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Exam
Name___________________________________
MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question.
1)
What is a company said to have if it has cash and/or more spare debt capacity?
1)
A)
Indirect costs
B)
Financial slack
C)
Financial risk
D)
Signals
2)
Which two terms best fit the blanks in the following statement: "When compared with equity
finance, debt finance is ________ and ________ for the company."?
2)
A)
cheaper; less risky
B)
cheaper; more risky
C)
more expensive; less risky
D)
more expensive; more risky
3)
Which of the following examples of signaling is most likely to be used by managers?
3)
A)
Decreasing gearing levels to send a positive sign to the financial markets
B)
Increasing gearing levels to send a positive sign to the financial markets
C)
Increasing borrowing to show that there has been a reduction in cash flow
D)
Increasing borrowing to show that there has been increase in cash flow
4)
How is an increased gearing level likely to be viewed by the financial markets?
4)
A)
As a sign of increasing cash flow
B)
As a sign that management and existing shareholders are confident about the firm's prospects
C)
As a sign of decreasing profits
D)
As a negative sign
1
5)
What is the primary effect of financial gearing?
5)
A)
To ensure that shareholders’ returns exceed the firm’s income
B)
To ensure that the firm’s income closely reflects the shareholders’ returns
C)
To reduce the degree of variation in a firm’s income for shareholders’ returns
D)
To magnify the impact of variation in a firm’s income on shareholders’ returns
6)
How does financial gearing affect the extent to which shareholders' returns vary as a result of
changes in a firm’s income?
6)
A)
It has little effect on it.
B)
It magnifies the effects.
C)
It introduces a time lag.
D)
It reduces the effects.
7)
Which of the following most accurately describes operating gearing?
7)
A)
It is concerned with the proportion of the annual income stream which is devoted to the prior
claims of debt holders.
B)
It concerns the proportion of equity in the capital structure.
C)
It refers to the extent to which the firm’s total costs are fixed.
D)
It concerns the proportion of debt in the capital structure.
8)
Which of the following correctly relates to levels of gearing, financial distress, and the cost of
capital?
8)
A)
At low gearing, distress risks are low but the cost of capital is high.
B)
At low gearing, distress risks are high and the cost of capital is high.
C)
At high gearing, distress risks are low but the cost of capital is high.
D)
At high gearing, distress risks are high and the cost of capital is high.
2
9)
Which of the following most accurately defines what is meant by 'agency costs' in finance theory?
9)
A)
The costs of allowing financial intermediaries to take decisions on your behalf which may not
be optimal for you
B)
The direct and indirect costs of ensuring that agents (e.g. managers of firms) act in the best
interests of principals (e.g. shareholders of firms)
C)
The initial cost of purchasing an asset through an agent, e.g. a travel agent’s fee
D)
The costs of buying an asset through an agent such as a stock broker or estate agent
10)
Which two of the following best relate to business risk and financial risk?
10)
A)
The increased expected return from increasing debt more than compensates for the higher
variability resulting in climbing share prices.
B)
The decreased expected return from increasing debt more than compensates for the lower
variability resulting in climbing share prices.
C)
Firms with high business risk are in a position to take on higher levels of financial risk than
those with low business risk.
D)
Firms with low business risk are in a position to take on higher levels of financial risk than
those with high business risk.
11)
Which of the following most accurately describes income gearing?
11)
A)
It refers to the extent to which the firm’s total income is fixed by external factors.
B)
It is concerned with the proportion of the annual income stream which is devoted to the prior
claims of debt holders.
C)
It concerns the proportion of payments of dividends in the capital structure.
D)
It concerns the proportion of repayments for debt in the capital structure.
12)
Which two of the following are correct, in a world with tax but no distress costs, when the capital of
a company is almost entirely made up of debt?
12)
A)
WACC is at its highest.
B)
Corporate value is at its highest.
C)
Corporate value is at its lowest.
D)
WACC is at its lowest.
3
13)
Which expression would be most useful when calculating the value of the firm in a World without
growth?
13)
A)
(Cash flows one year hence)/(Weighted average cost of capital)
B)
(Weighted average cost of capital)/(Cash flows one year hence)
C)
(Cash flows one year hence) + (Weighted average cost of capital)
D)
(Cash flows one year hence) - (Weighted average cost of capital)
14)
Which of the following most accurately describes capital gearing?
14)
A)
The ratio of capital employed to sales
B)
The ratio of debt to shareholders’ funds or total assets
C)
The ratio of current borrowing to this year’s capital repayments
D)
The ratio of interest charges to profits
15)
Which three of the following apply to interest cover?
15)
A)
The lower the interest cover, the greater the chance of interest payment default.
B)
The inverse of interest cover is known as income gearing.
C)
Interest cover = (Profit before interest and tax)/Interest charges
D)
Interest cover is used to assess the risks for potential borrowers.
16)
For the financial manager who cannot decide on a suitable level of gearing, which of the following
is the best guideline?
16)
A)
Keep gearing to a minimum
B)
Aim to achieve the maximum possible levels of gearing
C)
Adopt the gearing used by average firms in the industry
D)
Gear at the level of tax exhaustion
4
17)
Which two of the following best describe the effect of a fall in profit, assuming there is no change in
interest charges?
17)
A)
Taxation increases.
B)
The risk of liquidation falls.
C)
Interest cover will fall.
D)
There is an increase in the chance of interest payment defaults.
18)
Which three of the following are reasons why financing a business through borrowing is cheaper
than using equity?
18)
A)
Issuing and transaction costs associated with raising and servicing debt are generally less
than for ordinary shares.
B)
Debt financial securities present lower costs than shares because they have prior claims on
annual income and in liquidation.
C)
Lenders require a lower rate of return than ordinary shareholders.
D)
Debt interest can be offset against pre-tax profits before calculating the corporation tax bill,
thus reducing the tax paid.
19)
What will shareholders do if they see a firm taking on increasing debt levels?
19)
A)
Demand longer repayment periods
B)
Demand higher levels of return
C)
Demand lower levels of return
D)
Demand higher levels of gearing
20)
Which of the following does not accurately apply to the various types of capital gearing?
20)
A)
They vary in the degree to which they reflect historical or current value of assets.
B)
They all have values of between zero and 100 per cent.
C)
They vary in the degree to which they include short-term and long-term debt.
D)
They all measure the extent to which the capital structure consists of debt.
5
21)
Which type of gearing is concerned with the proportion of the annual income that is devoted to the
prior claims of debt holders?
21)
A)
Operating gearing
B)
Financial gearing
C)
Capital gearing
D)
Income gearing
22)
Which type of gearing relates to the proportion of debt in the capital structure?
22)
A)
Financial gearing
B)
Leveraged gearing
C)
Operating gearing
D)
Income gearing
23)
What effect is the risk of financial distress likely to have on the level of optimal gearing of a firm
from the point of view of shareholders' value maximisation?
23)
A)
It will encourage managers to gradually increase the level.
B)
It will have little effect.
C)
It will moderate the level of gearing.
D)
It will increase the level of gearing.
24)
Which three of the following are motives explaining the manifestation of a pecking order in
financing decisions?
24)
A)
Ordinary shares are more expensive to issue than issuing debt capital and using retained
earnings.
B)
The issue of equity is perceived as an act of desperation.
C)
The firm does not have any more assets unpledged to use as collateral for loans.
D)
Managers follow the line of least resistance with respect to communications and approval of
finance promoters.
6
25)
There is a risk in all large firms that managers may not always act in the best interests of the equity
or debt holders. What is this problem called?
25)
A)
Agency cost
B)
Business risk
C)
Empowerment
D)
Disempowerment
26)
What is the value of the following firm where:
• free net cash flows are expected to be a constant £3m per year to infinity;
• cost of debt capital after tax is 6 per cent per annum;
• the cost of equity capital is 14 per cent per annum;
• half the firm’s capital is debt and half is equity (market values)?
26)
A)
£40m
B)
£25m
C)
£30m
D)
£35m
27)
Which of the following statements correctly describe interest cover?
27)
A)
The inverse of interest cover is capital gearing.
B)
Interest cover = (Profit before interest and tax)/(Interest charges)
C)
Interest cover = (Interest charges)/(Profit before interest and tax)
D)
The inverse of interest cover is income gearing.
28)
Which three of the following are Modigliani and Miller’s three propositions for a perfect no-tax
world?
28)
A)
The total market value of any company is independent of its capital structure.
B)
The expected rate of return on equity increases proportionately with the gearing ratio.
C)
The effect of gearing is to magnify the degree of variation in a firm’s income for shareholders’
returns.
D)
The cut-off rate of return for new projects is equal to the weighted average cost of capital —
which is constant regardless of gearing.
7
29)
What is meant by the term 'financial distress'?
29)
A)
Where there are low levels of income
B)
Where obligations to creditors are not met or are met with difficulty
C)
Where obligations to shareholders are not met or are met with difficulty
D)
Where levels of taxation are high
30)
Which two competing effects result for the company taking on higher levels of debt?
30)
A)
There is a lower risk of incurring the costs of financial distress.
B)
There is a greater risk of incurring the costs of financial distress.
C)
There is an increased tax relief on increasing debt levels.
D)
There is a decreased tax relief on increasing debt levels.
31)
What are the likely results as the level of gearing rises?
31)
A)
Risk of financial distress decreases; cost of capital rises
B)
Risk of financial distress increases; cost of capital falls
C)
Risk of financial distress decreases; cost of capital falls
D)
Risk of financial distress increases; cost of capital rises
32)
How are high levels of gearing likely to affect managers’ motivation?
32)
A)
The resulting low level of debt discourages managers.
B)
The resulting low level of debt encourages managers to perform better.
C)
The resulting high level of debt discourages managers.
D)
The resulting high level of debt encourages managers to perform better.
8
33)
Which of the following correctly shows the 'pecking order' for financing, showing the most
important first?
33)
A)
Internally generated funds; new issue of equity; borrowings
B)
New issue of equity; borrowings; internally generated funds
C)
Internally generated funds; borrowings; new issue of equity
D)
Borrowings; internally generated funds; new issue of equity
34)
Which three of the following are most likely to be costs of financial distress?
34)
A)
Uncertainties in customers’ minds about dealing with this firm
B)
Temptation to fire sell healthy businesses as this will raise the most cash
C)
Low staff morale
D)
If assets can be sold quickly the price may be very high.
35)
What is meant by the term 'business risk'?
35)
A)
The greatest negative change in share value over a 10-year period
B)
The percentage change in share value per year
C)
The variability of the firm’s operating income
D)
The variability in the return to shareholders
36)
What levels of gearing are most likely to be suitable for a food retailer and a steel producer?
36)
A)
Food retailer: High; Steel producer: High
B)
Food retailer: Low; Steel producer: Low
C)
Food retailer: High; Steel producer: Low
D)
Food retailer: Low; Steel producer: High
9
37)
Which one of the following is the most likely reason why lenders would impose limits on total
borrowing?
37)
A)
Financial gearing is too low.
B)
Companies run out of suitable assets to offer as security against loans.
C)
Income gearing is too low.
D)
Financial risk is too high.
38)
How does a high level of gearing affect reinvestment risk?
38)
A)
It removes the risk.
B)
It increases the risk.
C)
It diminishes the risk.
D)
It has no short term effect.
39)
Which three of the following are most likely to be costs of financial distress?
39)
A)
Management may give excessive emphasis to short-term liquidity.
B)
More efficient long-term management of the firm
C)
If assets are to be be sold quickly the price may be very low.
D)
Uncertainties in suppliers’ minds about dealing with this firm
40)
Which two words correctly complete the following statement: "Financial distress and agency costs
eventually outweigh the lower cost of debt as gearing rises causing the WACC to ________ and the
firm's value to _______."?
40)
A)
rise; rise
B)
rise; fall
C)
fall; rise
D)
fall; fall
10
41)
A company decides to raise its gearing level. What is the effect on shareholder wealth, according to
Modigilani and Miller's theory for a world without taxes?
41)
A)
It is impossible to predict what will happen.
B)
Shareholder wealth increases.
C)
Shareholder wealth decreases.
D)
There is no effect on shareholder wealth.
42)
What are the two main benefits of using the measure of Capital gearing = Long-term debt/Total
market capitalisation?
42)
A)
It is generally closer to the market-value-based gearing measures.
B)
It exaggerates the effect of financial distress.
C)
It gives some indication of the relative share of the company’s total value belonging to
debtholders and shareholders.
D)
It ignores the fact that many firms have no access to overdrafts or similar borrowing.
43)
Most tax regimes permit companies to offset the interest paid on debt against taxable profit. Which
of the following is the key outcome for companies?
43)
A)
An increased tax cost which decreases the effective cost of debt capital
B)
A tax saving which increases the effective cost of debt capital
C)
An increased tax cost which reduces the effective cost of equity capital
D)
A tax saving which reduces the effective cost of debt capital
44)
What are the two major problems with relying on the measure Capital gearing = Long-term
debt/Shareholders' funds?
44)
A)
It ignores the fact that many firms have no access to overdrafts or similar borrowing.
B)
The book value of assets can be quite different from the sale value.
C)
A range of values from zero to infinity is possible and this makes inter-firm comparisons
difficult.
D)
It exaggerates the effect of financial distress.
11
45)
Which of the following situations obeys Modigliani and Miller’s propositions regarding financial
gearing (in a world with no tax)?
45)
A)
Company B has an enterprise value of £550m when it is financed entirely by equity and a
value of £600m when 40 per cent of its capital is debt.
B)
Company D has an enterprise value of £50m when debt is 60 per cent of total capital and an
enterprise value of £50m when debt is 95 per cent of total capital.
C)
Company A has a weighted average cost of capital (WACC) of 14 per cent and an enterprise
value of £10m when debt is 30 per cent of total capital, and a WACC of 12 per cent at a debt
level of 50 per cent of total capital.
D)
Company C has the lowest weighted average cost of capital at the highest possible gearing
level.
46)
Which type of gearing relates to the extent to which the firm’s total costs are fixed?
46)
A)
Capital gearing
B)
Leveraged gearing
C)
Operating gearing
D)
Financial gearing
47)
Which of the following does not correctly describe influences on the level of gearing?
47)
A)
The risk of financial distress causes firms to moderate their gearing levels.
B)
In Modigliani and Miller’s world with corporate tax, the optimal gearing is the highest
possible.
C)
Reinvestment risk is diminished by high gearing.
D)
Managers generally have a preference for high gearing levels.
48)
Which of the following defines financial risk?
48)
A)
The risk that the financial system may collapse because of a loss of confidence
B)
The additional variability in returns to shareholders that arises because the financial structure
contains debt
C)
The additional variability in returns to stock market investors because of systematic risk
D)
The risk to which an investor is exposed when purchasing a financial security
12
49)
Which three of the following are most likely to influence the risk of financial distress?
49)
A)
The proportion of fixed to variable costs
B)
The liquidity and marketability of the firm’s assets
C)
The sensitivity of the company’s revenues to the general level of economic activity
D)
An improvement in relationships with suppliers
13
Answer Key
Testname: C21
