Question 1

Despite the extensive research conducted in recent years in the area of capital structure theory, it is not yet possible to provide financial managers with a specified methodology for use in determining a firm's optimal capital structure.

Accepted Answer

Despite the significant amount of research in capital structure theory, there is no specific method available to financial managers to determine the best capital structure for their firm.

Question 2

Business risk is the risk to a firm of being unable to cover operating costs.

Accepted Answer

Business risk refers to the potential of a firm not being able to generate sufficient revenue to meet its operating costs, which can lead to financial difficulties and possibly bankruptcy.

Question 3

Financial risk is the risk to a firm of being unable to cover operating costs.

Accepted Answer

Financial risk refers to the risk of a firm being unable to meet its financial obligations, such as paying its debts or covering its operating costs.

Question 4

Effective capital structure decisions can lower the cost of capital, resulting in higher NPVs and more acceptable projects, thereby increasing the value of a firm.

Accepted Answer

Effective capital structure decisions can lead to a reduction in the cost of capital, which can result in higher net present values (NPVs) and more acceptable projects. This can increase the overall value of a firm. Therefore, the statement is true.

Question 5

Because of the extensive research conducted in recent years in the area of capital structure theory, it is now possible for financial managers to pinpoint with great accuracy a firm's optimal capital structure.

Accepted Answer

Although extensive research has been conducted on capital structure theory, it is difficult to pinpoint with great accuracy a firm's optimal capital structure as it depends on various factors such as the industry, business risks, growth opportunities, etc. Therefore, optimal capital structure is subjective and not a one-size-fits-all approach.

Question 6

Asymmetric information results when managers of a firm have more information about the firm's operations and future prospects than investors have.

Accepted Answer

Asymmetric information occurs when there is an imbalance in the knowledge between two parties involved in a transaction, and in the case of a firm, it often refers to situations where the managers or insiders possess more information than outside investors or stakeholders. This can lead to issues such as adverse selection, moral hazard, and market inefficiencies.

Question 7

Business risk is the risk to the firm of being unable to cover required financial obligations.

Accepted Answer

Business risk refers to the risk associated with the inability of a company to generate sufficient revenue to cover its operational expenses, not specifically its financial obligations.

Question 8

When considering fixed operating cost increases, a financial manager must weigh the increased financial risk associated with greater operating leverage against the expected increase in returns.

Accepted Answer

The answer of When considering fixed operating cost increases, a...

Question 9

Pecking order is a hierarchy of financing beginning with retained earnings, followed by debt financing, and finally external equity financing.

Accepted Answer

The definition of pecking order states that retained earnings are the preferred choice, followed by debt financing, and then external equity financing.

Question 10

The pecking order explanation of capital structure states that a hierarchy of financing exists for firms, in which retained earnings are employed first, followed by debt financing and finally by external equity financing.

Accepted Answer

The pecking order theory of capital structure suggests that companies prioritize using their own retained earnings for funding, followed by debt financing and finally resorting to external equity financing as a last resort. This theory is based on the idea that firms prefer to maintain control and avoid the transaction costs associated with external financing.

Question 11

Holding all other factors constant, a firm that is subject to a greater level of business risk should employ more total leverage than an otherwise equivalent firm that is subject to a lesser level of business risk.

Accepted Answer

A firm with a greater level of business risk should generally employ less total leverage to avoid exacerbating its risk exposure, as leverage amplifies the effects of fluctuations in operating income on net income.

Question 12

The pecking order explanation of capital structure states that a hierarchy of financing exists for firms, in which new external debt financing is employed first, followed by retained earnings and finally by external equity financing.

Accepted Answer

The pecking order theory actually suggests that companies prioritize their sources of financing (from internal financing to equity) according to the principle of least effort, or least resistance, preferring to raise equity as a last resort. Hence, firms prefer to use internal funds first (retained earnings), then debt, and issue new equity only as a last resort.

Question 13

The asymmetric information explanation of capital structure suggests that firms will issue new equity only when the managers believe the firm's stock is overvalued; as a result, issuing new equity is considered a negative signal that will result in a decline in share price.

Accepted Answer

The asymmetric information explanation of capital structure suggests that managers will try to avoid issuing new equity when they believe the stock is undervalued as the issuance of new equity may convey negative information to the market and lead to a decline in share price. Therefore, the statement is true.

Question 14

In general, a firm's theoretical optimal capital structure is that which balances the tax benefits of debt financing against the increase probability of bankruptcy that result from its use.

Accepted Answer

This statement is true. A firm's optimal capital structure involves finding the right balance between the benefits of debt financing, such as tax deductibility of interest payments, and the costs of debt, such as increased probability of bankruptcy. This balance is important for maximizing the value of the firm and its ability to generate profits for shareholders.

Question 15

A shift toward more fixed costs increases business risk, which in turn causes earnings before interest and taxes to increase by less for a given increase in sales.

Accepted Answer

The answer of A shift toward more fixed costs increases...

Question 16

The more fixed cost financing a firm has in its capital structure, the greater is its financial leverage and risk.

Accepted Answer

Financial leverage refers to the degree to which a company uses fixed costs in its capital structure, such as debt or preferred shares. As the amount of fixed cost financing increases in a company's capital structure, its financial leverage also increases, which can amplify both gains and losses. This increased financial leverage also increases the company's risk. Therefore, the statement is true.

Question 17

In general, a firm's theoretical optimal capital structure is that which balances the tax benefits of equity financing against the increase probability of bankruptcy that results from its use.

Accepted Answer

The theoretical optimal capital structure balances the tax benefits of debt financing against the increased probability of bankruptcy that results from its use, not equity financing.

Question 18

In general, non-U.S. companies have much higher debt ratios than their U.S. counterparts because financial markets are much more developed in the United States than elsewhere.

Accepted Answer

Financial markets in the United States are more developed than in other countries, which makes it easier for companies to raise debt financing. As a result, non-U.S. companies have to rely more on debt financing, which leads to higher debt ratios.

Question 19

The asymmetric information explanation of capital structure suggests that firms will issue new debt only when the managers believe the firm's stock is overvalued; as a result, issuing new debt is considered a negative signal that will result in a decline in share price.

Accepted Answer

The asymmetric information explanation of capital structure actually suggests that firms prefer to issue debt rather than equity when they believe their stock is undervalued, because issuing equity under such conditions would dilute the value for existing shareholders. The negative signal is associated with issuing new equity, not debt.

Question 20

In general, the greater a firm's operating leverage, the higher its business risk.

Accepted Answer

Operating leverage refers to the degree to which a firm uses fixed costs in its operations. A firm with high fixed costs and low variable costs will have a higher operating leverage. This means that a small change in sales volume can have a larger impact on the firm's profits. As a result, a firm with high operating leverage is more risky as it is more vulnerable to changes in sales volume, which can affect its profitability. Therefore, the higher a firm's operating leverage, the higher its business risk.

Quiz 13: Leverage and Capital Structure