Deck 12: Capital Structure

Question 1

According to MM,in a world without taxes,the optimal capital structure for a firm should approach 100 percent debt financing.

Answer 1

False

Question 2

The management of a firm can control the degree of total leverage to some extent.

Answer 2

True

Question 3

Financial leverage affects both EPS and EBIT,while operating leverage only affects EBIT.

Answer 3

False

Question 4

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

Question 5

Other things held constant,an increase in financial leverage will increase a firm's market (or systematic)risk as measured by its beta coefficient.

Question 6

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

Question 7

Business risk will not affect a firm's beta,because beta is determined by the market and thus is outside the control of the firm.

Question 8

The ability of a firm to raise sufficient capital on competitive terms under adverse conditions in order to sustain steady operations is referred to as financial flexibility.

Question 9

Since the degree of total leverage is equal to the degree of operating leverage times the degree of financial leverage,the degree of total leverage must always be greater than or equal to positive 1.0.

Question 10

Firms which maintain an adequate reserve borrowing capacity will be able to borrow money at reasonable cost when good investment opportunities arise.

Question 11

The central result from the work of Miller and Modigliani (MM)and subsequent researchers,is that it is now possible to precisely identify a firm's optimal capital structure.

Question 12

You are the president of a small,publicly traded corporation.Since you believe that your firm's stock price is temporarily depressed,all additional capital funds required during the current year will be raised using debt.Thus,the appropriate marginal cost of capital for the current year is the after-tax cost of debt.

Question 13

According to the signaling theory of capital structure,the issuance of equity for a firm with various financing alternatives signals that the firm has very favorable prospects which it wants to share with new shareholders.

Question 14

The degree of financial risk is the single most important determinant of a firm's capital structure.

Question 15

The probability of incurring bankruptcy increase as the firm increases as the debt/equity ratio decreases.

Question 16

One of the implications of signaling theory for capital structure decisions is that firms should normally seek to maintain a reserve borrowing capacity.

Question 17

As long as a firm is near its target capital structure it will not have to concern itself with financial flexibility.

Question 18

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

Question 19

According to the signaling theory of capital structure,the issuance of equity for a firm with various financing alternatives signals that the firm has unfavorable prospects which it wants to share with new shareholders.

Question 20

Because creditors can foresee,to at least some extent,the costs of bankruptcy,they charge an interest rate that has a premium built into it to compensate for the present value of bankruptcy costs.

Question 21

As the debt ratio rises,the WACC is reduced because the after-tax cost of debt is usually lower than the cost of equity.What limits the substitution of debt for equity in the capital structure is that as the debt ratio rises the costs of both components eventually increase.

Question 22

The TIE ratio depends on the percentage of debt in the capital structure of the firm,the interest rate on the debt,and the profitability of the firm.

Question 23

An all equity firm has some risk inherent in its operations.When the firm decides to finance some of its operations with debt,it exposes itself to financial risk and it increases its business risk.

Question 24

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

Question 25

Two firms,although they operate in different industries,have the same expected earnings per share and the same standard deviation of expected EPS.Thus,the two firms must have the same business risk.

Question 26

A consistent supply of capital is essential for the long-run success of a firm.Although a firm may have access to capital under all types of economic conditions,the concept of financial flexibility implies that the firm can obtain capital on acceptable,competitive terms.

Question 27

Although the exact relationship between a firm's degree of financial leverage and its beta is difficult to estimate,it has been shown both theoretically and empirically that a firm's beta increases with its degree of financial leverage.

Question 28

The fact that some managers are more aggressive in their use of debt financing in attempting to boost profits does not influence the optimal or value-maximizing capital structure.

Question 29

The weighted average cost of capital (WACC)declines as more of the lowest cost component is added.What limits a firm from using nearly all debt is that as the debt ratio rises,the absolute interest expense gets very large.The large interest expense reduces income and results in a debt ratio limit even though the WACC continues to decline.

Question 30

As the percentage of debt in a firm's capital structure increases,its financial risk increases.Once the firm increases its debt beyond the optimal level,rising interest charges result in an immediate decrease in EPS.

Question 31

Firms in industries that are cyclical,oriented toward research,or subject to huge liability suits normally will maintain high levels of debt in their capital structure.

Question 32

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 33

The benefit to the firm of the tax deductibility of interest can be lowered if the firm's marginal tax rate is reduced by accumulated depreciation or tax-loss carry-forwards.

Question 34

Firm A has a higher degree of business risk than Firm B.Firm A can offset this by using less financial leverage.Therefore,the variability of both firms' expected EBITs could actually be identical.

Question 35

If Miller and Modigliani had considered the cost of bankruptcy,it is unlikely that they would have concluded that 100 percent debt financing is optimal for the firm.

Question 36

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

Question 37

Generally,as debt is substituted for equity,risk,as measured by the coefficient of variation of EPS,increases.This negative effect works against the positive effect of substituting debt for equity,which is that higher leverage increases expected EPS.

Question 38

If we include the cost of bankruptcy in the MM analysis of capital structure in a world with taxes,we would tend to believe that the cost of debt increases as leverage increases and that there is probably an optimal capital structure.

Question 39

If we consider only agency costs associated with the issuance of debt,then this implies that the firm should move toward 100 percent debt financing.

Question 40

Risk can be apportioned between 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 41

Allyson,who is the CFO of Mundane Minerals & Mining (MMM),is trying to decide whether to issue debt or common stock to finance the capital budgeting projects she has evaluated as acceptable (that is,the projects have positive net present values,NPV).Because MMM is a relatively small company,Allyson believes that the type of capital she uses to finance the projects will send a signal to investors.As a result,which of the following actions would you recommend Allyson take?

A) Issue equity, because investing in positive NPV projects is not in the best interests of the firm, and the existing stockholders will want to share such "bad news" with new stockholders.
B) Issue equity so as to dilute ownership and share the increase in wealth that results from investing in positive NPV projects with new stockholders.
C) Issue debt, because debt is riskier than common stock, thus the value of existing stockholders' stock will increase more than if new equity is issued.
D) Issue debt, because investing in positive NPV projects increases the value of the firm, and the existing stockholders probably prefer not to share such good fortune with new stockholders.
E) Investors do not care which source of funds the firm uses as long as the funds are invested in positive NPV projects; therefore it shouldn't matter which type of capital is used.

Question 42

As a general rule,the capital structure that

A) Maximizes expected EPS also maximizes the price per share of common stock.
B) Minimizes the interest rate on debt also maximizes the expected EPS.
C) Minimizes the required rate on equity also maximizes the stock price.
D) Maximizes the price per share of common stock also minimizes the weighted average cost of capital.
E) None of the above.

Question 43

Which of the following factors does not affect a firm's business risk?

A) Demand variability.
B) Input price variability.
C) Interest cost variability.
D) Operating leverage.
E) Sales price variability.

Question 44

A firm that has high interest payments relative to other companies is said to have

A) a poor finance department.
B) a high degree of financial leveraging.
C) no financial leveraging.
D) a high degree of operating leverage.

Question 45

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

A) degree of financial leverage (DFL).
B) maximum WACC.
C) maximum business risk.
D) optimal capital structure.

Question 46

If the announcement of a stock sale does in fact trigger a decline in stock price,this reinforces the effects of flotation costs incurred with new equity issues.Further,this implies a larger break in the MCC schedule.

Question 47

Which of the following statements is most correct?

A) Increasing financial leverage is one way to increase a firm's basic earning power (BEP).
B) Firms with lower fixed costs tend to have greater operating leverage.
C) The debt ratio which maximizes EPS generally exceeds the debt ratio which maximizes share price.
D) Both a and b are correct.
E) Both a and c are correct.

Question 48

Which of the following statements is correct?

A) As a rule, the optimal capital structure is found by determining the debt-equity mix that maximizes expected EPS.
B) The optimal capital structure simultaneously maximizes EPS and minimizes the WACC.
C) The optimal capital structure minimizes the cost of equity, which is a necessary condition for maximizing the stock price.
D) The optimal capital structure simultaneously minimizes the cost of debt, the cost of equity, and the WACC.
E) Each of the above statements is false.

Question 49

Which of the following factors affects business risk?

A) sales variability
B) proportion of debt in the firm's capital structure
C) taxes
D) preferred stock dividends

Question 50

Business risk is concerned with the operations of the firm.Which of the following is not associated with (or not a part of)business risk?

A) Demand variability.
B) Sales price variability.
C) The extent to which operating costs are fixed.
D) Changes in required returns due to financing decisions.
E) The ability to change prices as costs change.

Question 51

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 52

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.

Question 53

If debt financing is used,which of the following is correct?

A) The percentage change in net operating income is greater than a given percentage change in net income.
B) The percentage change in net operating income is equal to a given percentage change in net income.
C) The percentage change in net operating income depends on the interest rate charged on debt.
D) The percentage change in net operating income is less than the percentage change in net income.
E) The degree of operating leverage is greater than 1.

Question 54

The firm's target capital structure is consistent with which of the following?

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

Question 55

Which of the following statements is most correct?

A) The optimal capital structure minimizes the WACC.
B) If the after-tax cost of equity financing exceeds the after-tax cost of debt financing, firms are always able to reduce their WACC by increasing the amount of debt in their capital structure.
C) Increasing the amount of debt in a firm's capital structure is likely to increase the cost of both debt and equity financing.
D) Answers a and c are both correct.
E) Answers b and c are both correct.

Question 56

Generally speaking,companies in Italy and Japan use less debt in their capital structure than companies in the United States or Canada.

Question 57

According to the trade-off theory of capital structure,the __________ benefit of increasing debt is traded-off against the __________ cost of increasing debt to determine the firm's optimal capital structure.

A) bankruptcy; tax
B) operating; tax
C) tax; operating
D) tax; bankruptcy
E) operating; bankruptcy

Question 58

If a firm is operating at its optimal capital structure,then its weighted average cost of capital must be __________ and its value must be __________.

A) maximized; maximized
B) minimized; minimized
C) maximized; minimized
D) minimized; maximized
E) None of the above is a correct answer.

Question 59

If the firm's actual debt ratio is below its target level,expansion capital should be raised by issuing equity in order to preserve the firm's borrowing capacity.

Question 60

According to the text DFL stands for

A) Degree of Financial Leverage
B) Detrimental Financial Liability
C) Differential Finance Learning
D) Departmental Finance League
E) Derivative Finance Law

Question 61

Assume that a firm has a DFL of 1.25.If sales increase by 20 percent,the firm will experience a 60 percent increase in EPS,and it will have an EBIT of $100,000.What will be the EBIT for this firm if sales do not increase?

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

Question 62

Which of the following is not one of the four primary factors that influence capital structure decisions?

A) The firm's business risk.
B) The firm's tax position.
C) The firm's financial flexibility.
D) The firm's inventory valuation method.
E) The firm's managerial attitude.

Question 63

Which of the following are practical difficulties associated with capital structure and degree of leverage analyses?

A) It is nearly impossible to determine exactly how P/E ratios or equity capitalization rates (r_s values) are affected by different degrees of financial leverage.
B) Managers' attitudes toward risk differ and some managers may set a target capital structure other than the one that would maximize stock price.
C) Managers often have a responsibility to provide continuous service; they must preserve the long-run viability of the enterprise. Thus, the goal of employing leverage to maximize short-run stock price and minimize capital cost may conflict with long-run viability.
D) All of the above.
E) None of the above represent a serious impediment to the practical application of leverage analysis to capital structure determination.

Question 64

Which of the following statements is correct?

A) Suppose Company A's EPS is expected to experience a larger percentage change in response to a given percentage change in sales than Company B's EPS. Other things held constant, Company A would appear to have more business risk than Company B.
B) Statement a would be correct if the term "EBIT" were substituted for "EPS."
C) Statement a would be correct if the term "EBIT" were substituted for "sales."
D) Statement a would be correct if the words "financial risk" were substituted for "business risk."
E) The above statements are all false.

Question 65

If the debt ratio is 50 percent,the interest rate on all debt is 8 percent,the tax rate is 50 percent,and the return on equity is 10 percent,then the ratio of earnings before interest and taxes (EBIT)to total assets,or the basic earning power ratio,must be

A) 10%.
B) 14%.
C) 12%.
D) 8%.
E) 16%.

Question 66

If a given change in EBIT results in a larger relative change in EPS then we can definitely say that the firm has

A) a degree of operating leverage greater than one.
B) a degree of operating leverage less than one.
C) a degree of financial leverage greater than one.
D) a degree of financial leverage less than one.
E) a degree of total leverage less than one.

Question 67

If a change in sales results in a greater relative change in operating income (EBIT),we know that the firm has

A) a degree of operating leverage greater than one.
B) a degree of financial leverage greater than one.
C) a degree of operating leverage less than one.
D) a degree of financial leverage less than one.
E) none of the above.

Question 68

Howell Enterprises is forecasting EPS of $4.00 per share for next year.The firm has 10,000 shares outstanding,it pays 12 percent interest on its debt,and it faces a 40 percent marginal tax rate.Its estimated fixed costs are $80,000 while its variable costs are estimated at 40 percent of revenue.The firm's target capital structure is 40 percent equity and 60 percent debt and it has total assets of $400,000.On what level of sales is Howell basing its EPS forecast?

A) $1,000,000
B) $480,400
C) $316,722
D) $292,445
E) $105,280

Question 69

Which of the following statements is correct?

A) The degree of operating leverage (DOL) depends on a company's fixed costs, variable costs, and sales. The DOL formula assumes (1) that fixed costs are constant and (2) that variable costs are a constant proportion of sales.
B) The degree of total leverage (DTL) is equal to the DOL plus the degree of financial leverage (DFL).
C) Arithmetically, financial leverage and operating leverage offset one another so as to keep the degree of total leverage constant.
D) The above statements are all true.
E) The above statements are all false.

Question 70

All else equal,if a firm increases its leverage (either operating,financial,or both),its weighted average cost of capital probably will

A) increase because risk increases.
B) decrease because risk decreases.
C) increase because risk decreases.
D) remain about the same because risk does not change.
E) change somehow, but more information is needed to determine the direction.

Question 71

The optimal capital structure is the one that maximizes __________,and this will always be lower than the debt/equity ratio that maximizes __________.

A) expected EPS; the firm's stock price
B) net income, expected EPS
C) book value of the firm; net income
D) expected EPS; book value of the firm
E) the firm's stock price; expected EPS

Question 72

__________ is the situation where investors and managers have the same (identical)information about the firm's future prospects.

A) Symmetric information
B) Asymmetric information
C) Leverage
D) Target capital structure

Question 73

The "degree of leverage" concept is designed to show how changes in sales will affect EBIT and 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 74

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 EPS?

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

Question 75

Quick Launch Rocket Company,a satellite launching firm,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 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 DTL approach?

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

Question 76

Which of the following statements is correct?

A) There have been no significant observed differences in the capital structures of U.S. corporations in comparison to 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 should 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 probably lower in the United States than in Japan and Germany.

Question 77

Which of the following is correct?

A) Generally, debt to total assets ratios do not vary much among different industries although they do vary for firms within a particular industry.
B) Utilities generally have very high common equity ratios due to their need for vast amounts of equity supported capital.
C) The drug industry has a high debt to common equity ratio because their earnings are very stable and thus, can support the large interest costs associated with higher debt levels.
D) Wide variations in capital structures exist between industries and also between individual firms within industries and are influenced by unique firm factors including managerial attitudes.
E) Since most stocks sell at or around their book values, using accounting values provides an accurate picture of a firm's capital structure.

Question 78

Which of the following statements is correct?

A) When financial leverage is used, the graphical probability distribution of net income would tend to be more peaked than a distribution where no leverage is present, other things held constant.
B) From an operational standpoint the goal of maintaining financial flexibility translates into maintaining adequate reserve borrowing capacity.
C) While business risk varies form one industry to another and can change over time, it affects all firms equally within a particular industry.
D) The optimal capital structure is the one that maximizes EBIT, and this always calls for a debt ratio which is lower than the one that maximizes expected EPS.
E) The above statements are all false.

Question 79

If a given change in sales results in a larger relative change in EPS then we can definitely say that the firm has

A) a degree of financial leverage greater than one.
B) a degree of operating leverage less than one.
C) a degree of total leverage less than one.
D) a degree of financial leverage less than one.
E) a degree of total leverage greater than one.

Question 80

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 would you expect in the company's net income?

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