# 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

For full access to CoursePaper, a membership subscription is required.

333

Chapter 10--Analysis of Financing Activities

True/

False

L.O.’s

Level of

Difficulty

True/

False

L.O.’s

Level of

Difficulty

1

1

EASY

6

2

MOD

2

1

MOD

7

6

MOD

3

2

EASY

8

6

EASY

4

2

MOD

9

6

EASY

5

2

MOD

10

7

DIFF

Multiple

Choice

L.O.’s

Level of

Difficulty

Multiple

Choice

L.O.’s

Level of

Difficulty

Multiple

Choice

L.O.’s

Level of

Difficulty

1

1

MOD

19

2

MOD

37

1

MOD

2

1,6

EASY

20

2

DIFF

38

1

EASY

3

1

MOD

21

2

DIFF

39

2

MOD

4

1

MOD

22

2

MOD

40

1

MOD

5

1

MOD

23

2

MOD

41

6

EASY

6

2

MOD

24

2

MOD

42

6

EASY

7

2

MOD

25

2

MOD

43

6

MOD

8

2

MOD

26

1

EASY

44

6

EASY

9

2

EASY

27

2

MOD

45

6

DIFF

10

2

MOD

28

2

DIFF

46

6

MOD

11

2

MOD

29

2

MOD

47

2

MOD

12

2

MOD

30

3

EASY

48

6

MOD

13

2

MOD

31

3

EASY

49

6

EASY

14

2

MOD

32

3

EASY

50

6

MOD

15

2

DIFF

33

6

MOD

51

7

MOD

16

2

DIFF

34

3

MOD

52

7

EASY

17

2

MOD

35

3

MOD

53

7

DIFF

18

2

MOD

36

3

EASY

54

7

MOD

334 ♦ Chapter 10

Problem

L.O.’s

Level of

Difficulty

Problem

L.O.’s

Level of

Difficulty

Problem

L.O.’s

Level of

Difficulty

1

1

MOD

9

2

DIFF

17

7

MOD

2

6

MOD

10

2

DIFF

18

1-7

DIFF

3

1,2,6

MOD

11

2

MOD

19

1,2,3

MOD

4

2

MOD

12

2

DIFF

20

6,7

MOD

5

2

DIFF

13

2

DIFF

21

1,2,3,6,7

MOD

6

2

DIFF

14

2,3,6

MOD

22

1,2,3

MOD

7

2

MOD

15

2,3,6

MOD

23

6,7

MOD

8

2

MOD

16

2,3,6

MOD

Essay

L.O.’s

Level of

Difficulty

Essay

L.O.’s

Level of

Difficulty

1

1

MOD

6

6

MOD

2

1-7

MOD

7

6

MOD

3

2

MOD

8

6

MOD

4

7

MOD

9

1,2

DIFF

5

5

MOD

10

1,2

MOD

Matching

L.O.’s

Level of

Difficulty

Matching

L.O.’s

Level of

Difficulty

Matching

L.O.’s

Level of

Difficulty

1

2

MOD

8

2

MOD

15

1

EASY

2

2

MOD

9

2

MOD

16

2

MOD

3

2

MOD

10

6

MOD

17

6

EASY

4

2

MOD

11

6

EASY

18

5

EASY

5

2

MOD

12

7

MOD

19

7

MOD

6

2

MOD

13

6

EASY

20

5

EASY

7

2

MOD

14

5

MOD

21

2

EASY

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.

## Trusted by Thousands of

Students

Here are what students say about us.

###### Resources

###### Company

Copyright ©2022 All rights reserved. | CoursePaper is not sponsored or endorsed by any college or university.