Question 1

firm's business risk is largely determined by the financial characteristics of its industry, especially by the amount of debt the average firm in the industry uses.

Accepted Answer

A firm's business risk is determined by various factors, including competition, demand for its products or services, government regulations, and technological changes. While industry characteristics can have an impact, the amount of debt used by the average firm in the industry is not the sole determining factor of a firm's business risk.

Question 2

Business risk is affected by a firm's operations.Which of the following is NOT associated with (or does not contribute to) business risk?
A)Demand variability.
B)Sales price variability.
C)The extent to which operating costs are fixed.
D)The extent to which interest rates on the firm's debt fluctuate.
E)Input price variability.

Accepted Answer

Business risk is primarily affected by factors related to a firm's operations, such as demand variability, sales price variability, extent of fixed operating costs, and input price variability. Interest rate fluctuations on the firm's debt are generally considered to be a financial risk rather than a business risk.

Question 3

Which of the following statements is CORRECT?
A)Since debt financing raises the firm's financial risk, increasing a company's debt ratio will always increase its WACC.
B)Since debt financing is cheaper than equity financing, raising a company's debt ratio will always reduce its WACC.
C)Increasing a company's debt ratio will typically reduce the marginal cost of both debt and equity financing.However, this action still may raise the company's WACC.
D)Increasing a company's debt ratio will typically increase the marginal cost of both debt and equity financing.However, this action still may lower the company's WACC.
E)Since a firm's beta coefficient it not affected by its use of financial leverage, leverage does not affect the cost of equity.

Accepted Answer

Increasing a company's debt ratio can increase the marginal cost of both debt and equity due to higher financial risk. However, the tax shield from debt can lower the WACC despite the increased costs.

Question 4

is possible that two firms could have identical financial and operating leverage, yet have different degrees of risk as measured by the variability of EPS.

Accepted Answer

The variability of EPS is also affected by other factors such as the level of sales, level of fixed costs, and degree of competition in the industry. Therefore, two firms with identical leverage ratios can have different levels of risk depending on these other factors.

Question 5

Whenever a firm borrows money, it is using financial leverage.

Accepted Answer

Financial leverage refers to the use of debt or borrowed funds to finance a firm's operations or investments. Therefore, when a firm borrows money, it is using financial leverage.

Question 6

firm's capital structure does not affect its calculated free cash flows, because FCF reflects only operating cash flows.

Accepted Answer

Free cash flows are calculated by taking operating cash flows minus capital expenses. The capital structure of a firm (i.e. the proportion of debt and equity financing) does not directly impact either of these components. Therefore, the calculated free cash flows should remain the same regardless of the capital structure.

Question 7

the text indicates, a firm's financial risk has identifiable market risk and diversifiable risk components.

Accepted Answer

The answer of the text indicates, a firm's financial risk...

Question 8

Which of the following statements is CORRECT?
A)The capital structure that maximizes expected EPS also maximizes the price per share of common stock.
B)The capital structure that minimizes the interest rate on debt also maximizes the expected EPS.
C)The capital structure that minimizes the required return on equity also maximizes the stock price.
D)The capital structure that minimizes the WACC also maximizes the price per share of common stock.
E)The capital structure that gives the firm the best credit rating also maximizes the stock price.

Accepted Answer

The capital structure that minimizes the WACC (weighted average cost of capital) also maximizes the price per share of common stock. This is because WACC represents the minimum return required by both debt and equity holders, and minimizing it would lower the cost of capital for the firm, making it more valuable to investors. Maximizing the price per share of common stock is not necessarily the same as maximizing expected EPS or minimizing the interest rate on debt. Similarly, the capital structure that gives the firm the best credit rating may not necessarily maximize the stock price.

Question 9

graphical probability distribution of ROE for a firm that uses financial leverage would tend to be more peaked than the distribution if the firm used no leverage, other things held constant.

Accepted Answer

The answer of graphical probability distribution of ROE for a...

Question 10

increase in the debt ratio will generally have no effect on which of these items?
A)Business risk.
B)Total risk.
C)Financial risk.
D)Market risk.
E)The firm's beta.

Accepted Answer

Business risk is related to the operational aspects of a company and is independent of its capital structure, so an increase in the debt ratio does not affect it.

Question 11

Which of the following would increase the likelihood that a company would increase its debt ratio, other things held constant?
A)An increase in costs incurred when filing for bankruptcy.
B)An increase in the corporate tax rate.
C)An increase in the personal tax rate.
D)The Federal Reserve tightens interest rates in an effort to fight inflation.
E)The company's stock price hits a new low.

Accepted Answer

An increase in the corporate tax rate makes debt more attractive because interest payments are tax-deductible, reducing the company's taxable income and thus its tax liability.

Question 12

Provided a firm does not use an extreme amount of debt, financial leverage typically affects both EPS and EBIT, while operating leverage only affects EBIT.

Accepted Answer

The answer of Provided a firm does not use an...

Question 13

A has a higher degree of business risk than Firm B.Firm A can offset this by using less financial leverage.Therefore, the variability of both firms' expected EBITs could actually be identical.

Accepted Answer

The answer of A has a higher degree of business...

Question 14

a firm utilizes debt financing, an X% decline in earnings before interest and taxes (EBIT) will result in a decline in earnings per share that is larger than X.

Accepted Answer

When a firm utilizes debt financing, it incurs fixed interest expenses which must be paid regardless of the level of earnings. Therefore, a decline in EBIT will result in a larger decline in earnings per share as a smaller portion of earnings is available to be distributed among shareholders after paying interest expenses.

Question 15

Financial risk refers to the extra risk stockholders bear as a result of using debt as compared with the risk they would bear if no debt were used.

Accepted Answer

Financial risk is the risk that arises from the use of debt financing. By using debt financing, a company increases the financial risk for shareholders because they have to repay the debt regardless of the company's financial performance. If the company is unable to meet its debt obligations, it may have to declare bankruptcy, which could result in a significant reduction in the value of the shareholders' investments. Therefore, the use of debt financing increases the financial risk for shareholders compared to if no debt were used.

Question 16

Which of the following events is likely to encourage a company to raise its target debt ratio, other things held constant?
A)An increase in the corporate tax rate.
B)An increase in the personal tax rate.
C)An increase in the company's operating leverage.
D)The Federal Reserve tightens interest rates in an effort to fight inflation.
E)The company's stock price hits a new high.

Accepted Answer

The answer of Which of the following events is likely...

Question 17

Different borrowers have different risks of bankruptcy, and bankruptcy is costly to lenders.Therefore, lenders charge higher rates to borrowers judged to be more at risk of going bankrupt.

Accepted Answer

This is because lenders want to compensate for the higher risk of default and the cost associated with bankruptcy proceedings. Higher interest rates act as a safeguard for the lender, reducing the likelihood of losing their investment.

Question 18

trade-off theory states that the capital structure decision involves a tradeoff between the costs and benefits of debt financing.

Accepted Answer

Trade-off theory indeed states that the capital structure decision involves a tradeoff between the costs and benefits of debt financing.

Question 19

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 depends on various factors such as industry dynamics, regulatory environment, competition, etc. Therefore, even if two firms have the same expected earnings per share and standard deviation of expected EPS, they may still have different levels of business risk depending on their specific industry and other factors.

Question 20

Miller and Modigliani had incorporated the costs of bankruptcy into their model, it is unlikely that they would have concluded that 100% debt financing is optimal.

Accepted Answer

By incorporating the costs of bankruptcy, Miller and Modigliani would have recognized that increasing debt levels beyond a certain point would lead to higher risk of bankruptcy and therefore higher costs, making 100% debt financing not optimal.

Quiz 15: CAP Structure