Question 1

Which of the following is implied by perfect capital markets?
A) There are no transactions costs for buying and selling securities.
B) Relevant information is unavailable for individuals.
C) All investors can borrow and lend at the same rate.
D) A single investor can influence security prices.

Accepted Answer

C

Question 2

One of the primary assumptions of capital structure analysis is that the level and variability of ____ is not expected to change as changes in capital structure are contemplated.
A) net income
B) earnings before taxes
C) operating income
D) debt

Accepted Answer

One of the primary assumptions of capital structure analysis is that the level and variability of operating income (EBIT - Earnings Before Interest and Taxes) is not expected to change as changes in capital structure are contemplated. This assumption allows analysts to focus on the effects of financing decisions independent of the company's operational performance.

Question 3

Operating leverage involves the use of ____.
A) equity and debt in equal proportions
B) market power
C) debt
D) assets having fixed costs

Accepted Answer

Operating leverage involves the use of assets that have fixed costs, meaning that their cost remains constant regardless of changes in the level of production or sales. As a result, a company with high operating leverage will experience larger changes in its profits due to changes in sales volume compared to a company with low operating leverage.

Question 4

Which of the following statements is true concerning the relationship between the firm's cost of equity and its capital structure (as measured by the debt ratio)?
A) The exact relationship between the cost of equity and the debt ratio is difficult to determine.
B) The range of debt ratios where the cost of equity begins to increase rapidly varies by firm and industry depending on the firm's age.
C) The relationship is a saucer-shaped curve.
D) The relationship is determined by the static tradeoff theory.

Accepted Answer

The exact relationship between the cost of equity and the debt ratio is difficult to determine because different firms have different cost structures, financial risk, and other factors that affect their cost of equity. Additionally, the cost of equity is highly subjective and varies depending on the assumptions and models used to estimate it. Therefore, it is difficult to establish a general relationship between the cost of equity and the debt ratio that applies to all firms.

Question 5

Which of the following statements is true regarding the relationship between the firm's cost of debt and its capital structure (as measured by the debt ratio)?
A) The range of debt ratios where the cost of debt begins to increase rapidly varies by firm and industry, depending on the level of business risk.
B) The precise relationship between the cost of debt and the debt ratio is simple to determine.
C) The relationship is a saucer-shaped curve.
D) The relationship is determined by the static tradeoff theory.

Accepted Answer

The range of debt ratios where the cost of debt begins to increase rapidly varies by firm and industry, depending on the level of business risk. This is due to the fact that investors become increasingly concerned about default risk as a firm takes on more debt, causing the cost of debt to rise more rapidly past a certain point. Hence, the relationship between the cost of debt and the debt ratio is not simple and varies across firms and industries.

Question 6

The use of fixed cost sources of funds, such as debt and preferred stock, affect a firm's ____.
A) financial risk
B) degree of operating leverage
C) market power
D) business risk

Accepted Answer

The use of fixed cost sources of funds, such as debt and preferred stock, adds financial risk to a firm's capital structure. This is because these sources require a fixed payment, regardless of the firm's earnings or cash flow. In contrast, equity financing does not have a fixed payment and is considered more flexible. As a result, a higher proportion of debt and preferred stock in a firm's capital structure increases the financial risk of the firm.

Question 7

The use of fixed-cost financing sources is referred to as the use of ____.
A) operating leverage
B) a leveraged buyout
C) financial leverage
D) combined leverage

Accepted Answer

The use of fixed-cost financing sources is referred to as financial leverage. Operating leverage refers to the use of fixed operating costs in a company's cost structure, while a leveraged buyout is a type of acquisition that uses a significant amount of debt to finance the purchase. Combined leverage refers to the use of both operating and financial leverage in a company's capital structure.

Question 8

The amount of permanent short-term debt, long-term debt, preferred stock, and common stock used to finance a firm defines the firm's ____.
A) financial structure
B) capital structure
C) target capital structure
D) optimal financial structure

Accepted Answer

Capital structure is the composition of a company's funding sources, which may include debt, equity, and hybrid securities. It is important for a company to maintain an appropriate capital structure to balance risk and return and maximize shareholder value. The other answer choices (financial structure, target capital structure, and optimal financial structure) are related to capital structure but do not fully encompass its definition.

Question 9

The objective of capital structure management is to find the capital mix that leads to ____.
A) maximization of earnings per share
B) shareholder wealth maximization
C) maximization of net income
D) maximization of the current period's dividends

Accepted Answer

The objective of capital structure management is to find the capital mix that leads to shareholder wealth maximization. This means that the company aims to increase the value of its equity shares and provide greater returns to its shareholders, which in turn will attract more investors and positively impact the company's reputation and growth potential.

Question 10

Two prominent finance researchers (Modigliani and Miller) showed that the firm's ____.
A) optimal capital structure consists of approximately equal proportions of debt and equity
B) value is independent of its capital structure in perfect capital markets with no income taxes
C) cost of capital is minimized when its capital structure consists of approximately equal proportions of debt and equity
D) cost of capital is maximized when its capital structure consists of approximately equal proportions of debt and equity

Accepted Answer

Modigliani and Miller's proposition states that the value of a firm is independent of its capital structure in perfect capital markets with no income taxes. This means that the firm's optimal capital structure, cost of capital, or value are not affected by the mix of debt and equity in the absence of market imperfections such as taxes or bankruptcy costs. Therefore, choices A, C, and D are incorrect.

Question 11

Holding all other things equal, as the relative amount of debt in the capital structure of the firm increases, the cost of equity capital will ____.
A) increase
B) decrease
C) remain unchanged; there is no relationship between the two
D) initially rise rapidly, then increase slowly beyond some point

Accepted Answer

As the relative amount of debt in the capital structure of the firm increases, the riskiness of equity increases. This is because debt holders have a prior claim to the firm's assets and cash flows. Therefore, equity holders face a higher risk of the firm being unable to meet its debt obligations, which increases the required rate of return for equity investors. Hence, the cost of equity capital will increase.

Question 12

The mix of debt, preferred stock, and common equity that minimizes the weighted cost of capital to the firm is known as the ____.
A) optimal corporate structure
B) target financial structure
C) optimal capital structure
D) optimal degree of combined leverage

Accepted Answer

The term "optimal capital structure" refers to the mix of debt, preferred stock, and common equity that minimizes the weighted cost of capital to the firm. This means that the firm can borrow at the lowest possible cost and maximize shareholder value. The other options may be related to corporate finance, but they do not directly refer to the specific concept of optimal capital structure.

Question 13

The Modigliani-Miller theory that the value of the firm is independent of its capital structure is based on a(n) ____ process.
A) reinvestment
B) capital asset pricing model
C) arbitraging
D) compound interest

Accepted Answer

The Modigliani-Miller theory is based on the arbitraging process, which assumes that investors are capable of buying and selling securities at fair prices in a perfectly efficient market with no taxes or transaction costs. This allows investors to arbitrage between different capital structures, making the value of the firm independent of its capital structure.

Question 14

Generally the ____ a firm's business risk, the ____ the amount of financial leverage that will be used in the optimal capital structure.
A) greater; greater
B) smaller; less
C) greater; less
D) smaller; greater

Accepted Answer

Greater business risk typically leads to a preference for less financial leverage in a firm's capital structure to avoid adding financial risk on top of already high business risk.

Question 15

All except which of the following factors influence a firm's business risk?
A) Degree of operating leverage
B) Variability of interest rates
C) Variability of operating costs
D) Variability of selling prices

Accepted Answer

Variability of interest rates is a factor that influences a firm's financial risk, not business risk. Business risk is affected by factors such as degree of operating leverage, variability of operating costs, and variability of selling prices.

Question 16

With an optimal capital structure, ____.
A) overall capital costs are minimized
B) the net present value of new projects is minimized
C) financial leverage is minimized
D) the weighted cost of capital is maximized

Accepted Answer

With an optimal capital structure, overall capital costs are minimized. This means that the company can raise the necessary capital at the lowest cost possible, which will in turn maximize shareholder wealth. Minimizing the net present value of new projects or financial leverage would not necessarily lead to an optimal capital structure. Similarly, maximizing the weighted cost of capital would increase the cost of financing and reduce shareholder wealth.

Question 17

The optimal capital structure is determined by several factors, including all except which of the following?
A) Corporate capital gains
B) Business risk
C) Potential bankruptcy risk
D) Agency costs

Accepted Answer

Corporate capital gains do not play a direct role in determining the optimal capital structure. The factors that do play a direct role include business risk, potential bankruptcy risk, and agency costs.

Question 18

As more debt is added to the capital structure of a firm, the cost of debt capital ____.
A) initially rises slowly, then falls beyond some point
B) increases at a steady rate throughout the entire range
C) becomes greater than the cost of equity beyond a certain point
D) initially rises slowly, then increases rapidly beyond some point

Accepted Answer

As more debt is added to the capital structure of a firm, the cost of debt capital initially rises slowly as lenders are willing to accept a lower interest rate due to the lower risk associated with the additional debt. However, beyond some point, lenders become less willing to loan funds as the risk increases, causing the cost of debt to increase rapidly. This point is known as the firm's optimal capital structure, where the overall cost of capital is minimized. Therefore, D is the best choice.

Question 19

Financial leverage benefits shareholders when the return on ____.
A) assets is greater than the cost of debt
B) equity is greater than the cost of debt
C) investments is less than the weighted cost of capital
D) equity is less than the cost of debt

Accepted Answer

Financial leverage benefits shareholders when the return on assets is greater than the cost of debt because it results in higher returns on equity. Financial leverage amplifies the returns earned on the assets funded by debt, and if the return on those assets exceeds the cost of debt, then the excess return goes to equity shareholders.

Question 20

In analyzing the value of a firm as a function of capital structure, the present value of the tax shield benefit is offset by the present value of the expected ____, resulting in an interior optimal capital structure.
A) financial distress costs
B) agency costs
C) holding costs
D) financial distress costs and agency costs

Accepted Answer

The present value of the tax shield benefit is offset by the present value of both the expected financial distress costs and agency costs, according to trade-off theory in capital structure analysis. This balance between benefits and costs leads to an optimal capital structure.

Quiz 15: Capital Structure Concepts

Which of the following is implied by perfect capital markets?

One of the primary assumptions of capital structure analysis is that the level and variability of ____ is not expected to change as changes in capital structure are contemplated.

Operating leverage involves the use of ____.

Which of the following statements is true concerning the relationship between the firm's cost of equity and its capital structure (as measured by the debt ratio) ?

Which of the following statements is true regarding the relationship between the firm's cost of debt and its capital structure (as measured by the debt ratio) ?

The use of fixed cost sources of funds, such as debt and preferred stock, affect a firm's ____.

The use of fixed-cost financing sources is referred to as the use of ____.

The amount of permanent short-term debt, long-term debt, preferred stock, and common stock used to finance a firm defines the firm's ____.

The objective of capital structure management is to find the capital mix that leads to ____.

Two prominent finance researchers (Modigliani and Miller) showed that the firm's ____.

Holding all other things equal, as the relative amount of debt in the capital structure of the firm increases, the cost of equity capital will ____.

The mix of debt, preferred stock, and common equity that minimizes the weighted cost of capital to the firm is known as the ____.

The Modigliani-Miller theory that the value of the firm is independent of its capital structure is based on a(n) ____ process.

Generally the a firm's business risk, the the amount of financial leverage that will be used in the optimal capital structure.

All except which of the following factors influence a firm's business risk?

With an optimal capital structure, ____.

The optimal capital structure is determined by several factors, including all except which of the following?

As more debt is added to the capital structure of a firm, the cost of debt capital ____.

Financial leverage benefits shareholders when the return on ____.

In analyzing the value of a firm as a function of capital structure, the present value of the tax shield benefit is offset by the present value of the expected ____, resulting in an interior optimal capital structure.