Question 1

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 2

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

Accepted Answer

Asymmetric information occurs when one party in a transaction has more information than the other party. In the context of a firm, managers typically have more information about the company's operations, financial health, and future prospects than investors do, resulting in asymmetric information.

Question 3

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

Accepted Answer

Fixed cost financing includes debt, which increases financial leverage and risk for a firm. This is because the firm must make fixed interest payments regardless of its earnings, which can put it in a vulnerable position during economic downturns or unexpected events. As a result, the more fixed cost financing a firm has, the greater its financial leverage and risk.

Question 4

The relative inexpensiveness of debt capital is due to the fact that the lenders take the least risk of any long-term contributors of capital.

Accepted Answer

This statement is true as debt capital providers have the lowest risk among long-term contributors of capital as they have a legal claim on the borrower's assets and are paid before equity investors in the event of liquidation. Therefore, lenders may accept lower returns on their investment as compensation for their lower risk.

Question 5

In general, low debt-payment ratios are associated with high degrees of financial leverage.

Accepted Answer

The answer of In general, low debt-payment ratios are associated...

Question 6

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

Accepted Answer

The statement correctly defines the concept of pecking order in finance. Retained earnings are usually the first choice for financing, followed by debt financing and finally, external equity financing.

Question 7

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 suggests that firms prefer to finance their investments by using internal funds, followed by debt, and finally by external equity.

Question 8

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 well-established principle of capital structure theory, often referred to as the "trade-off theory." It suggests that firms should use debt financing to take advantage of the tax-deductibility of interest payments, but should not over-leverage themselves to the point where the risk of bankruptcy becomes unacceptable.

Question 9

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 firms will issue new equity only when the managers believe the firm's stock is overvalued, which means they have insider information of the stock being overvalued. This is considered a negative signal by the market, as it implies that the managers do not believe the stock is worth its current price. As a result, the share price typically declines after the new equity issuance.

Question 10

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

Accepted Answer

The answer of In general, a firm's theoretical optimal capital...

Question 11

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

Accepted Answer

Effective capital structure decisions can optimize the balance between debt and equity financing, leading to a lower cost of capital, which in turn could result in higher NPVs of projects and increase the overall value of the firm. Therefore, the statement is true.

Question 12

Due to its secondary position relative to equity, suppliers of debt capital face greater risk and therefore must be compensated with higher expected returns than suppliers of equity capital.

Accepted Answer

Suppliers of equity capital face greater risk than suppliers of debt capital because equity is in a subordinate position to debt in the event of liquidation. Therefore, equity investors require higher expected returns than debt investors to compensate for this higher risk.

Question 13

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 14

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 there has been extensive research in capital structure theory, determining a firm's optimal capital structure is still subject to many variables and uncertainties. Therefore, it is not possible to pinpoint with great accuracy a firm's optimal capital structure.

Question 15

Under certain circumstances, when the firm is in default debtholders and preferred stockholders may receive a voice in management; otherwise, only common stockholders have voting rights.

Accepted Answer

This is true. When a firm is in default, debtholders and preferred stockholders may have the right to vote and influence management decisions. In other situations, only common stockholders have voting rights.

Question 16

Poor capital structure decisions can result in a high cost of capital, thereby making some unacceptable investments acceptable.

Accepted Answer

Poor capital structure decisions can lead to a higher cost of capital, which can make even otherwise acceptable investments unattractive. This is because a high cost of capital can increase the financial risk associated with a project and reduce its potential returns, making it less desirable to investors. Therefore, companies should strive to maintain an optimal capital structure that balances debt and equity to minimize the cost of capital and maximize shareholder value.

Question 17

In general, non-U.S. companies have much higher debt ratios than do their U.S. counterparts because financial markets are much more developed in the United States than elsewhere and have played a much greater role in corporate financing than has been the case in other countries.

Accepted Answer

This statement is generally true as financial markets and their role in corporate financing vary across countries. The United States has a more developed financial market and has traditionally relied more heavily on borrowing to finance corporate activity than some other countries with less developed financial systems.

Question 18

When considering fixed operating cost increases, the 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, the...

Question 19

Debt capital less risky than equity capital because the firm is legally obligated to pay interest to bondholders but they are not legally obligated to pay dividends to preferred or common stockholders.

Accepted Answer

This statement is true. When a company issues debt capital (bonds), they have a legal obligation to pay interest to bondholders. However, they do not have the same legal obligation to pay dividends to preferred or common stockholders, who provide equity capital. As a result, debt capital is generally considered less risky than equity capital because bondholders have a higher priority in receiving payment in the event of bankruptcy or liquidation of the company.

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

Despite the extensive research, there is no specific methodology available for determining a firm's optimal capital structure.

Quiz 13: Leverage and Capital Structure