FIN 540 Quiz 4

In general, the capital structures used by non-financial U.S. firms

vary significantly

Homemade leverage is

the borrowing or lending of money by individual shareholders as a means of adjusting their level of financial leverage.

The basic lesson of the M&M theory is that the value of a firm is dependent upon

the total cash flow of the firm

Inflation benefits borrowers only if the inflation is unexpected.

True

The evidence indicates that, on average, a company's stock price declines when it announces a new issue of equity.

True

When a company is in financial distress, its shareholders may have an incentive to undertake excessively risky investments.

True

Which of the following is NOT likely to be a prudent financing policy for a rapidly growing business?

Borrow funds rather than limit growth, thereby limiting growth only as a last resort

The M&M irrelevance proposition assures financial managers that their choice between equity and debt financing will ultimately have no impact on firm value.

False

The interest tax shield reduces a firm's taxes by the amount of interest on its debt.

False

Which of the following factors favor the issuance of debt in the financing decision? I. Market signaling II. Distress costs III. Tax benefits IV. Financial flexibility

I and III only

According to the pecking order theory proposed by Stewart Myers of MIT, which of the following are correct? I. For financing needs, firms prefer to first tap internal sources, such as retained profits and excess cash. II. There is an inverse relationship between a firm's profit level and its debt level. III. Firms prefer to issue new equity rather than source external debt. IV. A firm's capital structure is dictated by its need for external financing.

I, II, and IV only

The interest tax shield has no value when a firm has: I. no taxable income. II. debt-equity ratio of 1. III. zero debt. IV. no leverage.

I, II, and IV only

According to the pecking order theory of capital structure, why do firms avoid issuing equity?

because equity issuance signals that managers believe their stock is overvalued, which causes the price of the stock to fall

Financial leverage I. increases expected ROE but does not affect its variability. II. increases breakeven sales, like operating leverage, but increases the rate of earnings per share growth once breakeven is achieved. III. is a fundamental financial variable affecting sustainable growth. IV. increases expected return and risk to owners.

II, III, and IV only

Which of the following is NOT an implication of the pecking order theory of capital structure? A. On average, a firm's stock price drops when it announces an equity issue. B. Firms may want to maintain a reserve of cash or unused borrowing capacity. C. More-profitable firms (all else equal) should have higher debt ratios. D. Firms may fail to undertake positive-NPV projects if they would have to be financed with a new issue of equity.

More profitable firms (all else equal) should have higher debt ratios

In some instances, additional debt financing can encourage managers to act more in the interests of owners.

True

Debt financing results in lower after-tax earnings relative to equity financing.

True

If the maturity of a company's liabilities is less than that of its assets, the company incurs a refinancing risk.

True

If the return on invested capital is greater than the after-tax interest rate, then a higher debt-to-equity ratio increases return on equity.

True