Question 1

In some instances,additional debt financing can encourage managers to act more in the interests of owners.

Accepted Answer

Additional debt financing can increase the financial risk for the company, which may encourage managers to act more in the interests of owners. This is because if the company defaults on its debt obligations, it could lead to bankruptcy, which would negatively impact the shareholders. Therefore, managers may be motivated to make decisions that prioritize the interests of shareholders and ensure the company's long-term financial success. However, this can also lead to a focus on short-term profitability at the expense of long-term growth and sustainability.

Question 2

Debt financing results in lower after-tax earnings relative to equity financing.

Accepted Answer

Debt financing involves making interest payments, which are tax deductible. However, the principal repayments are not tax deductible, and the interest payments reduce the amount of profit available for distribution to shareholders, leading to lower after-tax earnings compared to equity financing.

Question 3

Which of the following factors favor the issuance of debt in the financing decision?
I.Market signaling
II.Distress costs
III.Tax benefits
IV.Financial flexibility

Accepted Answer

Market signaling refers to the use of financing decisions to send a signal to the market about the company's prospects. This may be favorable for issuing equity rather than debt. Distress costs make debt a less attractive option as debt payments must be made regardless of whether the company is profitable or not, and failure to pay these payments can lead to bankruptcy. Tax benefits are an advantage of debt financing as interest payments are tax-deductible. Financial flexibility is also a benefit of debt financing as it allows the company to retain ownership and control over the company. Therefore, only factors I and III favor the issuance of debt, making choice B the correct one.

Question 4

The M&M irrelevance proposition assures financial managers that their choice between equity or debt financing will ultimately have no impact on firm value.

Accepted Answer

The M&M irrelevance proposition only holds under certain assumptions, such as perfect capital markets, no taxes, and no bankruptcy costs. In reality, these conditions are not always met, and therefore the choice between equity and debt financing can affect firm value.

Question 5

Which of the following factors favor the issuance of debt in the financing decision?
I.Market signaling
II.Distress costs
III.Management incentives
IV.Financial flexibility

Accepted Answer

Market signaling and management incentives are factors that can favor the issuance of debt. Market signaling refers to the positive signal sent to the market about a company's prospects by issuing debt, suggesting confidence in future cash flows. Management incentives can align with debt issuance, as debt can discipline management to focus on efficiency and profitability to meet debt obligations. Distress costs and financial flexibility generally argue against the issuance of debt, as they represent the costs of financial distress and the potential loss of flexibility in financial decision-making, respectively.

Question 6

The term "financial distress costs" includes which of the following?
I.Direct bankruptcy costs
II.Indirect bankruptcy costs
III.Direct costs related to being financially distressed,but not bankrupt
IV.Indirect costs related to being financially distressed,but not bankrupt

Accepted Answer

Financial distress costs encompass both the direct and indirect costs associated with bankruptcy as well as the direct and indirect costs related to being financially distressed but not necessarily bankrupt. This includes legal and administrative fees (direct bankruptcy costs), the impact on business operations and relationships (indirect bankruptcy costs), and costs incurred to avoid bankruptcy (direct and indirect costs of financial distress).

Question 7

The basic lesson of the M&M theory is that the value of a firm is dependent upon:

Accepted Answer

The Modigliani-Miller theorem, or M&M theory, posits that in a perfect market (without taxes, bankruptcy costs, agency costs, and asymmetric information), the value of a firm is determined by its total cash flows and not by how those cash flows are financed. This means that the capital structure (the mix of debt and equity financing) does not affect the total value of the firm.

Question 8

Financial leverage:
i.increases expected ROE but does not affect its variability.II.increases breakeven sales,like operating leverage,but increases the rate of earnings per share growth once breakeven is achieved.III.is a fundamental financial variable affecting sustainable growth.IV.increases expected return and risk to owners.

Accepted Answer

Financial leverage increases the expected return on equity (ROE) and its variability, making both the return and risk to owners higher. It also increases breakeven sales and the rate of earnings per share growth once breakeven is achieved, similar to operating leverage. Additionally, it is a fundamental financial variable affecting a company's sustainable growth rate.

Question 9

Which of the following is NOT a likely financing policy for a rapidly growing business?

Accepted Answer

Borrowing funds rather than limiting growth, thereby limiting growth only as a last resort, is not a likely financing policy for a rapidly growing business. A rapidly growing business needs to finance its growth, and borrowing funds is a common way to do this. Limiting growth only as a last resort is not a sustainable strategy for a rapidly growing business.

Question 10

Which of the following is/are helpful for evaluating the effect of leverage on a company's risk and potential returns?
I.Estimated pro forma coverage ratios
II.The recognition that financing decisions do not affect firm or shareholder value
III.A range of earnings chart and proximity of expected EBIT to the breakeven value
IV.A conservative debt policy that obviates the need to evaluate risk

Accepted Answer

Estimated pro forma coverage ratios (I) can help evaluate how much debt a company can take on without sacrificing its ability to make interest payments. A range of earnings chart and proximity of expected EBIT to the breakeven value (III) can help evaluate potential risk and returns. The recognition that financing decisions do not affect firm or shareholder value (II) is incorrect as financing decisions can affect both. A conservative debt policy that obviates the need to evaluate risk (IV) is not helpful for evaluating the effect of leverage on a company's risk and potential returns.

Question 11

Salinas Corporation has net income of $15 million per year on net sales of $90 million per year.It currently has no long-term debt,but is considering a debt issue of $20 million.The interest rate on the debt would be 7%.Salinas Corp.currently faces an effective tax rate of 40%.What would be the annual interest tax shield to Salinas Corp.if it goes through with the debt issuance?

Accepted Answer

Interest tax shield = interest rate × amount of debt × tax rate = 0.07 × 20,000,000 × 0.40= $560,000

Question 12

Which of the following is NOT an implication of the pecking order theory of capital structure?

Accepted Answer

The pecking order theory suggests that firms prefer to finance new projects first with internal funds, then with debt, and finally with equity if internal funds and debt are insufficient. It does not imply that more profitable firms should have higher debt ratios; in fact, more profitable firms are likely to use less debt because they can fund more of their operations with internal funds.

Question 13

When a company is in financial distress,its shareholders may have an incentive to undertake excessively risky investments.

Accepted Answer

When a company is in financial distress, its shareholders may feel pressure to take risks in order to try and recover from losses or maintain their investment. This can lead to excessive or ill-advised investments, as shareholders prioritize short-term gain over long-term stability.

Question 14

According to the pecking order theory proposed by Stewart Myers of MIT,which of the following are correct?
i.For financing needs,firms prefer to first tap internal sources such as retained profits and excess cash.II.There is an inverse relationship between a firm's profit level and its debt level.III.Firms prefer to issue new equity rather than source external debt.IV.A firm's capital structure is dictated by its need for external financing.

Accepted Answer

The pecking order theory states that firms prefer to first tap internal sources such as retained profits and excess cash, then issue new equity, and finally resort to external debt. This is because internal sources are the cheapest, followed by equity, and then debt. The theory also states that there is an inverse relationship between a firm's profit level and its debt level, as firms with higher profits are less likely to need to borrow money.

Question 15

In general,the capital structures used by non-financial U.S.firms:

Accepted Answer

Non-financial U.S. firms have varying capital structures depending on their respective industries. Industrial firms, for example, tend to have higher debt-to-equity ratios compared to technology firms which tend to use more equity financing. Therefore, option D is the best answer. Options A, B, and C are incorrect because they present generalizations that do not apply to all non-financial U.S. firms.

Question 16

The evidence indicates that,on average,a company's stock price declines when it announces a new issue of equity.

Accepted Answer

This is a well-established phenomenon known as "share dilution" or "stock dilution." When a company issues new shares of stock, it can often lead to a decrease in the value of each individual share, as the total value of the company is now spread across more shares. This can be seen as a negative signal to investors, as it suggests that the company is in need of additional funds and may be struggling financially. Of course, there are exceptions to this trend, and many companies are able to issue new shares without significantly impacting their stock price, but as a general rule, the evidence supports the idea that new equity offerings tend to drive down stock prices in the short term.

Question 17

The best financing choice is the one that:

Accepted Answer

Maximizing expected cash flows is the best financing choice because it takes into account the time value of money and the risk associated with different financing options.

Question 18

If the maturity of a company's liabilities is less than that of its assets,the company incurs a refinancing risk.

Accepted Answer

If a company's liabilities mature before its assets, then it will need to refinance its debts in order to maintain its operations. This exposes the company to refinancing risk, which is the risk that it may not be able to obtain new financing on favorable terms or at all, leading to default or financial distress.

Question 19

Which of the following factors favor the issuance of equity in the financing decision?
I.Market signaling
II.Distress costs
III.Management incentives
IV.Financial flexibility

Accepted Answer

Distress costs and financial flexibility favor equity issuance as they help reduce the risk of financial distress and maintain flexibility in capital structure.

Question 20

Homemade leverage is:

Accepted Answer

Homemade leverage refers to the borrowing or lending of money by individual shareholders to adjust their level of financial leverage. This is different from traditional financial leverage, which involves a company using debt to finance its operations. Homemade leverage can be a way for individual shareholders to increase their exposure to a company's equity without actually buying more shares.

Quiz 6: The Financing Decision