Question 1

The sensitivity of net income to changes in operating earnings, influenced by the use of debt, relative to equity, as a source of capital is best described as:
A) indifference point.
B) degree of total leverage.
C) degree of financial leverage.
D) degree of operating leverage.

Accepted Answer

The degree of financial leverage measures the sensitivity of net income to changes in operating earnings, influenced by the use of debt relative to equity. It quantifies how changes in EBIT (Earnings Before Interest and Taxes) affect the earnings available to equity shareholders.

Question 2

The number of units produced and sold at which the operating profit is zero is best described as:
A) indifference point.
B) EPS indifference point.
C) financial break-even point.
D) operating break-even point.

Accepted Answer

The operating break-even point refers to the number of units produced and sold at which the operating profit is zero, meaning that all fixed and variable costs have been covered, but no profit has been made.

Question 3

A company experiences a 60 percent change in net income for every 10 percent change in operating profit. What is this company's degree of financial leverage?
A) 0.166
B) 6.0
C) 16.6
D) 60.0

Accepted Answer

The degree of financial leverage (DFL) is calculated as the percentage change in net income divided by the percentage change in operating profit. Here, it's 60% / 10% = 6.0.

Question 4

ABC Company's net income went up 5 percent change in response to a 1 percent increase in operating profit. What is ABC Company's degree of financial leverage?
A) 0.20
B) 2
C) 5
D) 20

Accepted Answer

The degree of financial leverage (DFL) is calculated as the percentage change in net income divided by the percentage change in operating profit, which in this case is 5% / 1% = 5.

Question 5

Fox Company expects to sell 10,000 units of its product at a price of $20 per unit. The variable cost to produce a unit is $7, and the company has fixed operating costs of $10,000. The break-even units produced and sold is nearest to:
A) 76.92.
B) 500.
C) 769.23.
D) 10,000.

Accepted Answer

The break-even point in units can be calculated using the formula: Break-even units = Fixed Costs / (Selling Price per Unit - Variable Cost per Unit). Plugging in the given values: $10,000 / ($20 - $7) = $10,000 / $13 ≈ 769.23 units.

Question 6

Amarillo Company expects to sell 20,000 units of its product at a price of $15 per unit. The variable cost to produce a unit is $9, and the company has fixed operating costs of $14,000. The break-even units produced and sold is closest to:
A) 1,000.
B) 2,333.
C) 20,000.
D) 23,333.

Accepted Answer

The break-even point in units is calculated by dividing the fixed costs by the contribution margin per unit, where the contribution margin per unit is the selling price per unit minus the variable cost per unit. Here, the contribution margin per unit is $15 - $9 = $6. The fixed costs are $14,000. Therefore, the break-even point in units is $14,000 / $6 = 2,333 units.

Question 7

The return on investment at which the return on equity is zero is best described as the:
A) indifference point.
B) financial break-even.
C) operating break-even.

Accepted Answer

The return on investment at which the return on equity is zero is best described as the financial break-even. This point indicates where the company's earnings before interest and taxes (EBIT) are exactly sufficient to cover its interest expenses, resulting in no earnings (or losses) being passed on to equity holders.

Question 8

Which of the following statements is incorrect?
A) Debt is almost always the most expensive form of capital.
B) The amount of debt a company can carry depends on the underlying business risk of the asset being financed.
C) The more a company relies on debt financing, relative to equity financing, the greater the variation of returns to equity.
D) Financial leverage tends to increase returns at the expense of increased variability and increased risk of financial distress.

Accepted Answer

Debt is typically considered a less expensive form of capital compared to equity because interest payments on debt are tax-deductible, which reduces the effective cost of debt. Additionally, debt does not entail giving up any ownership interest in the company, unlike equity financing.

Question 9

Business risk is comprised of all of the following except:
A) sales risk.
B) economic risk.
C) operating risk.

Accepted Answer

Economic risk is not considered a component of business risk. Business risk typically refers to the potential for a company to have lower than anticipated profits or to experience a loss due to factors that affect its overall operation, such as sales risk and operating risk. Economic risk, on the other hand, refers to the potential impact of changes in the broader economy, such as inflation rates, exchange rates, and economic downturns, which can affect companies but is not specific to a company's internal operations or performance.

Question 10

Pirates, Inc. is examining two different financing strategies (1) 50% debt and 50% equity, and (2) 75% debt and 25% equity. At 750 units produced and sold, the ROE is the same for both financing methods. The point at which 750 units are produced and sold is best described as the:
A) ROE equality.
B) indifference point.
C) EPS indifference point.
D) finance flexibility point.

Accepted Answer

The point at which the Return on Equity (ROE) is the same for two different financing methods (in this case, 50% debt and 50% equity versus 75% debt and 25% equity) at a specific level of production and sales (750 units) is known as the indifference point. This term is used because at this point, the company is indifferent between the two financing options as they provide the same ROE.

Question 11

Which of the following is not one of the scenarios that the Modigliani and Miller Theories comprise?
A) A world with taxes and costs of financial distress
B) A world without taxes or costs of financial distress
C) A world with costs of financial distress, but no taxes
D) A world with taxes, but no costs of financial distress

Accepted Answer

The Modigliani and Miller Theories do not specifically consider a scenario with costs of financial distress but no taxes. They primarily focus on scenarios with and without taxes, and the implications of financial distress are typically considered alongside taxes.

Question 12

Costs of financial distress include all of the following except:
A) direct costs.
B) bankruptcy costs.
C) opportunity costs.
D) losses prior to bankruptcy.

Accepted Answer

Bankruptcy costs are a subset of the broader category of financial distress costs, not an exception. Financial distress costs include direct costs (such as legal and administrative expenses), indirect costs (such as lost sales, customers, or employees), and opportunity costs (such as lost investment opportunities). Losses prior to bankruptcy are also considered part of financial distress costs.

Question 13

Under which, Modigliani and Miller assumption is the value of the company not affected by the capital structure?
A) Taxes and costs to financial distress
B) No taxes, no costs of financial distress
C) Taxes, but no costs to financial distress

Accepted Answer

Under Modigliani and Miller's assumption, the value of the company is not affected by the capital structure in an ideal world with no taxes and no costs of financial distress. This is their Proposition I without taxes.

Question 14

What is the conclusion of part 2 of Modigliani and Miller - taxes, but no costs to financial distress?
A) The more debt, the greater value of the company
B) There is some optimal capital structure for a company
C) Management should be indifferent in how to finance the company

Accepted Answer

In part 2 of Modigliani and Miller's theory, which includes taxes but ignores costs of financial distress, the conclusion is that the more debt a company has, the greater its value. This is because debt interest payments are tax-deductible, reducing the company's taxable income and thus its tax liability, which in turn increases the value of the company.

Question 15

If there are no costs to financial distress, but there are taxes, the optimal capital structure, according to the Modigliani and Miller theory, is:
A) no debt.
B) almost all debt.
C) 50% debt, 50% equity.

Accepted Answer

The answer of If there are no costs to financial...

Question 16

The theory where a company uses debt to maximize its tax advantages up to the point where these benefits are outweighed by the associated estimated costs of financial distress and bankruptcy is best described as the:
A) agency theory.
B) bankruptcy theory.
C) pecking order theory.
D) static trade-off theory.

Accepted Answer

The static trade-off theory suggests that firms balance the benefits of debt, such as tax advantages, against the costs of potential financial distress and bankruptcy. This theory posits that there is an optimal level of debt that maximizes a firm's value by balancing these factors.

Question 17

An individual seeks to finance a home addition. This individual takes out a home equity line, due to the tax benefits of this type of financing, but only takes the loan in the amount in which she feels will not be over borrowing or too much debt for her financial situation. This would be an example of:
A) agency theory.
B) signaling theory.
C) pecking order theory.
D) static trade-off theory.

Accepted Answer

The answer of An individual seeks to finance a home...

Question 18

The correct order in which companies prefer to raise financing according to pecking order theory is:
A) internal cash flow, debt, issuing common equity.
B) issuing common equity, debt, internal cash flow.
C) issuing common equity, internal cash flow, debt.
D) debt, internal cash flow, issuing common equity
E) internal cash flow, issuing common equity, debt.

Accepted Answer

Pecking order theory suggests that companies prioritize their sources of financing from internal funds first, then debt, and finally equity as a last resort. This is because internal financing is the least expensive and least risky, while issuing new equity is often the most expensive due to flotation costs and the potential dilution of existing shareholders' value.

Question 19

Which of the following is not a direct cost of financial distress?
A) The loss of the use of tax loss carryovers
B) Legal and accounting costs experienced in a bankruptcy liquidation
C) Losses related to liquidation from reduced asset prices in distress sales
D) Opportunity cost of company making decisions to meet short-term cash needs instead of decisions it otherwise would have made

Accepted Answer

The opportunity cost of a company making decisions to meet short-term cash needs instead of decisions it otherwise would have made is considered an indirect cost of financial distress, not a direct cost. Direct costs include legal and accounting fees, and losses directly associated with the process of resolving financial distress, such as asset liquidation losses or the loss of tax benefits.

Question 20

Which of the following is not an assumption of Modigliani and Miller irrelevance theory?
A) No taxes
B) No transaction costs
C) No asymmetric information
D) No costs to financial distress
E) All of the above are assumptions of the Modigliani and Miller irrelevance theory

Accepted Answer

All the options listed are assumptions of the Modigliani and Miller irrelevance theory, which assumes a perfect market with no taxes, transaction costs, asymmetric information, or costs to financial distress.

Quiz 15: Capital Structure Decisions

The sensitivity of net income to changes in operating earnings, influenced by the use of debt, relative to equity, as a source of capital is best described as:

The number of units produced and sold at which the operating profit is zero is best described as:

A company experiences a 60 percent change in net income for every 10 percent change in operating profit. What is this company's degree of financial leverage?

ABC Company's net income went up 5 percent change in response to a 1 percent increase in operating profit. What is ABC Company's degree of financial leverage?

Fox Company expects to sell 10,000 units of its product at a price of $20 per unit. The variable cost to produce a unit is $7, and the company has fixed operating costs of $10,000. The break-even units produced and sold is nearest to:

Amarillo Company expects to sell 20,000 units of its product at a price of $15 per unit. The variable cost to produce a unit is $9, and the company has fixed operating costs of $14,000. The break-even units produced and sold is closest to:

The return on investment at which the return on equity is zero is best described as the:

Which of the following statements is incorrect?

Business risk is comprised of all of the following except:

Pirates, Inc. is examining two different financing strategies (1) 50% debt and 50% equity, and (2) 75% debt and 25% equity. At 750 units produced and sold, the ROE is the same for both financing methods. The point at which 750 units are produced and sold is best described as the:

Which of the following is not one of the scenarios that the Modigliani and Miller Theories comprise?

Costs of financial distress include all of the following except:

Under which, Modigliani and Miller assumption is the value of the company not affected by the capital structure?

What is the conclusion of part 2 of Modigliani and Miller - taxes, but no costs to financial distress?

If there are no costs to financial distress, but there are taxes, the optimal capital structure, according to the Modigliani and Miller theory, is:

The theory where a company uses debt to maximize its tax advantages up to the point where these benefits are outweighed by the associated estimated costs of financial distress and bankruptcy is best described as the:

The correct order in which companies prefer to raise financing according to pecking order theory is:

Which of the following is not a direct cost of financial distress?

Which of the following is not an assumption of Modigliani and Miller irrelevance theory?