Question 1

An increase in the financial leverage of a firm will generally increase the variability in EPS for the firm.

Accepted Answer

Financial leverage refers to the use of borrowed funds to finance investments. When a firm uses more debt (or financial leverage), its fixed interest payments increase. This can lead to variability in the earnings per share (EPS) of the firm because when earnings increase, the interest payments stay fixed, so the portion of earnings available to shareholders increases disproportionately. However, if earnings decrease, the interest payments still have to be paid, so the portion of earnings available to shareholders decreases disproportionately, leading to more variability in EPS. Therefore, an increase in financial leverage will generally increase the variability in EPS for the firm.

Question 2

Underlying the dividend irrelevance theory proposed by Miller and Modigliani is their argument that the value of the firm is determined only by its basic earning power and its business risk.

Accepted Answer

According to Miller and Modigliani's dividend irrelevance theory, the value of the firm is determined by its basic earning power and business risk. Therefore, dividends have no impact on the valuation of the firm.

Question 3

If the firm's actual debt-to-assets ratio is below its target level,expansion capital should be raised by issuing equity in order to preserve the firm's borrowing capacity.

Accepted Answer

If the firm's actual debt-to-assets ratio is below the target level, it means the firm has borrowing capacity available. In this case, it would be more appropriate to raise capital through debt financing rather than equity financing. Issuing equity would dilute the existing shareholders' ownership stake in the firm and may not be the best option for preserving the firm's borrowing capacity.

Question 4

How a firm splits its income between retained earnings and dividends does not affect its rate of growth,which is determined by the firm's basic earning power.

Accepted Answer

The way a firm splits its income between retained earnings and dividends can affect its rate of growth because retained earnings are an important source of funding for investment in new projects, which can lead to growth.

Question 5

Changing the capital structure of the firm will affect the riskiness inherent in the firm's common stock,which will affect the return demanded by stockholders and the stock's

Accepted Answer

Changing the capital structure of the firm, such as increasing the amount of debt, can increase the financial risk of the firm. This increased riskiness will impact the return that stockholders demand for the firm's common stock, as they will require a higher return to compensate for the added risk. Additionally, changes in the capital structure may also impact the dividends or other distributions paid to stockholders, further affecting the return on the stock.

Question 6

Generally,the more stable a firm's operations,the more debt it can handle in its capital structure.

Accepted Answer

This statement is generally true as a firm with stable operations is more likely to have predictable cash flows which can be used to service debt obligations. This makes lenders more willing to lend to the firm and allows the firm to take on more debt in its capital structure. However, it is important to note that there are other factors that also influence a firm's ability to handle debt, such as the level of interest rates, the firm's credit rating, and market conditions.

Question 7

Business risk is the single most important determinant of a firm's capital structure.

Accepted Answer

Business risk refers to the uncertainty and variability of a firm's earnings and profits, which in turn affects its ability to meet financial obligations, such as debt payments. Therefore, firms with higher business risk may prefer to have a lower debt-to-equity ratio in their capital structure to minimize the financial risk associated with their operations. On the other hand, firms with lower business risk may be comfortable with higher leverage and may use more debt financing to enhance their returns to shareholders. Thus, business risk is a crucial factor in determining a firm's optimal capital structure.

Question 8

The optimal capital structure is the one that maximizes the price of the stock,which always calls for a debt/asset ratio that is lower than the one that maximizes EPS.

Accepted Answer

The statement is true. Maximizing EPS may require taking on more debt to benefit from the tax shield, but a high debt/asset ratio also increases financial risk and reduces shareholder value, ultimately lowering the stock price. Therefore, the optimal capital structure is a balance between debt and equity that maximizes the overall value of the firm and the price of the stock.

Question 9

The announcement of a stock offering by a mature firm that seems to have financing alternatives is taken as a signal that the firm's prospects are very good.

Accepted Answer

The announcement of a stock offering by a mature firm may signal that the firm needs capital and could not obtain financing through other means, indicating potential financial difficulties, rather than good prospects.

Question 10

One implication of information asymmetry between investors and firm managers is that if a firm raises new capital by issuing debt rather than by selling stock,it signals that the firm has very good prospects.

Accepted Answer

Issuing debt rather than equity can signal to investors that managers are confident in the firm's future cash flows, as they are willing to commit to fixed interest payments, suggesting good prospects.

Question 11

A firm's capital structure and dividend policy can affect the firm's cash position but has no impact on the market value of the firm's stock.

Accepted Answer

A firm's capital structure and dividend policy can have a significant impact on the market value of its stock. For example, a firm that consistently pays high dividends may have a higher stock price, as investors value the reliable income stream. Additionally, a firm with a higher debt-to-equity ratio may have a higher cost of capital, which can decrease its stock price.

Question 12

A firm that follows a residual dividend policy must believe that the dividend irrelevance theory is correct.

Accepted Answer

A residual dividend policy means that the firm decides to first invest in all profitable projects and then distributes the remaining earnings as dividends. This policy is based on the belief that investors value the firm based on its future earnings potential, not on its dividend payout. Therefore, the firm does not follow the dividend irrelevance theory.

Question 13

If the information content,or signaling,hypothesis is correct,then changes in dividend policy can be important with respect to firm value and capital costs.

Accepted Answer

The information content hypothesis suggests that dividend policy conveys important information to investors, which can impact firm value and capital costs. Therefore, changes in dividend policy can be significant in terms of their effects on these factors.

Question 14

If Miller and Modigliani had considered the cost of bankruptcy,it is unlikely that they would have concluded that 100 percent debt financing is optimal for the firm.

Accepted Answer

Miller and Modigliani's theory assumes perfect markets and no transaction costs, which means that bankruptcy costs are not considered. If bankruptcy costs were considered, it is unlikely that they would have concluded that 100 percent debt financing is optimal for the firm, as higher debt increases the probability of bankruptcy and the associated costs.

Question 15

Business risk is the single most important determinant of a firm's capital structure.

Accepted Answer

Business risk refers to the uncertainty and variability of a firm's earnings and profits, which in turn affects its ability to meet financial obligations, such as debt payments. Therefore, firms with higher business risk may prefer to have a lower debt-to-equity ratio in their capital structure to minimize the financial risk associated with their operations. On the other hand, firms with lower business risk may be comfortable with higher leverage and may use more debt financing to enhance their returns to shareholders. Thus, business risk is a crucial factor in determining a firm's optimal capital structure.

Question 16

If the shape of the curve depicting a firm's WACC versus its debt-to-assets ratio is more like a sharp "V",as opposed to a shallow "U",it will be easier for the firm to maintain a steady dividend in the face of varying investment opportunities from year to year.

Accepted Answer

A sharp "V" shape indicates a more volatile cost of capital as the firm changes its debt-to-assets ratio, making it harder to predict and maintain steady financing costs, and thus more challenging to maintain steady dividends amidst varying investment opportunities.

Question 17

The higher a firm's time-interest-earned ratio,the higher the probability that the firm will default on its debt and experience financial distress.

Accepted Answer

This statement is false. A higher time-interest-earned ratio indicates that the firm has a greater ability to meet its interest payments, which lowers the probability of default and financial distress. A lower ratio indicates a greater risk of default and financial distress.

Question 18

If the announcement of a stock sale does in fact trigger a decline in stock price,this reinforces the effects of flotation costs incurred with new equity issues.Further,this implies a larger break in the MCC schedule.

Accepted Answer

If a stock sale announcement triggers a decline in stock price, it suggests that investors do not perceive the new equity issue as a positive development for the company. This can result in higher flotation costs, as it may be more difficult for the company to raise the desired amount of capital. Additionally, a larger break in the marginal cost of capital (MCC) schedule may result, as the cost of capital for the company may increase due to the negative perception of the equity issue.

Question 19

In signaling theory,when a manager has better information than outside investors about the firm,this is called asymmetric information.

Accepted Answer

In signaling theory, the existence of better information regarding the firm between the manager and outside investors is known as asymmetric information.

Question 20

If we consider only agency costs associated with the issuance of debt,then this implies that the firm should move toward 100 percent debt financing.

Accepted Answer

While increasing debt financing may reduce some agency costs associated with equity, it may also increase the agency costs associated with debt, such as the risk of default and the need to monitor the firm's financial situation. A optimal capital structure strikes a balance between the benefits and costs of both debt and equity financing.

Quiz 14: Capital Structure and Dividend Policy Decisions

An increase in the financial leverage of a firm will generally increase the variability in EPS for the firm.

Underlying the dividend irrelevance theory proposed by Miller and Modigliani is their argument that the value of the firm is determined only by its basic earning power and its business risk.

If the firm's actual debt-to-assets ratio is below its target level,expansion capital should be raised by issuing equity in order to preserve the firm's borrowing capacity.

How a firm splits its income between retained earnings and dividends does not affect its rate of growth,which is determined by the firm's basic earning power.

Changing the capital structure of the firm will affect the riskiness inherent in the firm's common stock,which will affect the return demanded by stockholders and the stock's

Generally,the more stable a firm's operations,the more debt it can handle in its capital structure.

Business risk is the single most important determinant of a firm's capital structure.

The optimal capital structure is the one that maximizes the price of the stock,which always calls for a debt/asset ratio that is lower than the one that maximizes EPS.

The announcement of a stock offering by a mature firm that seems to have financing alternatives is taken as a signal that the firm's prospects are very good.

One implication of information asymmetry between investors and firm managers is that if a firm raises new capital by issuing debt rather than by selling stock,it signals that the firm has very good prospects.

A firm's capital structure and dividend policy can affect the firm's cash position but has no impact on the market value of the firm's stock.

A firm that follows a residual dividend policy must believe that the dividend irrelevance theory is correct.

If the information content,or signaling,hypothesis is correct,then changes in dividend policy can be important with respect to firm value and capital costs.

If Miller and Modigliani had considered the cost of bankruptcy,it is unlikely that they would have concluded that 100 percent debt financing is optimal for the firm.

Business risk is the single most important determinant of a firm's capital structure.

If the shape of the curve depicting a firm's WACC versus its debt-to-assets ratio is more like a sharp "V",as opposed to a shallow "U",it will be easier for the firm to maintain a steady dividend in the face of varying investment opportunities from year to year.

The higher a firm's time-interest-earned ratio,the higher the probability that the firm will default on its debt and experience financial distress.

If the announcement of a stock sale does in fact trigger a decline in stock price,this reinforces the effects of flotation costs incurred with new equity issues.Further,this implies a larger break in the MCC schedule.

In signaling theory,when a manager has better information than outside investors about the firm,this is called asymmetric information.

If we consider only agency costs associated with the issuance of debt,then this implies that the firm should move toward 100 percent debt financing.