Question 1

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, such as finding the optimal mix of debt and equity financing, can reduce the overall cost of capital for a firm. This can lead to higher net present values (NPVs) for projects and make them more attractive to investors, ultimately increasing the overall value of the firm.

Question 2

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

Accepted Answer

Pecking order theory suggests that companies prefer to finance their investments first with retained earnings, second with debt, and finally with newly issued equity.

Question 3

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 4

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 5

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 one party in a transaction has more information than the other party. In the case of a firm, managers may have more information about the firm's operations and future prospects than investors do, leading to asymmetric information between the two parties.

Question 6

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 financial...

Question 7

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

Accepted Answer

The answer of Financial risk is the risk to a...

Question 8

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

The answer of In general,non-U.S.companies have much higher debt ratios...

Question 9

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 statement accurately describes the pecking order theory of capital structure, which suggests that firms prefer to finance projects with retained earnings first, then debt financing, and finally external equity financing, in order to maintain control and avoid information asymmetry.

Question 10

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 theory of capital structure suggests that firms will issue new equity only when they believe their stock is overvalued, because they have private information about the firm's future prospects. This can signal to investors that the firm's current value is not as high as previously thought, leading to a decline in share price. Therefore, issuing new equity is generally considered a negative signal under this theory.

Question 11

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

Accepted Answer

Operating leverage refers to the degree to which fixed costs are used in a firm's operations. A higher operating leverage means that a larger portion of the company's costs are fixed, so a small reduction in revenue can have a significant impact on profits. This results in higher business risk, as the company becomes more vulnerable to changes in the market or economy.

Question 12

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 suggests that firms will issue new equity only when the managers believe the firm's stock is overvalued, as this is an opportunity to sell stock at a high price. Issuing new debt is not considered a negative signal, but rather a way to take advantage of tax benefits and lower financing costs compared to equity financing.

Question 13

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 14

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 15

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 is a commonly accepted principle in finance theory known as the trade-off theory. The optimal capital structure is one that maximizes the value of the firm by balancing the benefits of debt financing (such as tax shields) with the costs (such as increased bankruptcy risk).

Question 16

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 17

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

While capital structure theory has advanced, it is still difficult to determine the exact optimal capital structure for a firm as it is highly dependent on various factors, including industry, market conditions, and the specific circumstances of the company.

Question 18

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 19

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

Accepted Answer

This statement is true as fixed cost financing, such as debt, increases the financial leverage of the company, which magnifies the impact of changes in operating income on net income. This increased leverage also increases the risk of bankruptcy, as fixed interest payments must still be made even if the company experiences a decline in revenue or profits.

Question 20

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

While there are many theories and factors to consider when determining a firm's optimal capital structure, there is no one-size-fits-all solution or methodology that financial managers can use. The decision ultimately depends on the unique characteristics of each individual firm.

Quiz 12: Leverage and Capital Structure