Deck 9: Cost of Capital, Capital Structure, and Financial Markets

Question 1

How are a company's total assets financed in terms of financial structure?

A) by permanent funds only
B) by short-term funds only
C) by short-term, long-term, and equity funds
D) by growth funds only

Answer 1

by short-term, long-term, and equity funds

Question 2

How is the economic value added (EVA) calculated?

A) by subtracting the cost of capital from the net operating profit before taxes
B) by subtracting dividends from the net operating profit after taxes
C) by subtracting the cost of capital from the net operating profit after taxes
D) by subtracting the dividends from the net operating profit before taxes

Answer 2

by subtracting the cost of capital from the net operating profit after taxes

Question 3

What is the cost of financing usually compared to?

A) the return on assets
B) the return on sales
C) the internal rate of return
D) the return on capital assets

Answer 3

the return on assets

Question 4

What is the cost of capital usually compared to?

A) the return on capital assets
B) the internal rate of return
C) the return on equity
D) the return on sales

Question 5

Which financing source usually costs the most?

A) common shares
B) mortgages
C) preferred shares
D) bonds

Question 6

Which investors get paid first?

A) unsecured bondholders
B) preferred shareholders
C) common shareholders
D) mortgage holders

Question 7

What is the cheapest source of financing?

A) common shares
B) preferred shares
C) bonds
D) short-term debt

Question 8

Which of the following does the weighted average cost of capital take into consideration?

A) long-term lenders only
B) short-term lenders only
C) all investors
D) trade creditors

Question 9

What does operating leverage address?

A) external financing
B) mix of internal and external financing
C) dividends and interest
D) fixed costs and variable costs

Question 10

What does financial leverage address?

A) EBIT and interest
B) internal financing
C) mix of internal and external financing
D) fixed costs and variable costs

Question 11

When is a favourable operating leverage achieved?

A) when a change in revenue generates a smaller change in EBIT
B) when a change in revenue generates a larger change in EBIT
C) when a change in fixed costs generates a smaller change in EBIT
D) when a change in fixed costs generates a larger change in EBIT

Question 12

What are owners attempting to do when they use financial leverage?

A) They are attempting to generate more profit using other people's money.
B) They are attempting to generate more profit using their own money.
C) They are attempting to reduce debt using their own money.
D) They are attempting to reduce debt using other people's money.

Question 13

Will an entrepreneur starting up a business with very little cash be able to use or benefit from financial leverage?

A) they will be able to use financial leverage during their first years of operation because banks will lend them money
B) they will NOT be able to benefit from financial leverage because banks will be unwilling to lend them money
C) they will be able to benefit from financial leverage because banks will be unwilling to lend them money
D) they will be able to use financial leverage during their first years of operation because banks will NOT lend them money

Question 14

If company A increases its revenue from $1,500 to $1,650 and profit for the year from $400 to $470, while company B increases its revenue from $600 to $660 and profit for the year from $35 to $50, what impact will the results have on the companies operating leverage?

A) neither company demonstrates operating leverage
B) company A has a more favourable operating leverage than company B
C) company B has a more favourable operating leverage than company A
D) both companies have the same operating leverage

Question 15

If an accountant prepares a plan that shows revenue increasing by 10% and profit for the year increasing by 7.5%, what will be the impact on the company's leverage?

A) the plan demonstrates a favourable combined leverage because profit for the year increases less than revenue
B) the plan demonstrates an unfavourable operating leverage because profit for the year increases more than revenue
C) the plan demonstrates a favourable operating leverage because profit for the year increases more than revenue
D) the plan demonstrates an unfavourable combined leverage because profit for the year increases less than revenue

Question 16

What concept forms the basis for operating leverage analysis?

A) financial leverage analysis
B) combined leverage analysis
C) fixed leverage analysis
D) break-even analysis

Question 17

Which of the following statements is true?

A) the weighted average cost of capital can be compared to ROA to ensure that the return
Generated from a particular investment justifies the cost and risk
B) the weighted average cost of capital can be compared to share capital
C) the weighted average cost of capital can be compared to the price-earnings ratio
D) the weighted average cost of financing calculation includes accounts such as non-current assets

Question 18

What is a disadvantage of common share financing??

A) common share financing does not carry a fixed maturity date
B) common share financing is generally obtained from "external sources"
C) the capital structure largely determines the cost of capital
D) common share financing has to carry a fixed maturity date

Question 19

What is the cost of capital compared to for decision making?

A) to the return on assets
B) to the marginal cost of capital which ignores the cost of share capital
C) to the internal rate of return
D) to the accounting rate of return

Question 20

Under which situation will a company use operating leverage for decision making?

A) operating leverage is used to determine the most favourable capital structure
B) operating leverage deals with the behaviour of costs at the financing level
C) operating leverage analysis is an excellent analytical tool to determine whether a plant should be modernized
D) operating leverage deals with the relationship between debt financing and equity financing

Question 21

What financial technique is used to determine the extent to which fixed costs are used relative to variable costs?

A) financial leverage
B) operating leverage
C) variable leverage
D) relative leverage

Question 22

What financial technique is used to determine the most favourable capital structure (debt versus equity)?

A) operating leverage
B) capital leverage
C) financial leverage
D) structure leverage

Question 23

What does the following formula calculate?
Contribution margin
--------------------------------------
Contribution margin - Fixed costs

A) PV ratio
B) combined leverage
C) operating leverage
D) financial leverage

Question 24

A company's revenue increases by 10% while profit for the year increases by 7.5%. What type of leverage does this company have?

A) a favourable financial leverage
B) a favourable combined leverage
C) an unfavourable combined leverage
D) a favourable operating leverage

Question 25

A company has a favourable operating leverage. How fast does its revenue increase?

A) faster than EBIT
B) faster than fixed costs
C) slower than EBIT
D) slower than fixed costs

Question 26

What does the following formula calculate?
EBIT
-------------------
EBIT - Interest

A) fixed leverage
B) combined leverage
C) operating leverage
D) financial leverage

Question 27

A company's EBIT increases by 10% while its profit for the year increases by 16%. What kind of leverage does this company have?

A) a favourable operating leverage
B) a favourable financial leverage
C) a declining leverage
D) a favourable combined leverage

Question 28

Given the following information, what is the financial leverage?
EBIT $ 400
Interest 150

A) 0.375
B) 0.625
C) 1.6
D) 2.0

Question 29

What does the following formula calculate?
Contribution margin
------------------------
EBIT - Interest

A) the contribution margin
B) financial leverage
C) operating leverage
D) combined leverage

Question 30

What is the combined leverage of a company with an operating leverage of 1.7 and a financial leverage of 1.6?

A) 0.942
B) 1.0625
C) 2.72
D) 3.3

Question 31

Under what economic conditions should a company avoid leverage??

A) during poor economic conditions,
B) when the cost of borrowing goes up, and customers are NOT willing to pay higher prices
C) during good economic conditions
D) leverage should never be avoided no matter what the economic conditions

Question 32

What do money markets deal with?

A) loans on residential, commercial, and industrial real estate
B) reselling existing securities
C) long-term securities
D) short-term securities

Question 33

What theory states that dividends have little effect on share price?

A) the dividend irrelevance theory
B) the dividend payout theory
C) the dividend preference theory
D) the dividend aversion theory

Question 34

Weighted average cost of capital means borrowing funds from investors (lenders and shareholders) to finance a business.

Question 35

Leverage analysis is a financial technique used to determine the most suitable cost of capital that is required by a business to finance its working capital.

Question 36

The purpose of comparing ROA to the weighted average cost of capital is to ensure that the return generated from a particular investment justifies the cost and risk.

Question 37

The level of sales volume is an important element that helps to select the most suitable operating and financial mix (or capital structure).

Question 38

Financial structure deals with the permanent financing sources used to buy capital assets.

Question 39

Capital structure deals with sources of financing such as long-term borrowings and share capital.

Question 40

The cost of financing calculation reveals how much a business is charged to finance the assets that are shown on a company's statement of financial position.

Question 41

A return on assets of 8.0% and a weighted average cost of capital of 10% is positive.

Question 42

The weighted average cost of financing is somewhat irrelevant unless it is compared to the return that a company earns on its assets.

Question 43

Weighted average cost of financing is usually calculated on a before-tax basis.

Question 44

The capital structure largely determines the cost of capital.

Question 45

Weighted average cost of financing usually takes into consideration the trade and other payable element that is included in current liabilities.

Question 46

Weighted average cost of capital usually excludes the short-term borrowing portion of the debt package.

Question 47

The economic value added (EVA) is a financial tool that measures the wealth a company creates for its investors.

Question 48

The economic value added (EVA) is calculated by deducting a company's distribution costs from its net operating profits after taxes.

Question 49

Two key reasons for the increasing popularity of the economic value added (EVA) as a financial tool is that it promotes management accountability and helps to make better decisions.

Question 50

Weighted average cost of capital is defined as the average rate of return shareholders and lenders expect to earn on the money they invested in their business.

Question 51

Calculating the weighted average cost of capital takes into account sources of financing such as share capital and retained earnings.

Question 52

The opportunity cost is defined as the weighted average cost of capital incurred by a business in order to finance the purchase of its non-current assets.

Question 53

Leverage can be explained as the percentage of debt a business uses to finance the purchase of assets.

Question 54

There is an important relationship between the major areas of finance, namely, capital structure, cost of capital, and capital budgeting.

Question 55

In order to calculate the weighted average cost of capital, it is important to weigh each cost in order to determine its proportion.

Question 56

The four major sources of long-term borrowings are: long-term debts, preferred shares, common shares and trade and other payables.

Question 57

Three of the most important characteristics that will determine the choice of long-term borrowings are payout, risk and voting rights.

Question 58

Both, preferred share and common share financing are always calculated on an after-tax basis.

Question 59

Common share dividends are tax deductible when calculating the weighted average cost of capital.

Question 60

One key advantage of retained earnings as a source of financing is that the company avoids the cost of issue.

Question 61

Cost of mortgages and bonds are always calculated on a before-tax basis when calculating the weighted average cost of capital.

Question 62

One advantage of debt financing is that finance costs are tax deductible.

Question 63

Cost of preferred shares includes fixed interest charges paid to shareholders and the flotation costs.

Question 64

Cost of common shares includes dividends paid to shareholders, flotation costs, and growth rate.

Question 65

Cost of retained earnings includes dividends paid to shareholders and the flotation costs charged by underwriting firms.

Question 66

The marginal cost of capital can be explained as the increased level of average cost resulting from having borrowed new funds at higher rates than those previously borrowed.

Question 67

Usually, the weighted average cost of capital is compared to the internal rate of return (IRR) in order to accept or reject capital budgeting projects.

Question 68

Leverage analysis is used to determine the financing package or cost structure that will optimize the most the worth of a business.

Question 69

There are basically three types of leverages: operating leverage, financial leverage and the budgeting leverage.

Question 70

Operating leverage is a financial technique used to analyze the relationship between fixed costs and variable costs.

Question 71

Operating leverage and break-even analysis are similar techniques that deal with both fixed and variable cost structures.

Question 72

Financial leverage is a technique used to determine the most favourable capital structure (debt versus equity).

Question 73

Combined leverage is a financial technique used to analyze the relationship between revenue and the contribution margin.

Question 74

Financial markets deal with businesses, individuals and government institutions including procedures involved in the buying and selling of financial assets.

Question 75

Investment dealers facilitate the transfer of funds between shareholders and employees.

Question 76

Money markets are defined as the markets for long-term debt securities.

Question 77

The stock market is a network of exchanges, brokers, and investors that trade securities.

Question 78

A prospectus discloses information about the stock market.

Question 79

The acronym IPO stands for Initial Public Offering.

Question 80

A listed company means that a business has the option to list its name in the yellow pages.