Question 1

The asymmetric information explanation of capital structure suggests that firms will issue new debt only when the managers believe the firm's stock is overvalued; as a result, issuing new debt is considered a negative signal that will result in a decline in share price.

Accepted Answer

The asymmetric information explanation of capital structure suggests that firms will issue new equity only when the managers believe the firm's stock is overvalued; as a result, issuing new equity is considered a negative signal that will result in a decline in share price. Firms will issue new debt when they believe the firm's stock is undervalued or fairly priced.

Question 2

Holding all other factors constant, a firm that is subject to a greater level of business risk should employ more operating leverage than an otherwise equivalent firm that is subject to a lesser level of business risk.

Accepted Answer

The answer of Holding all other factors constant, a firm...

Question 3

Which of the following is NOT a reason why debt capital is considered to be the least risky source of capital?
A) It has a high priority claim against assets and earnings.
B) It has a strong legal position.
C) It is a low cost source of capital because interest payments are tax deductible.
D) It does not normally have to be repaid at a specific future date.

Accepted Answer

Debt capital typically has a specific repayment schedule or maturity date, so option D is incorrect. Options A, B, and C are correct reasons why debt capital is considered less risky, as it has a higher priority claim against assets and earnings, a strong legal position, and interest payments are tax deductible.

Question 4

Holding all other factors constant, a firm that is subject to a greater level of business risk should employ less total leverage than an otherwise equivalent firm that is subject to a lesser level of business risk.

Accepted Answer

This is because a firm with higher business risk is already exposed to a greater level of uncertainty and potential financial difficulties. By employing less total leverage, the firm can mitigate the risk of defaulting on its debt obligations and potentially experiencing financial distress. In contrast, a firm with lower business risk may feel more comfortable employing greater leverage to potentially maximize returns for its shareholders.

Question 5

The inexpensive nature of long-term debt in a firm's capital structure is due to the fact that
A) the equity holders are the true owners of the firm.
B) equity capital has a fixed return.
C) creditors have a higher position in the priority of claims.
D) dividend payments are tax-deductible.

Accepted Answer

Creditors have a higher position in the priority of claims, meaning that they have the first claim on the firm's assets if the firm goes bankrupt. This lower risk leads to lower interest rates on long-term debt, thereby making it an inexpensive source of capital for the firm. The other options mentioned in the question are not relevant to the low cost of long-term debt.

Question 6

After satisfying obligations to creditors, the government, and preferred stockholders, any remaining earnings will most likely be allocated to any of the following EXCEPT
A) common shareholders as cash dividends.
B) common shareholders as stock dividends.
C) retained by the firm for future investment.
D) a combination of retained earnings and cash dividends.

Accepted Answer

Any remaining earnings can be allocated as cash dividends, retained by the firm for future investment, or a combination of both. However, stock dividends are not a way of allocating remaining earnings, but rather a way of distributing additional shares of stock to existing shareholders.

Question 7

________ risk is the risk of being unable to cover financial costs.
A) Business
B) Financial
C) Total
D) Leverage

Accepted Answer

Financial risk refers to the risk of not being able to meet financial obligations such as debt payments, interest payments, or dividends. Business risk refers to the risk of not generating enough revenue, while total risk refers to the combined risk of both business and financial risk. Leverage risk refers specifically to the risk associated with using debt financing to increase potential returns, but also increases the risk of financial distress. Therefore, the best choice for the given definition is B) Financial.

Question 8

In theory, the firm should maintain financial leverage consistent with a capital structure that
A) meets the industry standard.
B) maximizes the earnings per share.
C) maximizes the owner's wealth.
D) maximizes dividends.

Accepted Answer

The ultimate goal of any firm is to maximize the wealth of its owners or shareholders. Therefore, the firm should maintain financial leverage that maximizes the value of the firm and ultimately maximizes the owners' wealth. Meeting industry standards or maximizing EPS and dividends may not necessarily lead to wealth maximization.

Question 9

________ risk is the risk of being unable to cover operating costs.
A) Business
B) Financial
C) Leverage
D) Total

Accepted Answer

Business risk refers to the risks associated with the business's ability to generate enough revenues to cover its operating costs. It is a type of risk that is specific to the nature of the business itself and not related to financial or leverage risks.

Question 10

Probability of bankruptcy is determined by
A) financial risk.
B) total risk.
C) business risk.
D) interest rate risk.

Accepted Answer

The answer of Probability of bankruptcy is determined by
A) financial...

Question 11

Holding all other factors constant, a firm that is subject to a greater level of business risk should employ more financial leverage than an otherwise equivalent firm that is subject to a lesser level of business risk.

Accepted Answer

A firm with a greater level of business risk should generally employ less financial leverage to avoid compounding risk, as higher leverage increases the firm's financial risk on top of its existing business risk.

Question 12

The key differences between debt and equity capital include all of the following EXCEPT
A) voice in management.
B) maturity.
C) tax treatment.
D) effect on operating leverage.

Accepted Answer

Debt and equity capital differ in terms of maturity, tax treatment, and voice in management. However, they both have the potential to affect a company's operating leverage. Therefore, option D is incorrect.

Question 13

All of the following affect business risk EXCEPT
A) operating leverage.
B) interest rate stability.
C) cost stability.
D) revenue stability.

Accepted Answer

Interest rate stability is not directly related to business risk. Operating leverage, cost stability, and revenue stability are all factors that can impact business risk.

Question 14

Holding all other factors constant, a firm that is subject to a greater level of business risk should employ less financial leverage than an otherwise equivalent firm that is subject to a lesser level of business risk.

Accepted Answer

This is because a firm with higher business risk is more likely to experience fluctuations in earnings, making it difficult to meet interest payments on debt. Therefore, it is safer for the firm to rely more on equity financing and less on debt financing.

Question 15

The basic sources of capital for a firm include all of the following EXCEPT
A) long-term debt.
B) preferred stock.
C) current liabilities.
D) common stock.

Accepted Answer

Current liabilities are not a source of capital, as they represent short-term obligations that must be paid off within a year. The other options, long-term debt, preferred stock, and common stock, are all sources of capital for a firm.

Question 16

Business risk is affected by all of the following EXCEPT
A) revenue stability.
B) cost stability.
C) operating leverage.
D) earnings per share.

Accepted Answer

Business risk is affected by revenue stability, cost stability, and operating leverage. Earnings per share (EPS) is a measure of profitability and is not directly related to business risk. However, a company with low or unstable EPS may be perceived as having higher business risk by investors.

Question 17

The lower risk nature of long-term debt in a firm's capital structure is due to the fact that
A) the equity holders are the true owners of the firm.
B) equity capital has a fixed return.
C) creditors have a higher position in the priority of claims.
D) dividend payments are tax-deductible.

Accepted Answer

Creditors have a higher position in the priority of claims, meaning that in case of bankruptcy, they have a higher likelihood of being paid back before equity holders. This makes long-term debt a lower risk option for a firm's capital structure.

Question 18

Holding all other factors constant, a firm that is subject to a greater level of business risk should employ less operating leverage than an otherwise equivalent firm that is subject to a lesser level of business risk.

Accepted Answer

This is because greater business risk increases the likelihood of fluctuations in earnings, making it more difficult to cover fixed costs. Employing less operating leverage can help mitigate the effects of these fluctuations and increase the firm's overall financial stability.

Question 19

The firm's ________ is the mix of long-term debt and equity utilized by the firm, which may significantly affect its value by affecting return and risk.
A) dividend policy
B) capital budget
C) capital structure
D) working capital

Accepted Answer

Capital structure refers to the way a company finances its assets through the use of different sources of funds. The choice of capital structure can have a significant impact on the returns to shareholders as well as the risk profile of the company. This is because different sources of funds have different costs, and some may be riskier than others. Therefore, the capital structure is an important consideration for a company and is a key factor in determining its overall value.

Question 20

The inexpensive nature of long-term debt in a firm's capital structure is due to the fact that
A) the equity holders are the true owners of the firm.
B) equity capital has a fixed return.
C) interest payments are tax-deductible.
D) equity holders have a higher position in the priority of claims.

Accepted Answer

Interest payments on long-term debt are tax-deductible, which reduces the overall cost of borrowing for the firm. This makes long-term debt a relatively inexpensive source of capital compared to equity capital, which does not have tax-deductible payments.

Quiz 12: Leverage and Capital Structure

The asymmetric information explanation of capital structure suggests that firms will issue new debt only when the managers believe the firm's stock is overvalued; as a result, issuing new debt is considered a negative signal that will result in a decline in share price.

Holding all other factors constant, a firm that is subject to a greater level of business risk should employ more operating leverage than an otherwise equivalent firm that is subject to a lesser level of business risk.

Which of the following is NOT a reason why debt capital is considered to be the least risky source of capital?

Holding all other factors constant, a firm that is subject to a greater level of business risk should employ less total leverage than an otherwise equivalent firm that is subject to a lesser level of business risk.

The inexpensive nature of long-term debt in a firm's capital structure is due to the fact that

After satisfying obligations to creditors, the government, and preferred stockholders, any remaining earnings will most likely be allocated to any of the following EXCEPT

________ risk is the risk of being unable to cover financial costs.

In theory, the firm should maintain financial leverage consistent with a capital structure that

________ risk is the risk of being unable to cover operating costs.

Probability of bankruptcy is determined by

Holding all other factors constant, a firm that is subject to a greater level of business risk should employ more financial leverage than an otherwise equivalent firm that is subject to a lesser level of business risk.

The key differences between debt and equity capital include all of the following EXCEPT

All of the following affect business risk EXCEPT

Holding all other factors constant, a firm that is subject to a greater level of business risk should employ less financial leverage than an otherwise equivalent firm that is subject to a lesser level of business risk.

The basic sources of capital for a firm include all of the following EXCEPT

Business risk is affected by all of the following EXCEPT

The lower risk nature of long-term debt in a firm's capital structure is due to the fact that

Holding all other factors constant, a firm that is subject to a greater level of business risk should employ less operating leverage than an otherwise equivalent firm that is subject to a lesser level of business risk.

The firm's ________ is the mix of long-term debt and equity utilized by the firm, which may significantly affect its value by affecting return and risk.

The inexpensive nature of long-term debt in a firm's capital structure is due to the fact that