Question 1

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

Accepted Answer

Operating characteristics, such as the level of risk and volatility in a company's industry or market, can affect a company's capital structure decisions. For example, companies with stable and predictable cash flows may be more inclined to use more debt financing, while companies with more uncertain cash flows may choose to use less debt and more equity financing.

Question 2

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

Accepted Answer

The equity beta of a firm is determined by both its business risk and its financial policy, including its debt-to-equity ratio and capital structure decisions.

Question 3

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 is favorable when EBIT is high because it amplifies earnings per share by using debt financing, while it is unfavorable when EBIT is low due to the fixed interest costs.

Question 4

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

Accepted Answer

This is because the target capital structure is the optimal mix of debt and equity that maximizes the firm's value by balancing the benefits and risks of each source of financing. At this point, the cost of capital is minimized, and the firm is able to generate the highest possible return for its shareholders.

Question 5

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 6

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

Accepted Answer

Higher financial leverage increases a firm's fixed financial costs, which raises the break-even EBIT needed to cover these costs.

Question 7

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

Accepted Answer

Tax rate affects the interest tax shield of debt, which in turn affects the optimal level of debt for a firm. High tax rates increase the value of debt financing by reducing the amount of taxes paid, leading to a higher optimal level of debt. Conversely, low tax rates decrease the value of debt financing, leading to a lower optimal level of debt.

Question 8

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

Accepted Answer

When a firm is operating at its target capital structure point, the debt-equity ratio may or may not be equal to 1. The target capital structure is the mix of debt and equity that maximizes the value of the firm, taking into consideration factors such as cost of capital, risk, and taxes. The optimal mix could result in a debt-equity ratio that is different from 1.

Question 9

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

Accepted Answer

This is true because high volatility in earnings increases the risk of financial distress, making it more difficult for a firm to meet its debt obligations. Therefore, firms with high earnings volatility will have a lower optimal level of debt compared to firms with more stable earnings.

Question 10

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

Accepted Answer

When EBIT is positive, increasing financial leverage increases the amount of interest expense, which reduces net income and EPS. However, if EBIT increases, the effect of the increased interest expense on EPS and ROE will be magnified as a result of the higher financial leverage. Therefore, EPS and ROE will become more sensitive to changes in EBIT with increasing financial leverage.

Question 11

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

In the absence of personal or corporate income taxes and assuming the firm's WACC is unaffected by its capital structure, the cost of equity is determined solely by the firm's business and financial risks. Therefore, option A is correct.

Question 12

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 point, it means that it has achieved the optimal mix of debt and equity financing that results in the lowest cost of capital for the firm. This, in turn, maximizes the total value of the firm.

Question 13

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

Accepted Answer

Ignoring financial distress costs, borrowing money may actually increase the value of the firm by allowing the firm to take advantage of the tax shield on interest payments. This tax shield reduces the firm's tax liability.

Question 14

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

Accepted Answer

The nature of assets, such as their liquidity and stability, can determine the level of risk associated with a firm's borrowing, which in turn impacts the optimal level of debt that can be sustained. For example, a firm with stable, predictable cash flows from tangible assets (like real estate) may be able to take on more debt than a firm that relies on more variable revenue streams from intangible assets (like patents or brand recognition).

Question 15

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

Accepted Answer

Capital structures can vary depending on factors such as industry type, size of the company, and financial goals. Therefore, it is common to see differences in capital structures across different industry groups.

Question 16

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

Accepted Answer

This is true because at the target capital structure, the cost of debt and cost of equity both are minimized, resulting in a lower overall cost of capital or WACC. If the firm deviates from its target capital structure, it will result in a higher WACC.

Question 17

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

M&M Proposition II incorporates taxes into the analysis, which results in a negative slope for the line representing the firm's WACC. Therefore, if the graph illustrating M&M Proposition II has a negative slope, it must be incorporating taxes.

Question 18

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

Accepted Answer

This is true, as there has been a trend towards greater use of debt financing by corporations in recent years.

Question 19

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 statement is true. The optimal capital structure is the one that balances the benefits of debt (tax shields and lower cost of capital) with the costs of debt (increased risk of bankruptcy and financial distress). This balance results in a lower cost of capital and higher value for the firm.

Question 20

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.

Quiz 16: Financial Leverage and Capital Structure Policy

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

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

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.

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

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?

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

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

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

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

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

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.

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

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

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

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

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

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.

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

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.

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