firm's cost of capital, which in turn will help the firm to maximize shareholder wealth.

Question 13

A nonoptimal capital structure may lead the firm to reject some capital budgeting projects that could have increased shareholder wealth with an optimal financing mix.

Question 14

The weighted average cost of capital is used so project acceptance is not subject to how it is to be financed.

Question 15

Minimum cash flow ∕ Investment = Maximum rate of return.

Question 16

The firm's optimum debt/equity mix minimizes the firm's cost of capital, which in turn will help the firm to maximize shareholder wealth.

Question 17

The firm's capital structure is the mix of debt and equity used to finance its assets.

Question 18

The required return, the cost of capital, and the discount rate are actually three distinctively different concepts.

Question 19

A nonoptimal capital structure may lead to higher financing costs.

Question 20

The minimum acceptable rate of return for a project is the return that generates sufficient cash flow to pay investors their expected return.

Question 21

The green growth rate is the estimate of how quickly a firm can grow when it uses internal equity and debt financing to keep its capital structure constant over time.

Question 22

Retained earnings are not directly related to net income.

Question 23

The weighted average cost of capital represents the maximum required rate of return on a capital-budgeting project and is found by multiplying the cost of each capital structure component by its appropriate weight and summing the terms.

Question 24

ROA = Profit margin / Total asset turnover.

Question 25

The retained earnings rate is the proportion of each dollar of earnings per share that is retained by the firm.

Question 26

The basic capital structure of a firm may include debt, preferred equity, common equity, and bonds.

Question 27

The internal growth rate measures how quickly a firm can grow when it uses both internal equity and debt financing to keep its capital structure constant over time.

Question 28

Retained earnings represent cost-free financing to the firm.

Question 29

Issuance costs are costs of issuing stock; includes accounting, legal, and printing costs of offering shares to the public, as well as the commission or fees earned by the investment bankers.

Question 30

For any firm's given growth strategy, its dividend decision directly affects its capital structure decision.

Question 31

Surveys of U.S. firms find that most firms use before-tax WACC as their required rate of return for projects.

Question 32

The dividend payout ratio is the proportion of each dollar of earnings that is paid to shareholders as a dividend; equals one minus the retention rate.

Question 33

Corporate bond yields are extremely stable over time.

Question 34

The sustainable growth rate measures how quickly a firm can increase its asset base over the next year without raising outside funds.

Question 35

The internal growth rate measures how quickly a firm can increase its asset base over the next year without raising outside funds.

Question 36

The sustainable growth rate measures how quickly a firm can grow when it uses both internal equity and debt financing to keep its capital structure constant over time.

Question 37

Corporate stock prices are extremely stable over time.

Question 38

Financial theory favors the method using the market values of the firm's debt and equity to compare target and actual weights.

Question 39

Similar to the net present value method, there is a formula to determine the proportions of debt and equity a firm should use to finance its assets.

Question 40

A reduction in the dividend payout ratio implies a higher retention rate.

Question 41

Variations in EBIT will produce changes in earnings per share.

Question 42

Leverage does not affect EPS for most firms.

Question 43

A firm's degree of combined leverage is the product of its degree of operating leverage and its degree of financial leverage

Question 44

The degree of financial leverage measures the sensitivity of earnings per share to sales.

Question 45

Financial risk affects the bottom half of the income statement.

Question 46

The degree of financial leverage measures the sensitivity of earnings per share to changes in EBIT.

Question 47

A firm's business risk is measured by its variability in EBIT over time.

Question 48

When the interest expense is zero, the percentage change in earnings per share will be the same as the percentage change in EBIT.

Question 49

EBIT/eps analysis inadequately captures the risk facing investors and how it affects shareholder wealth.

Question 50

EBIT/EPS analysis shows the ranges of EBIT where a firm may prefer one capital structure over another.

Question 51

A firm's financial risk is measured by its variability in EBIT over time.

Question 52

Operating leverage affects the top portion of a firm's income statement whereas financial leverage affects the bottom half of the income statement.

Question 53

The degree of financial leverage may be measured by taking the firm's earnings before interest and taxes and dividing by earnings before taxes.

Question 54

Business risk is measured by the degree of financial leverage.

Question 55

EBIT/EPS analysis allows managers to see how different capital structures affect the earnings levels of their firms.

Question 56

Operating leverage is affected by such items as rental payments, contractual employee salaries, and general and administrative overhead expenses.

Question 57

The EPS/EBIT indifference level represents the level of EBIT at which the firm would be indifferent between two different capital structures because they both result in the same level of EPS.

Question 58

The greater the total fixed operating costs of a firm, the greater the degree of operating leverage and the greater the degree of combined leverage.

Question 59

The degree of combined leverage is the percentage change in earnings per share that results from a one percent change in EBIT.

Question 60

The degree of combined leverage is measured by adding the degree of operating leverage and degree of financial leverage.

Question 61

All of the following statements are correct, except:

A) The firm's optimum debt/equity mix minimizes the firm's cost of capital, which in turn helps the firm to maximize shareholder wealth
B) A firm's mix of debt and equity used to finance its assets is not the firm's capital structure.
C) A non-optimal capital structure with either too much or too little debt leads to higher financing costs, and the firm will likely reject some capital budgeting projects that could have increased shareholder wealth with an optimal financing mix.
D) A project's NPV represents the increase in shareholders' wealth from undertaking a project; thus, a lower weighted average cost of capital gives higher project net present values and results in higher levels of shareholder wealth.

Question 62

The pecking order hypothesis implies that firm's have no optimal debt/equity ratios.

Question 63

Some classes of common equity may have superior voting rights.

Question 64

What should be the relation between the target capital structure for a firm and the firm's optimum capital structure?

A) Target and optimum capital structures should be the same.
B) Target capital structure is more conservative overall.
C) Target capital structure contains more debt.
D) Target capital structure excludes preferred stock.

Question 65

Preferred stock has a claim on the firm that is senior to the bondholder claim and also senior to the common shareholder claim.

Question 66

All classes of common equity may have the same dividends.

Question 67

Of the components shown below, which is least likely to be of value in calculating the cost of preferred stock?

A) flotation costs per share
B) book value of a preferred share
C) dividends per share
D) market price per share

Question 68

All classes of common equity may have the same voting rights.

Question 69

All of the following statements are correct except:

A) Venture capitalists usually are members of partnerships that consist of a few general partners.
B) The typical venture capital partnership manages between $500 million and $1billion in assets.
C) It is common to organize a venture capital fund as a limited partnership in which the venture capitalist is the general partner and the other investors are limited investors.
D) At the end of a fund's life, cash and securities are distributed to the investors.

Question 70

The probability of financial distress and bankruptcy rises as a firm's bond ratings decline.

Question 71

Firms with highly variable EBIT can afford to issue large amounts of debt.

Question 72

A firm's DOL affects the amount of debt it can issue.

Question 73

The static trade-off hypothesis states that firms will balance the advantages of debt with its disadvantages.

Question 74

All of the following statements are correct except:

A) The firm's optimum debt/equity mix maximizes the firm's cost of capital, which in turn helps the firm to maximize shareholder wealth
B) A firm's mix of debt and equity used to finance its assets defines the firm's capital structure.
C) A non-optimal capital structure with either too much or too little debt leads to higher financing costs, and the firm will likely reject some capital budgeting projects that could have increased shareholder wealth with an optimal financing mix.
D) A project's NPV represents the increase in shareholders' wealth from undertaking a project; thus, a lower weighted average cost of capital gives higher project net present values and results in higher levels of shareholder wealth.

Question 75

The project's pre-tax minimum rate of return must equal which of the following:

A) Lender's interest - Shareholders' return
B) Lender's interest + Shareholders' return
C) Minimum cash flow x Investment
D) Minimum cash flow ∕ Investment

Question 76

A firm's mix of debt and equity defines the firm's:

A) capital structure
B) working capital
C) net working capital
D) degree of operating leverage

Question 77

Firms prefer to issue stock when earnings expectations by the market are overly optimistic.

Question 78

Which of the following is a different concept from the other three?

A) required rate of return
B) cost of capital
C) discount rate
D) net profit margin

Question 79

To compensate the firm's investors adequately, the project should generate an annual pretax expected cash flow equal to which of the following:

A) Lender's interest - Shareholders' return
B) Lender's interest + Shareholders' return
C) Minimum cash flow x Investment
D) Minimum cash flow ∕ Investment

Question 80

An implication of the pecking order and market timing hypotheses is that the firm has no optimal capital structure.