Question 1

If a firm utilizes debt financing, a decrease in earnings before interest and taxes (EBIT) will result in a more than proportionate decrease in earnings per share.

Accepted Answer

When a firm utilizes debt financing, it incurs fixed interest expense that must be paid regardless of the level of earnings. Thus, a decrease in EBIT will result in a decrease in net income available to common shareholders. As the number of shares outstanding remains constant, the decrease in net income will result in a more than proportionate decrease in earnings per share. This is because the interest expense reduces the amount of income available to common shareholders, which magnifies the impact of the decrease in EBIT on earnings per share.

Question 2

The optimal capital structure is that capital structure which strikes a balance between risk and return such that the firm's stock price is maximized.

Accepted Answer

The optimal capital structure is designed to find the optimal balance between risk and return in order to maximize the company's stock price.

Question 3

You are the president of a small, publicly-traded corporation.Since you believe that your firm's stock price is temporarily depressed, all additional capital funds required during the current year will be raised using debt.Thus, the appropriate marginal cost of capital for the current year is the after-tax cost of debt.

Accepted Answer

The answer of You are the president of a small,...

Question 4

The ability of a firm to raise sufficient capital on competitive terms under adverse conditions in order to sustain steady operations is referred to as financial flexibility.

Accepted Answer

Financial flexibility refers to a company's ability to maintain stable operations even during challenging market conditions, including its ability to access capital at competitive rates.

Question 5

The central result from the work of Miller and Modigliani (MM) and subsequent researchers, is that it is now possible to precisely identify a firm's optimal capital structure.

Accepted Answer

The central result from the work of Miller and Modigliani (MM) and subsequent researchers is that the capital structure is irrelevant to the value of the firm in a perfect market. Therefore, it is not possible to precisely identify a firm's optimal capital structure.

Question 6

Financial risk refers to the extra risk stockholders bear as a result of the use of debt as compared with the risk they would bear if no debt were used.

Accepted Answer

Financial risk is the risk that arises from the use of debt financing, which increases the potential return to stockholders but also increases the potential for financial losses. Therefore, stockholders bear extra risk when debt is used compared to if no debt was used.

Question 7

The optimal capital structure is that which results in the highest earnings per share because that will ensure maximum stock price.

Accepted Answer

The optimal capital structure is not solely dependent on earnings per share. It also takes into consideration factors such as cost of capital, financial flexibility, and risk. Maximizing earnings per share may not necessarily result in the highest stock price if it is achieved at the cost of increasing the company's financial risk.

Question 8

Asymmetric information involves a situation where the firm's managers have different (better) information about their firm's prospects than do investors.

Accepted Answer

Asymmetric information occurs when one party has more or better information than another party, causing potential problems for decision making and market efficiency. In this case, the firm's managers have access to private information about the firm's prospects that investors do not have, leading to a disparity in information between the two groups.

Question 9

If a firm uses no debt, the uncertainty inherent in projections of future returns on equity can be described as business risk.

Accepted Answer

Business risk refers to the uncertainty inherent in projections of future returns on equity when a firm uses no debt financing. This is because all the investment is funded by equity, and any fluctuations in the business will directly impact the owners' returns.

Question 10

As long as a firm is near its target capital structure it will not have to concern itself with financial flexibility.

Accepted Answer

This statement is incorrect. Even if a firm is at its target capital structure, unexpected events or opportunities may arise that require additional financing. Therefore, firms must always maintain financial flexibility to effectively respond to these situations.

Question 11

Financial leverage affects both EPS and EBIT, while operating leverage only affects EBIT.

Accepted Answer

The answer of Financial leverage affects both EPS and EBIT,...

Question 12

The mix of debt, preferred stock, and common equity with which the firm plans to support its asset structure is known as the target capital structure.

Accepted Answer

The statement is true. The target capital structure refers to the ideal mix of debt, preferred stock, and common equity that a company plans to use to finance its assets in order to maximize shareholder value.

Question 13

Business risk, which is the risk inherent in a firm's assets if it uses less than its optimal amount of debt, is one important influence in the capital structure decision.

Accepted Answer

Business risk refers to the risk associated with the firm's operations and is independent of the financing mix or the amount of debt used by the firm. It does not change with the level of debt.

Question 14

Because creditors can foresee, to at least some extent, the costs of bankruptcy, they charge an interest rate that has a premium built into it to compensate for the present value of bankruptcy costs.

Accepted Answer

Creditors do include a premium in the interest rate to cover the potential costs of bankruptcy.

Question 15

According to MM, in a world without taxes, the optimal capital structure for a firm should approach 100 percent debt financing.

Accepted Answer

According to Modigliani and Miller's proposition (with no taxes), the capital structure of a firm does not affect its total value or cost of capital. Therefore, there is no optimal capital structure that should approach 100 percent debt financing.

Question 16

Business risk will not affect a firm's beta, because beta is determined by the market and thus is outside the control of the firm.

Accepted Answer

Business risk can affect a firm's beta because beta measures the stock's volatility relative to the market, and business risk can impact the stock's expected returns and volatility. Factors such as changes in industry conditions, competition, and company-specific events can all increase or decrease a firm's business risk, which can consequently impact its beta.

Question 17

Other things held constant, an increase in financial leverage will increase a firm's market (or systematic) risk as measured by its beta coefficient.

Accepted Answer

Financial leverage refers to the use of debt to finance a firm's assets. By increasing the amount of debt in its capital structure, a firm increases its fixed interest payments, which can result in greater variability in its earnings and cash flows. This in turn can increase the uncertainty or riskiness of its future cash flows, which will be reflected in a higher beta coefficient. Beta measures a stock's sensitivity to changes in the overall market, and a higher beta means that the stock is more volatile or risky than the market as a whole.

Question 18

In a world with no taxes, MM show that the capital structure of a firm does not affect the value of the firm.However, when taxes are considered, MM show a positive relationship between debt and firm value.

Accepted Answer

MM stands for Modigliani and Miller, who formulated the theory of capital structure in a world with no taxes. According to their theory, in such a world, the capital structure of a firm does not affect its value. However, when taxes are considered, MM show a positive relationship between debt and firm value, as tax shields from deductibility of interest expense reduce the net cost of debt and increase the value of the firm.

Question 19

The degree of financial risk is the single most important determinant of a firm's capital structure.

Accepted Answer

While the degree of financial risk is an important factor, a firm's capital structure is determined by a variety of factors including market conditions, the firm's operational risk, tax considerations, flexibility needs, and the cost of financing options, among others.

Question 20

The level of sales at which expected EPS will be the same regardless of whether the firm uses debt or common stock financing is called the EPS indifference point.

Accepted Answer

This statement is true. The EPS indifference point is the level of sales at which the expected EPS of the firm is the same regardless of whether the firm uses debt or common stock financing. This is because the use of debt financing increases the financial risk of the firm, which must be compensated with a higher expected return for the shareholders. As a result, the EPS of the firm will be higher at low levels of sales with debt financing, but the advantage will disappear as the level of sales increases.

Quiz 14: Capital Structure and Dividend Policy Decisions