Question 1

A company with a low level of liabilities in relation to shareholders' equity is likely to have a very high debt-to-equity ratio.

Accepted Answer

A low level of liabilities in relation to shareholders' equity would result in a low debt-to-equity ratio, as there is less debt relative to equity.

Question 2

The debt-to-equity ratio enables financial statement users to assess the risk of a company's financing structure.

Accepted Answer

The debt-to-equity ratio is a measure of a company's financial leverage and is used to evaluate the risk of a company's financing structure. It compares a company's total liabilities to its shareholder equity and provides insight into the amount of debt that a company is using to finance its operations. A higher debt-to-equity ratio indicates that a company has a higher level of debt relative to equity, which can increase financial risk.

Question 3

A company's debt-to-equity ratio was 1.0 at the end of Year 1. By the end of Year 2, it had increased to 1.7. Since the ratio increased from Year 1 to Year 2, the degree of risk in the firm's financing structure decreased during Year 2.

Accepted Answer

The statement is false. An increase in the debt-to-equity ratio represents an increase in the firm's reliance on debt financing and, therefore, an increase in the degree of risk in its financing structure.

Question 4

A bond is a written promise to pay an amount identified as the par value of the bond along with interest.

Accepted Answer

A bond is indeed a written promise to pay a specified par value along with interest.

Question 5

Bond interest paid by a corporation is an expense, whereas dividends paid are not an expense of the corporation.

Accepted Answer

Bond interest paid is considered an expense because it reduces the corporation's taxable income, while dividends paid are not deductible and do not reduce the corporation's taxable income.

Question 6

The use of debt financing insures an increase in return on equity.

Accepted Answer

Debt financing can increase return on equity if the firm earns more on the borrowed funds than it pays in interest. However, it also increases financial risk, and if the cost of debt exceeds the returns generated by its use, it can decrease return on equity.

Question 7

The debt-to-equity ratio is calculated by dividing total shareholders' equity by total liabilities.

Accepted Answer

The debt-to-equity ratio is calculated by dividing total liabilities by total shareholders' equity.

Question 8

The present value of an annuity factor for 6 years at 10% is 4.3553. This implies that an annuity of six $2,000 payments at 10% would equal $8,710.60.

Accepted Answer

The present value of an annuity factor is used to calculate the present value of a series of future cash flows. In this case, the present value of an annuity factor for 6 years at 10% is 4.3553, which means that the present value of six $2,000 payments at 10% is $8,710.60. Therefore, the statement is true.

Question 9

Return on equity increases when the expected rate of return from the acquired assets is higher than the interest rate on the debt issued to finance the acquired assets.

Accepted Answer

This statement is true. Return on equity (ROE) is a measure of a company's profitability in relation to the amount of equity invested by shareholders. When a company uses debt to finance an acquisition, the interest rate on the debt is a cost that is subtracted from the company's earnings. If the return on the acquired assets is higher than the interest rate on the debt, then the company's overall earnings increase, which in turn increases ROE.

Question 10

A company has assets of $350,000 and total liabilities of $200,000. Its debt-to-equity ratio is 0.6.
If total assets and total liabilities are $350,000 and $200,000, respectively, shareholders' equity must be $150,000. Thus, the debt-to-equity ratio is $200,000/$150,000 or 1.3.

Accepted Answer

The statement is incorrect. The debt-to-equity ratio would be $200,000/$150,000, which is 1.33, not 0.6.

Question 11

A company's ability to issue unsecured debt depends on its credit standing.

Accepted Answer

A company's credit standing determines how creditworthy it is perceived by investors and lenders. If a company has a strong credit rating, it is seen as less risky, making it easier and cheaper to issue unsecured debt. On the other hand, if a company has a poor credit rating, it may be required to provide collateral or pay higher interest rates to compensate for the increased risk.

Question 12

An advantage of bond financing is that issuing bonds does not affect owner control.

Accepted Answer

Bond financing is a form of debt financing in which a company issues bonds to investors who then become creditors to the company. Unlike equity financing, the company does not give up any ownership control to the bondholders. The bondholders have no voice in the management and decision-making of the company.

Question 13

The contract rate on previously issued bonds changes as the market rate of interest changes.

Accepted Answer

The contract rate (also known as the coupon rate) on previously issued bonds remains fixed and does not change with fluctuations in the market rate of interest.

Question 14

Long-term bonds have relatively higher interest rates because they carry higher risk due to the longer time period.

Accepted Answer

Long-term bonds are generally riskier than short-term bonds because the longer time period increases the likelihood of changes in interest rates, inflation, and other economic factors that can affect the bond's value. Therefore, in order to compensate investors for the higher risk, long-term bonds typically offer a relatively higher interest rate.

Question 15

When the contract rate on a bond issue is less than the market rate, the bonds will generally sell at a discount.

Accepted Answer

When the contract rate on a bond issue is less than the market rate, it means the bond's interest rate is lower than the current market interest rate. As a result, investors are not willing to pay the full face value or par value for the bond. Thus, the bonds will generally sell at a discount, which means the bond's price is lower than the face value.

Question 16

The present value of an annuity factor at 8% for 10 years is 6.7101. This implies that an annuity of ten $15,000 payments at 8% yields a present value of $2,235.

Accepted Answer

The present value of an annuity is calculated by multiplying the annuity payment by the present value annuity factor. For an annuity of $15,000 payments at 8% for 10 years, the present value would be $15,000 * 6.7101 = $100,651.50, not $2,235.

Question 17

When the contract rate is above the market rate, a bond sells at a discount.

Accepted Answer

When the contract rate is above the market rate, a bond sells at a premium, not at a discount. When the contract rate is below the market rate, a bond sells at a discount.

Question 18

Collateral from unsecured loans may be sold to offset the loan obligation if the loan is in default.

Accepted Answer

Unsecured loans do not require collateral, so there is no collateral to sell in case of default.

Question 19

Interest payments on bonds are determined by multiplying the par value of the bond by the stated contract rate.

Accepted Answer

The interest payments on bonds are determined by multiplying the par value of the bond by the stated contract rate, which is also known as the coupon rate. The interest payments are typically made semi-annually, based on this rate.

Question 20

A 10-year bond issue with a $100,000 par value, 8% annual contract rate, with interest payable semiannually means that the issuer must repay $100,000 at the end of 10 years and make 20 semiannual interest payments of $4,000 each.

Accepted Answer

A 10-year bond with a $100,000 par value and 8% annual contract rate means that the issuer will make 20 semiannual interest payments (10 years x 2 semiannual periods per year = 20) of $4,000 each ($100,000 x 8% / 2 = $4,000). The issuer will also repay the $100,000 par value at the end of the 10 years.

Quiz 14: Long-Term Liabilities