Chapter 10 Capital structure refers to the relative amounts of debt

Document Type
Test Prep
Book Title
Financial Accounting: A Bridge to Decision Making 6th Edition
Authors
Robert W. Ingram, Thomas L. Albright
333
Chapter 10--Analysis of Financing Activities
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334 Chapter 10
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Analysis of Financing Activities 335
TRUE/FALSE
1. Capital structure refers to the relative amounts of debt and equity used by a company to finance its
assets.
2. Return on equity is computed as net income divided by total assets.
3. Liquidity is a measure of the use of debt to increase a company's return on equity.
4. Financial leverage works for the benefit of stockholders when a company performs well and
against stockholders when a company performs poorly.
5. Return on equity = return on assets x financial leverage.
6. A firm can improve its debt to equity ratio by acquiring assets through capital leases instead of
through purchases.
7. Limitations on a company's ability to borrow additional money or pay dividends or requiring a
certain debt ratio are default limitations.
8. As the amount of debt in a company's capital structure increases, the default risk increases.
9. Almost all successful corporations have a high dividend payout ratio.
336 Chapter 10
10. The market value used in the market to book value ratio is computed as the price of a firm's stock
multiplied by the number of shares of stock outstanding.
MULTIPLE CHOICE
1. Identify the TRUE statement regarding capital structure.
a.
it is measured by the price-earnings ratio
b.
most firms in a given industry will have approximately the same capital structure
c.
can affect shareholders’ returns on their investments
d.
the more capital structure a company has the greater is its efficiency
2. A firm's capital structure affects a company’s
a.
default risk but not return on equity
b.
return on equity but not default risk
c.
default risk and return on equity
d.
neither default risk nor return on equity
3. Which of the following must be used when analyzing the capital structure of a firm?
a.
long-term assets
b.
liabilities
c.
current assets
d.
expenses
4. Which of the following does NOT affect the capital structure of a company?
a.
accounts payable
b.
cash
c.
bonds payable
d.
paid-in capital
5. Which of the following ratios is NOT a measure of capital structure?
a.
debt to equity
b.
return on equity
c.
debt to assets
d.
assets to sales
Analysis of Financing Activities 337
6. The use of debt to increase a company's return on equity
a.
is known as financial leverage
b.
will always improve a company’s financial leverage
c.
measured by the debt to equity ratio
d.
is less risky than selling additional stock
7. Which of the following statements about financial leverage is FALSE?
a.
financial leverage is beneficial to stockholders when a company performs well
b.
financial leverage is beneficial to stockholders when a company performs poorly
c.
financial leverage works against stockholders when a company performs poorly
d.
the use of financial leverage magnifies a firm's return on assets
8. If an investor (stockholder) discovers by analyzing financial statements that she "lost 5 cents for
each dollar she had invested in the company," which ratio did she examine?
a.
debt to equity
b.
debt to assets
c.
return on equity
d.
financial leverage
9. The use of financial leverage always has which of the following effects on a company's financial
statements?
a.
increased revenue
b.
increased assets
c.
increased stockholders' equity
d.
increased liabilities
10. Financial leverage will result in a(n)
a.
increase in liquidity
b.
increase in return on equity
c.
decrease in risk
d.
more volatile return on equity
11. Which of the following would indicate a high degree of financial leverage?
a.
a low debt to equity ratio
b.
a high return on equity
c.
a high debt to assets ratio
d.
a low return on equity
338 Chapter 10
12. To achieve the benefits from the use of high financial leverage, a company needs to generate a
a.
higher level of net income
b.
larger amount of assets
c.
larger amount of liabilities
d.
larger amount of stockholders' equity
13. Which of the following is a TRUE statement?
a.
return on equity is always greater than return on assets
b.
if there is any debt in a company's capital structure, the financial leverage will be greater
than one
c.
a company should avoid debt if it wants to improve its return on equity
d.
if a company has a negative return on assets, the use of financial leverage will improve the
return on equity
14. If a company with existing debt, issues common stock in order to obtain funds to buy assets
a.
financial leverage will increase
b.
financial leverage will decrease
c.
financial leverage will remain unchanged
d.
the effect on financial leverage cannot be determined
15. Given below is financial information about two firms as of the end of a recent accounting period:
Bravo Company: Easy Company:
Assets $12,180 Assets $ 18,659
Liabilities 5,608 Liabilities 7,703
Equity 6,572 Equity 10,956
Net Income 906 Net Income 1,743
Which of the following can be determined from the above information?
a.
Bravo Company has a higher dividend payout ratio than Easy Company
b.
Bravo Company employs more financial leverage than Easy Company
c.
Bravo Company has a higher current ratio than does Easy Company
d.
Bravo Company's common stock will sell for a higher price than Easy Company's
Analysis of Financing Activities 339
16. Which of the following is a TRUE statement about a company's use of financial leverage?
a.
potential increased returns may be available to the common stockholders
b.
firms in industries with low margins usually have high levels of financial leverage so as to
magnify the return to common stockholders
c.
financial leverage is usually the highest in firms having the largest portion of assets
invested in current assets
d.
the higher the volatility of earnings, the greater is the likelihood that a firm employs
significant amounts of financial leverage
17. Suppose a company issues common stock to retire its debt. Which of the following effects may
occur?
a.
financial leverage will increase
b.
financial leverage will decrease
c.
financial leverage will remain unchanged
d.
the effect on financial leverage cannot be determined
18. The choices a company makes about its use of financial leverage
a.
is unrelated to the firm's capital structure
b.
can be affected by the type of its assets it uses in its transformation process
c.
will affect the return on assets
d.
doesn't affect the firm's business risk
19. As the proportion of debt increases in a firm's capital structure, what happens to the firm's risk and
financial leverage?
a.
both decrease
b.
both increase
c.
risk increases but leverage decreases
d.
leverage increases but risk decreases
20. Which of the following circumstances would encourage a firm to increase its degree of financial
leverage?
a.
interest rates are increasing economy-wide
b.
the mix of company assets is changing toward use of short-term assets
c.
a change in the company's business is leading to more stable earnings
d.
common stock prices are increasing rapidly in the financial markets
340 Chapter 10
21. Which of the following is NOT an advantage of financial leverage?
a.
tax benefits from interest expense
b.
potential increased returns to common stockholders
c.
return on equity that is greater than return on assets
d.
less volatile return on equity
22. Which of the following events would result in a decrease in a firm's financial leverage?
a.
payment of dividends
b.
issuing common stock to purchase assets
c.
issuing debt to purchase assets
d.
purchasing inventory on credit
23. As a firm's debt to equity ratio increases, it can be expected that
a.
financial leverage will increase
b.
overall financial risk will decrease
c.
net income will decrease
d.
the dividend payout ratio will decrease
24. Return on equity is a measure of
a.
financial leverage
b.
firm value
c.
company performance
d.
liquidity
25. Which of the following events would cause an increase in a firm's financial leverage?
a.
repaying a note payable
b.
issuing common stock to retire debt
c.
issuing debt to purchase assets
d.
purchasing an asset for cash
Analysis of Financing Activities 341
26. Return on equity is computed as net income divided by
a.
total assets
b.
liabilities plus stockholders' equity
c.
contributed capital
d.
stockholders' equity
27. Which of the following companies has the greatest financial leverage?
A
B
C
D
Return on Assets
2%
2%
3%
3%
Return on Equity
2%
5%
5%
6%
a.
A
b.
B
c.
C
d.
D
28. Which of the following sets of measurements of capital structure would indicate a high degree of
financial leverage?
Debt/Assets Debt/Equity Assets/Equity
a.
High Low Low
b.
High High Low
c.
Low High High
d.
High High High
29. Which of the following euqations is TRUE?
a.
return on equity = return on assets x dividend payout
b.
return on assets = debt to assets x net income
c.
return on equity = return on assets x financial leverage
d.
dividend payout ratio = net income x dividends
30. A firm's ability to meet its current cash requirements is known as
a.
financial leverage
b.
solvency
c.
liquidity
d.
measured by the debt to assets ratio
342 Chapter 10
31. If a company does not pay dividends to shareholders, it may be because
a.
its an emerging market
b.
the Board of Directors needs the money
c.
it needs to use the cash to finance the acquisition of assets
d.
the shareholders need to purchase were stock
32. A company will increase risk if it
a.
issues stock and has to pay dividends
b.
borrows money and has to pay interest
c.
reinvests its earnings
d.
increases its current ratio by delaying payments to suppliers
33. Which of the following ratios is a measure of liquidity?
a.
debt to assets
b.
assets to equity
c.
current assets to current liabilities
d.
dividend payout
34. You have computed a firm's dividend payout ratio for the past seven years as follows (2013 is the
most recent year):
2013
2012
2011
2010
2009
2008
2007
63.2%
65.1%
57.9%
48.2%
55.1%
37.4%
25.2%
One possible explanation for this situation is that the firm
a.
is in a high technology industry and is earning very high profits
b.
has few profitable opportunities in which to reinvest profits
c.
is using more and more of its capital to finance expanding operations
d.
has resold all its treasury stock holdings over the period shown
35. If a company uses cash to purchase equipment,
a.
financial leverage will increase
b.
financial leverage will decrease
c.
financial leverage will remain unchanged
d.
the effect on financial leverage cannot be determined
Analysis of Financing Activities 343
36. American Enterprises has bonds payable and common stock outstanding. Which of the following
can lead to bankruptcy for the firm?
Failure to make Failure to
interest payments pay dividends
a.
Yes Yes
b.
Yes No
c.
No Yes
d.
No No
37. Clean Diapers delivery services purchased a delivery truck by making a $1,000 down payment and
signing a note payable for the balance. What effect will this have on the firm's financial leverage?
a.
financial leverage will increase
b.
financial leverage will decrease
c.
financial leverage will remain unchanged
d.
the effect on financial leverage cannot be determined
38. Which of the following would NOT be included in an analysis of a firm's capital structure?
a.
retained earnings
b.
common stock
c.
current assets
d.
current liabilities
39. Which of the following would indicate a low amount of financial leverage?
a.
high debt to equity ratio
b.
low debt to assets ratio
c.
low return on equity
d.
high return on equity
40. Return on equity for Norris company is 7%. This means that
a.
Norris will pay a dividend of $0.07 on each share of common stock
b.
the market value of Norris's common stock will increase by 7%
c.
Norris earned $0.07 for each dollar of investment
d.
the book value of Norris's common stock will increase by 7%
344 Chapter 10
41. The likelihood that a company will not be able to make debt or interest payments when they come
due is
a.
financial leverage
b.
insolvency
c.
liquidity
d.
default risk
42. The dividend payout ratio is
a.
dividends / retained earnings
b.
dividends paid / dividends declared
c.
dividends / net income
d.
dividends / cash
43. The dividend payout ratio yields information about the
a.
portion of net income that is being distributed to stockholders in cash
b.
rate of return that an investor has enjoyed on his/her common stock
c.
fluctuation in interest rate risk that has occurred in the past year
d.
degree of financial leverage that the firm is using
44. The dividend payout ratio indicates
a.
the degree of financial leverage used by the firm
b.
the return on investment earned by the investor this period
c.
whether more shares should be purchased in the future
d.
the portion of current earnings paid out in dividends
45. In general, what relationship would you expect between the dividend payout ratio and the nature
of the business?
a.
retailing companies would have a high ratio while manufacturers would have a low ratio
b.
high profit companies would have a low ratio while low profit companies would have a
high ratio
c.
new companies would have a high ratio while old companies would have a low ratio
d.
high growth potential firms would have a low ratio while low growth potential companies
would have a high ratio
Analysis of Financing Activities 345
46. An increase in financial leverage would be riskiest for which of the following companies?
a.
a company with a high dividend payout
b.
a company with a negative return on assets
c.
a company with a low debt to assets
d.
a company with a high market to book value ratio
47. Amalgamated, Inc. reported net income of $20 million. Total liabilities and common stock
remained unchanged. No dividends were paid. As a result,
a.
financial leverage will increase
b.
financial leverage will decrease
c.
financial leverage will remain unchanged
d.
the effect on financial leverage cannot be determined
48. Which of the following would be the most useful to help an investor assess a company's default
risk?
a.
debt to total assets ratio
b.
dividend payout ratio
c.
return on assets
d.
market to book value ratio
49. Debt covenants protect the interests of which of the following parties?
a.
employees
b.
companies
c.
stockholders
d.
creditors
50. Which of the following would be an appropriate interpretation of a current ratio of 1.76?
a.
the company earned $1.76 for every dollar of assets
b.
the company has $1.76 of current assets for every dollar of current liabilities
c.
the company's debt is 176% of its capital structure
d.
the company has $1.76 of current assets for every dollar of total assets
346 Chapter 10
51. Which of the following is a measure of a firm’s economic value?
a.
return on assets
b.
financial leverage
c.
dividend payout ratio
d.
market to book value ratio
52. Which of the following is a measure of company value?
a.
current ratio
b.
debt-equity ratio
c.
return on assets
d.
market to book
53. Sanitex Corporation has a market to book ratio of 1.10. This implies that
a.
each dollar of investment is worth $1.10
b.
a purchase of the company's stock today will yield a return of 10%
c.
each stockholder will receive a dividend of $0.10
d.
for every $1.00 in equity, the company has $1.10 in debt
54. What is Magic Co.'s market to book value ratio, given the following information about the
company:
Total stockholders' equity
$2,800,000
Number of common shares
$224,000
Stock price per share
$30
Total assets
$4,480,000
a.
2.40
b.
12.50
c.
1.60
d.
0.42
Analysis of Financing Activities 347
MATCHING
For each of the management decisions below, determine what effect (if any) there would be on the
debt to equity ratio. Indicate, in the space provided, whether there would be
a.
an increase
b.
a decrease
c.
no effect
1. Sold common stock to investors who already owned some of the firm's bonds
2. Borrowed $35,000 on a short-term note from a bank
3. Declared and paid cash dividends on preferred stock
4. Purchased inventory for cash
5. Pay off bonds at maturity
6. Bought debentures of another corporation
7. Acquired treasury stock in exchange for cash
8. Called a bond issue
9. Sold convertible bonds at a discount
348 Chapter 10
Match each term with the correct definition.
a.
Capital structure
b.
Financial leverage
c.
Liquidity
d.
Default risk
e.
Book value
f.
Debt covenants
10. Limitations that protect the interests of creditors against a company's paying cash to stockholders
when it has too much debt
11. The ability to meet current cash needs
12. The amount of stockholders' equity reported on the balance sheet
13. The likelihood that a company will not be able to make debt or interest payment when they come
due
14. The use of debt to increase return on equity
15. The relative amounts of debt and equity used by a company to finance its assets
Analysis of Financing Activities 349
Match each term with the best answer.
a.
Return on equity
b.
Return on assets
c.
Financial leverage
d.
Debt to equity
e.
Dividend payout ratio
f.
Market to book value
16. Used as a measure of capital structure
17. Dividends / net income
18. Net income / stockholders' equity
19. Measures company value
20. Net income / total assets
21. Total assets / stockholders' equity
350 Chapter 10
PROBLEM
1. Respond to the following:
Required:
a.
Define the term "Capital Structure."
b.
List five different decisions that management might make that would result in a
change in the firm's capital structure. For each decision, explain how the firm's
capital structure would change.

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