9) Theoretically, the more the earnings, the more a firm should use debt for financing purposes.
10) In basic terms, a business must earn a return on capital that exceeds the cost of capital.
11) Using debt financing to replace equity financing always leads to greater EPS for the firm.
12) Pierce Corp. is looking at two possible capital structures. Currently, the firm is an all-equity
firm with $1.2 million dollars in assets and 200,000 shares outstanding. The market value of each
stock is $6.00. The CEO of Pierce is thinking of leveraging the firm by selling $600,000 of debt
financing. The cost of debt is 8% annually, and the current corporate tax rate for Pierce is 30%.
What is the break-even EBIT for Pierce with these two possible capital structures?
13) Garson Corp. is looking at two possible capital structures. Currently, the firm is an all-equity
firm with $1.2 million dollars in assets and 200,000 shares outstanding. The market value of each
share of stock is $6.00. The CEO of Garson is thinking of leveraging the firm by selling
$600,000 of debt financing and retiring 100,000 shares, leaving 100,000 outstanding. The cost of
debt is 10% annually, and the current corporate tax rate for Garson is 30%. If the CEO believes
that Garson will earn $100,000 per year before interest and taxes, should she leverage the firm?
Explain.
14) Landry Corp. is looking at two possible capital structures. Currently, the firm is an all-equity
firm with $1.2 million dollars in assets and 200,000 shares outstanding. The market value of each
stock is $6.00. The CEO of Landry is thinking of leveraging the firm by selling $600,000 of debt
financing and retiring 100,000 shares, leaving 100,000 outstanding. The cost of debt is 10%
annually, and the current corporate tax rate for Landry is 30%. If the CEO believes that Landry’s
EBIT will be $120,000, should the CEO leverage the firm? Explain.
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Copyright © 2019 Pearson Education, Inc.
16.4 Pecking Order
1) Moving from one source of funding to another in a particular order is called the ________.
A) Pecking Order Hypothesis
B) Barnyard Order Hypothesis
C) Funding Order Hypothesis
D) Capital Market Hypothesis
2) Information is asymmetric when one party in a transaction has a different set of ________
from the other party in the transaction.
A) asymmetries
B) information
C) hypotheses
D) earnings
3) ________ means that managers or owners of a company know more about the future
performance of the company than potential outside lenders.
A) Symmetric information
B) External financing
C) Asymmetric information
D) Two-sided information
4) With the background ideas of using the cheapest source first and the impact of asymmetric
information, the Pecking Order Hypothesis predicts which of the following?
A) Firms prefer internal financing second to external financing.
B) If external financing is required, firms should first seek equity financing.
C) If external financing is required, firms will choose to issue the riskiest security first, starting
with debt financing and using equity as a last resort.
D) If external financing is required, firms will choose to issue the safest or cheapest security first,
starting with debt financing and using equity as a last resort.
5) The Pecking Order Hypothesis predicts which of the following?
A) Firms prefer internal financing first.
B) If external financing is required, firms should first seek debt financing.
C) If external financing is required, firms will choose to issue the safest or cheapest security first,
starting with debt financing and using equity as a last resort.
D) All of these
6) Corporate financing problems are ________ personal financing ones.
A) really quite different from
B) extremely different from
C) really not all that different from
D) identical compared to
7) Which of the statements below is FALSE?
A) External lenders generally require the company to provide private information about the
company, its plans, current operations, and past performance.
B) Corporate financing problems are really not all that different from personal financing ones.
C) If information is proprietary and the company feels that it could be helpful to a competitor if it
was to become public knowledge through lending, then the company’s logical choice is to use
internal funds if they are sufficient for funding a new project.
D) None of the above statements is false.
8) Given a choice, firms will exhaust the cheapest source of external funding first before moving
on to the ________ source.
A) more economic
B) most cheap
C) most expensive
D) next cheapest
9) Which of the statements below is TRUE?
A) Debt capacity refers to the ability to add equity financing to the current borrowing of the firm
and still be able to make interest and principal repayments on time.
B) The asymmetric information foundation for the Pecking Order Hypothesis (POH) is that
managers know less about their companies than the outside world.
C) There are three implications of the POH. One of these is that profitable companies will
borrow less (because they have more internal funds available) and may have lower debt-equity
ratios because they have more debt capacity.
D) There are three implications of the POH. One of these is that more profitable companies will
need more external funding and will first seek debt financing in an asymmetric world, avoiding
the equity market.
10) According to the Pecking Order Hypothesis, less profitable companies in an asymmetric
world will need more ________; they will first seek ________ and will avoid ________.
A) external funding; equity funding; debt market
B) internal funding; the use of retained earnings; debt market
C) external funding; debt financing; equity market
D) internal funding; the use of retained earnings; equity market
11) The Pecking Order Hypothesis suggests that less profitable companies will need more
external funding and will first seek debt financing in an asymmetric world, avoiding the equity
market.
12) The Pecking Order Hypothesis suggests that as a last resort, firms will sell equity to fund
investment opportunities.
13) The Pecking Order Hypothesis suggests that profitable companies will borrow less (because
they have more internal funds available) and may have higher debt-equity ratios because they
have more debt capacity.
14) The ability to add debt financing to the current borrowing of the firm and be able to make
interest and principal repayments on time is known as the firm’s debt-to-equity ratio.
15) According to the Pecking Order Hypothesis, selling equity is the first choice for firms that
require outside financing.
16) Firms in need of financing tend to use external funds first and then revert to internal funds, or
retained earnings, as a last resort.
17) Describe the Pecking Order Hypothesis.
18) With the background ideas of using the cheapest source first and the impact of asymmetric
information, what does the Pecking Order Hypothesis predict?
1) The initial decision of what products and services to produce has a much ________ on the
profitability of the firm when compared to the ________.
A) smaller impact; financing decision
B) larger impact; dividend decision
C) larger impact; investment decision
D) larger impact; financing decision
2) To say that the investing decision and financing decision of a firm are separable is to say
________.
A) that firms first select what products or services they will produce and then select how best to
finance these products or services
B) that firms first select how best to finance products or services and then select what products or
services they will produce
C) that firms first select what services they want and then what products they will produce
D) that firms first select what products they will produce and then what services they want
3) Which of the statements below is TRUE?
A) The investment decision, although minor in comparison to the financing decision, is still an
important consideration.
B) The financing decision, although minor in comparison to the investing decision, is still an
important consideration.
C) The financing decision is minor in comparison to the investing decision and thus can be
ignored.
D) The financing and investing decisions are equally important in terms of determining firm
value.
4) In their first venture into the optimal capital structure question, Nobel laureates Franco
Modigliani and Merton Miller began with a very simple model and a hypothetical world of
________.
A) bankruptcy costs but no taxes
B) taxes but no bankruptcy
C) no taxes and no bankruptcy
D) both taxes and bankruptcy
5) M&M Proposition I states that, in a world of no taxes and no bankruptcy, ________.
A) the cost of debt increases with leverage
B) the choice of financing is relevant to determining the firm’s value in the short-run
C) how the company finances its operations affects firm value
D) how the company finances its operations does not affect firm value
6) Which of the formulations below expresses the weighted average cost of capital (WACC)
formula?
A) WACC = × Re + × Rd × (1 – Tc)
B) WACC = × Re + × Rd × (1 – Tc)
C) WACC = × Re × (1 – Tc) + × Rd
D) WACC = × Rd + × Re × (1 – Tc)
8) Proposition II from M&M says that the cost of equity is a function of which of the items
below?
A) The required return on assets (which is the same for firms with identical assets or investment
choices)
B) The cost of debt
C) The debt-equity ratio of the firm
D) All of these
9) The contribution of M&M comes from the fact that there is a constant trade-off ratio. Which
of the statements below describe this constant trade-off ratio?
A) When a firm adds more low cost debt, it automatically increases the cost of equity so that the
overall cost of capital remains constant.
B) When a firm adds more low cost debt, it automatically increases the cost of equity so that the
overall cost of capital increases.
C) When a firm adds more low cost debt, it automatically increases the cost of equity so that the
overall cost of capital decreases.
D) None of these
10) M&M’s Proposition II suggests that in a world of no taxes and no bankruptcy, ________.
A) no matter what the debt-equity ratio is, the Ra or WACC of the firm increases with debt
B) the value of the firm is sensitive to the funding choice between debt and equity
C) in simple terms, as the firm adds more debt to the financing mix, the shareholders require a
higher and higher return on equity such that it exactly offsets the use of the cheaper debt
D) Statements A, B, and C are all incorrect.