Question 1

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.

Accepted Answer

The answer of You are the president of a small,publicly-traded...

Question 2

The optimal capital structure is that which results in the highest earnings per share because that will ensure maximum stock price.

Accepted Answer

While a high earnings per share is an important consideration for a company's capital structure, it is not the only factor. Other factors, such as the cost of debt and equity and the company's ability to meet debt obligations, also play a role in determining the optimal capital structure. Additionally, the goal of maximizing stock price may not always be the primary consideration for a company; other goals, such as maintaining financial stability, may be more important.

Question 3

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.

Accepted Answer

Business risk can affect a firm's beta, as beta measures the volatility of a firm's returns in relation to the overall market. Higher business risk can lead to higher beta, while lower business risk can lead to lower beta.

Question 4

Asymmetric information involves a situation where the firm's managers have different (better)information about their firm's prospects than do investors.

Accepted Answer

Asymmetric information refers to a situation where one party in a transaction has more or better information than the other party. In the case of a firm, managers have access to more detailed and current information about the company's operations, financials and future prospects than investors or the public. This can lead to informational advantages and disadvantages, mispricings, or market inefficiencies.

Question 5

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.

Accepted Answer

The statement accurately describes the concept of financial flexibility.

Question 6

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.

Accepted Answer

The statement is true. The optimal capital structure is the one that balances the risk and return of a firm, and when it is achieved, the firm's stock price is maximized.

Question 7

The mix of debt,preferred stock,and common equity with which the firm plans to support its asset structure is known as the target capital structure.

Accepted Answer

This statement is true. The target capital structure refers to the combination of debt, preferred stock, and common equity that a company intends to use to finance its assets.

Question 8

If a firm utilizes debt financing,a decrease in earnings before interest and taxes (EBIT)will result in a more than proportionate decrease in earnings per share.

Accepted Answer

When a company uses debt financing, it has to pay interest on the debt. As a result, a decrease in EBIT means there is less money available to pay interest expenses, which will decrease earnings per share by more than proportionally due to the added interest expense. This is known as financial leverage or the debt-equity ratio.

Question 9

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

Accepted Answer

While the degree of financial risk is an important factor, a firm's capital structure is determined by a variety of factors including market conditions, the firm's operational risk, tax considerations, flexibility needs, and the cost of financing options, among others.

Question 10

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

Accepted Answer

The answer of Financial leverage affects both EPS and EBIT,while...

Question 11

Financial risk refers to the extra risk stockholders bear as a result of the use of debt as compared with the risk they would bear if no debt were used.

Accepted Answer

Financial risk is indeed the extra risk borne by stockholders due to the use of debt. This is because debt comes with fixed payment obligations and interest payments, which can be a burden in times of financial distress for the company. As a result, stockholders bear more risk when debt is used, as the probability of bankruptcy increases with higher debt levels.

Question 12

In a world with no taxes,MM show that the capital structure of a firm does not affect the value of the firm.However,when taxes are considered,MM show a positive relationship between debt and firm value.

Accepted Answer

This is the basic premise of Modigliani-Miller theorem (MM theorem) which states that the value of the firm is determined by its earning power and the risk of its underlying assets, and not by the way it is financed. In other words, in a world with no taxes, it doesn't matter whether a firm is financed by debt, equity or a mix of both, as long as the overall cost of capital (WACC) remains the same. However, when taxes are introduced, the interest on debt becomes tax-deductible, which lowers the overall cost of debt and therefore makes debt cheaper than equity. As a result, an optimal capital structure that includes some debt can increase the value of the firm as it reduces the tax liability and increases the return on equity.

Question 13

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

Accepted Answer

Even if a firm is near its target capital structure, it should still concern itself with financial flexibility as it may need to adjust its capital structure in response to changes in the market, business environment or operational needs. Financial flexibility allows the firm to quickly and efficiently adjust its capital structure and funding sources to take advantage of growth opportunities or mitigate financial risks.

Question 14

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

Accepted Answer

Business risk refers to the uncertainty associated with a firm's future earnings or returns on equity, which can arise from various factors such as competition, market conditions, technological changes, and management decisions. In the absence of debt, the risk of bankruptcy due to financial leverage is eliminated, but the business risk remains as an inherent part of the firm's operations and industry environment.

Question 15

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

Accepted Answer

According to Modigliani and Miller's proposition (with no taxes), the capital structure of a firm does not affect its total value or cost of capital. Therefore, there is no optimal capital structure that should approach 100 percent debt financing.

Question 16

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.

Accepted Answer

Creditors usually charge a premium interest rate to compensate for the potential cost of bankruptcy, as they are aware that there is always a chance that the borrower may not be able to repay the loan. This premium helps to cover the present value of bankruptcy costs that creditors may incur in case the borrower defaults on the loan.

Question 17

The level of sales at which expected EPS will be the same regardless of whether the firm uses debt or common stock financing is called the EPS indifference point.

Accepted Answer

This statement is true. The EPS indifference point is the level of sales at which the company's earnings per share (EPS) will be the same regardless of whether the firm uses debt or equity financing. At this point, the cost of debt and the cost of equity will be balanced, resulting in the same EPS.

Question 18

Business risk,which is the risk inherent in a firm's assets if it uses less than its optimal amount of debt,is one important influence in the capital structure decision.

Accepted Answer

Business risk refers to the risk associated with the firm's operations and is independent of the financing mix or the amount of debt used by the firm. It does not change with the level of debt.

Question 19

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

Accepted Answer

Financial leverage increases a firm's fixed costs, which can lead to a greater impact on its earnings in times of economic downturns. This higher risk is reflected in a higher beta coefficient, which measures a stock's sensitivity to the overall market movements.

Question 20

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.

Accepted Answer

The statement is false. Miller and Modigliani's work showed that in a perfect market, capital structure does not affect a firm's value and there is no optimal capital structure. Subsequent research has suggested that factors such as taxes, bankruptcy costs, and agency costs may affect a firm's optimal capital structure. However, there is no precise calculation or formula for determining a firm's optimal capital structure due to the complexity of varying factors and uncertainties in the market.

Quiz 14: Capital Structure and Dividend Policy Decisions