Question 1

A firm should raise capital according to its optimal capital structure so as to maximize its _____. 
A)earnings per share (EPS)
B)stock price
C)weighted average cost of capital (WACC)
D)net income
E)retained earnings

Accepted Answer

The optimal capital structure is the mix of debt and equity that maximizes the firm's stock price. By raising capital according to this structure, the firm can minimize its cost of capital while maximizing the value of the company to its shareholders. Earnings per share, net income, and retained earnings are all affected by the financing decisions of the company, but they are not the main focus of the optimal capital structure. The weighted average cost of capital (WACC) is a consideration in determining the optimal capital structure, but it is not the ultimate goal.

Question 2

As a general rule, the optimal capital structure is the one that:
A)maximizes both the firm's expected EPS and its stock price.
B)minimizes the interest rate on its debt and maximizes its expected earnings per share.
C)minimizes its required rate on equity and maximizes its stock price.
D)maximizes its stock price and minimizes its weighted average cost of capital.
E)minimizes its expected earnings per share and maximizes its weighted average cost of capital.

Accepted Answer

The optimal capital structure is the one that maximizes the firm's stock price and minimizes its weighted average cost of capital. This means finding the balance between debt and equity financing that results in a low cost of capital while still providing enough financial leverage to drive up the stock price. Maximizing EPS or minimizing interest rate on debt are not sufficient criteria for determining the optimal capital structure.

Question 3

Financial leverage is the:
A)presence of fixed operating costs.
B)portion of earnings that is paid out as dividends to the common stockholders.
C)risk associated with a firm's operations.
D)combination of the debt and the equity a firm uses to finance its assets.
E)extent to which fixed-income securities are used in a firm's capital structure.

Accepted Answer

Financial leverage refers to the extent to which a firm uses fixed-income securities, such as debt, in its capital structure to finance its assets.

Question 4

The combination of debt financing and equity financing that maximizes a firm's value is known as its:
A)optimum degree of financial leverage (DFL).
B)maximum weighted average cost of capital (WACC).
C)maximum business risk.
D)optimal capital structure.
E)optimal indifference point.

Accepted Answer

Optimal capital structure refers to the combination of debt and equity financing that yields the lowest possible cost of funds (maximum value) for a firm. It is the combination that produces the highest possible stock price while minimizing the cost of capital. The optimal capital structure is considered a tradeoff between the business and financial risks of a firm.

Question 5

The risk associated with a firm's operations, ignoring any financing effects, is known as _____ risk. 
A)market
B)business
C)leverage
D)liquidity
E)inflation

Accepted Answer

Business risk refers to the uncertainty associated with a firm's operations, regardless of its financial structure or leverage. This risk includes factors such as competition, changes in consumer preferences, technological innovations, and other industry-specific factors that can affect a firm's revenues, profitability, and overall performance.

Question 6

At its optimal capital structure, the firm's debt/assets ratio will always be lower than the one that maximizes its _____. 
A)expected earnings per share (EPS)
B)weighted average cost of capital
C)beta coefficient
D)degree of financial leverage
E)net operating income

Accepted Answer

The optimal capital structure minimizes the weighted average cost of capital (WACC), while the debt/assets ratio that maximizes expected earnings per share (EPS) is typically higher, as it involves more leverage.

Question 7

Which of the following would be considered part of a firm's business risk?
A)The firm's default risk
B)The risk that some of the firm's bonds will be repaid prior to their maturities
C)The general liability that is associated with the product line the firm manufactures and sells
D)Risk of loss due to currency fluctuations
E)Interest rate reinvestment risk

Accepted Answer

The general liability associated with the product line a firm manufactures and sells is part of its business risk, as it refers to the risk that the firm may face legal action or compensation claims from customers who suffer harm or loss from its products. The other options, such as default risk, bond repayment risk, currency risk, and interest rate reinvestment risk, are more related to financial risks that may affect the firm's ability to meet its financial obligations or manage its cash flows.

Question 8

The presence of fixed operating costs is known as _____. 
A)financial leverage
B)operating leverage
C)beta risk
D)market risk
E)firm-specific risk

Accepted Answer

The presence of fixed operating costs is known as operating leverage. Operating leverage measures the degree to which a company's operating income changes in response to a change in revenue. Companies with high fixed costs have higher operating leverage, meaning a small increase in revenue can lead to a larger increase in operating income. On the other hand, a small decrease in revenue can lead to a larger decrease in operating income.

Question 9

A company's capital structure consists of common stock only, which amounts to $14 million. However, this year, the company plans to issue $7 million of debt, and use the proceeds to repurchase $7 million of its existing equity. The stock repurchase should not change the size of the company. As a result, any change in the firm's earnings per share (EPS) must be a result of the change in its:
A)level of operations.
B)beta coefficient.
C)EPS coefficient of variation.
D)capital structure.
E)EPS standard deviation.

Accepted Answer

The issuance of debt to repurchase equity will increase the company's debt component of its capital structure while decreasing the equity component, resulting in a change in the company's overall capital structure. This change in the capital structure will affect the company's earnings per share (EPS) by altering its interest expense and its tax shield, resulting in a change in the firm's earnings available to common shareholders. Therefore, the change in EPS is a result of the change in the company's capital structure.

Question 10

A firm's optimal capital structure is the combination of debt financing and equity financing that ______. 
A)maximizes its expected earnings per share (EPS).
B)simultaneously maximizes its EPS and minimizes its weighted average cost of capital (WACC).
C)minimizes its cost of equity, which is a necessary condition for maximizing the firm's stock price.
D)simultaneously minimizes its cost of debt, its cost of equity, and its WACC.
E)maximizes its stock price.

Accepted Answer

The optimal capital structure is the one that maximizes the firm's stock price, as it reflects the best balance of risk and return for shareholders.

Question 11

Which of the following situations would intensify the business risk borne by a firm's common stockholders?
A)The firm issues new fixed-income securities, such as bonds, to raise funds to support operations.
B)The firm takes actions to stabilize its annual sales.
C)The firm starts purchasing from a supplier that allows it to renegotiate raw materials costs every six months.
D)The firm reduces its use of fixed operating costs.
E)The firm issues new common stock to raise funds.

Accepted Answer

Issuing new fixed-income securities, such as bonds, increases the firm's fixed financial obligations (interest payments), which amplifies the variability of net income and, consequently, the business risk for common stockholders.

Question 12

If a firm increases the proportions of debt and preferred stock that are contained in its capital structure, its _____. 
A)financial risk will increase
B)business risk will decrease
C)tax liability will increase
D)operating leverage will decrease
E)financial leverage will decrease

Accepted Answer

Increasing the proportion of debt and preferred stock increases the financial leverage of the firm, which in turn increases the financial risk. This is because debt requires regular interest payments and preferred stock requires fixed dividend payments, which must be paid regardless of whether the company earns a profit or not. This increases the company's fixed financial expenses, which makes it more difficult for the company to cover its expenses during times of low profitability.

Question 13

A firm sets a target capital structure to use when raising new funds in an effort to:
A)maximize its earnings per share (EPS).
B)minimize its cost of debt (rd).
C)maximize the dividend per share it pays commons stockholders.
D)minimize its cost of equity (rs).
E)minimize its weighted average cost of capital (WACC).

Accepted Answer

The main goal of setting a target capital structure is to minimize the weighted average cost of capital (WACC). By achieving the optimal mix of debt and equity, a firm can minimize its overall cost of capital and maximize shareholder value. Option A is incorrect because maximizing EPS may not always align with maximizing shareholder value. Option B is incorrect because minimizing the cost of debt alone may not necessarily result in the lowest WACC. Option C is incorrect because maximizing dividend per share may not be the most optimal use of resources for a firm. Option D is incorrect because minimizing the cost of equity alone may not result in the lowest WACC.

Question 14

Which of the following is considered a component of financial risk?
A)Fixed operating costs
B)Variable operating costs
C)The variability of a product's selling price
D)Interest payments on bonds
E)Fixed labor costs

Accepted Answer

Interest payments on bonds are considered a component of financial risk because they represent a fixed financial obligation that the company must meet regardless of its financial performance. Financial risk generally refers to the risk associated with financing, including the risk of being unable to meet fixed financial obligations such as interest payments.

Question 15

Operating leverage refers to the presence of _____. 
A)fixed-income securities
B)beta risks
C)firm-specific risks
D)variable operating costs
E)fixed operating costs

Accepted Answer

Operating leverage refers to the degree to which a company uses fixed operating costs in its operations. As such, the correct answer is E (fixed operating costs). Option A (fixed-income securities) and B (beta risks) are unrelated to operating leverage. Option C (firm-specific risks) is not necessarily related to operating costs, while option D (variable operating costs) is the opposite of fixed operating costs and therefore not related to operating leverage.

Question 16

Copybold Corporation is a start-up company that has a capital structure with a debt/assets ratio equal to 0.75. Copybold has no preferred stock. There are two possible scenarios with respect to the firm's operations: Feast or Famine. The Feast scenario has a 60 percent probability of occurring, and the forecast earnings before interest and taxes (EBIT) in this scenario is $60,000. The Famine scenario has a 40 percent chance of occurring, and the EBIT is expected to be $20,000. Further, the firm's cost of debt is 12 percent. The firm has $400,000 in total assets, and its marginal tax rate is 40 percent. The company has 10,000 shares of stock outstanding. What is the difference between the earnings per share (EPS) forecasts for the Feast scenario and the Famine scenario?
A)$1.44 per share
B)$2.40 per share
C)$1.48 per share
D)$0.48 per share
E)$0.96 per share

Accepted Answer

First, we need to calculate the firm's net income in each scenario:
- Feast scenario: EBIT = $60,000, interest expense = $400,000 x 0.75 x 12% = $36,000, taxable income = $24,000, net income = $14,400 (after 40% tax rate)
- Famine scenario: EBIT = $20,000, interest expense = $400,000 x 0.75 x 12% = $36,000, taxable loss = ($16,000), net income = $0 (after 40% tax rate)
Next, we can calculate the earnings per share (EPS) in each scenario:
- Feast scenario: EPS = ($14,400 - 0) / 10,000 = $1.44/share
- Famine scenario: EPS = ($0 - 0) / 10,000 = $0/share
The difference between EPS forecasts for Feast and Famine scenarios is $1.44/share - $0/share = $1.44/share.
Therefore, the best choice is B.

Question 17

Everything else equal, and for one particular firm, in which of the following capital structures would the common stockholders have to bear the greatest amount of of business risk?
A)100 percent equity
B)25 percent equity and 75 percent debt
C)50 percent equity and 50 percent debt
D)1 percent equity and 99 percent debt
E)75 percent equity and 25 percent debt

Accepted Answer

In option D, common stockholders have only 1 percent equity and 99 percent debt. This means that most of the financing is done through debt, which increases the business risk for the common stockholders. In case of financial distress, the debt holders have a priority claim on the assets and cash flows of the firm, which leaves little for the common stockholders. Therefore, when there is a large amount of debt in the capital structure, the common stockholders bear the greatest amount of business risk.

Question 18

A firm's ______ is the combination of debt and equity it uses to finance its assets. 
A)capital budgeting plan
B)business risk
C)asset structure
D)securitization table
E)capital structure

Accepted Answer

Capital structure refers to the mix of debt and equity financing that a firm uses to finance its assets. The capital structure decision is important because it affects the firm's cost of capital, financial flexibility, and risk profile. The capital structure can be adjusted over time as the firm's needs and circumstances change.

Question 19

Which of the following industries normally has relatively low business risk?
A)Durable goods manufacturers, such as automobile manufacturers
B)Firms that produce staple goods, such as grocery stores and utility companies
C)Cyclical companies, such as construction companies
D)Firms that engage in fairly risky research and development, such as pharmaceutical research companies.
E)Small, single-product firms, especially those that sell primarily to a single customer

Accepted Answer

Firms that produce staple goods, such as grocery stores and utility companies, usually have relatively stable demand for their products or services, which makes their business risk lower compared to other industries. The demand for their products or services is less likely to be impacted by economic cycles or changes in consumer behavior.

Question 20

Which of the following factors would tend to reduce a firm's business risk?
A)The firm changes its operations to make them more cyclical.
B)The firm increases its operating leverage.
C)The firm increases the fixed costs that are associated with the manufacture of its products.
D)The firm shifts its sales strategy in an effort to sell substantially more high-priced durable goods than low-priced staple goods, which reverses the sales trend that occurred during the past decade.
E)The firm takes actions to improve the stability of its day-to-day operations.

Accepted Answer

Taking actions to improve the stability of its day-to-day operations would reduce a firm's business risk by minimizing unexpected disruptions or fluctuations in its operations, thereby making its business more predictable and stable. The other options would likely increase business risk by increasing the firm's exposure to economic cycles, increasing fixed costs, or introducing sales trends that may not be sustainable.

Quiz 12: Capital Structure

A firm should raise capital according to its optimal capital structure so as to maximize its _____.

As a general rule, the optimal capital structure is the one that:

Financial leverage is the:

The combination of debt financing and equity financing that maximizes a firm's value is known as its:

The risk associated with a firm's operations, ignoring any financing effects, is known as _____ risk.

At its optimal capital structure, the firm's debt/assets ratio will always be lower than the one that maximizes its _____.

Which of the following would be considered part of a firm's business risk?

The presence of fixed operating costs is known as _____.

A firm's optimal capital structure is the combination of debt financing and equity financing that ______.

Which of the following situations would intensify the business risk borne by a firm's common stockholders?

If a firm increases the proportions of debt and preferred stock that are contained in its capital structure, its _____.

A firm sets a target capital structure to use when raising new funds in an effort to:

Which of the following is considered a component of financial risk?

Operating leverage refers to the presence of _____.

Everything else equal, and for one particular firm, in which of the following capital structures would the common stockholders have to bear the greatest amount of of business risk?

A firm's ______ is the combination of debt and equity it uses to finance its assets.

Which of the following industries normally has relatively low business risk?

Which of the following factors would tend to reduce a firm's business risk?