Deck 12: Capital Structure

Question 1

The combination of debt and equity used to finance a firm is known as _____.

A) capital budgeting
B) the trade-off theory
C) syndication
D) securitization
E) the capital structure

Answer 1

E

Question 2

The degree of operating leverage is defined as the percentage change in operating earnings associated with a given percentage change in sales.

Answer 2

True

Question 3

The optimal capital structure is the capital structure that strikes a balance between risk and return such that the firm's stock price is maximized.

Answer 3

True

Question 4

One implication of information asymmetry between investors and firm managers is that if the firm raises new capital by issuing debt rather than by selling stock, it will signal that the firm has very good prospects.

Question 5

From a tax standpoint, in countries where capital gains are taxed, investors should show a preference for stocks compared to investors in countries that do not have capital gains taxes.

Question 6

The announcement of a stock offering by a mature firm that seems to have financing alternatives is taken as a signal that the firm's prospects are very good.

Question 7

Companies in Italy and Japan use less debt in their capital structures than companies in the United States or Canada.

Question 8

One implication of the signaling theory of capital structure is that firms should borrow as much as the trade-off theory of capital structure predicts.

Question 9

Which of the following leads to less business risks compared to other factors?

A) High percentage of fixed costs
B) High operating leverage
C) More financial risk
D) High interest rates
E) More stable operations

Question 10

Which of the following is an example of business risk?

A) Default risk
B) Prepayment risk
C) Strategic risk
D) Currency risk
E) Equity risk

Question 11

Which of the following types of businesses can take on more debt than other types of businesses?

A) Single-product firms
B) Non-cyclical firms
C) Seasonal-product firms
D) Small firms
E) Cyclical firms

Question 12

If a firm uses no debt, the uncertainty inherent in projections of future returns on equity can be described as business risk.

Question 13

Risk can be apportioned as financial and business risk. Financial risk and business risk are related in that as business risk increases so does financial risk, although the correlation between the two is not perfect.

Question 14

The lower the times-interest-earned ratio, the lower the probability that a firm will default on its debt.

Question 15

_____ is the single most important determinant of the capital structure of a firm.

A) Financial leverage
B) Financial risk
C) Operating income
D) Business risk
E) Sales revenue

Question 16

The probability of incurring bankruptcy increases as a firm's debt/equity ratio decreases.

Question 17

The fact that interest is tax-deductible makes corporate debt less expensive than common stock or preferred stock.

Question 18

In the United States, equity monitoring costs are comparatively lower than other countries.

Question 19

If the debt/assets ratio increases, the costs of both debt and equity decrease.

Question 20

It is easy to determine how P/E ratios are affected by the degree of financial leverage (DFL).

Question 21

A firm should raise capital according to its optimal capital structure so as to maximize its _____.

A) earnings per share (EPS)
B) stock price
C) weighted average cost of capital (WACC)
D) net income
E) retained earnings

Question 22

Copybold Corporation is a start-up that has a capital structure that calls for a debt/assets ratio of 0.75. There are two possible scenarios with respect to the firm's operations: Feast andFamine. The Feast scenario has a 60 percent probability of occurring, and the forecast earnings before interest and taxes (EBIT) in this scenariois $60,000. The Famine scenariohas a 40 percent chance of occurring, and the EBIT is expected to be $20,000. Further, the cost of debt for this capital structure will be 12 percent. The firm will have $400,000 in total assets, and it will face a marginal tax rate of 40 percent. The company has 10,000 outstanding shares. What is the difference between the earnings per share (EPS) forecasts for Feast and Famine?

A) $0
B) $2.40
C) $1.48
D) $0.62
E) $0.98

Question 23

What is the cause of financial risks that are placed on the common stockholders of a firm?

A) Unstable sales volume
B) Uncertain input price
C) Use of fixed-income securities
D) High fixed operating costs
E) Inability to adjust to selling prices

Question 24

Using debt and preferred stock in the capital structure of a firm will _____.

A) increase financial risk
B) decrease business risk
C) increase the tax payableby the firm.
D) decrease operating leverage
E) increase the book value of common stock

Question 25

Which of the following is considered a part of financial risk?

A) Demand variability
B) Sales price variability
C) The extent to which operating costs are fixed
D) Changes in interest rates on debt
E) The ability to change prices as costs change

Question 26

The optimal capital structure will always be lower than the debt/assets ratio that maximizes the _____.

A) expected EPS
B) weighted average cost of capital
C) beta coefficients
D) degree of financial leverage
E) net operating income

Question 27

As a general rule, the optimal capital structure is the one that:

A) maximizes expected EPS and the price per share of common stock.
B) minimizes the interest rate on debt and maximizes the expected earnings per share.
C) minimizes the required rate on equity and maximizes the stock price.
D) maximizes the price per share of common stock and minimizes the weighted average cost of capital.
E) minimizes the expected earnings per share and maximizes the weighted average cost of capital.

Question 28

Operating leverage refers tothe presence of _____ that do not change when the level of sales changes.

A) fixed-income securities
B) beta risks
C) firm-specific risks
D) variable costs
E) fixed costs

Question 29

The presence of fixed operating costs that do not change when the level of sales changes is known as _____.

A) financial leverage
B) operating leverage
C) beta risk
D) market risk
E) firm-specific risk

Question 30

Which of the following is an indication of a firm's risk with its capital structure?

A) Indifference point
B) Coefficient of variation
C) Earnings per share
D) Net operating income
E) Weighted average cost of capital

Question 31

In which of the following combinations of capital structuredo the common stockholders have to bear the maximum risk?

A) 100 percent equity
B) 100 percent debt
C) 50 percent equity and 50 percent debt
D) 25 percent equity and 75 percent debt
E) 75 percent equity and 25 percent debt

Question 32

Which of the following statements is true ofthe optimal capital structure?

A) It is found by determining the debt-equity mix that maximizes expected EPS.
B) It simultaneously maximizes EPS and minimizes the WACC.
C) It minimizes the cost of equity, which is a necessary condition for maximizing the stock price.
D) It simultaneously minimizes the cost of debt, the cost of equity, and the WACC.
E) It should have the combination of debt and equity thatwill maximize the price of the firm's stock.

Question 33

With which of the followingis a firm's target capital structure consistent?

A) Maximum earnings per share
B) Minimum cost of debt (rd)
C) Minimum risk
D) Minimum cost of equity (rs)
E) Minimum weighted average cost of capital

Question 34

The risk associated with afirm's operations, ignoring any financing effects, is known as _____.

A) market risk
B) business risk
C) firm-specific risk
D) financial risk
E) beta risk

Question 35

The level of sales at which earnings per share (EPS) will be the same whether the firm uses debt or common stock financing is known as _____.

A) the optimal capital structure
B) the beta point
C) the indifference point
D) the standard deviation of EPS
E) the coefficient of variation

Question 36

What is financial leverage?

A) The presence of fixed operating costs that do not change when the level of sales changes
B) The portion of stockholders' risk, over and above basic business risk
C) The risk associated with afirm's operations, ignoring any financing effects
D) The combination of debt and equity used to finance a firm
E) The extent to which fixed-income securities are used in a firm's capital structure

Question 37

In 2015, a company had a total debt of $7 million. In 2016, the debt increased to $9 million. The change in earnings per share (EPS) of the company will be a direct result of change in its:

A) level of operations.
B) net operating income.
C) coefficient of variation.
D) capital structure
E) standard deviation.

Question 38

The combination of debt and equity that maximizes a firm's value is known as the:

A) degree of financial leverage (DFL).
B) maximum weighted average cost of capital (WACC).
C) maximum business risk.
D) optimal capital structure.
E) indifference point.

Question 39

If a high percentage of a firm's operating costs are fixed and hence do not decline when demand falls off, this will _____.

A) decrease financial leverage
B) optimize the capital structure of the firm
C) increase the business risk of the firm
D) decrease the firm-specific risk of the firm
E) intensify the risk borne by thefirm's common stockholders

Question 40

Which of the following intensifies the business risk borne by the common stockholders of a firm?

A) Fixed-income securities
B) Sales variability
C) Input price variability
D) Operating leverage
E) Firm-specific risk

Question 41

The percentage change in earnings before interest and taxes associated with a given percentage change in sales is known as the _____.

A) degree of financial leverage
B) degree of operating leverage
C) degree of total leverage
D) degree of combined leverage
E) degree of working capital leverage

Question 42

A firm expects to have a 15 percent increase in sales over the coming year. If it has operating leverage equal to 1.25 and financial leverage equal to 3.50, then what will be the percentage change in earnings per share (EPS)?

A) 30%
B) 47%
C) 66%
D) 15%
E) 22%

Question 43

Assume that a firm has a degree of financial leverage (DFL) of 1.25. If sales increase by 20 percent, the firm will experience a 60 percent increase in earnings per share (EPS) and it will have an earnings before interest and taxes (EBIT) of $100,000. What will be the EBIT for the firm if sales do not increase?

A) $67,568
B) $100,000
C) $113,412
D) $84,375
E) $42,115

Question 44

The degree of leverage concept is designed to show how changes in sales affect earnings before interest and taxes (EBIT) and earnings per share (EPS). If a 10 percent increase in sales causes EPS to increase from $1.00 to $1.50 and if the firm uses no debt, then what is its degree of operating leverage?

A) 3.6
B) 4.2
C) 4.7
D) 5.0
E) 5.5

Question 45

Bell Brothers has $3,000,000 in sales. Its fixed costs are estimated to be $100,000, and its variable costs are equal to fifty cents for every dollar of sales. The company has $1,000,000 in debt outstanding at a before-tax cost of 10 percent. If Bell Brothers' sales were to increase by 20 percent, how much of a percentage increase can one expect in the company's net income?

A) 15.66%
B) 18.33%
C) 19.24%
D) 21.50%
E) 23.08%

Question 46

The degree of financial leverage is defined as _____.

A) the percentage change in EBIT that results from a given percentage change in sales
B) the percentage change in sales that results from a given percentage change in EPS
C) the percentage change in EPS that results from a given percentage change in sales
D) the percentage change in EPS that results from a given percentage change in EBIT
E) the percentage change in sales that results from a given percentage change in EBIT

Question 47

Quick Launch Rocket Company, expects its sales to increase by 50 percent in the coming year as a result of NASA's recent problems with the space shuttle. The firm's current earnings per share (EPS) is $3.25. Its degree of operating leverage is 1.6, while its degree of financial leverage is 2.1. What is the firm's projected EPS for the coming year using the degree of total leverage (DTL) approach?

A) $3.25
B) $5.46
C) $10.92
D) $8.71
E) $19.63

Question 48

A ratio that measures the firm's ability to meet its annual interest obligations is known as the _____.

A) times-interest-earned (TIE) ratio
B) degree of financial leverage (DFL)
C) debt/assets ratio
D) capitalization interest rate
E) current interest ratio

Question 49

Which of the following is true of the times-interest earned (TIE) ratio of a firm?

A) The lower the TIE ratio, the higher the probability that the firm will default on its debt.
B) The TIE ratio is calculated by dividing net income by interest charges.
C) The TIE ratio increases if the debt/assets ratio increases and vice versa.
D) The TIE ratio is always more than 1.
E) The TIE ratio shows the effects of both operating leverage and financial leverage.

Question 50

Trueware Corporation is a start-up firm that has a capital structure that calls for a debt/assets ratio of 0.25. The firm has two possible scenarios for its operations: Ruby or Emerald. The Ruby scenario has a 70 percent probability of occurring and forecast earnings before interest and taxes (EBIT) in this state is $80,000. The Emerald state has a 30 percent chance of occurring and the EBIT is expected to be $32,000. Further, the cost of debt for this capital structure will be 10 percent. The firm will have $500,000 in total assets and it will face a marginal tax rate of 30 percent. The company has 22,000 outstanding shares. Calculate the difference in EPS for the capital structure.

A) $1.0
B) $1.20
C) $1.48
D) $2.24
E) $3.15

Question 51

A degree of operating leverage of 1.5 times indicates that _____.

A) for every 1 percent change in EPS there will be a 1.5 percent change in sales
B) for every 1 percent change in interest there will be a 1.5 percent change in EBIT
C) for every 1 percent change in sales there will be a 1.5 percent change in EBIT
D) for every 1 percent change in EBIT there will be a 1.5 percent change in EPS
E) for every 1 percent change in sales there will be a 1.5 percent change in EPS

Question 52

Which of the following statements is true about the relationship between the debt/assets ratio and the times-interest-earned ratio (TIE) of a firm?

A) If the debt/assets ratio increases, the TIE ratio will also increase.
B) If the debt/assets ratio decreases, the TIE ratio will increase.
C) If the debt/assets ratio decreases, the TIE ratio will also decrease.
D) The debt/assets ratio will always be equal to the TIE ratio.
E) The debt/assets ratio and the TIE ratio are not related to each other.

Question 53

Which of the following is affected by financial leverage?

A) Earnings per share
B) Net operating income
C) Sales
D) Variable costs
E) Fixed costs

Question 54

What does a degree of financial leverage (DFL) of 2.0 indicate?

A) For every 1 percent change in sales, the EBIT will change by 2 percent.
B) For every 1 percent change in EPS, the sales will change by 2 percent.
C) For every 1 percent change in EBIT, the EPS will change by 2 percent.
D) For every 1 percent change in EPS, the EBIT will change by 2 percent.
E) For every 1 percent change in EBIT, the sales will change by 2 percent.

Question 55

Given the following information, calculate the current price per share (P0) for Olson Corporation. The data all pertain to the year that just ended. Round the answer to two decimal places. Net income $27,475
Beta 1.5
RRF 5%
RM 9%
Dividend payout ratio 40%
Growth rate in earnings and dividends 7%
Common stock shares outstanding 10,000 shares

A) $39.20
B) $57.84
C) $29.40
D) $61.90
E) 19.59

Question 56

The percentage change in earnings per share (EPS) that results from a given percentage change in sales is known as the _____.

A) degree of financial leverage
B) degree of operating leverage
C) degree of working capital leverage
D) degree of current asset leverage
E) degree of total leverage

Question 57

When will a firm's degree of operating leverage be at its highest level?

A) When sales is equal to zero
B) When earnings per share is equal to one
C) When fixed costs are equal to variable costs
D) When variable costs are more than sales
E) When EBIT is equal to zero

Question 58

What is the formula for calculating the times-interest earned (TIE) ratio?

A) TIE ratio = Interest charges ÷ Total liabilities
B) TIE ratio = Earnings per share ÷ Interest charges
C) TIE ratio = Sales ÷ Interest charges
D) TIE ratio = EBIT ÷ Interest charges
E) TIE ratio = Interest charges ÷ Net income

Question 59

For every 1 percent decrease in sales of a firm, the EBIT decreases by 3.2 percent. What does this statement indicate?

A) The debt/assets ratio of the firm is 3.2 times.
B) The degree of operating leverage of the firm is 3.2 times.
C) The current assets of the firm are 3.2 times its current liabilities.
D) The expenses of the firm are 3.2 percent of its income.
E) The degree of financial leverage of the firm is 3.2 times.

Question 60

Which of the following is true of the degree of financial leverage of a firm?

A) The degree of financial leverage affects the earnings before interest and taxes of the firm.
B) The degree of financial leverage is defined as the percentage change in net operating income with a given percentage change in sales.
C) A lower degree of financial leverage suggests that higher risk is associated with the firm's normal operating activities.
D) The degree of financial leverage affects the operating section of the income statement.
E) A higher degree of financial leverage suggests that higher risk is associated with the firm's mix of debt and equity financing.

Question 61

According to the signaling theory, when should a firm use debt beyond the normal target capital structure?

A) When the debt/assets ratio is greater than one
B) When marginal tax shelter benefits are equal to marginal bankruptcy-related costs
C) When investors and managers have identical information about the firm's prospects
D) When the firm has favorable prospects
E) When the firm is entirely equity financed

Question 62

The situation in which managers have different (better) information about their firm's prospects than outside investors is known as _____.

A) symmetric information
B) contingent information
C) asymmetric information
D) favorable information
E) unfavorable information

Question 63

If a mature firm announces a new stock offering, the price of its stock will decline. To avoid this, the firm should _____.

A) repurchase the existing stock
B) finance only through debt
C) maintain a reserve borrowing capacity
D) convert all common stock into preferred stock
E) maintain a minimum amount of floating stock

Question 64

According to the signaling theory, which of the following is considered a signal from an investor's point of view?

A) A small company raising any required new capital by issue of new shares
B) A mature company raising any required new capital by issue of new shares
C) A small company maintaining a reserve borrowing capacity
D) A mature company maintaining a reserve borrowing capacity
E) A mature company raising any required new capital using debt beyond the normal target capital structure

Question 65

Which of the following plays an important role in determining the capital structure of a firm?

A) Managerial attitudes
B) Reserve borrowing capacity
C) Shareholders' expectations
D) Asymmetric information
E) Bankruptcy-related costs

Question 66

Which of the following is true of companies in Japan with respect to their capital structures?

A) Companies in Japan are financed entirely through equity.
B) Companies in Japan use greater proportions of debt than others.
C) Dividends are taxed as income in Japan.
D) Equity monitoring costs are low in Japan.
E) Companies in Japan raise most of their corporate debt through publicly issued bonds.

Question 67

A times-interest-earned (TIE) ratio of less than 1 indicates _____.

A) a less debt in the capital structure of the firm
B) a low probability that the firm will default
C) the firm's inability to meet its annual interest obligations
D) that the firm is financed only by equity
E) that the debt/assets ratio of the firm is very low

Question 68

According to the basic capital structure theory proposed by Modigliani and Miller (MM), when will a firm's value be maximum?

A) When it is financed entirely through equity
B) When it is financed 50 percent through debt and 50 percent through equity
C) When it is financed entirely through its retained earnings
D) When it is financed 100% through debt
E) When it is financed 50 percent through equity and 50 percent through its profits

Question 69

According to the trade-off theory, which of the following is the least expensive form of financing?

A) Common stock
B) Preferred stock
C) Corporate debt
D) Retained earnings
E) Government subsidies

Question 70

Which of the following assumptions outlined by Modigliani and Miller (MM) theory is realistic?

A) Brokerage costs do not exist.
B) Personal income taxes do not exist.
C) Bankruptcy does not exist.
D) The value of a firm will be maximized by financing almost entirely with debt.
E) Interest on capital debt is tax deductibile.

Question 71

Which of the following is true of the assumptions outlined by the capital structure theory published by Professors Franco Modigliani and Merton Miller (MM)?

A) Personal income taxes are deductible.
B) Brokerage costs do not exist.
C) The value of the firm will be maximized by financing completely through equity.
D) A high debt/assets ratio decreases the value of the firm.
E) Bankruptcy costs are high when the firm uses no debt.

Question 72

Which of the following statements is true of capital structures around the world?

A) There have been no significant observed differences between the capital structures of U.S. corporations and their German and Japanese counterparts.
B) Different countries use essentially the same international accounting conventions with respect to reporting assets on a historical versus replacement cost basis.
C) An analysis of both bankruptcy and equity reporting costs leads to the conclusion that U.S. firms have more equity and less debt than firms in Japan and Germany.
D) Equity monitoring costs are higher in the United States than in Japan and Germany.
E) Debt monitoring costs are lower in the United States than in Japan and Germany.

Question 73

Which of the following is an advantage of debt financing?

A) Interest charges on debt is very minimal.
B) Interest charges on debt are tax deductible.
C) Interest charges on debt are based on the net income of the firm.
D) The higher the interest charges, the lower the bankruptcy costs.
E) Firms that are entirely debt financed have to pay very minimal taxes.

Question 74

Which of the following capital structure theories assumes that market information is symmetric?

A) Signaling theory
B) Contingent theory
C) Arbitrary theory
D) Budgeting theory
E) MM capital structure theory

Question 75

If a firm with favorable prospects sells new shares, _____.

A) the debt/assets ratio of the firm will increase
B) the marginal bankruptcy-related costs of the firm will increase
C) the retained earnings of the firm will decrease
D) the tax payable by the firm will decrease
E) the value of the firm's stock will decrease.

Question 76

According to Modigliani and Miller (MM)'s basic theory of capital structure, which of the following is considered when determining the value of a firm?

A) Tax deductible interests
B) Personal income taxes
C) Brokerage costs
D) Bankruptcy costs
E) Retained earnings

Question 77

According to the signaling theory, what is symmetric information?

A) The situation in which investors and managers have identical information about the firm's prospects
B) The situation in which employees and managers have identical information about the firm's prospects
C) The situation in which investors and creditors have identical information about the firm's prospects
D) The situation in which managers have different (better) information about their firm's prospects than outside investors
E) The situation in which employees have different (better) information about their firm's prospects than managers

Question 78

According to the trade-off theory, under which of the following conditions will a firm's capital structure be optimal?

A) Marginal bankruptcy-related costs = 0
B) Marginal tax shelter benefits - Marginal bankruptcy-related costs = Interest charges
C) Debt/assets ratio = Marginal tax shelter benefits
D) Marginal tax shelter benefits = Marginal bankruptcy-related costs
E) Marginal tax shelter benefits = Interest charges

Question 79

Which of the following countries uses the lowest proportion of debt among the industrialized countries?

A) The United States
B) Canada
C) Italy
D) The United Kingdom
E) Japan

Question 80

According to the signaling theory, why will a firm with unfavorable prospects want to sell stock?

A) To share the losses with new investors
B) To increase bankruptcy cost with more debt
C) To skip the dividends payable on common stock
D) To maintain a reserve borrowing capacity
E) To have tax benefit/bankruptcy cost trade-off