Question 1

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.

Accepted Answer

The answer of One implication of information asymmetry between investors...

Question 2

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.

Accepted Answer

Firms in cyclical industries, those focused on research, or those facing large liability risks typically maintain lower levels of debt to avoid financial distress during downturns or uncertain periods.

Question 3

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.

Accepted Answer

The answer of Firm A has a higher degree of...

Question 4

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.

Accepted Answer

The optimal or value-maximizing capital structure is determined by factors such as the company's cash flow, growth opportunities, and risk level, and should not be influenced by a manager's personal preferences or aggressiveness in using debt financing.

Question 5

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.

Accepted Answer

The TIE ratio (or interest coverage ratio) is calculated by dividing the earnings before interest and taxes (EBIT) by the interest expense. Therefore, it depends on the profitability of the firm (measured by EBIT) and the interest rate on the debt. The percentage of debt in the capital structure of the firm is not a direct determinant of the TIE ratio but may indirectly affect it by influencing the interest rate and the credit risk perception of the firm.

Question 6

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.

Accepted Answer

This is because the cost of bankruptcy is a real-world consideration that can impact a firm's profitability and value. By not taking this into account, Miller and Modigliani's theory does not fully capture the complexities of financial decision-making in practice.

Question 7

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.

Accepted Answer

The announcement of a stock offering may indicate that a mature firm is seeking financing for various reasons, such as funding growth or paying off debt. However, it does not necessarily indicate that the firm's prospects are very good as it may also indicate that the firm is facing financial difficulties or uncertainty.

Question 8

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.

Accepted Answer

While increasing debt financing may reduce some agency costs associated with equity, it introduces new agency costs associated with debt such as potential bankruptcy costs and the need to monitor the firm's leverage ratio. Therefore, the optimal capital structure for a firm must balance the costs and benefits of both debt and equity financing.

Question 9

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.

Accepted Answer

Financing with debt introduces financial risk due to the obligation to pay interest and principal on the debt, but it does not increase business risk, which is inherent to the firm's operations and market environment.

Question 10

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.

Accepted Answer

Including the cost of bankruptcy in the analysis of capital structure would increase the cost of debt as leverage increases, which would lead to the belief that there is an optimal capital structure. This is because at low levels of leverage, the tax shield from interest payments outweighs the cost of bankruptcy, but as leverage increases, the cost of bankruptcy becomes more significant and offsets the tax shield, resulting in a U-shaped cost of capital curve.

Question 11

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.

Accepted Answer

Financial flexibility refers to the ability of a firm to obtain capital under all types of economic conditions on acceptable, competitive terms. Therefore, a consistent supply of capital is essential for the long-run success of a firm.

Question 12

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.

Accepted Answer

While expected EPS and standard deviation of expected EPS are factors to consider when evaluating business risk, they alone do not provide a complete picture of a firm's risk. Other factors, such as the nature of the industry, financial leverage, and market conditions, can significantly impact a firm's risk level. Therefore, two firms with the same expected EPS and standard deviation of expected EPS can still have different levels of business risk.

Question 13

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.

Accepted Answer

The Weighted Average Cost of Capital (WACC) initially decreases with more debt due to the tax shield on interest. However, excessive debt increases financial risk, raising both the cost of debt and equity, which eventually increases WACC.

Question 14

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.

Accepted Answer

As debt increases, the risk measured by the coefficient of variation of EPS also increases. This means that the variability of earnings per share increases which is a negative effect of substituting debt for equity. However, higher leverage still increases the expected earnings per share.

Question 15

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.

Accepted Answer

If a firm's marginal tax rate is reduced by accumulated depreciation or tax-loss carry-forwards, then the benefit of tax deductibility of interest will be less valuable to the firm. This is because a lower marginal tax rate means that the firm is already paying less in taxes, so the deduction for interest payments doesn't provide as much of a reduction in tax liability.

Question 16

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

Accepted Answer

This is the correct definition of the degree of operating leverage.

Question 17

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.

Accepted Answer

It has been shown both theoretically and empirically that a firm's beta increases with its degree of financial leverage.

Question 18

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.

Accepted Answer

The answer of The weighted average cost of capital (WACC)...

Question 19

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.

Accepted Answer

The answer of Risk can be apportioned between financial and...

Question 20

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.

Accepted Answer

The answer of As the percentage of debt in a...

Quiz 13: Distribution of Retained Earrings: Dividends and Stock Repurchases