Question 1

The combination of debt and equity used to finance a firm is known as _____.
A) capital budgeting
B) the trade-off theory
C) syndication
D) securitization
E) the capital structure

Accepted Answer

The combination of debt and equity used to finance a firm is known as the capital structure.

Question 2

The degree of operating leverage is defined as the percentage change in operating earnings associated with a given percentage change in sales.

Accepted Answer

The definition of degree of operating leverage is correctly stated.

Question 3

The optimal capital structure is the capital structure that 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 achieve the right balance between debt and equity financing to maximize the company's value and ultimately the stock price. Achieving the right proportion of debt and equity financing this can minimize the cost of capital, but also maintain financial flexibility and avoid excessive risk.

Question 4

One implication of information asymmetry between investors and firm managers is that if the firm raises new capital by issuing debt rather than by selling stock, it will signal that the firm has very good prospects.

Accepted Answer

Issuing debt instead of equity can signal to investors that managers are confident in the firm's future cash flows, as they are willing to commit to fixed interest payments.

Question 5

From a tax standpoint, in countries where capital gains are taxed, investors should show a preference for stocks compared to investors in countries that do not have capital gains taxes.

Accepted Answer

Investors in countries without capital gains taxes may prefer stocks more, as they can realize gains without tax implications, unlike in countries where such gains are taxed.

Question 6

The announcement of a stock offering by a mature firm that seems to have financing alternatives is taken as a signal that the firm's prospects are very good.

Accepted Answer

The announcement of a stock offering by a mature firm indicates that the firm needs financing and may not have better alternatives. It does not necessarily signal that the firm's prospects are very good.

Question 7

Companies in Italy and Japan use less debt in their capital structures than companies in the United States or Canada.

Accepted Answer

The answer of Companies in Italy and Japan use less...

Question 8

One implication of the signaling theory of capital structure is that firms should borrow as much as the trade-off theory of capital structure predicts.

Accepted Answer

The signaling theory suggests that firms should use their financing choices, such as debt or equity issuance, to signal information to investors about their future prospects. This theory suggests that firms may choose to issue less debt than predicted by the trade-off theory in order to signal their financial strength and ability to handle risk. Therefore, the correct answer is B, false.

Question 9

Which of the following leads to less business risks compared to other factors?
A) High percentage of fixed costs
B) High operating leverage
C) More financial risk
D) High interest rates
E) More stable operations

Accepted Answer

More stable operations lead to less business risks as it means less uncertainty and variability in the company's revenue and expenses. High fixed costs and high operating leverage increase business risks as they make the company vulnerable to changes in the market and demand. More financial risk and high interest rates also increase business risks as they increase the company's debt burden and cost of capital.

Question 10

Which of the following is an example of business risk?
A) Default risk
B) Prepayment risk
C) Strategic risk
D) Currency risk
E) Equity risk

Accepted Answer

Strategic risk refers to the risk associated with a company's strategy and potential for failure in executing it. This type of risk could be caused by changes in the market, technological advancements, or competition, among other factors.

Question 11

Which of the following types of businesses can take on more debt than other types of businesses?
A) Single-product firms
B) Non-cyclical firms
C) Seasonal-product firms
D) Small firms
E) Cyclical firms

Accepted Answer

Non-cyclical firms can take on more debt because their revenues are more stable and less affected by economic downturns, making them more reliable for lenders.

Question 12

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 is the risk of fluctuations in a firm's future earnings and is directly related to the use of equity financing rather than debt financing. Therefore, if a firm uses no debt, the uncertainty inherent in projections of future returns on equity would be classified as business risk.

Question 13

Risk can be apportioned as financial and business risk. Financial risk and business risk are related in that as business risk increases so does financial risk, although the correlation between the two is not perfect.

Accepted Answer

The answer of Risk can be apportioned as financial and...

Question 14

The lower the times-interest-earned ratio, the lower the probability that a firm will default on its debt.

Accepted Answer

The lower the times-interest-earned ratio, the higher the probability that a firm will default on its debt. This is because the ratio measures the amount of income a firm has available to cover its interest expense, and a lower ratio means there is less income available to cover the expense.

Question 15

_____ is the single most important determinant of the capital structure of a firm.
A) Financial leverage
B) Financial risk
C) Operating income
D) Business risk
E) Sales revenue

Accepted Answer

Business risk, or the risk associated with a company's operations, is the single most important determinant of its capital structure. This is because higher business risk typically leads to a lower debt-to-equity ratio, as lenders are less willing to provide financing to companies with riskier operations. On the other hand, companies with lower business risk may be able to take on more debt and maintain a higher debt-to-equity ratio.

Question 16

The probability of incurring bankruptcy increases as a firm's debt/equity ratio decreases.

Accepted Answer

The statement is incorrect. The probability of incurring bankruptcy increases as a firm's debt/equity ratio increases.

Question 17

The fact that interest is tax-deductible makes corporate debt less expensive than common stock or preferred stock.

Accepted Answer

Interest on corporate debt is tax-deductible, which means that the borrowing company can deduct the interest payments from their taxable income. This reduces the company's overall tax liability and makes the cost of debt financing cheaper than the cost of equity financing (such as common stock or preferred stock) which is not tax-deductible.

Question 18

In the United States, equity monitoring costs are comparatively lower than other countries.

Accepted Answer

Various studies and reports have shown that equity monitoring costs in the United States are relatively lower than in other countries, such as European nations, Japan, and Australia. This is due to factors such as a more developed financial market, lower transaction costs, and relatively lower legal fees. However, it's important to note that equity monitoring costs can vary depending on the type of investor, type of stock, and other variables.

Question 19

If the debt/assets ratio increases, the costs of both debt and equity decrease.

Accepted Answer

When the debt/assets ratio increases, it indicates that the company has taken on more debt relative to its assets. This makes the company riskier and less attractive to investors, causing the costs of both debt and equity to increase. Therefore, the statement is false.

Question 20

It is easy to determine how P/E ratios are affected by the degree of financial leverage (DFL).

Accepted Answer

The relationship between P/E ratios and financial leverage is complex, as leverage affects both earnings and risk, which in turn influence the P/E ratio.

Quiz 12: Capital Structure

The combination of debt and equity used to finance a firm is known as _____.