Question 1

Fixed cost sources of financing include both debt and common stock.

Accepted Answer

Fixed cost sources of financing typically refer to debt financing, which involves payments of fixed interest rates, and preferred stock financing, which involves fixed dividend payments. Common stock, on the other hand, does not involve fixed costs as dividends paid out to shareholders are not fixed and may vary based on the company's performance.

Question 2

The many factors influencing business risk can be placed in one of two categories. What are these two categories?
A)factors affecting sales revenue and those affecting assets
B)factors affecting assets and those effecting costs
C)factors affecting operating costs and those affecting financial costs
D)factors affecting sales revenue and those affecting costs

Accepted Answer

The two categories are factors affecting sales revenue and those affecting costs. These are the two main factors that can affect a business's risk. Factors affecting sales revenue can include market competition, changing consumer preferences, and economic trends. Factors affecting costs can include rising operational costs, supply chain disruptions, and fluctuations in raw material prices. Both categories of factors can have a significant impact on a business's profitability and overall risk.

Question 3

What is financial risk?
A)the risk arising from a firms over reliance on short-term sources of financing
B)the ordinary business risk arising from a firm's basic operations
C)the risk arising from a firm's use of variable cost sources of financing
D)the risk arising from a firm's use of fixed cost sources of financing

Accepted Answer

Financial risk refers to the risk associated with a firm's use of fixed cost sources of financing, such as debt, which can lead to financial distress if the firm is unable to meet its financial obligations.

Question 4

Financial risk is the risk arising from the use of fixed cost sources of financing.

Accepted Answer

Financial risk is the risk that a company may not be able to meet its financial obligations due to its use of fixed cost sources of financing, such as debt. Higher levels of debt increase the financial risk of a company, as it becomes more vulnerable to changes in interest rates or economic conditions that could impact its ability to meet its debt payments. Therefore, financial risk is directly related to the use of fixed cost sources of financing.

Question 5

What is a firm doing if it is using financial leverage?
A)Marketable securities is part of its assets structure.
B)It is using common stock as part of its capital structure.
C)It is using debt or preferred stock as part of its capital structure.
D)Accounts receivable is part of its asset structure.

Accepted Answer

If a firm is using financial leverage, it is using debt or preferred stock as part of its capital structure. Financial leverage refers to the use of borrowed funds to finance a company's operations or investments with the aim of increasing returns for shareholders. This borrowing can be in the form of debt or preferred stock, which are both forms of financial leverage. Therefore, choice C is the best answer.

Question 6

What is a firm's capital structure?
A)a firm's proportion of short-term financing provided by accounts payable, notes payable and other short-term sources
B)a firm's composition of current assets broken up into cash, accounts receivable, and inventory
C)a firm's proportion of long-term financing provided by debt, preferred stock, and common equity
D)a firm's composition of debt broken up into short-term debt and long-term debt

Accepted Answer

A firm's capital structure refers to the mix of long-term financing sources, such as debt, preferred stock, and common equity. Choices A, B, and D address aspects of a firm's financing or asset composition, but not the specific proportion of long-term financing sources that make up a firm's capital structure.

Question 7

Which of the following is most likely to cause a firm to use more financial leverage?
A)the current owners concern for maintaining control of a healthy firm
B)concern for the firm's Moodys and S & P bond ratings
C)concern for maintaining excess borrowing capacity
D)management's concern for their own risk

Accepted Answer

The use of more financial leverage means a firm is using more debt relative to equity. When current owners are concerned about maintaining control of a healthy firm, they may prefer to use debt financing rather than issuing new equity, which could dilute their ownership percentage. The other options typically lead to a preference for less financial leverage due to concerns about credit ratings, maintaining borrowing capacity, or personal risk aversion from management.

Question 8

Which of the following is most likely to cause a firm to use less financial leverage?
A)currently low profits, but a large need for new funds
B)concern for the firm's Moodys and S & P bond ratings
C)low business risk
D)avoidance of a corporate takeover

Accepted Answer

Concern for the firm's Moody's and S&P bond ratings is most likely to cause a firm to use less financial leverage. High leverage can negatively impact a firm's credit rating, making it more expensive to borrow in the future.

Question 9

How does financial leverage affect firm risk?
A)Financial leverage increases the volatility of a firm's sales revenue.
B)Financial leverage increases the volatility of a firm's return on equity.
C)Financial leverage increases the volatility of a firm's EBIT.
D)Financial leverage increases the volatility of a firm's operating costs.

Accepted Answer

Financial leverage refers to the use of debt to finance a company's operations. By using debt, the company can increase its return on equity (ROE) by earning a higher rate of return on the money it borrowed than the interest rate it is paying. However, this also increases the company's risk because if the company is not able to generate enough cash flow to service its debt, it may default on its obligations. This increases the volatility of the company's ROE, making it riskier for investors.

Question 10

As a firm increases its use of debt financing, what is the impact upon the cost of equity?
A)The cost of equity decreases.
B)The cost of equity remains the same.
C)The cost of equity increases.
D)None of the above.

Accepted Answer

As a firm increases its use of debt financing, the risk for equity holders also increases. This is because debt holders have a legal claim on the company's assets and cash flows, which reduces the amount of money available for equity holders. As the risk to equity holders increases, they will demand a higher return on their investment, leading to an increase in the cost of equity. Therefore, the correct answer is option C - the cost of equity increases.

Question 11

The desire to maintain excess borrowing capacity will tend to increase the use of debt financing in a firm's capital structure.

Accepted Answer

The desire to maintain excess borrowing capacity actually leads to a decrease in the use of debt financing in a firm's capital structure, as firms want to ensure they have the ability to borrow in the future when needed.

Question 12

Increasing financial leverage decreases the volatility of owners' returns.

Accepted Answer

Increasing financial leverage actually increases the volatility of owners' returns. This is because leverage magnifies gains and losses, so when a company's profits increase, the return to equity holders is amplified by the leverage. However, when a company's profits decrease, the losses are amplified, which can result in larger losses to equity holders.

Question 13

Which of the following is true at a firm's optimal capital structure?
A)The firm's cost of capital is minimized.
B)The firm is financed 100% with equity.
C)The firm's cost of equity is minimized.
D)The firm's cost of debt is minimized.

Accepted Answer

The optimal capital structure is achieved when the firm's cost of capital is minimized, which considers both the cost of debt and equity financing. Choosing 100% equity financing (B) may result in a high cost of equity and potentially decreased profitability, while minimizing only the cost of debt (D) would not necessarily result in the overall lowest cost of capital. Minimizing only the cost of equity (C) would not take into account the cost of debt financing.

Question 14

An optimal capital structure minimizes a firm's cost of capital.

Accepted Answer

An optimal capital structure is a mix of debt and equity that minimizes a firm's cost of capital. This means that the firm should try to find the ideal balance between debt and equity financing that will result in the lowest possible cost of capital for the company. By finding this optimal mix, the firm can maximize its value for shareholders and be better positioned to achieve its long-term goals.

Question 15

How does high business risk affect firm risk?
A)Higher business risk increases the volatility of capital structure.
B)Higher business risk increases the volatility of EBIT.
C)Higher business risk increases the volatility of financial costs.
D)Higher business risk increases the volatility of the firm's asset structure.

Accepted Answer

Higher business risk increases the volatility of EBIT (earnings before interest and taxes) which in turn affects the overall firm risk. This is because high business risk leads to a greater possibility of not meeting financial obligations and a higher likelihood of financial distress, which can negatively impact shareholders and the firm's overall value. Other choices (A, C, and D) may also be affected by high business risk, but do not directly impact the overall firm risk as much as EBIT volatility.

Question 16

Bankruptcy costs are one type of financial distress cost.

Accepted Answer

Bankruptcy costs include legal fees, court costs, and fees associated with restructuring or liquidating assets. These costs are incurred when a firm is in financial distress and is unable to pay its debts. Therefore, bankruptcy costs are a type of financial distress cost.

Question 17

A firm's capital structure is its proportion of short-term assets composed of cash, accounts receivables, and inventory.

Accepted Answer

A firm's capital structure refers to the way it finances its operations through a combination of debt and equity, not the proportion of short-term assets. Short-term assets are part of a firm's current assets.

Question 18

A firm's use of more debt financing creates more risk to owners and thus increases the cost of equity.

Accepted Answer

When a firm uses debt financing, the owners of the firm take on more risk because they have to pay back the debt with interest, regardless of the firm's financial performance. This increased risk means that investors who provide equity financing will require a higher return to compensate for the added risk, resulting in an increased cost of equity.

Question 19

Financial risk is the basic risk inherent in the operations of a firm. It can be viewed as the volatility of a firm's EBIT.

Accepted Answer

Financial risk refers to the risk associated with the use of financial leverage by a firm, specifically the potential for increased variability in a firm’s earnings per share (EPS) and return on equity (ROE) due to the presence of fixed financial costs, such as interest on debt. The basic risk inherent in the operations of a firm, related to the volatility of its EBIT, is more accurately termed "business risk."

Question 20

The desire to maintain high bond ratings will tend to increase the use of debt financing in a firm's capital structure.

Accepted Answer

The desire to maintain high bond ratings typically leads to a more conservative approach to debt financing, as excessive debt can lead to a downgrade in bond ratings. Companies may limit their use of debt to ensure they keep a high rating, which indicates lower risk to investors.

Quiz 12: Capital Structure

Fixed cost sources of financing include both debt and common stock.

The many factors influencing business risk can be placed in one of two categories. What are these two categories?

What is financial risk?

Financial risk is the risk arising from the use of fixed cost sources of financing.

What is a firm doing if it is using financial leverage?

What is a firm's capital structure?

Which of the following is most likely to cause a firm to use more financial leverage?

Which of the following is most likely to cause a firm to use less financial leverage?

How does financial leverage affect firm risk?

As a firm increases its use of debt financing, what is the impact upon the cost of equity?