26. Some people–including the former chairman of the Federal Reserve Board of Governors (Ben Bernanke)–have argued that one advantage of corporate debt from the stockholders’ standpoint is that the existence of debt forces managers to focus on cash flow and to refrain from spending too much of the firm’s money on private plane and other “perks.” This is one of the factors that led to the rise of LBOs and private equity firms.
Answer Choices:
a. Trueb. False
Answer: a. True
27. The Modigliani and Miller (MM) articles implicitly assumed, among other things, that outside stockholders have the same information about a firm’s future prospects as its managers. That was called “symmetric information,” and it is questionable. The introduction of “asymmetric information” led to the development of the “signaling” theory of capital structure, which postulated that firms are reluctant to issue new stock because investors will interpret such an act as a signal that the firm’s managers are worried about its future. Other actions give off different signals, and the end result is that capital structure is affected by managers’ perceptions about how their financing decisions will affect investors’ views of the firm and thus its value.
Answer Choices:
a. Trueb. False
Answer: a. True
28. According to the signaling theory of capital structure, firms first use common equity for their capital, then use debt if and only if they can raise no more equity on “reasonable” terms. This occurs because the use of debt financing signals to investors that the firm’s managers think that the future does not look good.
Answer Choices:
a. Trueb. False
Answer: b. False
29. Other things held constant, firms with more stable and predictable sales tend to use more debt than firms with less stable sales.
Answer Choices:
a. Trueb. False
Answer: a. True
30. Other things held constant, firms that use assets that can be sold easily (like trucks) tend to use more debt than firms whose assets are harder to sell (like those engaged in research and development).
Answer Choices:
a. Trueb. False
Answer: a. True
31. Other things held constant, the lower a firm’s tax rate, the more logical it is for the firm to use debt.
Answer Choices:
a. Trueb. False
Answer: b. False
32. A firm’s treasurer likes to be in a position to raise funds to support operations whenever such funds are needed, even in “bad times.” This is called “financial flexibility,” and the lower the firm’s debt ratio, the greater its financial flexibility, other things held constant.
Answer Choices:
a. Trueb. False
Answer: a. True
33. If a firm utilizes debt financing, a 10% decline in earnings before interest and taxes (EBIT) will result in a decline in earnings per share that is larger than 10%, and the higher the debt ratio, the larger this difference will be.
Answer Choices:
a. Trueb. False
Answer: a. True
34. An increase in the debt ratio will generally have no effect on which of these items?
Answer Choices:
a. Business risk.b. Total risk.c. Financial risk.d. Market risk.
Answer: a. Business risk.
35. Business risk is affected by a firm’s operations. Which of the following is NOT directly associated with (or does not directly contribute to) business risk? a. Demand variability. b. Sales price variability. c. The extent to which operating costs are fixed. d. The extent to which interest rates on the firm’s debt fluctuate. e. Input price variability.
Answer Choices:
[No answer choices shown in source]
Answer: d. The extent to which interest rates on the firm’s debt fluctuate.
36. Which of the following statements is CORRECT? a. Since debt financing raises the firm’s financial risk, increasing the target debt ratio will always increase the WACC. b. Since debt financing is cheaper than equity financing, raising a company’s debt ratio will always reduce its WACC. c. Increasing a company’s debt ratio will typically reduce the marginal costs of both debt and equity financing. However, this action still may raise the company’s WACC. d. Increasing a company’s debt ratio will typically increase the marginal costs of both debt and equity financing. However, this action still may lower the company’s WACC. e. Since a firm’s beta coefficient is not affected by its use of financial leverage, leverage does not affect the cost of equity.
Answer Choices:
[No answer choices shown in source]
Answer: d. Increasing a company’s debt ratio will typically increase the marginal costs of both debt and equity financing. However, this action still may lower the company’s WACC.
37. Which of the following statements is CORRECT? a. The capital structure that maximizes expected EPS also maximizes the price per share of common stock. b. The capital structure that minimizes the interest rate on debt also maximizes the expected EPS. c. The capital structure that minimizes the required return on equity also maximizes the stock price. d. The capital structure that minimizes the WACC also maximizes the price per share of common stock. e. The capital structure that gives the firm the best bond rating also maximizes the stock price.
Answer Choices:
[No answer choices shown in source]
Answer: d. The capital structure that minimizes the WACC also maximizes the price per share of common stock.
38. Based on the information below, what is the firm’s optimal capital structure? a. Debt = 40%; Equity = 60%; EPS = $2.95; Stock price = $260.50. b. Debt = 60%; Equity = 40%; EPS = $3.05; Stock price = $289.00. c. Debt = 50%; Equity = 50%; EPS = $3.18; Stock price = $312.00. d. Debt = 80%; Equity = 20%; EPS = $3.42; Stock price = $304.00. e. Debt = 70%; Equity = 30%; EPS = $3.31; Stock price = $300.00.
Answer Choices:
[No answer choices shown in source]
Answer: c. Debt = 50%; Equity = 50%; EPS = $3.18; Stock price = $312.00.
39. Which of the following statements best describes the optimal capital structure? a. The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company’s earnings per share (EPS).
Answer Choices:
[No answer choices shown in source]
Answer: a. The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company’s earnings per share (EPS).
Which of the following events is likely to encourage a company to raise its target debt ratio, other things held constant?
Answer Choices:
a. An increase in the corporate tax rate.b. An increase in the personal tax rate.c. An increase in the company’s operating leverage.d. The Federal Reserve tightens interest rates in an effort to fight inflation.e. The company’s stock price hits a new high.
Answer: a
Which of the following would tend to increase a firm’s target debt ratio, other things held constant?
Answer Choices:
a. The costs associated with filing for bankruptcy increase.b. The corporate tax rate is increased.c. The personal tax rate is increased.d. The Federal Reserve tightens interest rates in an effort to fight inflation.e. The company’s stock price hits a new low.
Answer: b
Which of the following statements is CORRECT?
Answer Choices:
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. The optimal capital structure simultaneously maximizes the stock price and minimizes the WACC.
Answer: e
The firm’s target capital structure should do which of the following?
Answer Choices:
a. Maximize the earnings per share (EPS).b. Minimize the cost of debt (rd).c. Obtain the highest possible bond rating.d. Minimize the cost of equity (rs).e. Minimize the weighted average cost of capital (WACC).
Answer: e
Which of the following is most likely to occur as a result of the recapitalization?
Answer Choices:
a. The ROA would increase.b. The ROA would remain unchanged.c. The return on investors’ capital would decline.d. The return on investors’ capital would increase.e. The ROE would increase.
Answer: e