22) When considering fixed operating cost increases, a financial manager must weigh the
increased financial risk associated with greater operating leverage against the expected increase
in returns.
23) 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.
24) 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.
25) 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.
26) In general, a firm’s theoretical optimal capital structure is that which balances the tax benefits
of equity financing against the increase probability of bankruptcy that results from its use.
27) 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.
28) 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.
29) 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.
30) The asymmetric information explanation of capital structure suggests that firms will issue
new debt only when the managers believe the firm’s stock is overvalued; as a result, issuing new
debt is considered a negative signal that will result in a decline in share price.
31) Holding all other factors constant, a firm that is subject to a greater level of business risk
should employ less operating leverage than an otherwise equivalent firm that is subject to a
lesser level of business risk.
32) Holding all other factors constant, a firm that is subject to a greater level of business risk
should employ more operating leverage than an otherwise equivalent firm that is subject to a
lesser level of business risk.
33) Holding all other factors constant, a firm that is subject to a greater level of business risk
should employ less financial leverage than an otherwise equivalent firm that is subject to a lesser
level of business risk.
34) Holding all other factors constant, a firm that is subject to a greater level of business risk
should employ more financial leverage than an otherwise equivalent firm that is subject to a
lesser level of business risk.
35) Holding all other factors constant, a firm that is subject to a greater level of business risk
should employ less total leverage than an otherwise equivalent firm that is subject to a lesser
level of business risk.
36) A firm’s ________ is the mix of long-term debt and equity utilized by the firm, which may
significantly affect its value by affecting return and risk.
A) dividend policy
B) capital budget
C) capital structure
D) working capital
37) The lower risk nature of long-term debt in a firm’s capital structure is due to the fact that
________.
A) the debt holders are the true owners of the firm
B) equity capital has a fixed return
C) creditors have a higher position in the priority of claims
D) dividend payments are tax-deductible
38) Which of the following is a reason why equity capital is considered riskier than debt capital?
A) Equity capital has a higher priority claim against assets and earnings.
B) Equity capital requires regular periodic payments in the form of dividends.
C) Equity capital expects dividend payments which are not tax-deductible.
D) Equity capital remains invested in a firm indefinitely.
39) The inexpensive nature of long-term debt in a firm’s capital structure is due to the fact that
________.
A) the debt holders are the true owners of the firm
B) equity capital has a fixed return
C) long-term debt has a fixed return and a maturity date
D) dividend payments are tax-deductible
40) The inexpensive nature of long-term debt in a firm’s capital structure is due to the fact that
________.
A) the equity holders are the true owners of the firm
B) equity capital has a fixed return
C) creditors have a higher position in the priority of claims
D) dividend payments are tax-deductible
41) The inexpensive nature of long-term debt in a firm’s capital structure is due to the fact that
________.
A) the equity holders are the true owners of the firm
B) equity capital has a fixed return
C) interest payments are tax-deductible
D) equity holders have a higher position in the priority of claims
42) Which of the following is a basic source of capital for a firm?
A) short-term debt
B) discounts from suppliers
C) current liabilities
D) common stock
43) Which of the following affects business risk?
A) revenue stability
B) financial leases
C) operating leverage
D) preferred stock
44) A decrease in fixed financial costs will result in a(n)________.
A) increase in financial risk
B) decrease in financial risk
C) increase in operating leverage
D) decrease in operating leverage
45) As debt is substituted for equity in the capital structure and the debt ratio increases, the
behavior of the overall cost of capital is partially explained by ________.
A) the tax-deductibility of interest payments
B) the increase in the number of common shares outstanding
C) the reduction in risk as perceived by the common shareholders
D) the decrease in the cost of equity
46) Which of the following is the correct order in which corporations generally raise funds to
enhance the wealth of stockholders and to send positive signals to the market?
A) retained earnings, equity, debt
B) retained earnings, debt, equity
C) debt, retained earnings, equity
D) equity, retained earnings, debt
47) ________ is the risk of being unable to cover financial obligations of a firm.
A) Systematic risk
B) Business risk
C) Financial risk
D) Diversifiable risk
48) ________ is the risk of being unable to cover operating costs of a firm.
A) Systematic risk
B) Business risk
C) Financial risk
D) Diversifiable risk
49) Which of the following affects business risk?
A) operating leverage
B) interest rate stability
C) preferred stock
D) financial lease
50) Revenue stability affects ________.
A) dividend risk
B) maturity risk
C) business risk
D) interest rate risk
51) Which of the following is a difference between debt and equity capital?
A) Debt capital does not require periodic payments, whereas equity capital requires period
payments.
B) Debt capital requires returns in proportion to profits, whereas equity capital requires a fixed
rate of return.
C) Debt capital provides a tax shield, whereas equity capital does not provide a tax shield.
D) Debt capital affects operating leverage, whereas equity capital affects financial leverage.
52) Which of the following is a difference between debt and equity capital?
A) Debt capital does not require periodic payments, whereas equity capital requires period
payments.
B) Debt capital requires a fixed rate of return, whereas equity capital requires returns in
proportion to profits.
C) Debt capital does not provides a tax shield, whereas equity capital provides a tax shield.
D) Debt capital affects operating leverage, whereas equity capital affects financial leverage.
53) After satisfying obligations to creditors, the government, and preferred stockholders, any
remaining earnings will most likely be allocated to ________.
A) common shareholders as cash dividends
B) common shareholders as stock dividends
C) other firms requiring capital
D) pay future preferred dividends
54) The cost of debt financing results from ________.
A) the decreased probability of bankruptcy caused by debt obligations
B) the risk–return trade-off associated with ownership of a firm
C) the costs associated with lenders having less information about a firm’s prospects than
investors and managers
D) the agency costs of the lenders’ monitoring and controlling a firm’s actions
55) A corporation borrows $1,000,000 at 10 percent annual rate of interest. The firm has a 40
percent tax rate. The yearly, after-tax cost of this debt is ________.
A) $40,000
B) $60,000
C) $100,000
D) $166,667
56) A corporation has $5,000,000 of 8 percent preferred stock outstanding and a 40 percent tax
rate. The after-tax cost of the preferred stock is ________.
A) $400,000
B) $240,000
C) $666,667
D) $160,000
57) A corporation has $10,000,000 of 10 percent preferred stock outstanding and a 40 percent
tax rate. The amount of earnings before interest and taxes (EBIT) required to pay the preferred
dividends is ________.
A) $1,000,000
B) $400,000
C) $600,000
D) $1,666,667
58) A corporation has $5,000,000 of 10 percent bonds and $3,000,000 of 12 percent preferred
stock outstanding. The firm’s financial breakeven (assuming a 40 percent tax rate) is ________.
A) $860,000
B) $716,000
C) $1,100,000
D) $1,400,000
59) The conflict resulting from a manager’s desire to increase a firm’s risk without increasing
current borrowing costs and lenders’ desire to limit lending is one effect of the ________
problem.
A) agency
B) leverage
C) capital
D) variable cost
60) Operating and financial constraints placed on a corporation by loan provision are ________.
A) agency costs to lenders
B) agency costs to a firm
C) necessary to regulate ownership of a firm
D) necessary to control the risk of a firm
61) The risk of the debt capital is less than that of other long-term contributors of capital because
________.
A) they have a lower priority of claim against any earnings or assets available for payment
B) they have the stockholders’ personal assurance for all future interest payments
C) there is no interest rate risk as the interest rate is predetermined
D) the tax-deductibility of interest payments lowers the debt cost to a firm substantially
62) Management has just discovered an excellent investment for which it needs additional
funding. Relative to the discussion on asymmetric information, the firm should ________.
A) finance with new common stock if management believes the firm is undervalued
B) finance with debt if management believes the firm is undervalued
C) finance with debt if management believes the firm is overvalued
D) finance with preferred stock if the firm is at value
12.4 Explain the optimal capital structure using a graphical view of the firm’s cost-of-capital
functions and a zero-growth valuation model.
1) Minimizing the weighted average cost of capital allows management to undertake a larger
number of profitable projects, thereby further increasing the value of a firm.
2) Optimal capital structure is the capital structure at which the weighted average cost of capital
is minimized, thereby maximizing a firm’s value.
3) An increase in fixed operating and financial cost results in an increase in risk, since the firm
will have to achieve a higher level of sales just to break even.
4) The cost of equity is greater than the cost of debt and increases with increasing financial
leverage, but generally less rapidly than the cost of debt.