Deck 21: Derivatives

Question 1

Which of the following most accurately describes operating gearing?

A) It is concerned with the proportion of the annual income stream which is devoted to the prior claims of debt holders.
B) It concerns the proportion of equity in the capital structure.
C) It refers to the extent to which the firm's total costs are fixed.
D) It concerns the proportion of debt in the capital structure.

Answer 1

C

Question 2

What will shareholders do if they see a firm taking on increasing debt levels?

A) Demand longer repayment periods
B) Demand higher levels of return
C) Demand lower levels of return
D) Demand higher levels of gearing

Answer 2

B

Question 3

How is an increased gearing level likely to be viewed by the financial markets?

A) As a sign of increasing cash flow
B) As a sign that management and existing shareholders are confident about the firm's prospects
C) As a sign of decreasing profits
D) As a negative sign

Answer 3

B

Question 4

What is the primary effect of financial gearing?

A) To ensure that shareholders' returns exceed the firm's income
B) To ensure that the firm's income closely reflects the shareholders' returns
C) To reduce the degree of variation in a firm's income for shareholders' returns
D) To magnify the impact of variation in a firm's income on shareholders' returns

Question 5

Which of the following examples of signaling is most likely to be used by managers?

A) Decreasing gearing levels to send a positive sign to the financial markets
B) Increasing gearing levels to send a positive sign to the financial markets
C) Increasing borrowing to show that there has been a reduction in cash flow
D) Increasing borrowing to show that there has been increase in cash flow

Question 6

Which two of the following are correct, in a world with tax but no distress costs, when the capital of a company is almost entirely made up of debt?

A) WACC is at its highest.
B) Corporate value is at its highest.
C) Corporate value is at its lowest.
D) WACC is at its lowest.

Question 7

Which of the following does not accurately apply to the various types of capital gearing?

A) They vary in the degree to which they reflect historical or current value of assets.
B) They all have values of between zero and 100 per cent.
C) They vary in the degree to which they include short- term and long- term debt.
D) They all measure the extent to which the capital structure consists of debt.

Question 8

Which expression would be most useful when calculating the value of the firm in a World without growth?

A) (Cash flows one year hence)/(Weighted average cost of capital)
B) (Weighted average cost of capital)/(Cash flows one year hence)
C) (Cash flows one year hence) + (Weighted average cost of capital)
D) (Cash flows one year hence) - (Weighted average cost of capital)

Question 9

Which two of the following best relate to business risk and financial risk?

A) The increased expected return from increasing debt more than compensates for the higher variability resulting in climbing share prices.
B) The decreased expected return from increasing debt more than compensates for the lower variability resulting in climbing share prices.
C) Firms with high business risk are in a position to take on higher levels of financial risk than those with low business risk.
D) Firms with low business risk are in a position to take on higher levels of financial risk than those with high business risk.

Question 10

Which of the following correctly relates to levels of gearing, financial distress, and the cost of capital?

A) At low gearing, distress risks are low but the cost of capital is high.
B) At low gearing, distress risks are high and the cost of capital is high.
C) At high gearing, distress risks are low but the cost of capital is high.
D) At high gearing, distress risks are high and the cost of capital is high.

Question 11

What is a company said to have if it has cash and/or more spare debt capacity?

A) Indirect costs
B) Financial slack
C) Financial risk
D) Signals

Question 12

Which of the following most accurately defines what is meant by 'agency costs' in finance theory?

A) The costs of allowing financial intermediaries to take decisions on your behalf which may not be optimal for you
B) The direct and indirect costs of ensuring that agents (e.g. managers of firms) act in the best interests of principals (e.g. shareholders of firms)
C) The initial cost of purchasing an asset through an agent, e.g. a travel agent's fee
D) The costs of buying an asset through an agent such as a stock broker or estate agent

Question 13

Which of the following most accurately describes income gearing?

A) It refers to the extent to which the firm's total income is fixed by external factors.
B) It is concerned with the proportion of the annual income stream which is devoted to the prior claims of debt holders.
C) It concerns the proportion of payments of dividends in the capital structure.
D) It concerns the proportion of repayments for debt in the capital structure.

Question 14

Which of the following most accurately describes capital gearing?

A) The ratio of capital employed to sales
B) The ratio of debt to shareholders' funds or total assets
C) The ratio of current borrowing to this year's capital repayments
D) The ratio of interest charges to profits

Question 15

Which two terms best fit the blanks in the following statement: "When compared with equity finance, debt finance is and for the company."?

A) cheaper; less risky
B) cheaper; more risky
C) more expensive; less risky
D) more expensive; more risky

Question 16

Which three of the following apply to interest cover?

A) The lower the interest cover, the greater the chance of interest payment default.
B) The inverse of interest cover is known as income gearing.
C) Interest cover = (Profit before interest and tax)/Interest charges
D) Interest cover is used to assess the risks for potential borrowers.

Question 17

How does financial gearing affect the extent to which shareholders' returns vary as a result of changes in a firm's income?

A) It has little effect on it.
B) It magnifies the effects.
C) It introduces a time lag.
D) It reduces the effects.

Question 18

Which two of the following best describe the effect of a fall in profit, assuming there is no change in interest charges?

A) Taxation increases.
B) The risk of liquidation falls.
C) Interest cover will fall.
D) There is an increase in the chance of interest payment defaults.

Question 19

Which three of the following are reasons why financing a business through borrowing is cheaper than using equity?

A) Issuing and transaction costs associated with raising and servicing debt are generally less than for ordinary shares.
B) Debt financial securities present lower costs than shares because they have prior claims on annual income and in liquidation.
C) Lenders require a lower rate of return than ordinary shareholders.
D) Debt interest can be offset against pre- tax profits before calculating the corporation tax bill, thus reducing the tax paid.

Question 20

For the financial manager who cannot decide on a suitable level of gearing, which of the following is the best guideline?

A) Keep gearing to a minimum
B) Aim to achieve the maximum possible levels of gearing
C) Adopt the gearing used by average firms in the industry
D) Gear at the level of tax exhaustion

Question 21

There is a risk in all large firms that managers may not always act in the best interests of the equity or debt holders. What is this problem called?

A) Agency cost
B) Business risk
C) Empowerment
D) Disempowerment

Question 22

Which two competing effects result for the company taking on higher levels of debt?

A) There is a lower risk of incurring the costs of financial distress.
B) There is a greater risk of incurring the costs of financial distress.
C) There is an increased tax relief on increasing debt levels.
D) There is a decreased tax relief on increasing debt levels.

Question 23

Which one of the following is the most likely reason why lenders would impose limits on total borrowing?

A) Financial gearing is too low.
B) Companies run out of suitable assets to offer as security against loans.
C) Income gearing is too low.
D) Financial risk is too high.

Question 24

What is meant by the term 'business risk'?

A) The greatest negative change in share value over a 10- year period
B) The percentage change in share value per year
C) The variability of the firm's operating income
D) The variability in the return to shareholders

Question 25

Which type of gearing relates to the proportion of debt in the capital structure?

A) Financial gearing
B) Leveraged gearing
C) Operating gearing
D) Income gearing

Question 26

How does a high level of gearing affect reinvestment risk?

A) It removes the risk.
B) It increases the risk.
C) It diminishes the risk.
D) It has no short term effect.

Question 27

Which three of the following are Modigliani and Miller's three propositions for a perfect no- tax world?

A) The total market value of any company is independent of its capital structure.
B) The expected rate of return on equity increases proportionately with the gearing ratio.
C) The effect of gearing is to magnify the degree of variation in a firm's income for shareholders' returns.
D) The cut- off rate of return for new projects is equal to the weighted average cost of capital - which is constant regardless of gearing.

Question 28

What is meant by the term 'financial distress'?

A) Where there are low levels of income
B) Where obligations to creditors are not met or are met with difficulty
C) Where obligations to shareholders are not met or are met with difficulty
D) Where levels of taxation are high

Question 29

What is the value of the following firm where: • free net cash flows are expected to be a constant £3m per year to infinity;
• cost of debt capital after tax is 6 per cent per annum;
• the cost of equity capital is 14 per cent per annum;
• half the firm's capital is debt and half is equity (market values)?

A) £40m
B) £25m
C) £30m
D) £35m

Question 30

Which three of the following are most likely to be costs of financial distress?

A) Management may give excessive emphasis to short- term liquidity.
B) More efficient long- term management of the firm
C) If assets are to be be sold quickly the price may be very low.
D) Uncertainties in suppliers' minds about dealing with this firm

Question 31

What levels of gearing are most likely to be suitable for a food retailer and a steel producer?

A) Food retailer: High; Steel producer: High
B) Food retailer: Low; Steel producer: Low
C) Food retailer: High; Steel producer: Low
D) Food retailer: Low; Steel producer: High

Question 32

What effect is the risk of financial distress likely to have on the level of optimal gearing of a firm from the point of view of shareholders' value maximisation?

A) It will encourage managers to gradually increase the level.
B) It will have little effect.
C) It will moderate the level of gearing.
D) It will increase the level of gearing.

Question 33

What are the likely results as the level of gearing rises?

A) Risk of financial distress decreases; cost of capital rises
B) Risk of financial distress increases; cost of capital falls
C) Risk of financial distress decreases; cost of capital falls
D) Risk of financial distress increases; cost of capital rises

Question 34

Which type of gearing is concerned with the proportion of the annual income that is devoted to the prior claims of debt holders?

A) Operating gearing
B) Financial gearing
C) Capital gearing
D) Income gearing

Question 35

Which of the following correctly shows the 'pecking order' for financing, showing the most important first?

A) Internally generated funds; new issue of equity; borrowings
B) New issue of equity; borrowings; internally generated funds
C) Internally generated funds; borrowings; new issue of equity
D) Borrowings; internally generated funds; new issue of equity

Question 36

Which three of the following are motives explaining the manifestation of a pecking order in financing decisions?

A) Ordinary shares are more expensive to issue than issuing debt capital and using retained earnings.
B) The issue of equity is perceived as an act of desperation.
C) The firm does not have any more assets unpledged to use as collateral for loans.
D) Managers follow the line of least resistance with respect to communications and approval of finance promoters.

Question 37

How are high levels of gearing likely to affect managers' motivation?

A) The resulting low level of debt discourages managers.
B) The resulting low level of debt encourages managers to perform better.
C) The resulting high level of debt discourages managers.
D) The resulting high level of debt encourages managers to perform better.

Question 38

Which of the following statements correctly describe interest cover?

A) The inverse of interest cover is capital gearing.
B) Interest cover = (Profit before interest and tax)/(Interest charges)
C) Interest cover = (Interest charges)/(Profit before interest and tax)
D) The inverse of interest cover is income gearing.

Question 39

Which three of the following are most likely to be costs of financial distress?

A) Uncertainties in customers' minds about dealing with this firm
B) Temptation to fire sell healthy businesses as this will raise the most cash
C) Low staff morale
D) If assets can be sold quickly the price may be very high.

Question 40

Which two words correctly complete the following statement: "Financial distress and agency costs eventually outweigh the lower cost of debt as gearing rises causing the WACC to and the firm's value to _."?

A) rise; rise
B) rise; fall
C) fall; rise
D) fall; fall

Question 41

Which of the following defines financial risk?

A) The risk that the financial system may collapse because of a loss of confidence
B) The additional variability in returns to shareholders that arises because the financial structure contains debt
C) The additional variability in returns to stock market investors because of systematic risk
D) The risk to which an investor is exposed when purchasing a financial security

Question 42

Most tax regimes permit companies to offset the interest paid on debt against taxable profit. Which of the following is the key outcome for companies?

A) An increased tax cost which decreases the effective cost of debt capital
B) A tax saving which increases the effective cost of debt capital
C) An increased tax cost which reduces the effective cost of equity capital
D) A tax saving which reduces the effective cost of debt capital

Question 43

Which of the following situations obeys Modigliani and Miller's propositions regarding financial gearing (in a world with no tax)?

A) Company B has an enterprise value of £550m when it is financed entirely by equity and a value of £600m when 40 per cent of its capital is debt.
B) Company D has an enterprise value of £50m when debt is 60 per cent of total capital and an enterprise value of £50m when debt is 95 per cent of total capital.
C) Company A has a weighted average cost of capital (WACC) of 14 per cent and an enterprise value of £10m when debt is 30 per cent of total capital, and a WACC of 12 per cent at a debt level of 50 per cent of total capital.
D) Company C has the lowest weighted average cost of capital at the highest possible gearing level.

Question 44

What are the two main benefits of using the measure of Capital gearing = Long- term debt/Total market capitalisation?

A) It is generally closer to the market- value- based gearing measures.
B) It exaggerates the effect of financial distress.
C) It gives some indication of the relative share of the company's total value belonging to debtholders and shareholders.
D) It ignores the fact that many firms have no access to overdrafts or similar borrowing.

Question 45

What are the two major problems with relying on the measure Capital gearing = Long- term debt/Shareholders' funds?

A) It ignores the fact that many firms have no access to overdrafts or similar borrowing.
B) The book value of assets can be quite different from the sale value.
C) A range of values from zero to infinity is possible and this makes inter- firm comparisons difficult.
D) It exaggerates the effect of financial distress.

Question 46

Which of the following does not correctly describe influences on the level of gearing?

A) The risk of financial distress causes firms to moderate their gearing levels.
B) In Modigliani and Miller's world with corporate tax, the optimal gearing is the highest possible.
C) Reinvestment risk is diminished by high gearing.
D) Managers generally have a preference for high gearing levels.

Question 47

Which three of the following are most likely to influence the risk of financial distress?

A) The proportion of fixed to variable costs
B) The liquidity and marketability of the firm's assets
C) The sensitivity of the company's revenues to the general level of economic activity
D) An improvement in relationships with suppliers

Question 48

Which type of gearing relates to the extent to which the firm's total costs are fixed?

A) Capital gearing
B) Leveraged gearing
C) Operating gearing
D) Financial gearing

Question 49

A company decides to raise its gearing level. What is the effect on shareholder wealth, according to Modigilani and Miller's theory for a world without taxes?

A) It is impossible to predict what will happen.
B) Shareholder wealth increases.
C) Shareholder wealth decreases.
D) There is no effect on shareholder wealth.