CFIN4
Chapter 12 – Capital Structure
1. The optimal capital structure is that capital structure which strikes a balance between risk and return such that the
firm’s stock price is maximized.
a. True
b. False
2. Business risk will not affect a firm‘s beta, because beta is determined by the market and thus is outside the control of
the firm.
a. True
b. False
3. If a firm uses no debt, the uncertainty inherent in projections of future returns on equity can be described as business
risk.
a. True
b. False
4. The ability of a firm to raise sufficient capital on competitive terms under adverse conditions in order to sustain
steady operations is referred to as financial flexibility.
a. True
b. False
CFIN4
Chapter 12 – Capital Structure
5. As long as a firm is near its target capital structure it will not have to concern itself with financial flexibility.
a. True
b. False
6. The degree of financial risk is the single most important determinant of a firm‘s capital structure.
a. True
b. False
7. Other things held constant, an increase in financial leverage will increase a firm’s market (or systematic) risk as
measured by its beta coefficient.
a. True
b. False
8. Financial leverage affects both EPS and EBIT, while operating leverage only affects EBIT.
a. True
b. False
9. The management of a firm can control the degree of total leverage to some extent.
a. True
b. False
CFIN4
Chapter 12 – Capital Structure
10. Since the degree of total leverage is equal to the degree of operating leverage times the degree of financial leverage,
the degree of total leverage must always be greater than or equal to positive 1.0.
a. True
b. False
11. The central result from the work of Miller and Modigliani (MM) and subsequent researchers, is that it is now
possible to precisely identify a firm‘s optimal capital structure.
a. True
b. False
12. Because creditors can foresee, to at least some extent, the costs of bankruptcy, they charge an interest rate that has
a premium built into it to compensate for the present value of bankruptcy costs.
a. True
b. False
13. According to MM, in a world without taxes, the optimal capital structure for a firm should approach 100 percent debt
financing.
a. True
b. False
CFIN4
Chapter 12 – Capital Structure
14. You are the president of a small, publicly traded corporation. Since you believe that your firm’s stock price is
temporarily depressed, all additional capital funds required during the current year will be raised using debt. Thus, the
appropriate marginal cost of capital for the current year is the after-tax cost of debt.
a. True
b. False
15. One of the implications of signaling theory for capital structure decisions is that firms should normally seek to
maintain a reserve borrowing capacity.
a. True
b. False
16. The fact that interest is tax deductible makes corporate debt less expensive than common of preferred stock.
a. True
b. False
17. The probability of incurring bankruptcy increases as the firm’s debt/equity ratio decreases.
a. True
b. False
CFIN4
Chapter 12 – Capital Structure
18. According to the signaling theory of capital structure, the issuance of equity for a firm with various financing
alternatives signals that the firm has very favorable prospects which it wants to share with new shareholders.
a. True
b. False
19. According to the signaling theory of capital structure, the issuance of equity for a firm with various financing
alternatives signals that the firm has unfavorable prospects which it wants to share with new shareholders.
a. True
b. False
20. Firms which maintain an adequate reserve borrowing capacity will be able to borrow money at reasonable cost when
good investment opportunities arise.
a. True
b. False
21. Firms in industries that are cyclical, oriented toward research, or subject to huge liability suits normally will maintain
high levels of debt in their capital structure.
a. True
b. False
CFIN4
Chapter 12 – Capital Structure
22. The TIE ratio depends on the percentage of debt in the capital structure of the firm, the interest rate on the debt, and
the profitability of the firm.
a. True
b. False
23. The degree of operating leverage is defined as the percentage change in operating earnings associated with a given
percentage change in sales.
a. True
b. False
24. Two firms, although they operate in different industries, have the same expected earnings per share and the same
standard deviation of expected EPS. Thus, the two firms must have the same business risk.
a. True
b. False
25. A consistent supply of capital is essential for the long–run success of a firm. Although a firm may have access to
capital under all types of economic conditions, the concept of financial flexibility implies that the firm can obtain
capital on acceptable, competitive terms.
a. True
b. False
CFIN4
Chapter 12 – Capital Structure
26. The benefit to the firm of the tax deductibility of interest can be lowered if the firm’s marginal tax rate is reduced by
accumulated depreciation or tax-loss carry-forwards.
a. True
b. False
27. An all equity firm has some risk inherent in its operations. When the firm decides to finance some of its operations
with debt, it exposes itself to financial risk and it increases its business risk.
a. True
b. False
28. Risk can be apportioned between financial and business risk. Financial risk and business risk are related in that, as
business risk increases so does financial risk, although the correlation between the two is not perfect.
a. True
b. False
29. The fact that some managers are more aggressive in their use of debt financing in attempting to boost profits does
not influence the optimal or value-maximizing capital structure.
a. True
b. False
CFIN4
Chapter 12 – Capital Structure
30. If we include the cost of bankruptcy in the MM analysis of capital structure in a world with taxes, we would tend to
believe that the cost of debt increases as leverage increases and that there is probably an optimal capital structure. a.
True
b. False
31. As the percentage of debt in a firm’s capital structure increases, its financial risk increases. Once the firm increases
its debt beyond the optimal level, rising interest charges result in an immediate decrease in EPS.
a. True
b. False
32. Firm A has a higher degree of business risk than Firm B. Firm A can offset this by using less financial leverage.
Therefore, the variability of both firms’ expected EBITs could actually be identical.
a. True
b. False
33. Generally, as debt is substituted for equity, risk, as measured by the coefficient of variation of EPS, increases. This
negative effect works against the positive effect of substituting debt for equity, which is that higher leverage
increases expected EPS.
a. True
b. False
CFIN4
Chapter 12 – Capital Structure
34. Although the exact relationship between a firm’s degree of financial leverage and its beta is difficult to estimate, it
has been shown both theoretically and empirically that a firm’s beta increases with its degree of financial leverage.
a. True
b. False
35. The weighted average cost of capital (WACC) declines as more of the lowest cost component is added. What limits
a firm from using nearly all debt is that as the debt ratio rises, the absolute interest expense gets very large. The
large interest expense reduces income and results in a debt ratio limit even though the WACC continues to decline.
a. True
b. False
36. As the debt ratio rises, the WACC is reduced because the after-tax cost of debt is usually lower than the cost of
equity. What limits the substitution of debt for equity in the capital structure is that as the debt ratio rises the costs of
both components eventually increase.
a. True
b. False
37. If Miller and Modigliani had considered the cost of bankruptcy, it is unlikely that they would have concluded that 100
percent debt financing is optimal for the firm.
a. True
b. False
CFIN4
Chapter 12 – Capital Structure
38. If we consider only agency costs associated with the issuance of debt, then this implies that the firm should move
toward 100 percent debt financing.
a. True
b. False
39. One implication of information asymmetry between investors and firm managers is that if a firm raises new capital
by issuing debt rather than by selling stock, it signals that the firm has very good prospects.
a. True
b. False
40. The announcement of a stock offering by a mature firm that seems to have financing alternatives is taken as a signal
that the firm’s prospects are very good.
a. True
b. False
41. If the announcement of a stock sale does in fact trigger a decline in stock price, this reinforces the effects of
flotation costs incurred with new equity issues. Further, this implies a larger break in the MCC schedule.
a. True
b. False
CFIN4
Chapter 12 – Capital Structure
42. If the firm’s actual debt ratio is below its target level, expansion capital should be raised by issuing equity in order to
preserve the firm’s borrowing capacity.
a. True
b. False
43. One implication of the signaling theory of capital structure is that firms should borrow as much as the trade-off
theory of capital structure predicts.
a. True
b. False
44. Generally speaking, companies in Italy and Japan use less debt in their capital structure than companies in the United
States or Canada.
a. True
b. False
CFIN4
Chapter 12 – Capital Structure
45. Which of the following statements is most correct?
a. Increasing financial leverage is one way to increase a firm’s basic earning power (BEP).
b. Firms with lower fixed costs tend to have greater operating leverage.
c. The debt ratio which maximizes EPS generally exceeds the debt ratio which maximizes share price.
d. Both a and b are correct.
e. Both a and c are correct.
46. Business risk is concerned with the operations of the firm. Which of the following is not associated with (or not a
part of) business risk?
a. Demand variability.
b. Sales price variability.
c. The extent to which operating costs are fixed.
d. Changes in required returns due to financing decisions.
e. The ability to change prices as costs change.
47. Which of the following factors does not affect a firm’s business risk?
a. Demand variability.
b. Input price variability.
c. Interest cost variability.
d. Operating leverage.
e. Sales price variability.
CFIN4
Chapter 12 – Capital Structure
48. Which of the following statements is correct?
a. As a rule, the optimal capital structure is found by determining the debt-equity mix that maximizes expected
EPS.
b. The optimal capital structure simultaneously maximizes EPS and minimizes the WACC.
c. The optimal capital structure minimizes the cost of equity, which is a necessary condition for maximizing the
stock price.
d. The optimal capital structure simultaneously minimizes the cost of debt, the cost of equity, and the WACC.
e. Each of the above statements is false.
49. The firm’s target capital structure is consistent with which of the following?
a. Maximum earnings per share.
b. Minimum cost of debt (rd).
c. Minimum risk.
d. Minimum cost of equity (rs).
e. Minimum weighted average cost of capital.
50. Allyson, who is the CFO of Mundane Minerals & Mining (MMM), is trying to decide whether to issue debt or
common stock to finance the capital budgeting projects she has evaluated as acceptable (that is, the projects have
positive net present values, NPV). Because MMM is a relatively small company, Allyson believes that the type of
capital she uses to finance the projects will send a signal to investors. As a result, which of the following actions
would you recommend Allyson take?
a. Issue equity, because investing in positive NPV projects is not in the best interests of the firm, and the existing
stockholders will want to share such “bad news” with new stockholders.
b. Issue equity so as to dilute ownership and share the increase in wealth that results from investing in positive
NPV projects with new stockholders.
c. Issue debt, because debt is riskier than common stock, thus the value of existing stockholders’ stock will
increase more than if new equity is issued.
d. Issue debt, because investing in positive NPV projects increases the value of the firm, and the existing
stockholders probably prefer not to share such good fortune with new stockholders.
e. Investors do not care which source of funds the firm uses as long as the funds are invested in positive NPV
projects; therefore it shouldn’t matter which type of capital is used.
CFIN4
Chapter 12 – Capital Structure
51. The combination of debt and equity that maximizes a firm‘s value is known as the
a. degree of financial leverage (DFL).
b. maximum WACC.
c. maximum business risk.
d. optimal capital structure.
52. A firm should raise capital according to its optimal capital structure so as to maximize its
a. earnings per share (EPS).
b. stock price.
c. weighted average cost of capital (WACC).
d. net income.
53. If a firm is operating at its optimal capital structure, then its weighted average cost of capital must be and its
value must be .
a. maximized; maximized
b. minimized; minimized
c. maximized; minimized
d. minimized; maximized
e. None of the above is a correct answer.
CFIN4
Chapter 12 – Capital Structure
54. Which of the following factors affects business risk?
a. sales variability
b. proportion of debt in the firm’s capital structure
c. taxes
d. preferred stock dividends
55. A firm that has high interest payments relative to other companies is said to have
a. a poor finance department.
b. a high degree of financial leverage
c. no financial leveraging.
d. a high degree of operating leverage.
56. According to the text DFL stands for
a. Degree of Financial Leverage
b. Detrimental Financial Liability
c. Differential Finance Learning
d. Departmental Finance League
e. Derivative Finance Law
57. According to the trade-off theory of capital structure, the benefit of increasing debt is traded-off against the
potential cost of
a. bankruptcy; tax
b. operating; tax
c. tax; operating
d. tax; bankruptcy
due to increasing debt when determining the firm’s optimal capital structure.
e. operating; bankruptcy
CFIN4
Chapter 12 – Capital Structure
58. As a general rule, the capital structure that
a. Maximizes expected EPS also maximizes the price per share of common stock.
b. Minimizes the interest rate on debt also maximizes the expected EPS.
c. Minimizes the required rate on equity also maximizes the stock price.
d. Maximizes the price per share of common stock also minimizes the weighted average cost of capital.
e. None of the above.
59. Which of the following statements is most correct?
a. The optimal capital structure minimizes the WACC.
b. If the after-tax cost of equity financing exceeds the after-tax cost of debt financing, firms are always able to
reduce their WACC by increasing the amount of debt in their capital structure.
c. Increasing the amount of debt in a firm’s capital structure is likely to increase the cost of both debt and equity
financing.
d. Answers a and c are both correct.
e. Answers b and c are both correct.