Question 1

As the debt ratio rises,the WACC is reduced because the after-tax cost of debt is usually lower than the cost of equity.What limits the substitution of debt for equity in the capital structure is that as the debt ratio rises the costs of both components eventually increase.

Accepted Answer

The answer of As the debt ratio rises,the WACC is...

Question 2

The TIE ratio depends on the percentage of debt in the capital structure of the firm,the interest rate on the debt,and the profitability of the firm.

Accepted Answer

The interest coverage ratio (TIE) measures a firm's ability to meet interest payments on its debt. It is calculated by dividing earnings before interest and taxes (EBIT) by interest expenses. The TIE ratio is influenced by the percentage of debt in the capital structure, the interest rate on the debt, and the profitability of the firm. Therefore, the statement is true.

Question 3

An all equity firm has some risk inherent in its operations.When the firm decides to finance some of its operations with debt,it exposes itself to financial risk and it increases its business risk.

Accepted Answer

Financing with debt introduces financial risk due to the obligation to pay interest and principal on the debt, but it does not increase business risk, which is inherent to the firm's operations and market environment.

Question 4

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

Accepted Answer

The answer of One implication of information asymmetry between investors...

Question 5

Two firms,although they operate in different industries,have the same expected earnings per share and the same standard deviation of expected EPS.Thus,the two firms must have the same business risk.

Accepted Answer

While expected EPS and standard deviation of expected EPS are factors to consider when evaluating business risk, they alone do not provide a complete picture of a firm's risk. Other factors, such as the nature of the industry, financial leverage, and market conditions, can significantly impact a firm's risk level. Therefore, two firms with the same expected EPS and standard deviation of expected EPS can still have different levels of business risk.

Question 6

A consistent supply of capital is essential for the long-run success of a firm.Although a firm may have access to capital under all types of economic conditions,the concept of financial flexibility implies that the firm can obtain capital on acceptable,competitive terms.

Accepted Answer

Financial flexibility allows a firm to obtain capital on acceptable terms under different economic conditions, which is crucial for its long-term success.

Question 7

Although the exact relationship between a firm's degree of financial leverage and its beta is difficult to estimate,it has been shown both theoretically and empirically that a firm's beta increases with its degree of financial leverage.

Accepted Answer

This statement is true. The degree of financial leverage refers to the proportion of a company's financing that comes from debt. When a company has a higher proportion of debt, it has higher financial leverage, and this can increase the company's beta, which measures the volatility of its stock returns compared to the overall market. This relationship has been supported by both theoretical models and empirical studies.

Question 8

The fact that some managers are more aggressive in their use of debt financing in attempting to boost profits does not influence the optimal or value-maximizing capital structure.

Accepted Answer

The optimal capital structure is determined by factors such as taxes, bankruptcy costs, and agency costs, and is not influenced by the aggressiveness of a manager in using debt financing to boost profits. Therefore, the answer is True.

Question 9

The weighted average cost of capital (WACC)declines as more of the lowest cost component is added.What limits a firm from using nearly all debt is that as the debt ratio rises,the absolute interest expense gets very large.The large interest expense reduces income and results in a debt ratio limit even though the WACC continues to decline.

Accepted Answer

The answer of The weighted average cost of capital (WACC)declines...

Question 10

As the percentage of debt in a firm's capital structure increases,its financial risk increases.Once the firm increases its debt beyond the optimal level,rising interest charges result in an immediate decrease in EPS.

Accepted Answer

The answer of As the percentage of debt in a...

Question 11

Firms in industries that are cyclical,oriented toward research,or subject to huge liability suits normally will maintain high levels of debt in their capital structure.

Accepted Answer

The answer of Firms in industries that are cyclical,oriented toward...

Question 12

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 that seems to have financing alternatives suggests that the firm may be struggling to find financing through other means and may need to dilute existing shareholders' ownership in the company. Therefore, it may be a signal of financial insecurity rather than a sign of good prospects.

Question 13

The benefit to the firm of the tax deductibility of interest can be lowered if the firm's marginal tax rate is reduced by accumulated depreciation or tax-loss carry-forwards.

Accepted Answer

When a firm's marginal tax rate is reduced by accumulated depreciation or tax-loss carry-forwards, the benefit of tax deductibility of interest is also reduced. This is because the tax shield provided by interest payments decreases as the company's tax liabilities decrease. Therefore, option A is true.

Question 14

Firm A has a higher degree of business risk than Firm B.Firm A can offset this by using less financial leverage.Therefore,the variability of both firms' expected EBITs could actually be identical.

Accepted Answer

The answer of Firm A has a higher degree of...

Question 15

If Miller and Modigliani had considered the cost of bankruptcy,it is unlikely that they would have concluded that 100 percent debt financing is optimal for the firm.

Accepted Answer

If Miller and Modigliani had considered the cost of bankruptcy, they would have realized that there are significant costs associated with having too much debt, such as the risk of default and the potential for bankruptcy. Therefore, they would have been unlikely to conclude that 100 percent debt financing is optimal for the firm.

Question 16

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 degree of operating leverage (DOL) is a measure of how sensitive a company’s operating income is to a change in sales. It is calculated by dividing the percentage change in operating income by the percentage change in sales. Therefore, the statement is true.

Question 17

Generally,as debt is substituted for equity,risk,as measured by the coefficient of variation of EPS,increases.This negative effect works against the positive effect of substituting debt for equity,which is that higher leverage increases expected EPS.

Accepted Answer

This statement is true. Substituting debt for equity increases financial risk, which in turn increases the variability of earnings per share (EPS). While higher leverage may increase expected EPS, it also amplifies the negative impact on EPS in times of financial distress.

Question 18

If we include the cost of bankruptcy in the MM analysis of capital structure in a world with taxes,we would tend to believe that the cost of debt increases as leverage increases and that there is probably an optimal capital structure.

Accepted Answer

Including the cost of bankruptcy in the MM analysis recognizes that there is a cost associated with the risk of default on debt. As leverage increases, the likelihood of bankruptcy increases, and therefore the cost of debt also increases. This can lead to an optimal capital structure where the benefits of debt (tax shields, lower cost of capital) are balanced against the cost of bankruptcy.

Question 19

If we consider only agency costs associated with the issuance of debt,then this implies that the firm should move toward 100 percent debt financing.

Accepted Answer

While reducing agency costs associated with debt issuance is important, it is not the only consideration in determining an optimal capital structure. Factors such as the cost of debt, tax implications, and potential bankruptcy risks also need to be taken into account. Therefore, it cannot be assumed that 100 percent debt financing is always the best choice for a firm.

Question 20

Risk can be apportioned between 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 between financial and...

Quiz 12: Capital Structure