Chapter 13

____ represents the permanent sources of the firm's financing. a. Financial structure b. Capital structure c. Equity structure d. Cost structure

b. Capital structure

The optimal capital structure of a firm is a function of the ____. a. business risk of the firm b. tax structure c. business risk of the firm and the tax structure d. the variability of sales volumes

c. business risk of the firm and the tax structure

Due to both financial distress and agency costs, a firm should have a capital structure that a. contains all debt b. contains all equity c. contains both debt and equity d. contains only long-term debt

c. contains both debt and equity

The tax deductibility of interest payments provides the firm with a: a. market advantage b. learning curve c. tax shield d. safeguard against auditing

c. tax shield

In analyzing the value of the firm as a function of capital structure, the present value of the tax shield benefit is offset by the present value of the expected ____, resulting in an interior optimal capital structure. a. financial distress costs b. agency costs c. holding costs d. financial distress costs and agency costs

d. financial distress costs and agency costs

As more debt is added to the capital structure of a firm, the cost of debt capital a. initially rises slowly, then falls beyond some point b. increases at a steady rate throughout the entire range c. beyond some point, becomes greater than the cost of equity d. initially rises slowly, then increases rapidly beyond some point

d. initially rises slowly, then increases rapidly beyond some point

Which of the following statements is (are) true concerning the relationship between the firm's cost of equity and its capital structure (as measured by the debt ratio)? a. The exact relationship between the cost of equity and the debt ratio is difficult to determine. b. The range of debt ratios where the cost of equity begins to increase rapidly varies by firm and industry depending on the firm's age. c. The relationship is a saucer-shaped curve. d. The relationship is determined by the static tradeoff theory.

a. The exact relationship between the cost of equity and the debt ratio is difficult to determine.

Which of the following statements is true regarding the relationship between the firm's cost of debt and its capital structure (as measured by the debt ratio)? a. The range of debt ratios where the cost of debt begins to increase rapidly varies by firm and industry, depending on the level of business risk. b. The precise relationship between the cost of debt and the debt ratio is simple to determine. c. The relationship is a saucer-shaped curve. d. The relationship is determined by the static tradeoff theory.

a. The range of debt ratios where the cost of debt begins to increase rapidly varies by firm and industry, depending on the level of business risk.

The optimal capital structure is determined by several factors including all of the following except: a. corporate capital gains b. business risk c. potential bankruptcy risk d. agency costs

a. corporate capital gains

The amount of debt in a firm's optimal capital structure is often referred to as the firm's: a. debt capacity b. lending ability c. line of credit d. loan limit

a. debt capacity

The use of fixed cost sources of funds, such as debt and preferred stock affect a firm's ____. a. financial risk b. degree of operating leverage c. market power d. business risk

a. financial risk

Holding all other things equal, as the relative amount of debt in the capital structure of the firm increases, the cost of equity capital will a. increase b. decrease c. remain unchanged; there is no relationship between the two d. initially rise rapidly, then increase slowly beyond some point

a. increase

Investors' required returns and the cost of equity capital ____ as the relative amount of debt used to finance the firm ____. a. increase, increases b. increase, decreases c. remain constant, increases d. remain constant, decreases

a. increase, increases

With an optimal capital structure a. overall capital costs are minimized b. the net present value of new projects is minimized c. financial leverage is minimized d. the weighted cost of capital is maximized

a. overall capital costs are minimized

____ refers to the argument that officers and managers have access to information about the expected future earnings of the firm that is not available to outside investors. a. Insider trading b. Asymmetric information c. Signaling effect d. Pecking order theory

b. Asymmetric information

With financial leverage, a change in EBIT results in a change in: a. fixed costs b. EPS c. financial risk d. EBT

b. EPS

The amount of permanent short-term debt, long-term debt, preferred stock, and common stock used to finance a firm defines the firm's a. financial structure b. capital structure c. target capital structure d. optimal financial structure

b. capital structure

The greater the variability of costs, the greater the business risk of the firm. This is reflected in the: a. selling price b. cost of inputs used to produce a firm's output c. sales volume d. existence of market power

b. cost of inputs used to produce a firm's output

Modigliani and Miller show that the value of a firm is ____ capital structure given perfect capital markets and no corporate income taxes. a. maximized by having no debt in the b. independent of c. maximized by having an optimal d. dependent on the

b. independent of

In considering the arbitrage process in perfect capital markets with no income taxes, the market value of a firm is _________________. a. dependent on its capital structure. b. independent of its capital structure. c. reliant on stock equity prices. d. reliant on management expertise.

b. independent of its capital structure.

The less a firm's business risk, the ____ the amount of ____ that will be used in the optimal capital structure, holding constant all other relevant factors. a. less; financial leverage b. more; financial leverage c. less; equity capital d. more; debt capital

b. more; financial leverage

The objective of capital structure management is to find the capital mix that leads to a. maximization of earnings per share b. shareholder wealth maximization c. maximization of net income d. maximization of the current period's dividends

b. shareholder wealth maximization

The capital structure decision attempts to minimize ____ which maximizes the value of the firm. a. leverage costs b. the cost of capital c. labor costs d. compensation packages

b. the cost of capital

A survey of Fortune 500 firms indicate that they prefer internal financing (retained earnings) to external financing. This preference is known as ____. a. financial slack b. the pecking order theory c. capital structure theory d. asymmetric capital

b. the pecking order theory

The tax deductibility of the interest payments on corporate debt is known as: a. the tax structure b. the tax shield c. the optimal capital structure d. Section 402a of the IRS tax code.

b. the tax shield

Two prominent finance researchers (Modigliani and Miller) showed that a. the firm's optimal capital structure consists of approximately equal proportions of debt and equity b. the value of the firm is independent of its capital structure in perfect capital markets with no income taxes c. the firm's cost of capital is minimized when its capital structure consists of approximately equal proportions of debt and equity d. the firm's cost of capital is maximized when its capital structure consists of approximately equal proportions of debt and equity

b. the value of the firm is independent of its capital structure in perfect capital markets with no income taxes

All of the following factors influence a firm's business risk except: a. degree of operating leverage b. variability of interest rates c. variability of operating costs d. variability of selling prices

b. variability of interest rates

What is optimal capital structure? a. It is the mix of debt, preferred stock and common equity that maximizes profits. b. It is the mix of debt, preferred stock and common equity that minimizes risk. c. It is the mix of debt, preferred stock and common equity that minimizes the weighted cost of the firm's employed capital. d. It is the mix of common and preferred stock that maximizes dividends to the stockholders.

c. It is the mix of debt, preferred stock and common equity that minimizes the weighted cost of the firm's employed capital.

Perfect capital markets imply the following: a. there are no transactions costs for buying and selling securities b. relevant information is unavailable for individuals c. all investors can borrow and lend at the same rate d. a single investor can influence security prices

c. all investors can borrow and lend at the same rate

The process of simultaneously buying and selling the same or equivalent securities in different markets to take advantage of price differences and make a profit is called: a. option pricing b. diversification c. arbitrage d. margining

c. arbitrage

The Modigliani-Miller theory that the value of the firm is independent of its capital structure is based on a(n) ____ process. a. reinvestment b. capital asset pricing model c. arbitraging d. compound interest

c. arbitraging

According to the "pecking order theory," firms prefer to issue ____ securities first and then issue ____ securities as a last resort. a. equity, debt b. debt, convertible debt c. debt, equity d. equity, convertible debt

c. debt, equity

The use of fixed-cost financing sources is referred to as the use of a. operating leverage b. a leveraged buyout c. financial leverage d. combined leverage

c. financial leverage

The increased variability in earnings per share due to the firm's use of debt is a definition of ____. a. combined leverage b. agency risk c. financial risk d. operating risk

c. financial risk

A firm with highly liquid assets plus unused debt capacity is said to have ____. a. arbitrage structural capacity b. the optimal capital structure c. financial slack d. optimal financial structure

c. financial slack

Generally the ____ a firm's business risk, the ____ the amount of financial leverage that will be used in the optimal capital structure. a. greater, greater b. smaller, less c. greater, less d. smaller, greater

c. greater, less

The airline industry is extremely price competitive, as well as having huge fixed costs and very low variable costs. This is an example of: a. low asset performance b. high profitability c. high operating leverage d. low fixed threshold

c. high operating leverage

A firm accepts the risk of fixed-cost financing is to: a. increase stock sales. b. decrease overhead costs. c. increase possible returns to stockholders. d. develop synergy.

c. increase possible returns to stockholders.

In determining the capital structure for an international firm, the managerial objective is to a. minimize exchange rate risk b. minimize the risk of expropriation c. minimize the overall cost of capital d. minimize available local low-cost financing

c. minimize the overall cost of capital

One of the primary assumptions of capital structure analysis is that the level and variability of ____ is not expected to change as changes in capital structure are contemplated. a. net income b. earnings before taxes c. operating income d. debt

c. operating income

The mix of debt, preferred stock, and common equity that minimizes the weighted cost of capital to the firm is known as the a. optimal corporate structure b. target financial structure c. optimal capital structure d. optimal degree of combined leverage

c. optimal capital structure

The market value of a levered firm can be represented by the following equation: Market value of levered firm = Market value of unlevered firm ____ Present value of tax shield ____ Present value of financial distress costs ____ Present value of agency costs a. minus; plus; plus b. plus; plus; plus c. plus; minus; minus d. minus, plus, minus

c. plus; minus; minus

Studies of capital structure changes have found that actions that increase leverage have generally been associated with ____ stock returns and actions that decrease leverage are associated with ____ stock returns. a. negative, positive b. negative, no change in c. positive, negative d. no change in, negative

c. positive, negative

Protection for debt holders takes the form of protective covenants in the bond indenture. These covenants place restrictions on which of the following activities? a. the sale of assets b. payment of dividends c. the issuance of additional debt d. all of the above are typical protective covenants

d. all of the above are typical protective covenants

The optimal capital structure is a function of ____. a. corporate income taxes b. financial distress costs c. agency costs d. corporate income taxes, financial distress costs, and agency costs

d. corporate income taxes, financial distress costs, and agency costs

In considering a firm's capital structure, the firm should increase its ____ which will maximize its value. a. stock outstanding b. earnings c. cash flow from investing d. debt

d. debt

Agency costs a. increase as the debt/total assets ratio decreases b. affect the present value of the tax shield c. decrease as financial distress increases d. reduce the market value of the levered firm

d. reduce the market value of the levered firm

Arbitrage transactions are: a. risky b. illegal c. speculative d. risk-free

d. risk-free

The managerial implications of capital structure theory include all of the following except: a. capital structure changes transmit important information to investors b. changes in capital structure result in changes in the market value of the firm's equity c. optimal capital structure is influenced heavily by the business risk facing the firm d. tax shield benefits from equity lead to increased firm value

d. tax shield benefits from equity lead to increased firm value

Financial leverage benefits shareholders when the a. return on assets is greater than the cost of debt b. return on equity is greater than the cost of debt c. return on investments is less than the weighted cost of capital d. return on equity is less than the cost of debt

a. return on assets is greater than the cost of debt

As the proportion of debt in the capital structure increases, investors require a ____ return and the value of existing debt will ____. a. higher, increase b. higher, decrease c. lower, increase d. lower, decrease

b. higher, decrease

Operating leverage involves the use of a. equity and debt in equal proportions b. market power c. debt d. assets having fixed costs

d. assets having fixed costs