Question 1

Which event is likely to encourage a company to raise its target debt ratio,other things held constant?

Accepted Answer

An increase in the corporate tax rate makes debt financing more attractive because interest payments on debt are tax-deductible, effectively reducing the cost of borrowing. This tax shield encourages companies to increase their target debt ratio to capitalize on the tax benefits.

Question 2

If debt financing is used,which of the following is correct?

Accepted Answer

When debt financing is used, interest on the debt becomes an additional expense that reduces net income. As a result, the percentage change in net income will be greater than the percentage change in net operating income.

Question 3

On which of the following items will an increase in the debt ratio generally have no effect?

Accepted Answer

Business risk is related to the operational aspects of a company and is independent of its capital structure, so an increase in the debt ratio does not affect it.

Question 4

Volga Publishing is considering a proposed increase in its debt ratio,which would also increase the company's interest expense.The plan would involve issuing new bonds and using the proceeds to buy back shares of its common stock.The company's CFO thinks the plan will not change total assets or operating income but that it will increase earnings per share (EPS).Assuming the CFO's estimates are correct,which of the following statements is correct?

Accepted Answer

Increasing the debt ratio increases the financial risk of the company, which might not be viewed positively by shareholders. Therefore, even if EPS increases, the share price might still fall.

Answer: C 
 If the plan increases EPS, it means that net income is likely to increase, as EPS is calculated by dividing net income by the number of outstanding shares.

Therefore, the correct choices are A and C.

Option B is incorrect, as if the plan reduces the WACC, it would reduce the cost of capital for the company, and the share price is likely to increase, not decline. Option D is incorrect, as the share price might not increase at the same rate as EPS, as shareholders might not view an increase in financial risk positively.

Question 5

During a recession,companies with a significant portion of their capital structure in the form of debt (i.e.,high leverage) often struggle to meet their legally binding interest obligations.

Accepted Answer

During a recession, companies with high leverage may have difficulty generating enough cash flow to meet their debt obligations, including interest payments. This can lead to financial distress and potential default on their debt. Therefore, high leverage can be a disadvantage during a recession.

Question 6

Firms having positive prospects try to raise new equity capital by selling new stocks.

Accepted Answer

Firms with positive prospects may prefer other financing methods like debt to avoid diluting existing shareholders' equity and to take advantage of tax benefits associated with debt financing.

Question 7

Which of the following would increase the likelihood that a company would increase its debt ratio,other things held constant?

Accepted Answer

An increase in the corporate tax rate would make debt financing more attractive because interest payments on debt are tax-deductible, effectively reducing the company's taxable income and thus its tax liability. This tax shield makes increasing the debt ratio more appealing.

Question 8

The MM model employs the concept of arbitrage to develop its theory.

Accepted Answer

The MM (Modigliani-Miller) model is based on the concept of arbitrage, which refers to the process of taking advantage of price differences to make profits without incurring any risk. In their model, Modigliani and Miller showed that under certain assumptions, the value of a firm is independent of its capital structure, meaning that the cost of capital and the value of the firm remain constant regardless of how the firm is financed. This theory is also known as the capital structure irrelevance principle.

Question 9

During a recession,companies with a significant portion of their capital structure in the form of common share equity (i.e.,low leverage) often struggle to provide a continuous stream of dividend income to their shareholders.

Accepted Answer

Companies with low leverage (i.e.,high equity) are more likely to have a strong financial position and be able to maintain dividend payments during a recession. On the other hand, companies with high leverage (i.e.,low equity) may struggle to meet their debt obligations and may need to suspend or cut their dividend payments.

Question 10

What should the firm's target capital structure be set to do?

Accepted Answer

The primary objective of setting a target capital structure is to minimize the weighted average cost of capital (WACC). WACC represents the average cost of capital that a company must pay for all its financing sources. By minimizing the WACC, a company can maximize the value of its operations to shareholders. Therefore, D is the best choice. Maximizing EPS or minimizing the cost of debt or equity are not the primary objectives of setting a target capital structure.

Question 11

Which of the following statements regarding risk,or the avoidance of risk,is correct?

Accepted Answer

Risk due to industry characteristics, such as demand variability, input cost variability, and the degree of competition, is generally beyond the direct control of a firm's management. These external factors are part of the business environment in which a firm operates.

Question 12

Which of the following statements best describes WACC?

Accepted Answer

Increasing a company's debt ratio generally increases the marginal cost of both debt and equity financing due to the higher financial risk. However, because debt financing is cheaper than equity financing due to tax deductibility of interest, this can still result in a lower overall Weighted Average Cost of Capital (WACC) up to a certain point.

Question 13

Based on the information below,what is Ezzel Enterprises' optimal capital structure?

Accepted Answer

The optimal capital structure for a firm is the one that maximizes its value and reduces its cost of capital. Ezzel Enterprises' optimal capital structure is characterized by a debt-to-equity ratio of 60:40, with debt accounting for 60% of the financing and equity accounting for 40%. This is because the firm's EPS is highest at $3.18 and the common share price is also highest at $31.20 at this capital structure. Additionally, this capital structure balance reduces the firm's cost of capital while still providing a reasonable degree of financial leverage.

Question 14

Suppose a firm increases the operating leverage used to produce a given quantity of output.What will this normally lead to?

Accepted Answer

Increasing operating leverage typically involves increasing fixed costs relative to variable costs. This does not decrease the standard deviation of expected EBIT, decrease business risk, or decrease the variability of expected EPS. Instead, it often leads to a reduction in the fixed assets turnover ratio because the firm is utilizing more fixed assets (increasing fixed costs) relative to its sales.

Question 15

Which statement best describes the optimal capital structure?

Accepted Answer

The optimal capital structure is the one that maximizes the company's stock price, not just its earnings per share (EPS), cost of equity, or cost of debt. This is because the stock price reflects the present value of future cash flows, taking into account the risk and return associated with the company's capital structure.

Question 16

The presence of personal taxes completely eliminates the benefits of debt financing.

Accepted Answer

Personal taxes do not completely eliminate the benefits of debt financing. Although interest payments on debt are tax-deductible for businesses, personal taxes may apply to the owner of a sole proprietorship or partnership. However, the benefits of debt financing, such as leverage, remain even with personal taxes taken into account.

Question 17

A firm's financial policy drives its equity beta.

Accepted Answer

A firm's financial policy, such as its capital structure and dividend policy, can impact its overall risk and therefore affect its equity beta. For example, a firm with a higher level of debt may have a higher equity beta as the increased financial leverage increases the volatility and risk of the company's earnings and stock price. Therefore, financial policy can have an impact on a company's equity beta.

Question 18

Which of the following statements best describes capital structure?

Accepted Answer

Capital structure refers to the mix of debt and equity that a company uses to finance its operations. The capital structure that minimizes the weighted average cost of capital (WACC) also maximizes the value of the firm and therefore the price per share of common shares. This is because minimizing the WACC means maximizing the return to both debt and equity investors, which in turn increases the likelihood of investors buying the firm's shares, driving up the share price. Therefore, option D is the best choice.

Question 19

Which statement best describes optimal capital structure?

Accepted Answer

The optimal capital structure is the one that balances debt and equity in a way that maximizes the company's stock price while minimizing its weighted average cost of capital (WACC). This balance is crucial because it affects a company's ability to finance new projects at the lowest possible cost, thereby enhancing shareholder value.

Question 20

Business risk is affected by a firm's operations.Which of the following is NOT associated with (or does not contribute to) business risk?

Accepted Answer

The extent to which interest rates on the firm's debt fluctuate is not associated with business risk because it is a financial risk, which is separate from the risk inherent in a firm's operations. Factors such as demand variability, input price variability, and the extent to which operating costs are fixed are all associated with business risk because they directly affect a firm's profitability and ability to generate revenue.

Quiz 12: Capital Structure Decisions