Question 1

According to the signaling theory, when should a firm use debt to finance beyond the normal target capital structure?

Accepted Answer

A) When the debt/assets ratio is greater than one 
B) When marginal tax shelter benefits are equal to marginal bankruptcy-related costs 
C) When investors and managers have identical information about the firm's prospects 
D) When the firm has favorable prospects 
E) When the firm is entirely equity financed

Question 2

A firm's optimal capital structure is the combination of debt financing and equity financing that ______.

Accepted Answer

A) maximizes its expected earnings per share (EPS). 
B) simultaneously maximizes its EPS and minimizes its weighted average cost of capital (WAC
C) . 
C) minimizes its cost of equity, which is a necessary condition for maximizing the firm's stock price. 
D) simultaneously minimizes its cost of debt, its cost of equity, and its WACC. 
E) maximizes its stock price.

Question 3

Which of the following statements is true about the relationship between the debt/assets ratio and the times-interest-earned ratio (TIE) of a firm? Consider everything else equal.

Accepted Answer

A) If the debt/assets ratio increases, the TIE ratio will also increase. 
B) If the debt/assets ratio decreases, the TIE ratio will increase. 
C) If the debt/assets ratio decreases, the TIE ratio will also decrease. 
D) The debt/assets ratio will always be equal to the TIE ratio. 
E) The debt/assets ratio and the TIE ratio are not related to each other.

Question 4

According to the signaling theory to explain differences in firms' capital structures, an announcement of a new stock issue by a mature, seasoned firm that has numerous financing alternatives generally is seen as a signal that the its future prospects are very positive.

Accepted Answer

A) True 
 B)False

Question 5

This year, Ferro Inc. generated sales of $10 million. Its fixed operating cost is $1 million and its variable cost ratio is 30 percent of sales. Ferro has $60 million of debt outstanding with a before-tax cost of 12 percent. Which of the following statements about Ferro's times interest earned (TIE) ratio is correct?

Accepted Answer

A) Ferro's TIE ratio is 1.20, which suggests it has enough earnings to meet the required interest payments. 
B) Ferro's TIE ratio is 0.83, which suggests it does not have enough earnings to meet the required interest payments. 
C) Ferro's TIE ratio is 0.83, which suggests it has enough earnings to meet the required interest payments. 
D) Ferro's TIE ratio is 1.39, which suggests it does not have enough earnings to meet the required interest payments. 
E) Ferro's TIE ratio is 1.00, which suggests it has just enough earnings to meet the required interest payments.

Question 6

The risk associated with a firm's operations, ignoring any financing effects, is known as _____ risk.

Accepted Answer

A) market 
B) business 
C) leverage 
D) liquidity 
E) inflation

Question 7

Which of the following statements concerning a firm's degree of financial leverage (DFL) is correct?

Accepted Answer

A) The DFL affects the earnings before interest and taxes of the firm. 
B) The DFL is defined as the percentage change in net operating income that results from a given percentage change in sales. 
C) A lower DFL suggests that higher risk is associated with the firm's normal operating activities. 
D) The DFL directly affects the operating section of the income statement. 
E) A higher DFL suggests that higher risk is associated with the firm's mix of debt and equity financing.

Question 8

Which of the following is a major advantage of debt financing?

Accepted Answer

A) Market interest rates on debt normally do not exceed 5 percent, which is much lower than market rates associated with common stock. 
B) Interest payments on debt are a tax-deductible expense to the issuing firm. 
C) Generally, interest payments on debt are based on the firm's net income, which means the interest is not paid unless the firm has enough income to cover the payments. 
D) Normally the market values of bonds remain fairly stable, whereas common stock prices change substantially every day. 
E) Firms that use great amounts of debt do not pay much in corporate taxes.

Question 9

Which of the following industries normally has relatively low business risk?

Accepted Answer

A) Durable goods manufacturers, such as automobile manufacturers 
B) Firms that produce staple goods, such as grocery stores and utility companies 
C) Cyclical companies, such as construction companies 
D) Firms that engage in fairly risky research and development, such as pharmaceutical research companies. 
E) Small, single-product firms, especially those that sell primarily to a single customer

Question 10

Symmetric information is defined as the situation in which _______.

Accepted Answer

A) investors and managers have identical information about the firm's prospects 
B) employees and managers have identical information about the firm's prospects 
C) investors and creditors have identical information about the firm's prospects 
D) managers have different (better) information about their firm's prospects than outside investors 
E) employees have different (better) information about their firm's prospects than managers

Question 11

________ is a measure that indicates a firm's ability to meet the annual interest obligations on its outstanding debt.

Accepted Answer

A) Times-interest-earned (TI
E)  ratio 
B) Degree of operating leverage (DOL) 
C) Debt/assets ratio 
D) Dividend payout ratio 
E) Current ratio

Question 12

The degree of leverage concept is designed to show how changes in sales affect earnings before interest and taxes (EBIT) and earnings per share (EPS). If a 10 percent increase in sales causes EPS to increase from $1.00 to $1.50 and if the firm uses no debt, then what is its degree of operating leverage?

Accepted Answer

A) 0.5× 
B) 1.5× 
C) 2.0× 
D) 5.0× 
E) 7.5×

Question 13

The degree of operating leverage is defined as the percentage change in earnings before interest and taxes (EBIT) associated with a given percentage change in sales.

Accepted Answer

A) True 
 B)False

Question 14

Which of the following factors would tend to reduce a firm's business risk?

Accepted Answer

A) The firm changes its operations to make them more cyclical. 
B) The firm increases its operating leverage. 
C) The firm increases the fixed costs that are associated with the manufacture of its products. 
D) The firm shifts its sales strategy in an effort to sell substantially more high-priced durable goods than low-priced staple goods, which reverses the sales trend that occurred during the past decade. 
E) The firm takes actions to improve the stability of its day-to-day operations.

Question 15

If a firm increases the proportions of debt and preferred stock that are contained in its capital structure, its _____.

Accepted Answer

A) financial risk will increase 
B) business risk will decrease 
C) tax liability will increase 
D) operating leverage will decrease 
E) financial leverage will decrease

Question 16

Among industrialized countries, which of the following uses the lowest proportion of debt?

Accepted Answer

A) The United States 
B) Canada 
C) Italy 
D) The United Kingdom 
E) Japan

Question 17

A times-interest-earned (TIE) ratio that is less than 1 suggests that a firm _____.

Accepted Answer

A) is using a low proportion of debt financing in its capital structure 
B) has a low probability of defaulting on its loans 
C) might not be able to meet its annual interest obligations on its debt 
D) is financed with equity only 
E) has an extremely low debt/assets ratio

Question 18

Which of the following statements concerning differences in capital structures and financing alternatives around the world is correct?

Accepted Answer

A) In most countries, the capital gains taxes paid by investors are substantially higher than in the United States. 
B) In many countries, the costs to monitor companies' debt are lower than in the United States because foreign firms use substantially greater amounts of bank loans to finance assets than do U.S. companies. 
C) Bank loans to businesses are of little amounts in foreign countries. 
D) In most countries, neither the interest nor the dividends firms pay are tax deductible. 
E) The threat of potential bankruptcy is high in firms that are primarily financed with equity than in firms that are financed with bank loans.

Question 19

In countries where capital gains are not taxed, investors should prefer to own stocks rather than debt compared to investors in countries where capital gains are taxed.

Accepted Answer

A) True 
 B)False

Question 20

A firm sets a target capital structure to use when raising new funds in an effort to:

Accepted Answer

A) maximize its earnings per share (EPS). 
B) minimize its cost of debt (rd). 
C) maximize the dividend per share it pays commons stockholders. 
D) minimize its cost of equity (rs). 
E) minimize its weighted average cost of capital (WAC
C) .

Exam 12: Capital Structure

According to the signaling theory, when should a firm use debt to finance beyond the normal target capital structure?

A firm's optimal capital structure is the combination of debt financing and equity financing that ______.

Which of the following statements is true about the relationship between the debt/assets ratio and the times-interest-earned ratio (TIE) of a firm? Consider everything else equal.

According to the signaling theory to explain differences in firms' capital structures, an announcement of a new stock issue by a mature, seasoned firm that has numerous financing alternatives generally is seen as a signal that the its future prospects are very positive.

The risk associated with a firm's operations, ignoring any financing effects, is known as _____ risk.

Which of the following statements concerning a firm's degree of financial leverage (DFL) is correct?

Which of the following is a major advantage of debt financing?

Which of the following industries normally has relatively low business risk?

Symmetric information is defined as the situation in which _______.

________ is a measure that indicates a firm's ability to meet the annual interest obligations on its outstanding debt.

The degree of operating leverage is defined as the percentage change in earnings before interest and taxes (EBIT) associated with a given percentage change in sales.

Which of the following factors would tend to reduce a firm's business risk?

If a firm increases the proportions of debt and preferred stock that are contained in its capital structure, its _____.

Among industrialized countries, which of the following uses the lowest proportion of debt?

A times-interest-earned (TIE) ratio that is less than 1 suggests that a firm _____.

Which of the following statements concerning differences in capital structures and financing alternatives around the world is correct?

In countries where capital gains are not taxed, investors should prefer to own stocks rather than debt compared to investors in countries where capital gains are taxed.

A firm sets a target capital structure to use when raising new funds in an effort to: