Question 1

Effective capital structure decisions can lower the cost of capital, resulting in higher NPVs and more acceptable projects, thereby increasing the value of the firm.

Accepted Answer

Effective capital structure decisions can lead to a reduction in the cost of capital, which can increase the net present value (NPV) of potential projects and make them more attractive for the company to pursue. This can ultimately enhance the value of the firm.

Question 2

In general, a firm's theoretical optimal capital structure is that which balances the tax benefits of debt financing against the increase probability of bankruptcy that result from its use.

Accepted Answer

This statement is generally true. A firm's optimal capital structure is a balance between the tax benefits of debt financing, such as deductibility of interest expense from taxes, and the potential increase in bankruptcy risk associated with taking on too much debt. This balance varies depending on the specific circumstances and goals of the firm.

Question 3

The pecking order explanation of capital structure states that a hierarchy of financing exists for firms in which new external debt financing is employed first, followed by retained earnings and finally by external equity financing.

Accepted Answer

The pecking order theory actually suggests that companies prioritize their sources of financing (from internal financing to equity) according to the principle of least effort, or least resistance, preferring to raise equity as a last resort. Hence, firms prefer to use internal funds first (retained earnings), then debt, and issue new equity only as a last resort.

Question 4

Under certain circumstances, when the firm is in default debtholders and preferred stockholders may receive a voice in management; otherwise, only common stockholders have voting rights.

Accepted Answer

When a firm is in default, debtholders and preferred stockholders may receive a voice in management, even though they typically do not have voting rights.

Question 5

The relative inexpensiveness of debt capital is due to the fact that the lenders take the least risk of any long-term contributors of capital.

Accepted Answer

Lenders who provide debt capital have the lowest risk compared to equity holders and other long-term contributors of capital, as they have a legal claim to receive their principal and interest payments before any other claims can be made on the company's assets. This lower risk profile allows lenders to charge lower interest rates than equity investors expect to receive in return for their higher risk.

Question 6

Because of the extensive research conducted in recent years in the area of capital structure theory, it is now possible for financial managers to pinpoint with great accuracy a firm's optimal capital structure.

Accepted Answer

While extensive research has been conducted in the area of capital structure theory, there is no single universally accepted optimal capital structure that applies to all firms. The optimal capital structure for a given firm will depend on factors such as the nature of the business, the industry in which it operates, and the current economic and market conditions. Therefore, while financial managers can use capital structure theory to inform their decisions, they cannot pinpoint with great accuracy a firm's optimal capital structure.

Question 7

A shift toward more fixed costs increases business risk, which in turn causes earnings before interest and taxes to increase by less for a given increase in sales.

Accepted Answer

The answer of A shift toward more fixed costs increases...

Question 8

In general, non-U.S. companies have much higher debt ratios than do their U.S. counterparts because financial markets are much more developed in the United States than elsewhere and have played a much greater role in corporate financing than has been the case in other countries.

Accepted Answer

This statement is generally true as financial markets in the U.S. are more developed and have played a larger role in corporate financing compared to other countries, leading to lower reliance on debt for financing.

Question 9

Debt capital less risky than equity capital because the firm is legally obligated to pay interest to bondholders but they are not legally obligated to pay dividends to preferred or common stockholders.

Accepted Answer

Debt capital provides a lower risk to investors compared to equity capital because the firm has a legal obligation to pay interest to bondholders, but they are not legally obligated to pay dividends to preferred or common stockholders. In the case of default, bondholders generally have a higher claim on the assets of a company compared to equity investors.

Question 10

Poor capital structure decisions can result in a high cost of capital, thereby making some unacceptable investments acceptable.

Accepted Answer

Poor capital structure decisions can lead to a higher cost of capital, which can make even otherwise acceptable investments unattractive. This is because a high cost of capital can increase the financial risk associated with a project and reduce its potential returns, making it less desirable to investors. Therefore, companies should strive to maintain an optimal capital structure that balances debt and equity to minimize the cost of capital and maximize shareholder value.

Question 11

The pecking order explanation of capital structure states that a hierarchy of financing exists for firms in which retained earnings are employed first, followed by debt financing and finally by external equity financing.

Accepted Answer

The pecking order theory proposes that firms prioritize funding sources in a specific order, with retained earnings being the preferred choice, followed by debt and then external equity. This theory suggests that firms prefer internal financing over external financing to avoid the higher costs and information asymmetry associated with external financing.

Question 12

Due to its secondary position relative to equity, suppliers of debt capital face greater risk and therefore must be compensated with higher expected returns than suppliers of equity capital.

Accepted Answer

Suppliers of equity capital face greater risk than suppliers of debt capital because equity is in a subordinate position to debt in the event of liquidation. Therefore, equity investors require higher expected returns than debt investors to compensate for this higher risk.

Question 13

In general, low debt-payment ratios are associated with high degrees of financial leverage.

Accepted Answer

The answer of In general, low debt-payment ratios are associated...

Question 14

The asymmetric information explanation of capital structure suggests that firms will issue new equity only when the managers believe the firm's stock is overvalued; as a result, issuing new equity is considered a negative signal that will result in a decline in share price.

Accepted Answer

According to the asymmetric information explanation of capital structure, the issuance of new equity is considered a negative signal that suggests the firm's managers believe the stock is overvalued. This can result in a decline in share price due to the perception that the firm is not doing well. Therefore, the statement is true.

Question 15

When considering fixed operating cost increases, the financial manager must weigh the increased financial risk associated with greater operating leverage against the expected increase in returns.

Accepted Answer

The answer of When considering fixed operating cost increases, the...

Question 16

The more fixed cost financing a firm has in its capital structure, the greater its financial leverage and risk.

Accepted Answer

Fixed costs are expenses that do not vary with changes in the level of production or sales. Financing these fixed costs with debt increases a firm's financial leverage, or reliance on debt to finance operations. This in turn increases the firm's risk, as it must pay interest on the debt regardless of its profitability, and may be forced to default if it cannot meet its debt obligations. Therefore, the more fixed cost financing a firm has in its capital structure, the greater its financial leverage and risk.

Question 17

Pecking order is a hierarchy of financing beginning with retained earnings followed by debt financing and finally external equity financing.

Accepted Answer

This is the correct definition of pecking order in finance.

Question 18

In general, a firm's theoretical optimal capital structure is that which balances the tax disadvantage of debt financing against the increase probability of bankruptcy that results from its use.

Accepted Answer

The answer of In general, a firm's theoretical optimal capital...

Question 19

Despite the extensive research conducted in recent years in the area of capital structure theory, it is not yet possible to provide financial managers with a specified methodology for use in determining a firm's optimal capital structure.

Accepted Answer

Despite the research conducted, there is no one-size-fits-all method for determining a firm's optimal capital structure.

Question 20

Asymmetric information results when managers of a firm have more information about operations and future prospects than do investors.

Accepted Answer

Asymmetric information refers to situations in which one party has more information than the other party. In this case, the managers of a firm are assumed to have more information about the firm's operations and future prospects than do investors.

Quiz 12: Leverage and Capital Structure