Question 1

The announcement of an increase in the cash dividend always causes an increase in the price of the firm's common stock.

Accepted Answer

The answer of The announcement of an increase in the...

Question 2

In theory, dividends are determined as a residual item.Therefore, the better the firm's investment opportunities, the lower its dividend payments should be.

Accepted Answer

Dividends are typically paid out of a company's earnings, but they are not guaranteed. The decision to pay dividends is made by the company's board of directors and can be influenced by a variety of factors, including the firm's investment opportunities. In general, the better a company's investment opportunities, the more it may choose to reinvest its earnings into those opportunities rather than pay out a large dividend. This helps to maximize shareholder value over the long term. Therefore, in theory, dividends are determined as a residual item, meaning that they are paid out only after all other possible uses of the company's earnings, such as capital expenditures and debt payments, have been satisfied.

Question 3

Modigliani and Miller's dividend irrelevance theory says that dividend policy does not affect a firm's value but can affect its cost of capital.

Accepted Answer

Modigliani and Miller's dividend irrelevance theory posits that dividend policy does not affect a firm's value or its cost of capital, assuming perfect capital markets, no taxes, and no transaction costs.

Question 4

One of the implications of signaling theory for capital structure decisions is that firms should normally seek to maintain a reserve borrowing capacity.

Accepted Answer

Signaling theory suggests that firms with strong financial positions may choose to take on debt as a way to signal their confidence in their future prospects to outside investors. However, firms that are already heavily leveraged may not be able to effectively signal their financial strength through additional borrowing. Therefore, maintaining a reserve borrowing capacity can be beneficial as it allows a firm to signal its financial strength in the future if needed.

Question 5

The optimal dividend policy for a firm strikes a balance between payment of current dividends and retention of earnings for future growth, and results in the maximization of stock price.

Accepted Answer

The optimal dividend policy considers both current dividend payments and retention of earnings for future growth. This balance is aimed at maximizing shareholder wealth, reflected in the company's stock price.

Question 6

The weighted average cost of capital (WACC) declines as more of the lowest cost component is added.What limits a firm from using nearly all debt is that as the debt-to-assets ratio rises, the absolute interest expense gets very large.The large interest expense reduces income and results in a debt-to-assets ratio limit even though the WACC continues to decline.

Accepted Answer

The WACC does not necessarily continue to decline as more debt is added. While initially adding low-cost debt can reduce the WACC, beyond a certain point, the cost of debt increases due to the higher risk of default. This increased risk leads to higher interest rates demanded by lenders, which can increase the WACC. Additionally, the risk of financial distress and bankruptcy costs also limit the amount of debt a firm can use, contrary to the statement that the WACC continues to decline with more debt.

Question 7

As the debt-to-assets ratio rises, the WACC is reduced because the after-tax cost of debt is usually lower than the cost of equity.What limits the substitution of debt for equity in the capital structure is that as the debt-to-assets ratio rises, the costs of both components eventually increase.

Accepted Answer

The debt-to-assets ratio indicates the proportion of a company's assets that are financed by debt. As this ratio increases, the weighted average cost of capital (WACC) can initially decrease because debt financing is often cheaper than equity financing due to tax deductibility of interest. However, there's a limit to substituting debt for equity because as the debt level increases, it raises the financial risk for the company. This increased risk leads to higher interest rates demanded by lenders and can also increase the cost of equity as equity holders demand higher returns for increased risk, eventually increasing the overall WACC.

Question 8

If we include the cost of bankruptcy in the MM analysis of capital structure in a world with taxes, we would tend to believe that the cost of debt increases as leverage increases and that there is probably an optimal capital structure.

Accepted Answer

Including the cost of bankruptcy in the MM analysis of capital structure with taxes leads to the belief that the cost of debt increases as leverage increases, and that there is an optimal capital structure where the benefits of debt (tax shield) are balanced with the costs (bankruptcy).

Question 9

If investors do, in fact, prefer that firms retain most of their earnings, then firms that want to maximize stock price should hold dividend payments to low levels.

Accepted Answer

If investors prefer that firms retain most of their earnings, then holding dividend payments to low levels and using the money to reinvest in the firm's growth is likely to be viewed more favorably by investors. This is because reinvesting earnings generates the potential for future growth and increased profits, which can drive stock prices higher. Therefore, firms that want to maximize their stock price may be better off retaining earnings rather than paying out large dividends.

Question 10

An all equity firm has some risk inherent in its operations.When the firm decides to finance some of its operations with debt, it exposes itself to financial risk and it increases its business risk.

Accepted Answer

Financing with debt introduces financial risk due to the obligation to pay interest and principal on the debt, but it does not increase business risk, which is inherent to the firm's operations and market environment.

Question 11

The presence of asymmetric information affects capital structure because it can affect managers' financing decisions.

Accepted Answer

When there is asymmetric information, managers may have a better understanding of the true value of a company than investors. This can lead to managers making financing decisions that do not accurately reflect the company's true value and can impact the capital structure. For example, they may choose to use debt financing when equity financing would be more appropriate, or vice versa. This can affect the cost of capital and ultimately impact the overall financial health of the company.

Question 12

Once the target capital structure for a firm is decided, managerial decisions can result in the actual capital structure differing from the target structure, but operating conditions will have a negligible effect on actual capital structure.

Accepted Answer

While managerial decisions can certainly impact the actual capital structure of a firm, operating conditions such as market conditions and economic factors can also have a significant impact. The actual capital structure may deviate from the target structure as a result of these external factors.

Question 13

Two firms, although they operate in different industries, have the same expected earnings per share and the same standard deviation of expected EPS.Thus, the two firms must have the same business risk.

Accepted Answer

Business risk is not only determined by expected earnings and standard deviation of EPS, but also by factors such as industry competition, regulatory environment, and market demand. Therefore, firms in different industries can have different levels of business risk, even if they have the same expected EPS and standard deviation of EPS.

Question 14

The dividend irrelevance theory, proposed by Miller and Modigliani, says that as long as a firm pays a dividend, how much it pays does not affect either its cost of capital or its stock price.

Accepted Answer

The dividend irrelevance theory proposed by Miller and Modigliani argues that the value of a firm is determined solely by its earning power and the risk of its underlying assets and not affected by its dividend policy. However, they did not suggest that the amount of dividend does not affect the stock price or the cost of capital. In fact, in a world with taxes and transaction costs, they showed that a low dividend payout ratio could lead to a higher stock price and a lower cost of capital.

Question 15

As the percentage of debt in a firm's capital structure increases, its financial risk increases.Once the firm increases its debt beyond the optimal level, rising interest charges result in an immediate decrease in EPS.

Accepted Answer

The answer of As the percentage of debt in a...

Question 16

Debt has benefits for firms because interest is tax deductible.As long as a firm has positive earnings it can receive the full benefit of the tax deductibility of debt interest expense.

Accepted Answer

The answer of Debt has benefits for firms because interest...

Question 17

The fact that some managers are more aggressive in their use of debt financing in attempting to boost profits does not influence the optimal or value-maximizing capital structure.

Accepted Answer

The optimal capital structure is determined by various factors such as the company's cash flow, profitability, risk profile, and market conditions. The managerial preference for debt financing may impact the company's risk and liquidity, but it does not necessarily determine the optimal capital structure that maximizes the firm's value. Therefore, the statement is true.

Question 18

Generally, as debt is substituted for equity, risk, as measured by the coefficient of variation of EPS, increases.This negative effect works against the positive effect of substituting debt for equity, which is that higher leverage increases expected EPS.

Accepted Answer

As debt increases, the risk (measured by the coefficient of variation of EPS) also increases. This works against the positive effect of higher leverage on expected EPS.

Question 19

A consistent supply of capital is essential for the long-run success of a firm.Although a firm may have access to capital under all types of economic conditions, the concept of financial flexibility implies that the firm can obtain capital on acceptable, competitive terms.

Accepted Answer

Financial flexibility refers to a company's ability to access capital on acceptable terms, regardless of economic conditions, which is essential for long-term success. Therefore, the statement is true.

Question 20

The benefit to the firm of the tax deductibility of interest can be lowered if the firm's marginal tax rate is reduced by accumulated depreciation or tax-loss carry-forwards.

Accepted Answer

If the firm's marginal tax rate is reduced by accumulated depreciation or tax-loss carry-forwards, then the tax benefit of deducting interest expenses will also be reduced. This is because the firm will already have lower taxable income due to the depreciation or loss carry-forwards, which means there is less income to offset with the interest deduction.

Quiz 14: Capital Structure and Dividend Policy Decisions