Deck 18: Capital Structure and the Cost of Capital

Question 1

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.

Answer 1

False

Question 2

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

Answer 2

True

Question 3

A non-optimal capital structure may lead to higher financing costs.

Answer 3

True

Question 4

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

Question 5

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

Question 6

One advantage of preferred is that it increases a firm's equity without diluting the ownership and control of the common shareholders.

Question 7

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

Question 8

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

Question 9

Some classes of common equity may have superior voting rights.

Question 10

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

Question 11

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

Question 12

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

Question 13

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 14

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

Question 15

Corporate investors can exempt all preferred dividend income from income taxes.
Not in chapter

Question 16

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

Question 17

There is no opportunity cost associated with retained earnings.

Question 18

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

Question 19

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 20

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

Question 21

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

Question 22

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

Question 23

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

Question 24

Financial risk affects the bottom half of the income statement.

Question 25

Business risk is measured by the degree of financial leverage.

Question 26

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

Question 27

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 28

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

Question 29

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

Question 30

A greater percentage of European multinational firms use weighted average costs of capital as their project discount rates than U.S.firms.
Students don't really need to memorize this.

Question 31

Leverage does not affect EPS for most firms.

Question 32

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

Question 33

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

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

Question 36

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

Question 37

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

Question 38

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

Question 39

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

Question 40

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 41

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 42

In estimating the cost of equity, the rate of return on U.S.Treasury bills is often used as a proxy for the risk free rate of return.

Question 43

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

Question 44

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 45

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 46

When retained earnings are used up and new common stock is issued, we know that the cost of:

A)equity has increased
B)equity has dropped
C)equity is unaffected
D)both common and preferred stock are affected

Question 47

Which of the following is a correct way to calculate degree of combined leverage?

A)divide DFL by DOL
B)multiply DOL by DFL
C)divide DOL by DFL
D)add DOL and DFL

Question 48

Because the cost of capital is used to evaluate future investment proposals, it is important to include flotation costs because such costs would be incurred if a firm were to raise new capital to fund proposed projects.

Question 49

Which of the following is not potentially used in the weighted average cost of capital equation?

A)cost of retained earnings
B)weight of debt
C)average corporate income tax rate
D)marginal tax rate

Question 50

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

Question 51

A company experienced a 12 % increase in earnings before interest and taxes and a 3 % increase in sales.What is the degree of operating leverage for this company?

A)36
B)6
C)4
D)none of the above

Question 52

In calculating the cost of new common stock using the constant dividend growth model, it is important that the __________ are subtracted from the price of the stock.

A)flotation costs
B)par value
C)cost of retained earnings
D)proceeds of the sale

Question 53

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 54

A9.51 A firm's degree of combined leverage can be measured as degree of operating leverage __________ the degree of financial leverage:

A)plus
B)minus
C)times
D)divided by

Question 55

Smith Company has a degree of operating leverage of 5, while an industry competitor, Johnson Company, has a degree of operating leverage of 2.Supplied with this knowledge, pick the response below that is most typical of Johnson Company.

A)high fixed costs
B)conservative
C)large commitment to plant facilities
D)greater low sales.

Question 56

The degree of combined leverage shows us to what degree a percentage change in sales will cause a percentage change in:

A)earnings before interest and taxes
B)pre-tax earnings after tax
C)earnings per share
D)gross profit

Question 57

Flotation costs include:

A)cost of printing shares
B)legal and accounting costs
C)investment banker fees
D)all the above

Question 58

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

Question 59

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)initial market price per share

Question 60

The weighted average cost of capital represents the minimum 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.
Clone of prior item

Question 61

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

A)minimum risk
B)maximum earnings per share
C)minimum weighted average cost of capital
D)minimum cost of equity

Question 62

Which of the following statements is most correct?

A)All component costs in a firm's weighted average cost of capital must reflect after-tax costs, but the only component that requires an adjustment for taxes is the cost of new common stock.
B)An increase in the marginal corporate tax rate would lower the weighted average cost of capital for the firm, other things held constant.
C)The cost of debt is equal to one minus the marginal tax rate multiplied by the coupon rate on outstanding debt.
D)All the above statements are equally true.

Question 63

Which of the following securities have voting rights?

A)convertible bond
B)preferred stock
C)common stock
D)all the above

Question 64

The cost of debt:

A)is typically higher than the cost of preferred stock
B)must be adjusted to an after-tax cost
C)is higher than the cost of retained earnings
D)is the lowest component cost because corporations can deduct 70 percent of the interest expense

Question 65

Which of the following phrases make the statement false? As a firm increases its operating leverage for a given quantity of output, this:

A)decreases its financial leverage
B)changes its operating cost structure
C)increases its business risk
D)increases the variability on earnings per share

Question 66

Which of the following statements is false?

A)Combined leverage is the effect on earnings produced by the operating and financial leverage.
B)There is strong empirical evidence that firms adjust their degrees of operating leverage and degrees of financial leverage to match some standard degree of combined leverage.
C)Financial risk is the additional risk, above business risk, resulting from substituting debt into the capital structure.
D)All the above statements are true.

Question 67

As a general rule, the capital structure that maximizes stock price also:

A)minimizes the weighted average cost of capital
B)maximizes the weighted average cost of capital
C)minimizes the required rate of return on equity
D)maximizes the cost of debt

Question 68

A company with a DCL of 12 and a DFL of 2 has a DOL of?

A)24
B)14
C)6
D)cannot tell from this information

Question 69

Which of the following statements is most correct?

A)The degree of combined leverage measures the sensitivity of earnings per share ininto changes in EBIT.
B)A firm's business risk is measured by its variability in earnings per share over time.
C)A firm's degree of combined leverage is the product of its degree of operating leverage and its degree of financial leverage.
D)All the above statements are false.

Question 70

Which of the following is not an influence affecting a firm's capital structure choices?

A)corporate control
B)maturity matching
C)timing
D)all the above affect a firm's capital structure choices

Question 71

A decrease in contractual managers' salaries will result in:

A)an increase in the degree of combined leverage
B)a decrease in the degree of combined leverage
C)no change in the degree of combined leverage
D)none of the above

Question 72

Given the conflict between risk and return, the purpose of capital structure management is to find the debt level:

A)that will always be kept below the equity level
B)where the price of company stock is maximized
C)that most adequately supports corporate goals
D)that is equal in dollar value to the equity level

Question 73

A decrease in the debt ratio will normally have no effect on:

A)financial risk
B)business risk
C)total risk
D)systematic risk

Question 74

A decrease in contractual managers' salaries will result in:

A)an increase in the degree of financial leverage
B)a decrease in the degree of financial leverage
C)no change in the degree of financial leverage

Question 75

Which of the following statements is false?

A)Other factors being constant, higher fixed costs mean a higher operating leverage.
B)Corporate bonds and notes provide no voting rights.
C)The cost of debt is the minimum acceptable rate of return to a firm on a project of average risk.
D)All of the above statements are true.

Question 76

As a general rule, the capital structure that:

A)minimizes the cost of equity also maximizes the stock price
B)maximizes the stock price also minimizes the weighted average cost of capital
C)minimizes the cost of debt also maximizes the expected earnings per share
D)none of the above is a true statement

Question 77

The cost of retained earnings is:

A)the cheapest component cost
B)zero because the firm does not have to pay interest or dividend to itself
C)always less than the cost of new common stock
D)typically cheaper than the cost of preferred stock

Question 78

A firm with a DOL of 2, and no preferred stock, and no long-term debt will have a DCL of:

A)0
B)2
C)1
D)cannot tell from this information

Question 79

A high degree of financial leverage means that a small change in sales will result in:

A)a small change in earnings per share
B)a large change in earnings per share
C)no change in earnings per share
D)none of the above

Question 80

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.