Question 1

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 2

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

Accepted Answer

Fixed cost financing, such as debt, increases a firm's financial leverage by magnifying the effects of changes in earnings on the return to shareholders. This can result in higher risk as well, since companies with higher financial leverage are more vulnerable to economic downturns and changes in interest rates.

Question 3

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 implies that issuing new equity is seen as a negative signal by investors and could potentially result in a decline in share price.

Question 4

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 5

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 6

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 7

Financial risk refers to fluctuations in a firm's cash flows that occur because the firm uses financing sources like debt and preferred stock.

Accepted Answer

Financial risk arises due to the use of financing sources which include debt and preferred stock, and it refers to the possibility of fluctuations in a firm's cash flows.

Question 8

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 in capital structure theory, it is still difficult to pinpoint a firm's optimal capital structure with great accuracy. This is because optimal capital structure depends on various factors such as industry, market conditions, and company-specific factors.

Question 9

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 a result, issuing new equity is considered a negative signal that will result in a decline in share price. Issuing new debt, on the other hand, may be a positive signal as it suggests that the firm is able to generate enough cash flows to service the debt.

Question 10

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, which can result in one party having an unfair advantage. In the context of a firm, managers may have more information about the firm's operations and future prospects than investors, leading to an asymmetry of information.

Question 11

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 conducted in recent years, there is still no specified methodology available for financial managers to determine a firm's optimal capital structure.

Question 12

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

Accepted Answer

Operating leverage measures the extent to which a company uses fixed costs in its operations. A high operating leverage means that a company has high fixed costs relative to variable costs. This implies that a small change in sales can result in a large change in profits. Therefore, if sales decline, the impact on profits will be significant, leading to higher business risk.

Question 13

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 14

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 a mix of debt and equity financing, can help to lower the cost of capital, which can lead to higher NPVs and more acceptable projects. This can ultimately increase the overall value of a firm.

Question 15

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 16

Business risk is the risk that is reflected in fluctuations of the firm's cash flows before considering any debt financing.

Accepted Answer

Business risk refers to the risk that arises due to factors such as competition, changes in demand and supply, technological advancements, and other economic factors. It impacts the firm's cash flows before any debt financing is considered. Therefore, the statement is true.

Question 17

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

The statement is true. A firm's optimal capital structure should aim to maximize the tax benefits of debt financing while minimizing the risk of bankruptcy that comes with taking on too much debt. Finding the right balance between these factors can lead to a theoretically optimal capital structure.

Question 18

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 states that firms prefer to use internal financing (retained earnings), followed by debt financing, and external equity financing is used as a last resort.

Question 19

The pecking order theory describes a hierarchy of financing beginning with retained earnings,followed by debt financing,and finally external equity financing.

Accepted Answer

The statement accurately describes the pecking order theory, which suggests that companies prefer to finance their operations with retained earnings first, then with debt financing if needed, and finally with external equity financing if all other options are exhausted.

Question 20

When considering the decision to shift a firm's cost structure away from variable costs toward more fixed costs,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 the decision to shift a...

Quiz 12: Leverage and Capital Structure