Question 1

Protection for debt holders takes the form of protective covenants in the bond indenture. These covenants place restrictions on which of the following activities?
A) The sale of assets
B) Payment of dividends
C) The issuance of additional debt
D) All other choices are typical protective covenants.

Accepted Answer

Protective covenants can place restrictions on various activities to protect the interests of debt holders. Some of the typical activities that can be restricted include the sale of assets, payment of dividends, and issuance of additional debt. Other activities that can be restricted may include changes in management, mergers or acquisitions, and investments in new projects. Therefore, all other choices are potential protective covenants that can be included in a bond indenture.

Question 2

Modigliani and Miller show that the value of a firm is ____ capital structure given perfect capital markets and no corporate income taxes.
A) maximized by having no debt in the
B) independent of
C) maximized by having an optimal
D) dependent on the

Accepted Answer

According to Modigliani and Miller, in a world of perfect capital markets and no corporate income taxes, the value of a firm is independent of its capital structure. This is known as the Modigliani-Miller theorem. In such an ideal world, investors are assumed to be rational and pricing of securities is efficient, which means that the cost of equity and debt financing for a firm would be the same regardless of the firm's capital structure. Therefore, the choice is B – independent of.

Question 3

Studies of capital structure changes have found that actions that increase leverage have generally been associated with ____ stock returns and actions that decrease leverage are associated with ____ stock returns.
A) negative; positive
B) negative; no change in
C) positive; negative
D) no change in; negative

Accepted Answer

Studies have generally found that actions increasing leverage are associated with positive stock returns, as they may signal management's confidence in future cash flows. Conversely, actions decreasing leverage are often associated with negative stock returns, possibly due to concerns over a company's future growth prospects or profitability.

Question 4

The management of Graphicopy is trying to determine how much debt they should have in their capital structure. If they sell $500,000 in perpetual bonds with a 9% coupon, what would be the present value of the tax shield? Assume the marginal tax rate is 35%.
A) $18,750
B) $29,250
C) $175,000
D) $45,000

Accepted Answer

The present value of the tax shield is calculated as the amount of debt ($500,000) multiplied by the marginal tax rate (35%), which equals $175,000.

Question 5

The optimal capital structure is a function of ____.
A) corporate income taxes
B) financial distress costs
C) agency costs
D) corporate income taxes, financial distress costs, and agency costs

Accepted Answer

The optimal capital structure is a function of corporate income taxes, financial distress costs, and agency costs. Corporate income taxes affect debt usage as interest payments are tax-deductible. Financial distress costs occur when a firm is unable to meet its debt obligations and must declare bankruptcy, leading to costs such as legal fees and lost business. Agency costs arise due to conflicts of interest between shareholders and managers, which can lead managers to choose suboptimal capital structures. Therefore, all three factors must be considered when determining the optimal capital structure.

Question 6

____ refers to the argument that officers and managers have access to information about the expected future earnings of the firm that is not available to outside investors.
A) Insider trading
B) Asymmetric information
C) Signaling effect
D) Pecking order theory

Accepted Answer

Asymmetric information refers to the situation where one party in a transaction has more or better information than the other party. In the case of officers and managers of a firm, they may have access to information that is not available to outside investors, which can create an unfair advantage when making investment decisions. This can lead to accusations of insider trading if the information is used to make trades based on that knowledge.

Question 7

As the proportion of debt in the capital structure increases, investors require a ____ return and the value of existing debt will ____.
A) higher; increase
B) higher; decrease
C) lower; increase
D) lower; decrease

Accepted Answer

As the proportion of debt in the capital structure increases, the risk of default also increases. To compensate for this additional risk, investors require a higher return on their investment in the company. Therefore, the cost of debt increases, and the value of existing debt decreases due to the higher risk associated with it.

Question 8

A firm with highly liquid assets plus unused debt capacity is said to have ____.
A) arbitrage structural capacity
B) the optimal capital structure
C) financial slack
D) optimal financial structure

Accepted Answer

Financial slack refers to the excess liquidity or unused debt capacity of a company, which can be used to take advantage of investment opportunities or fund future projects. It is an important aspect of financial management as it provides a cushion for unexpected events and allows for flexibility in decision making. Therefore, a firm with highly liquid assets plus unused debt capacity is said to have financial slack.

Question 9

Investors' required returns and the cost of equity capital ____ as the relative amount of debt used to finance the firm ____.
A) increase; increases
B) increase; decreases
C) remain constant; increases
D) remain constant; decreases

Accepted Answer

Investors' required returns and the cost of equity capital increase as the relative amount of debt used to finance the firm increases. This is because a higher amount of debt increases the risk of default, making equity holders demand a higher return to compensate for the increased risk. As a result, the cost of equity increases, which in turn increases the required return of investors.

Question 10

The market value of a levered firm can be represented by the following equation: Market value of levered firm = Market value of unlevered firm ____ Present value of tax shield ____ Present value of financial distress costs ____ Present value of agency costs
A) minus; plus; plus
B) plus; plus; plus
C) plus; minus; minus
D) minus, plus, minus

Accepted Answer

According to the equation, the market value of a levered firm is equal to the market value of an unlevered firm plus the present value of tax shield, minus the present value of financial distress costs, and minus the present value of agency costs. Therefore, the correct choice is C, as the market value of a levered firm is positively related to the present value of tax shield and negatively related to the present value of financial distress costs and agency costs.

Question 11

In determining the capital structure for an international firm, the managerial objective is to minimize ____.
A) exchange rate risk
B) the risk of expropriation
C) the overall cost of capital
D) available local low-cost financing

Accepted Answer

The managerial objective in determining the capital structure for an international firm is to minimize the overall cost of capital. While minimizing exchange rate risk and the risk of expropriation may also be important considerations, the ultimate goal is to strike a balance between these factors and the cost of capital. Available local low-cost financing may not always be the most cost-effective option, so it should be evaluated alongside other financing alternatives.

Question 12

____ structure represents the permanent sources of the firm's financing.
A) Financial
B) Capital
C) Equity
D) Cost

Accepted Answer

Capital structure refers to how a firm finances its overall operations and growth through different sources of funds, including equity, debt, and hybrid securities. It represents the permanent sources of financing as opposed to temporary sources such as short-term bank loans or trade credit.

Question 13

The managerial implications of capital structure theory include all except which of the following?
A) Capital structure changes transmit important information to investors.
B) Changes in capital structure result in changes in the market value of the firm's equity.
C) Optimal capital structure is influenced heavily by the business risk facing the firm.
D) Tax shield benefits from equity lead to increased firm value.

Accepted Answer

The option D is incorrect because tax shield benefits from debt not equity lead to increased firm value. The other options are valid managerial implications of capital structure theory.

Question 14

The optimal capital structure of a firm is a function of the ____.
A) business risk of the firm
B) tax structure
C) business risk of the firm and the tax structure
D) the variability of sales volumes

Accepted Answer

The optimal capital structure of a firm takes into consideration both the business risk of the firm and the tax structure. Business risk refers to the level of risk associated with the firm's operations and the industry it operates in. Tax structure refers to the level of taxation placed on the firm's profits. Therefore, the optimal capital structure will vary depending on these two factors. The variability of sales volumes is also a factor to consider, but it is not the only factor to consider in determining the optimal capital structure.

Question 15

A survey of Fortune 500 firms indicates that they prefer internal financing (retained earnings) to external financing. This preference is known as ____.
A) financial slack
B) the pecking order theory
C) capital structure theory
D) asymmetric capital

Accepted Answer

The preference of Fortune 500 firms for internal financing over external financing is indicative of the pecking order theory, which suggests that firms prefer to use internal funds followed by debt financing and then equity financing, in that order. This theory suggests that firms have a hierarchy of financing preferences, with retained earnings being the most preferred because it is seen as the least costly and least risky form of financing.

Question 16

The increased variability in earnings per share due to the firm's use of debt is a definition of ____.
A) combined leverage
B) agency risk
C) financial risk
D) operating risk

Accepted Answer

Financial risk refers to the increased variability in earnings per share due to the use of debt. This is because interest expenses can fluctuate with changes in interest rates, which affects the firm's profitability and thus its EPS. Combined leverage refers to the use of both debt and equity financing, while agency risk and operating risk are different types of risks that are not directly related to the use of debt.

Question 17

Per the "pecking order theory," firms prefer to issue ____ securities first and then issue ____ securities as a last resort.
A) equity; debt
B) debt; convertible debt
C) debt; equity
D) equity; convertible debt

Accepted Answer

According to the pecking order theory, firms prefer to issue debt securities first as they have a lower cost of capital compared to equity securities. This is because debt securities have a fixed interest rate, whereas equity securities involve a share in the company's profits and may require dividend payments. Therefore, debt securities are seen as a safer option for investors. If a firm needs to raise further capital after issuing debt securities, it may issue equity securities or convertible debt, as these are seen as a last resort option as they can dilute the ownership or control of the firm.

Question 18

The less a firm's business risk, the ____ the amount of ____ that will be used in the optimal capital structure, holding constant all other relevant factors.
A) less; financial leverage
B) more; financial leverage
C) less; equity capital
D) more; debt capital

Accepted Answer

The less a firm's business risk, the more financial leverage (debt) it can use in its optimal capital structure because it can handle the fixed obligations associated with debt more comfortably.

Question 19

Agency costs _____.
A) increase as the debt/total assets ratio decreases
B) affect the present value of the tax shield
C) decrease as financial distress increases
D) reduce the market value of the levered firm

Accepted Answer

Agency costs refer to the costs incurred by a firm due to conflicts of interest between stakeholders, such as shareholders and management. One of the main ways to mitigate agency costs is through the use of debt financing, as creditors have a legal right to demand repayment and can thus limit the actions of management. However, excessive debt can also increase the risk of financial distress and bankruptcy, leading to higher agency costs. As a result, the market value of a levered firm can be lower due to the presence of agency costs. Therefore, D is the best answer. A is incorrect because agency costs tend to be lower when more debt is used. B is also incorrect because the tax shield is not directly related to agency costs. C is incorrect because financial distress can lead to higher agency costs.

Question 20

Due to both financial distress and agency costs, a firm should have a capital structure that contains ____.
A) all debt
B) all equity
C) both debt and equity
D) only long-term debt

Accepted Answer

A firm should have a capital structure that contains both debt and equity because using only debt can increase financial distress costs (the risk of bankruptcy due to high debt payments) and using only equity can lead to agency costs (when management prioritizes their interests over those of shareholders). A combination of debt and equity can balance these costs and maximize shareholder value. Long-term debt only would limit a firm's flexibility and access to short-term financing.

Quiz 15: Capital Structure Concepts

Protection for debt holders takes the form of protective covenants in the bond indenture. These covenants place restrictions on which of the following activities?

Modigliani and Miller show that the value of a firm is ____ capital structure given perfect capital markets and no corporate income taxes.

Studies of capital structure changes have found that actions that increase leverage have generally been associated with stock returns and actions that decrease leverage are associated with stock returns.

The management of Graphicopy is trying to determine how much debt they should have in their capital structure. If they sell $500,000 in perpetual bonds with a 9% coupon, what would be the present value of the tax shield? Assume the marginal tax rate is 35%.

The optimal capital structure is a function of ____.

____ refers to the argument that officers and managers have access to information about the expected future earnings of the firm that is not available to outside investors.

As the proportion of debt in the capital structure increases, investors require a return and the value of existing debt will .

A firm with highly liquid assets plus unused debt capacity is said to have ____.

Investors' required returns and the cost of equity capital as the relative amount of debt used to finance the firm .

The market value of a levered firm can be represented by the following equation: Market value of levered firm = Market value of unlevered firm Present value of tax shield Present value of financial distress costs Present value of agency costs

In determining the capital structure for an international firm, the managerial objective is to minimize ____.

____ structure represents the permanent sources of the firm's financing.

The managerial implications of capital structure theory include all except which of the following?

The optimal capital structure of a firm is a function of the ____.

A survey of Fortune 500 firms indicates that they prefer internal financing (retained earnings) to external financing. This preference is known as ____.

The increased variability in earnings per share due to the firm's use of debt is a definition of ____.

Per the "pecking order theory," firms prefer to issue securities first and then issue securities as a last resort.

The less a firm's business risk, the the amount of that will be used in the optimal capital structure, holding constant all other relevant factors.

Agency costs _____.

Due to both financial distress and agency costs, a firm should have a capital structure that contains ____.