Question 1

The equity beta of a firm depends on the firm's business risk and its financial policy.

Accepted Answer

The equity beta (also known as levered beta) reflects both the business risk inherent in the firm's operations and the financial risk introduced by the firm's use of debt financing, which is a component of its financial policy.

Question 2

When a firm is operating at its target capital structure point, the total value of the firm is maximized.

Accepted Answer

When a firm operates at its target capital structure, it has optimized its mix of debt, equity, and other financing sources to achieve the lowest possible weighted average cost of capital (WACC), which in turn maximizes the firm's total value.

Question 3

There appears to be some connection between operating characteristics and capital structure

Accepted Answer

Operating characteristics, such as the stability of cash flows, asset structure, and business risk, can influence a firm's choice of capital structure by affecting its capacity to service debt and its preference for financial flexibility.

Question 4

Nature of assets will affect the optimal level of debt for a firm.

Accepted Answer

Firms with more tangible and less risky assets can typically support higher levels of debt because these assets can serve as collateral, reducing the risk for lenders and allowing the firm to obtain debt more easily and possibly at lower costs.

Question 5

All else equal, higher financial leverage decreases a firm's break-even EBIT.

Accepted Answer

Higher financial leverage increases a firm's fixed financial obligations (interest payments), which in turn raises the break-even EBIT, as the company needs to generate more earnings before interest and taxes to cover both its operating and financial obligations.

Question 6

When a firm is operating at its target capital structure point, the firm's WACC is at its minimum point.

Accepted Answer

When a firm operates at its target capital structure, it has optimized the mix of debt, equity, and other financing sources to minimize its weighted average cost of capital (WACC), reflecting the lowest possible cost of financing its operations.

Question 7

D/E ratios are significantly higher today than they were in the 1960s.

Accepted Answer

Since the 1960s, there has been a general trend towards increased leverage among companies, leading to higher debt-to-equity (D/E) ratios. This is due to a variety of factors including changes in financial markets, increased access to debt financing, and shifts in corporate finance strategies.

Question 8

When EBIT is positive, high leverage decreases the returns to shareholders (as measured by ROE).

Accepted Answer

High leverage increases the potential returns to shareholders (as measured by ROE) when EBIT is positive because it amplifies the effects of financial leverage on earnings, assuming interest costs are covered by EBIT.

Question 9

Assume there are no personal or corporate income taxes and that the firm's WACC is unaffected by its capital structure, then a firm's cost of equity depends on the firm's business and financial risks.

Accepted Answer

The cost of equity is determined by the riskiness of the firm's business and financial structure. In the absence of personal or corporate income taxes, the WACC is unaffected by the capital structure, so the cost of equity is solely determined by the firm's business and financial risks.

Question 10

When EBIT is positive, increasing financial leverage increases the sensitivity of EPS and ROE to changes in EBIT.

Accepted Answer

When EBIT (Earnings Before Interest and Taxes) is positive, increasing financial leverage (using more debt relative to equity) amplifies the effects of changes in EBIT on both EPS (Earnings Per Share) and ROE (Return on Equity) because the fixed interest expenses magnify the impact of variations in operating income on the net income available to equity holders.

Question 11

When a firm is operating at its target capital structure point, the debt-equity ratio is equal to 1.

Accepted Answer

The target capital structure of a firm is unique to that firm and depends on its specific financial strategy, risk tolerance, and business model. A debt-equity ratio of 1 is not a universal target; some firms may target a higher or lower ratio based on their objectives and industry standards.

Question 12

All else the same, taxes and bankruptcy claims on the cash flows of the firm will tend to increase with decreases in the debt/equity ratio?

Accepted Answer

Taxes and bankruptcy claims on the cash flows of the firm will tend to increase with decreases in the debt/equity ratio because the firm will have less debt to cover these expenses.

Question 13

Suppose we wish to draw a graph illustrating M&M Proposition II. Let the vertical axis represent the cost of capital and the firm's debt-to-equity ratio represents the horizontal axis. If the line representing the firm's WACC has a negative slope, we must be incorporating taxes into the analysis.

Accepted Answer

When taxes are incorporated, the interest tax shield causes the WACC to decrease as the debt-to-equity ratio increases, resulting in a negatively sloped line.

Question 14

Tax rate will affect the optimal level of debt for a firm.

Accepted Answer

The tax shield benefit from debt interest payments can make debt financing more attractive, thus affecting the optimal level of debt a firm might choose to maintain.

Question 15

Ignoring financial distress costs, borrowing money decreases the value of the firm by increasing the firm's tax liability.

Accepted Answer

Borrowing money can actually increase the value of a firm due to the tax deductibility of interest payments, which reduces the firm's tax liability.

Question 16

When a firm is operating at its target capital structure point, shareholder value is maximized.

Accepted Answer

At its target capital structure, a firm balances the cost and benefits of debt and equity financing to minimize its overall cost of capital, thereby maximizing shareholder value by optimizing investment returns relative to risk.

Question 17

Volatility of earnings will affect the optimal level of debt for a firm.

Accepted Answer

Volatility in earnings can impact a firm's ability to service debt, leading to a preference for lower levels of debt in more volatile firms to minimize financial distress risks.

Question 18

When EBIT is positive, the effect of financial leverage depends on the company's EBIT, that is, leverage is unfavourable when EBIT is relatively high, and leverage is favourable when EBIT is relatively low.

Accepted Answer

Financial leverage becomes favourable when EBIT is relatively high, as it amplifies the returns to equity holders, and unfavourable when EBIT is relatively low, increasing the risk of financial distress.

Question 19

It appears that, capital structures vary quite a bit across differing industry groups.

Accepted Answer

Different industries have varying levels of asset tangibility, operational risks, and growth opportunities, which influence their optimal capital structure, leading to significant variations in debt-to-equity ratios and financing strategies across industries.

Question 20

The optimal capital structure is the mixture of debt and equity which maximizes the value of the firm and minimizes the firm's weighted average cost of capital.

Accepted Answer

The optimal capital structure is indeed the mix of debt and equity financing that minimizes a company's overall cost of capital and thereby maximizes the value of the firm. This concept is central to corporate finance theory.

Quiz 16: Financial Leverage and Capital Structure Policy