Deck 16: Capital Structure

Question 1

Which of the statements below is FALSE?

A) The "riskier" borrower will most likely have to pay a lower cost for funds.
B) In the bond market, we see different rates as the different yields on bonds for different companies.
C) In the equity market, we see different rates as the different required returns for companies due to their different betas.
D) In general, the cost of funds for an individual or company will be directly related to the lender's view of the risk of repayment of the funds.

Answer 1

A

Question 2

Capital structure refers to how the firm finances its operations and growth through a combination of ________.

A) equity types
B) security types
C) types of earnings
D) types of debt

Answer 2

B

Question 3

The municipal bond market is open only to ________.

A) state government agencies
B) local government agencies
C) the federal government
D) Both A & B

Answer 3

D

Question 4

________ capital structure refers to a combination of debt and equity that maximizes the value of the firm.

A) An optimal
B) An irrelevant
C) A perfect
D) A minimal

Question 5

________ financial world is one without taxes, bankruptcy, and other imperfections.

A) An imperfect
B) A friction-full
C) A perfect
D) A realistic

Question 6

A large public firm cannot issue which of the following types of securities?

A) Common stock
B) T-Bills
C) Preferred stock
D) Bonds

Question 7

The best combination of debt and equity creates what we call an imperfect capital structure.

Question 8

In a perfect financial world, a company's value is dependent on its capital structure.

Question 9

All markets are open to all borrowers.

Question 10

Investors Al and Bea lend $100,000 to each new idea. Al's history is that he selects low-risk projects or ideas that hit 50% of the time. Bea's history is that she takes on high-risk projects that hit 20% of the time. What rate of return must each successful project pay Al and Bea for them to break even?

A) Al's rate is 200% and Bea's rate is 450%.
B) Al's rate is 100% and Bea's rate is 400%.
C) Al's rate is 200% and Bea's rate is 400%.
D) Al's rate is 450% and Bea's rate is 100%.

Question 11

The return to the investor is the cost to the seller.

Question 12

In general, the cost of funds for an individual or company will be directly related to the lender's view of the risk of repayment of the funds.

Question 13

Alice lends $200,000 for each new idea. Alice's history is that she selects low-risk projects or ideas that hit 50% of the time. What rate of return must each successful project pay Alice for her to break even?

A) 0%
B) 50%
C) 100%
D) 200%

Question 14

The return to the investor is the ________.

A) reward to the borrower
B) cost to the borrower
C) cost to the manager
D) internal rate of return

Question 15

Which of the statements below is FALSE?

A) Two different individuals or companies could go to the same bank and request exactly the same amount of funding for their projects and yet could be required to pay different costs for their funds.
B) It is important to remember that a public company is a separate entity and in that capacity can borrow from bondholders, preferred stockholders, and common shareholders, but not from banks.
C) Lenders, regardless of their classification, all consider their funds as investments, for which they hope to make a positive return.
D) The return to the investor is the cost to the seller.

Question 16

A ________ is a separate entity and in that capacity can borrow from banks, bondholders, preferred stockholders, and common shareholders.

A) limited partnership
B) sole proprietorship
C) government organization
D) public company

Question 17

George lends $200,000 for each new idea. George's history is that he selects low-risk projects or ideas that hit 80% of the time. What rate of return must each successful project pay George for him to break even?

A) 20.50%
B) 22.00%
C) 23.50%
D) 25.00%

Question 18

The highest return to the investor is the lowest cost for the seller and vice versa.

Question 19

The federal government bond market is open only to ________.

A) state government agencies
B) local government agencies
C) the federal government
D) municipal government

Question 20

Investors Al and Bea lend $100,000 to each new idea. Al's history is that he selects low-risk projects or ideas that hit 80% of the time. Bea's history is that she takes on high-risk projects that hit 40% of the time. What rate of return must each successful project pay Al and Bea for them to break even?

A) Al's rate is 150%, and Bea's rate is 25%.
B) Al's rate is 40%, and Bea's rate is 40%.
C) Al's rate is 25%, and Bea's rate is 150%.
D) Al's rate is 30%, and Bea's rate is 150%.

Question 21

Financial leverage is the degree to which a firm or individual utilizes ________.

A) borrowed money to pay wages
B) borrowed money to pay dividends
C) borrowed money to magnify equity earnings
D) borrowed money to diminish equity earnings

Question 22

If company earnings reflect a rate of return less than the cost of debt, then more debt ________.

A) will increase the percentage of earnings available for distribution to the equity owners
B) will lower the percentage of earnings available for distribution to the debt owners
C) will increase the percentage of dividends available for distribution to the equity owners
D) will lower the percentage of earnings available for distribution to the equity owners

Question 23

You have a project that costs $800,000. It has a 1/3 chance of paying off $3,000,000 and a 2/3 chance of paying off $0. What is the expected payoff from the new project?

A) $500,000
B) $800,000
C) $1,000,000
D) $1,200,000

Question 24

Which of the statements below is FALSE?

A) When a company performs well, it can handle more debt and benefit the owners.
B) Borrowing from debt lenders at one rate and investing the money in the business and making a higher rate is bad for the owners.
C) Assume that the more debt the company has sold, the better off the shareholders are. This is the case where the earnings reflect a return greater than the cost of debt.
D) Financial leverage is the degree to which a firm or individual utilizes borrowed money to make money.

Question 25

If earnings reflect a return greater than the cost of debt, then ________.

A) the more debt the company has sold, the worse off the shareholders are
B) the less debt the company has sold, the better off the shareholders are
C) the more debt the company has sold, the better off the shareholders are
D) the more debt the company has bought, the better off the shareholders are

Question 26

You have a project that costs $800,000. It has a 1/3 chance of paying off $3,000,000 and a 2/3 chance of paying off $0. What is the expected profit from the new project?

A) $300,000
B) $200,000
C) $100,000
D) zero

Question 27

The decision on capital structure seems to be related to the expected earnings of the company: ________.

A) the less the earnings, the more debt we should sell
B) the more the earnings, the more debt we should sell
C) the more the earnings, the less debt we should sell
D) None of these

Question 28

Two different individuals or companies can go to the same bank and request exactly the same amount of funding for their projects and yet can be required to pay different costs for their funds. Why? Can we find a parallel situation in the bond and equity markets? Explain.

Question 29

Aaaction Graphics, Inc. has a project that costs $400,000. It has a 30% chance of paying off $1,000,000 and a 70% chance of paying off $200,000. What is the expected payoff and the expected profit or loss from the new project?

A) The expected payoff is $600,000, and the expected gain is $200,000.
B) The expected payoff is $440,000, and the expected loss is $40,000.
C) The expected payoff is $440,000, and the expected gain is $40,000.
D) The expected payoff is $600,000, and the expected loss is $200,000.

Question 30

Buck Stops Here, Inc. has a project that costs $900,000. It has a 50% chance of paying off $2,000,000 and a 50% chance of paying off $0. What is the expected payoff and the expected profit or loss from the new project?

A) The expected payoff is $1,000,000, and the expected loss is $10,000.
B) The expected payoff is $100,000, and the expected profit is $10,000.
C) The expected payoff is $100,000, and the expected loss is $100,000.
D) The expected payoff is $1,000,000, and the expected profit is $100,000.

Question 31

Consider two companies that are alike except in borrowing choices. Barry Corp. has no debt financing, and Crawford Corp. uses debt financing. The EBIT for both companies is $100. Barry Corp. has 40 shares outstanding and pays no interest. Crawford Corp. has 30 shares outstanding and pays $25 in interest. What is the EPS for each company?

A) Both companies have an EPS of $2.50.
B) Both companies have an EPS of $2.00.
C) Barry Corp. has an EPS of $2.50 and Crawford Corp. has an EPS of $2.00.
D) Barry Corp. has an EPS of $2.00 and Crawford Corp. has an EPS of $2.50.

Question 32

The process of borrowing money from others to make money on your idea is commonly known in the investment world as ________.

A) "losing other people's money"
B) "using other people's money"
C) "abusing other people's money"
D) "misusing other people's money"

Question 33

If company earnings give a rate of return less than the cost of debt, then it may be advantageous for the firm to be ________.

A) all-equity
B) owned mostly by debtholders
C) half owned by debtholders
D) one-third owned by equityholders

Question 34

Consider two companies that are alike except in borrowing choices. District Corp. has no debt financing, and Energy Corp. uses debt financing. The EBIT for both companies is $3,500,000. District Corp. has 400,000 shares outstanding and pays no interest. Energy Corp. has 250,000 shares outstanding and pays $500,000 in interest. What is the EPS for each company?

A) Both companies have an EPS of $8.75.
B) Both companies have an EPS of $12.00.
C) District Corp. has an EPS of $12.00 and Energy Corp. has an EPS of $8.75.
D) District Corp. has an EPS of $8.75 and Energy Corp. has an EPS of $12.00.

Question 35

The more ________ used, the greater the leverage a company employs on behalf of its owners.

A) debt
B) equity
C) debt and equity
D) All of these

Question 36

Bernadette's Boutique has a project that costs $90,000. It has a 50% chance of paying off $200,000 and a 50% chance of paying off $0. What is the expected payoff and the expected profit or loss from the new project?

A) The expected payoff is $100,000 and the expected profit is $10,000.
B) The expected payoff is $10,000 and the expected profit is $10,000.
C) The expected payoff is $100,000 and the expected loss is $100,000.
D) The expected payoff is $100,000 and the expected loss is $10,000.

Question 37

________ is the degree to which a firm or individual utilizes borrowed money to make money.

A) Variable leverage
B) Fixed leverage
C) Operating leverage
D) Financial leverage

Question 38

Investors Bill and Maggie lend $60,000 to each new idea. Bill picks low-risk projects that are successful 60% of the time. Maggie takes on high-risk projects that that are successful 20% of the time. What rate of return must each successful project pay Bill and Maggie for them to break even?

Question 39

One way of measuring the advantage of financial leverage to the owners of the company is ________.

A) to examine the earnings per share (EPS) of a company before borrowing from debt lenders
B) to examine the earnings per share (EPS) of a company after borrowing from debt lenders
C) to examine the dividends per share (DPS) of a company before and after borrowing from debt lenders
D) to examine the earnings per share (EPS) of a company before and after borrowing from debt lenders

Question 40

Consider two companies that are alike except in borrowing choices. Company 1 has no debt financing, and Company 2 uses debt financing. The EBIT for both companies is $800. Company 1 has 400 shares outstanding and pays no interest. Company 2 has 300 shares outstanding and pays $250 in interest. What is the EPS for each company?

A) Both companies have an EPS of $2.00.
B) Both companies have an EPS of $1.83.
C) Company 1 has an EPS of $2.00 and Company 2 has an EPS of $1.83.
D) Company 1 has an EPS of $2.00 and Company 2 has an EPS of $1.50.

Question 41

Leverage magnifies both gains and losses.

Question 42

Information is asymmetric when one party in a transaction has a different set of ________ from the other party in the transaction.

A) asymmetries
B) information
C) hypotheses
D) earnings

Question 43

Theoretically, the more the earnings, the more a firm should use debt for financing purposes.

Question 44

Shareholders can be made better off in terms of EPS with financial leverage when earnings are sufficiently high to offset the interest expense of debt.

Question 45

Donat Corp. is a small company looking at two possible capital structures. Currently, the firm is an all-equity firm with $600,000 in assets and 100,000 shares outstanding. The market value of each share is $6.00. The CEO of Donat is thinking of leveraging the firm by selling $300,000 of debt financing and retiring 50,000 shares, leaving 50,000 shares outstanding. The cost of debt is 5% annually, and the current corporate tax rate for Donat is 30%. The CEO believes that Donat will earn $50,000 per year before interest and taxes. Which of the statements below is TRUE?

A) All-equity EPS is $0.35.
B) 50/50 debt-to-equity EPS is $0.49.
C) Shareholders will be better off by $0.14 per share under a firm with $300,000 in debt financing versus a firm that is all-equity.
D) Statements (A) through (C) are all true.

Question 46

Garson Corp. is looking at two possible capital structures. Currently, the firm is an all-equity firm with $1.2 million dollars in assets and 200,000 shares outstanding. The market value of each share of stock is $6.00. The CEO of Garson is thinking of leveraging the firm by selling $600,000 of debt financing and retiring 100,000 shares, leaving 100,000 outstanding. The cost of debt is 10% annually, and the current corporate tax rate for Garson is 30%. If the CEO believes that Garson will earn $100,000 per year before interest and taxes, should she leverage the firm? Explain.

Question 47

Landry Corp. is looking at two possible capital structures. Currently, the firm is an all-equity firm with $1.2 million dollars in assets and 200,000 shares outstanding. The market value of each stock is $6.00. The CEO of Landry is thinking of leveraging the firm by selling $600,000 of debt financing and retiring 100,000 shares, leaving 100,000 outstanding. The cost of debt is 10% annually, and the current corporate tax rate for Landry is 30%. If the CEO believes that Landry's EBIT will be $120,000, should the CEO leverage the firm? Explain.

Question 48

Why is financial leverage attractive?

Question 49

Above the break-even EBIT, there is no benefit in debt financing.

Question 50

Below the break-even EBIT, the owners can benefit from financial leverage.

Question 51

Refer to the scenario above. If Southern Cornbread's EBIT is $1,800, compare EPS before and after the new debt.

A) All-equity EPS = $3.00, leveraged-equity EPS = $4.50
B) All-equity EPS = $4.50, leveraged-equity EPS = $3.00
C) All-equity EPS = $3.00, leveraged-equity EPS = $3.00
D) All-equity EPS = $4.50, leveraged-equity EPS = $4.50

Question 52

Firewall Corp. is a small company looking at two possible capital structures. Currently, the firm is an all-equity firm with $900,000 in assets and 100,000 shares outstanding. The market value of each share is $9.00. The CEO of Firewall is thinking of leveraging the firm by selling $270,000 of debt financing and retiring 30,000 shares, leaving 70,000 shares outstanding. The cost of debt is 6% annually, and the current corporate tax rate for Donat is 30%. The CEO believes that Donat will earn $100,000 per year before interest and taxes. Which of the statements below is TRUE?

A) All-equity EPS is $0.70.
B) 50/50 debt-to-equity EPS is $0.838.
C) Shareholders will be better off by almost $0.14 per share under a firm with $270,000 in debt financing versus a firm that is all-equity.
D) Statements (A) through (C) are all true.

Question 53

Refer to the scenario above. What level of EBIT would make this an attractive strategy?

A) $2,000
B) $1,800
C) $1,600
D) $1,400

Question 54

Using debt financing to replace equity financing always leads to greater EPS for the firm.

Question 55

Refer to the scenario above. What would the unleveraged and leveraged EPSs look like if EBIT were only $1,200?

A) All-equity EPS = $2.00, leveraged-equity EPS = $1.50
B) All-equity EPS = $3.00, leveraged-equity EPS = $2.00
C) All-equity EPS = $2.00, leveraged-equity EPS = $3.00
D) All-equity EPS = $4.50, leveraged-equity EPS = $3.00

Question 56

Pierce Corp. is looking at two possible capital structures. Currently, the firm is an all-equity firm with $1.2 million dollars in assets and 200,000 shares outstanding. The market value of each stock is $6.00. The CEO of Pierce is thinking of leveraging the firm by selling $600,000 of debt financing. The cost of debt is 8% annually, and the current corporate tax rate for Pierce is 30%. What is the break-even EBIT for Pierce with these two possible capital structures?

Question 57

Moving from one source of funding to another in a particular order is called the ________.

A) Pecking Order Hypothesis
B) Barnyard Order Hypothesis
C) Funding Order Hypothesis
D) Capital Market Hypothesis

Question 58

When earnings are less than the cost of debt, it follows that the more debt, the lower the percentage of earnings available for distribution to shareholders.

Question 59

In basic terms, a business must earn a return on capital that exceeds the cost of capital.

Question 60

Refer to the scenario above. What would be the unleveraged and leveraged EPSs look like if EBIT were $2,400?

A) All-equity EPS = $4.00, leveraged-equity EPS = $4.50
B) All-equity EPS = $3.00, leveraged-equity EPS = $4.00
C) All-equity EPS = $4.00, leveraged-equity EPS = $5.00
D) All-equity EPS = $3.00, leveraged-equity EPS = $3.50

Question 61

In their first venture into the optimal capital structure question, Nobel laureates Franco Modigliani and Merton Miller began with a very simple model and a hypothetical world of ________.

A) bankruptcy costs but no taxes
B) taxes but no bankruptcy
C) no taxes and no bankruptcy
D) both taxes and bankruptcy

Question 62

Corporate financing problems are ________ personal financing ones.

A) really quite different from
B) extremely different from
C) really not all that different from
D) identical compared to

Question 63

To say that the investing decision and financing decision of a firm are separable is to say ________.

A) that firms first select what products or services they will produce and then select how best to finance these products or services
B) that firms first select how best to finance products or services and then select what products or services they will produce
C) that firms first select what services they want and then what products they will produce
D) that firms first select what products they will produce and then what services they want

Question 64

Which of the statements below is TRUE?

A) Debt capacity refers to the ability to add equity financing to the current borrowing of the firm and still be able to make interest and principal repayments on time.
B) The asymmetric information foundation for the Pecking Order Hypothesis (POH) is that managers know less about their companies than the outside world.
C) There are three implications of the POH. One of these is that profitable companies will borrow less (because they have more internal funds available) and may have lower debt-equity ratios because they have more debt capacity.
D) There are three implications of the POH. One of these is that more profitable companies will need more external funding and will first seek debt financing in an asymmetric world, avoiding the equity market.

Question 65

The Pecking Order Hypothesis predicts which of the following?

A) Firms prefer internal financing first.
B) If external financing is required, firms should first seek debt financing.
C) If external financing is required, firms will choose to issue the safest or cheapest security first, starting with debt financing and using equity as a last resort.
D) All of these

Question 66

According to the Pecking Order Hypothesis, selling equity is the first choice for firms that require outside financing.

Question 67

With the background ideas of using the cheapest source first and the impact of asymmetric information, what does the Pecking Order Hypothesis predict?

Question 68

Given a choice, firms will exhaust the cheapest source of external funding first before moving on to the ________ source.

A) more economic
B) most cheap
C) most expensive
D) next cheapest

Question 69

With the background ideas of using the cheapest source first and the impact of asymmetric information, the Pecking Order Hypothesis predicts which of the following?

A) Firms prefer internal financing second to external financing.
B) If external financing is required, firms should first seek equity financing.
C) If external financing is required, firms will choose to issue the riskiest security first, starting with debt financing and using equity as a last resort.
D) If external financing is required, firms will choose to issue the safest or cheapest security first, starting with debt financing and using equity as a last resort.

Question 70

Firms in need of financing tend to use external funds first and then revert to internal funds, or retained earnings, as a last resort.

Question 71

The Pecking Order Hypothesis suggests that less profitable companies will need more external funding and will first seek debt financing in an asymmetric world, avoiding the equity market.

Question 72

The Pecking Order Hypothesis suggests that profitable companies will borrow less (because they have more internal funds available) and may have higher debt-equity ratios because they have more debt capacity.

Question 73

The ability to add debt financing to the current borrowing of the firm and be able to make interest and principal repayments on time is known as the firm's debt-to-equity ratio.

Question 74

The Pecking Order Hypothesis suggests that as a last resort, firms will sell equity to fund investment opportunities.

Question 75

The initial decision of what products and services to produce has a much ________ on the profitability of the firm when compared to the ________.

A) smaller impact, financing decision
B) larger impact, dividend decision
C) larger impact, investment decision
D) larger impact, financing decision

Question 76

Describe the Pecking Order Hypothesis.

Question 77

Which of the statements below is FALSE?

A) External lenders generally require the company to provide private information about the company, its plans, current operations, and past performance.
B) Corporate financing problems are really not all that different from personal financing ones.
C) If information is proprietary and the company feels that it could be helpful to a competitor if it was to become public knowledge through lending, then the company's logical choice is to use internal funds if they are sufficient for funding a new project.
D) None of the above statements is false.

Question 78

________ means that managers or owners of a company know more about the future performance of the company than potential outside lenders.

A) Symmetric information
B) External financing
C) Asymmetric information
D) Two-sided information

Question 79

According to the Pecking Order Hypothesis, less profitable companies in an asymmetric world will need more ________; they will first seek ________ and will avoid ________.

A) external funding; equity funding; debt market
B) internal funding; the use of retained earnings; debt market
C) external funding; debt financing; equity market
D) internal funding; the use of retained earnings; equity market

Question 80

Which of the statements below is TRUE?

A) The investment decision, although minor in comparison to the financing decision, is still an important consideration.
B) The financing decision, although minor in comparison to the investing decision, is still an important consideration.
C) The financing decision is minor in comparison to the investing decision and thus can be ignored.
D) The financing and investing decisions are equally important in terms of determining firm value.