CH13 TB LEVERAGE AND CAPITAL STRUCTURE

Question 1

Generally, increases in leverage result in increased return and risk.

T or F?

Answer 1

TRUE

Question 2

Generally, decreases in leverage result in increased return and risk, whereas increases in leverage result in decreased return and risk.

T or F?

Answer 2

FALSE

Question 3

Total leverage can be defined as the potential use of fixed costs, both operating and financial, to magnify the effect of changes in sales on a firm’s earnings per share.

T or F?

Answer 3

TRUE

Question 4

Leverage results from the use of equity to magnify returns to a firm’s owners.

T or F?

Answer 4

FALSE

Question 5

Operating leverage is concerned with the relationship between a firm’s sales revenue and its financial expenses.

T or F?

Answer 5

FALSE

operating expenses

Question 6

Financial leverage is concerned with the relationship between a firm’s earnings after interest and taxes and its common stock earnings per share.

T or F?

Answer 6

FALSE

EBIT

Question 7

Total leverage is concerned with the relationship between a firm’s sales revenue and its common stock earnings per share.

T or F?

Answer 7

TRUE

Question 8

A firm’s capital structure is the mix of the current liabilities, long-term debt, and equity maintained by the firm.

T or F?

Answer 8

FALSE

Question 9

The levels of fixed-cost assets and funds that management selects affect the variability of returns.

T or F?

Answer 9

TRUE

Question 10

The amount of leverage in a firm’s capital structure—the mix of long-term debt and equity maintained by the firm—can significantly affect its value by affecting return and risk.

T or F?

Answer 10

TRUE

Question 11

Both operating and financial leverage result in the magnification of return as well as risk.

T or F?

Answer 11

TRUE

Question 12

While operating leverage results only in a magnification of returns, financial leverage results only in a magnification of risk.

T or F?

Answer 12

FALSE

High risk, high return

Question 13

The dollar breakeven sales level can be solved for by dividing fixed costs by the contribution margin ratio.

T or F?

Answer 13

TRUE

Question 14

The dollar breakeven sales level can be solved for by dividing fixed costs by the dollar contribution margin.

T or F?

Answer 14

FALSE

Question 15

Breakeven analysis is used by a firm to determine the level of operations necessary to cover all fixed operating costs and to evaluate the profitability associated with various levels of production.

T or F?

Answer 15

FALSE

Question 16

A firm’s operating breakeven point is the level of sales necessary to cover all fixed operating costs.

T or F?

Answer 16

FALSE

fixed and variable operating costs

Question 17

In finding the operating breakeven point, it is important to divide the cost of goods sold and operating expenses into fixed and variable operating costs.

T or F?

Answer 17

TRUE

Question 18

At the operating breakeven point, the sales revenue is equal to the sum of the fixed and variable operating costs.

T or F?

Answer 18

TRUE

Question 19

Earnings before interest and taxes are positive above the operating breakeven point, and a loss occurs below it.

T or F?

Answer 19

TRUE

Question 20

For sales levels below the operating breakeven point, sales revenue exceeds total operating costs, and earnings before interest and taxes is greater than zero.

T or F?

Answer 20

FALSE

Question 21

An increase in cost (fixed cost or variable cost) tends to increase the operating breakeven point, whereas an increase in the sales price per unit will decrease the operating breakeven point.

T or F?

Answer 21

TRUE

Question 22

The use of a dollar breakeven point is important when a firm has more than one product, especially when each product is selling at a different price.

T or F?

Answer 22

TRUE

Question 23

The contribution margin is defined as the percent of each sales dollar that remains after satisfying fixed operating costs.

T or F?

Answer 23

FALSE

variable operating costs

Question 24

The breakeven point in dollars can be computed by dividing the contribution margin into the variable operating costs.

T or F?

Answer 24

FALSE

FC/CM ratio

Question 25

Due to the difficulty of allocating costs to products in a multiproduct firm, the breakeven model may fail to determine breakeven points for each product line. | T or F?

Answer 25

TRUE

Question 26

Since the sales price per unit generally decreases with volume and the cost per unit generally increases with volume, the true breakeven point may be different from those obtained using linear revenue and cost functions as assumed in the breakeven analysis. | T or F?

Answer 26

TRUE

Question 27

One of the limitations of breakeven analysis is its short-term time horizon. A large outlay in the current financial period could significantly raise the firm's breakeven point, while the benefits may occur over a period of years. | T or F?

Answer 27

TRUE

Question 28

The operating breakeven point can be found by solving for the sales level that just covers total fixed and variable costs. | T or F?

Answer 28

TRUE

Question 29

Which of the following is true of leverage? A) It refers to the effects that operating and financial fixed costs have on the returns that shareholders earn. B) It is associated with risks which are out of the control of managers. C) It includes the effect of operating fixed costs on the returns of shareholders and not the financial fixed costs. D) It is used to evaluate the profitability associated with various levels of sales.

Answer 29

A

Question 30

________ results from the use of fixed-cost assets or funds to magnify returns to a firm's owners. A) Long-term debt B) Equity C) Leverage D) Capital structure

Answer 30

C

Question 31

The three basic types of leverage are ________. A) operating, production, and financial B) operating, production, and total C) production, financial, and total D) operating, financial, and total

Answer 31

D

Question 32

Generally, increases in leverage result in ________ return and ________ risk. A) decreased; increased B) decreased; decreased C) increased; increased D) increased; decreased

Answer 32

C

Question 33

________ refers to the effects that fixed costs have on the returns that shareholders earn. A) Purchase power parity B) Leverage C) Business risk D) Pecking order theory

Answer 33

B

Question 34

________ analysis is a technique used to assess the returns associated with various cost structures and levels of sales. A) Time-series B) Marginal C) Breakeven D) Ratio

Answer 34

C

Question 35

Earnings before interest and taxes (EBIT) is a descriptive label for ________. A) operating profits B) net profits before taxes C) earnings per share D) gross profits

Answer 35

A

Question 36

________ costs are a function of time, not sales, and are typically contractual. A) Fixed B) Semi-variable C) Variable D) Operating

Answer 36

A

Question 37

In case of a manufacturing organization, which of the following is a variable cost that varies directly with the sales volume? A) interest cost B) dividend cost C) shipping cost D) rental cost

Answer 37

C

Question 38

A firm's ________ is the level of sales necessary to cover all operating costs, i.e., the point at which EBIT equals zero. A) cash breakeven point B) financial breakeven point C) operating breakeven point D) total breakeven point

Answer 38

C

Question 39

Which of the following is a fixed cost? A) inventory B) rent C) delivery costs D) direct labor

Answer 39

B

Question 40

________ costs require the payment of a specified amount in each accounting period. A) Operating B) Variable C) Semi-variable D) Fixed

Answer 40

D

Question 41

At the operating breakeven point, ________ equals zero. A) sales revenue B) fixed operating costs C) variable operating costs D) earnings before interest and taxes

Answer 41

D

Question 42

Breakeven analysis is used by a firm ________. A) to determine the level of operations necessary to cover all fixed operating costs B) to determine the least cost of producing goods and services C) to evaluate the profitability associated with various levels of sales D) to determine the demand of a product

Answer 42

C

Question 43

If a firm's fixed operating costs decrease, the firm's ________. A) operating breakeven point will decrease B) operating breakeven point will increase C) sale price per unit will decrease D) sale price per unit will increase

Answer 43

A

Question 44

If a firm's variable costs per unit increase,the firm's ________. A) financial breakeven point will decrease B) operating breakeven point will increase C) sale price per unit will decrease D) fixed costs per unit will increase

Answer 44

B

Question 45

If a firm's variable costs per unit increase,the firm's ________. A) financial breakeven point will decrease B) operating breakeven point will increase C) sale price per unit will decrease D) fixed costs per unit will increase

Answer 45

B

Question 46

If a firm's fixed *financial* costs decrease, the firm's operating breakeven point will ________. A) decrease B) increase C) remain unchanged D) change based on the sale price per unit

Answer 46

C

Question 47

A firm's operating breakeven point is the point at which ________. A) total operating costs equal total fixed costs B) total operating costs are zero C) EBIT is less than sales D) EBIT is zero

Answer 47

D

Question 48

A major assumption of breakeven analysis and one which causes severe limitations in its use is that ________. A) fixed costs really are fixed B) total revenue is nonlinear C) revenues and operating costs are linear D) all costs are really semi-variable

Answer 48

C

Question 49

________ is 100 percent minus total variable operating costs as a percentage of total sales. A) Profit margin B) Contribution margin C) Expense ratio D) Fixed coverage ratio

Answer 49

B

Question 50

One function of breakeven analysis is to ________. A) determine the profit attributable to each stockholder B) evaluate the effect of leverage on a firm's risks and returns C) evaluate the profitability of various sales levels D) determine the amount of financing needed by the firm

Answer 50

C

Question 51

The preferred approach to breakeven analysis for a multiproduct firm is the ________. A) breakeven point expressed in units B) breakeven point expressed in dollars C) cash breakeven point D) overall breakeven point

Answer 51

B

Question 52

Operating leverage is defined as the use of fixed operating costs to magnify the effects of changes in sales on a firm's earnings before interest and taxes. | T or F?

Answer 52

TRUE

Question 53

The degree of operating leverage will increase if a firm decides to compensate its sales representatives with a fixed salary and bonus rather than with a pure percent-of-sales commission. | T or F?

Answer 53

TRUE

Question 54

Comparison of the degree of operating leverage of two firms is valid only when the base level of sales used for each firm is the same. | T or F?

Answer 54

TRUE

Question 55

The degree of operating leverage depends on the base level of sales used as a point of reference. The closer the base sales level used is to the operating breakeven point, the greater the operating leverage. | T or F?

Answer 55

TRUE

Question 56

Operating leverage results from the existence of operating costs in a firm's income stream. | T or F?

Answer 56

FALSE

Question 57

Operating leverage may be defined as the potential use of fixed operating costs to magnify the effects of changes in sales on a firm's earnings before interest and taxes (EBIT). | T or F?

Answer 57

TRUE

Question 58

Operating leverage is present when a firm has fixed operating costs. | T or F?

Answer 58

TRUE

Question 59

Whenever the percentage change in earnings before interest and taxes resulting from a given percentage change in sales is greater than the percentage change in sales, operating leverage exists. | T or F?

Answer 59

TRUE

Question 60

When a firm has fixed operating costs, operating leverage is present. In that case, an increase in sales results in a more-than-proportional increase in EBIT, and a decrease in sales results in a more-than- proportional decrease in EBIT. | T or F?

Answer 60

TRUE

Question 61

Whenever the percentage change in EBIT resulting from a given percentage change in sales is greater than the percentage change in sales, operating leverage exists. | T or F?

Answer 61

TRUE

Question 62

The closer the base sales level used is to the operating breakeven point, the smaller the operating leverage. | T or F?

Answer 62

FALSE ## Footnote bigger

Question 63

The base level of EBIT must be held constant to compare the financial leverage associated with different levels of fixed financial costs. | T or F?

Answer 63

TRUE

Question 64

The effect of financial leverage is such that an increase in a firm's earnings before interest and taxes (EBIT) results in a more than proportional increase in the firm's earnings per share (EPS), while a decrease in the firm's EBIT results in a less than proportional decrease in EPS. | T or F?

Answer 64

FALSE

Question 65

Whenever the percentage change in earnings per share (EPS) resulting from a given percentage change in sales is greater than the percentage change in sales, financial leverage exists. | T or F?

Answer 65

FALSE

Question 66

Financial leverage results from the presence of variable financial costs in a firm's income stream. | T or F?

Answer 66

FALSE

Question 67

Financial leverage may be defined as the potential use of variable financial costs to magnify the effects of changes in earnings before interest and taxes (EBIT) on a firm's earnings per share (EPS). | T or F?

Answer 67

FALSE

Question 68

The relationship between operating and financial leverage is additive rather than multiplicative. | T or F?

Answer 68

FALSE ## Footnote Multiplicative

Question 69

The total leverage measures the combined effect of operating and financial leverage on a firm's risk. | T or F?

Answer 69

TRUE

Question 70

Total leverage exists whenever the percentage change in earnings per share (EPS) resulting from a given percentage change in sales is greater than the percentage change in sales. | T or F?

Answer 70

TRUE

Question 71

The base level of sales must be held constant to compare the total leverage associated with different levels of fixed costs. | T or F?

Answer 71

TRUE

Question 72

With the existence of fixed operating costs, an increase in sales will result in ________ increase in EBIT. A) a proportional B) an equal C) a less than proportional D) a more than proportional

Answer 72

D

Question 73

________ leverage is concerned with the relationship between **sales revenues** and **earnings before interest and taxes.** A) Investing B) Operating C) Variable D) Total

Answer 73

B

Question 74

________ is the potential use of fixed operating costs to magnify the effects of changes in sales on earnings before interest and taxes. A) Financial leverage B) Operating leverage C) Operating budget D) Ratio analysis

Answer 74

B

Question 75

With the existence of fixed operating costs, a decrease in sales will result in ________ in EBIT. A) a proportional increase B) an equal increase C) a less than proportional decrease D) a more than proportional decrease

Answer 75

D

Question 76

A decrease in fixed operating costs will result in ________ in the degree of financial leverage. A) a decrease B) an increase C) no change D) an undetermined change

Answer 76

D

Question 77

An increase in fixed operating costs will result in ________. A) a decrease in the degree of operating leverage B) an increase in the degree of operating leverage C) a decrease in the degree of financial leverage D) an increase in the degree of financial leverage

Answer 77

B

Question 78

As fixed operating costs increase and all other factors are held constant, ________. A) the degree of operating leverage will increase B) the degree of operating leverage will decrease C) the degree of total leverage will decrease D) the degree of total leverage will increase

Answer 78

B

Question 79

Operating leverage measures the effect of fixed operating costs on the relationship between ________. A) sales and EBIT B) sales and EPS C) EBIT and EPS D) EBIT and dividend

Answer 79

A

Question 80

Financial leverage measures the effect of fixed financial costs on the relationship between ________. A) sales and EBIT B) sales and EPS C) EBIT and EPS D) EBIT and preference dividend

Answer 80

C

Question 81

________ leverage is concerned with the relationship between **earnings before interest and taxes** and **earnings per share.** A) Financial B) Operating C) Variable D) Total

Answer 81

A

Question 82

In theory, a firm should maintain financial leverage consistent with a capital structure that ________. A) meets the industry standards B) meets the investor expectations C) maximizes the owner's wealth D) maximizes dividends

Answer 82

C

Question 83

The degree of financial leverage is the ratio of ________ to percentage change in EBIT. A) operating profit B) percentage change in sales C) percentage change in EPS D) long-term debt

Answer 83

C

Question 84

________ is the potential use of fixed financial charges to magnify the effects of changes in earnings before interest and taxes on a firm's earnings per share. A) Financial leverage B) Operating leverage C) Total leverage D) Degree of operating leverage

Answer 84

A

Question 85

Financial leverage measures the effect of fixed financing costs on the relationship between ________. A) sales and EBIT B) sales and EPS C) EBIT and EPS D) net income and sales

Answer 85

C

Question 86

________ leverage measures the effect of fixed ________ costs on the relationship between EBIT and EPS. A) Operating; operating B) Financial; financial C) Operating; financial D) Financial; operating

Answer 86

B

Question 87

Fixed financial charges include ________. A) common stock dividends and bond interest expense B) common stock dividends and preferred stock dividends C) bond interest expense and preferred stock dividends D) stock repurchase expense

Answer 87

C

Question 88

Higher financial leverage causes ________ to increase more for a given increase in ________. A) EBIT; sales B) EPS; sales C) EPS; EBIT D) EBIT; EPS

Answer 88

C

Question 89

________ is the potential use of fixed costs to magnify the effect of changes in **sales** on the firm's **earnings per share.** A) Investing leverage B) Total leverage C) Operating leverage D) Financial leverage

Answer 89

B

Question 90

Through the effects of financial leverage, when EBIT increases, ________. A) earnings per share will increase B) earnings per share will decrease C) fixed operating costs will decrease D) fixed operating costs will increase

Answer 90

A

Question 91

________ leverage is concerned with the relationship between sales revenue and earnings per share. A) Financial B) Operating C) Variable D) Total

Answer 91

D

Question 92

Because the degree of total leverage is multiplicative and not additive, when a firm has very high operating leverage it can moderate its total risk by ________. A) increasing sales B) using a higher level of financial leverage C) increasing EBIT D) using a lower level of financial leverage

Answer 92

D

Question 93

Total leverage measures the effect of fixed costs on the relationship between ________. A) sales and EBIT B) sales and EPS C) EBIT and EPS D) EBIT and dividend

Answer 93

B

Question 94

A firm's capital structure is the mix of short-term liabilities and long-term debt. | T or F?

Answer 94

FALSE

Question 95

Poor capital structure decisions can result in a high cost of capital, thereby making some unacceptable investments acceptable. | T or F?

Answer 95

FALSE ## Footnote Acceptable investments unacceptable

Question 96

Debt is a relatively inexpensive source of capital because lenders take the least risk among the long- term contributors of capital. | T or F?

Answer 96

TRUE

Question 97

Debt capital is less risky than equity capital because a firm is legally obligated to pay interest to bondholders but they are not legally obligated to pay dividends to preferred or common stockholders. | T or F?

Answer 97

TRUE

Question 98

Due to its secondary position relative to equity, suppliers of debt capital face greater risk and therefore must be compensated with higher expected returns than suppliers of equity capital. | T or F?

Answer 98

FALSE

Question 99

All items on the right-hand side of a firm's balance sheet, excluding current liabilities are sources of capital. | T or F?

Answer 99

TRUE

Question 100

Generally, the greater a firm's times interest earned ratio, the less able it is to meet payments as they come due. | T or F?

Answer 100

FALSE ## Footnote more

Question 101

A firm's capital structure can significantly affect the firm's value by affecting its risk and return. | T or F?

Answer 101

TRUE

Question 102

In general, a low times interest earned ratio and a low fixed-payment coverage ratio are associated with a high degree of financial leverage. | T or F?

Answer 102

TRUE

Question 103

The probability that a firm will become bankrupt is largely dependent on its level of both business and financial risk. | T or F?

Answer 103

TRUE

Question 104

Holding all other factors constant, a firm that is subject to a greater level of business risk should employ more total leverage than an otherwise equivalent firm that is subject to a lesser level of business risk. | T or F?

Answer 104

FALSE

Question 105

In general, the greater a firm's operating leverage, the higher its business risk. | T or F?

Answer 105

TRUE

Question 106

Business risk is the risk that is reflected in fluctuations of the firm's cash flows before considering any debt financing. | T or F?

Answer 106

TRUE

Question 107

Financial risk refers to fluctuations in a firm's cash flows that occur because the firm uses financing sources like debt and preferred stock. | T or F?

Answer 107

TRUE

Question 108

Business risk is the risk to the firm of being unable to cover required financial obligations. | T or F?

Answer 108

FALSE

Question 109

The more fixed cost financing a firm has in its capital structure, the greater is its financial leverage and risk. | T or F?

Answer 109

TRUE

Question 110

Asymmetric information results when managers of a firm have more information about the firm's operations and future prospects than investors have. | T or F?

Answer 110

TRUE

Question 111

In general, non-U.S. companies have much higher debt ratios than their U.S. counterparts because financial markets are much more developed in the United States than elsewhere. | T or F?

Answer 111

TRUE

Question 112

Effective capital structure decisions can lower the cost of capital, resulting in higher NPVs and more acceptable projects, thereby increasing the value of a firm. | T or F?

Answer 112

TRUE

Question 113

The pecking order theory describes a hierarchy of financing beginning with retained earnings, followed by debt financing, and finally external equity financing. | T or F?

Answer 113

TRUE

Question 114

A shift toward more fixed costs increases business risk, which in turn causes earnings before interest and taxes to increase by less for a given increase in sales. | T or F?

Answer 114

FALSE ## Footnote more

Question 115

When considering the decision to shift a firm's cost structure away from variable costs toward more fixed costs, a financial manager must weigh the increased financial risk associated with greater operating leverage against the expected increase in returns. | T or F?

Answer 115

FALSE

Question 116

Because of the extensive research conducted in recent years in the area of capital structure theory, it is now possible for financial managers to pinpoint with great accuracy a firm's optimal capital structure. | T or F?

Answer 116

FALSE

Question 117

Despite the extensive research conducted in recent years in the area of capital structure theory, it is not yet possible to provide financial managers with a specified methodology for use in determining a firm's optimal capital structure. | T or F?

Answer 117

TRUE

Question 118

In general, a firm's theoretical optimal capital structure is that which balances the tax benefits of debt financing against the increase probability of bankruptcy that result from its use. | T or F?

Answer 118

TRUE

Question 119

In general, a firm's theoretical optimal capital structure is that which balances the tax benefits of equity financing against the increase probability of bankruptcy that results from its use. | T or F?

Answer 119

FALSE ## Footnote Debt financing

Question 120

The pecking order explanation of capital structure states that a hierarchy of financing exists for firms, in which retained earnings are employed first, followed by debt financing and finally by external equity financing. | T or F?

Answer 120

TRUE

Question 121

The pecking order explanation of capital structure states that a hierarchy of financing exists for firms, in which new external debt financing is employed first, followed by retained earnings and finally by external equity financing. | T or F?

Answer 121

FALSE

Question 122

The asymmetric information explanation of capital structure suggests that firms will issue new equity only when the managers believe the firm's stock is overvalued; as a result, issuing new equity is considered a negative signal that will result in a decline in share price. | T or F?

Answer 122

TRUE

Question 123

The asymmetric information explanation of capital structure suggests that firms will issue new debt only when the managers believe the firm's stock is overvalued; as a result, issuing new debt is considered a negative signal that will result in a decline in share price. | T or F?

Answer 123

FALSE ## Footnote Stock

Question 124

Holding all other factors constant, a firm that is subject to a greater level of business risk should employ less operating leverage than an otherwise equivalent firm that is subject to a lesser level of business risk. | T or F?

Answer 124

TRUE

Question 125

Holding all other factors constant, a firm that is subject to a greater level of business risk should employ more operating leverage than an otherwise equivalent firm that is subject to a lesser level of business risk. | T or F?

Answer 125

FALSE

Question 126

Holding all other factors constant, a firm that is subject to a greater level of business risk should employ less financial leverage than an otherwise equivalent firm that is subject to a lesser level of business risk. | T or F?

Answer 126

TRUE

Question 127

Holding all other factors constant, a firm that is subject to a greater level of business risk should employ more financial leverage than an otherwise equivalent firm that is subject to a lesser level of business risk. | T or F?

Answer 127

FALSE

Question 128

Holding all other factors constant, a firm that is subject to a greater level of business risk should employ less total leverage than an otherwise equivalent firm that is subject to a lesser level of business risk. | T or F?

Answer 128

TRUE

Question 129

A firm's ________ is the mix of long-term debt and equity utilized by the firm, which may significantly affect its value by affecting return and risk. A) dividend policy B) capital budget C) capital structure D) working capital

Answer 129

C

Question 130

The lower risk nature of long-term debt in a firm's capital structure is due to the fact that ________. A) the debt holders are the true owners of the firm B) equity capital has a fixed return C) creditors have a higher position in the priority of claims D) dividend payments are tax-deductible

Answer 130

C

Question 131

Which of the following is a reason why equity capital is considered riskier than debt capital? A) Equity capital has a higher priority claim against assets and earnings. B) Equity capital requires regular periodic payments in the form of dividends. C) Equity capital expects dividend payments which are not tax-deductible. D) Equity capital remains invested in a firm indefinitely.

Answer 131

D

Question 132

The inexpensive nature of long-term debt in a firm's capital structure is partly because ________. A) the debt holders are the true owners of the firm B) equity capital has a fixed return C) long-term debt has a fixed return and a maturity date D) dividend payments are tax-deductible

Answer 132

C

Question 133

The inexpensive nature of long-term debt in a firm's capital structure is partly because ________. A) the equity holders are the true owners of the firm B) equity capital has a fixed return C) creditors have a higher position in the priority of claims D) dividend payments are tax-deductible

Answer 133

C

Question 134

The inexpensive nature of long-term debt in a firm's capital structure is partly because ________. A) the equity holders are the true owners of the firm B) equity capital has a fixed return C) interest payments are tax-deductible D) equity holders have a higher position in the priority of claims

Answer 134

C

Question 135

Which of the following is a basic source of capital for a firm? A) short-term debt B) discounts from suppliers C) current liabilities D) common stock

Answer 135

D

Question 136

A decrease in the use of financing that requires fixed payments will result in a(n)________. A) increase in financial risk B) decrease in financial risk C) increase in operating leverage D) decrease in operating leverage

Answer 136

B

Question 137

As debt is substituted for equity in the capital structure and the debt ratio increases, the behavior of the overall cost of capital is partially explained by ________. A) the tax-deductibility of interest payments B) the increase in the number of common shares outstanding C) the reduction in risk as perceived by the common shareholders D) the decrease in the cost of equity

Answer 137

A

Question 138

According to the pecking order theory, which of the following is the order in which corporations use different financing sources to fund investment projects? A) retained earnings, equity, debt B) retained earnings, debt, equity C) debt, retained earnings, equity D) equity, retained earnings, debt

Answer 138

B

Question 139

________ is the risk reflected in fluctuations of a firm's cash flows because it uses debt or other fixed- cost financing. A) Systematic risk B) Business risk C) Financial risk D) Diversifiable risk

Answer 139

C

Question 140

________ is the risk that is reflected in fluctuations of the firm's cash flows before considering any debt financing. A) Systematic risk B) Business risk C) Financial risk D) Diversifiable risk

Answer 140

B

Question 141

Which of the following affects business risk? A) operating leverage B) interest rate stability C) preferred stock D) financial lease

Answer 141

A

Question 142

Revenue stability affects ________. A) dividend risk B) maturity risk C) business risk D) interest rate risk

Answer 142

C

Question 143

Which of the following is a difference between debt and equity capital? A) Debt capital does not require periodic payments, whereas equity capital requires period payments. B) Debt capital requires returns in proportion to profits, whereas equity capital requires a fixed rate of return. C) Debt capital provides a tax shield, whereas equity capital does not provide a tax shield. D) Debt capital affects operating leverage, whereas equity capital affects financial leverage.

Answer 143

C

Question 144

Which of the following is a difference between debt and equity capital? A) Debt capital does not require periodic payments, whereas equity capital requires period payments. B) Debt capital requires a fixed rate of return, whereas equity capital requires returns in proportion to profits. C) Debt capital does not provides a tax shield, whereas equity capital provides a tax shield. D) Debt capital affects operating leverage, whereas equity capital affects financial leverage.

Answer 144

B

Question 145

After satisfying obligations to creditors, the government, and preferred stockholders, any remaining earnings will most likely be allocated to ________. A) common shareholders as cash dividends B) common shareholders as stock dividends C) other firms requiring capital D) pay future preferred dividends

Answer 145

A

Question 146

The conflict resulting from a manager's desire to increase a firm's risk without increasing current borrowing costs and lenders' desire to limit lending is one effect of the ________ problem. A) agency B) leverage C) capital D) variable cost

Answer 146

A

Question 147

Operating and financial constraints placed on a corporation by loan provision are ________. A) agency costs to lenders B) agency costs to a firm C) necessary to regulate ownership of a firm D) necessary to control the risk of a firm

Answer 147

B

Question 148

Management has just discovered an excellent investment for which it needs additional funding. Relative to the discussion on asymmetric information, the firm will ________. A) finance with new common stock if management believes the firm is undervalued B) finance with debt if management believes the firm is undervalued C) finance with debt if management believes the firm is overvalued D) finance with preferred stock if the firm is at value

Answer 148

B

Question 149

The EBIT-EPS approach to capital structure involves selecting the capital structure that maximizes earnings before interest and taxes (EBIT) over the expected range of earnings per share (EPS).

Answer 149

FALSE ## Footnote Maximizes EPS over the expected range of EBIT

Question 150

The EBIT-EPS analysis tends to concentrate on maximization of earnings rather than maximization of owners' wealth. | T or F?

Answer 150

TRUE

Question 151

The financial breakeven point represents the level of earnings after interest and taxes necessary for a firm to cover its fixed operating and financial changes—that is, the point at which dividends per share is equal to zero. | T or F?

Answer 151

FALSE ## Footnote EBIT = 0

Question 152

The higher the financial breakeven point and the steeper the slope of the capital structure line, the greater the financial risk. | T or F?

Answer 152

TRUE

Question 153

The higher the degree of financial leverage (DFL), the greater the leverage a given financing plan has, and the steeper its slope when plotted on EBIT-EPS axes. | T or F?

Answer 153

TRUE

Question 154

The steeper the slope of the EBIT-EPS capital structure line, the lower is the financial risk. | T or F?

Answer 154

FALSE ## Footnote higher

Question 155

Because risk premiums increase with increases in financial leverage, maximizing EPS does not assure owners' wealth maximization. | T or F?

Answer 155

TRUE

Question 156

The basic shortcoming of EBIT-EPS analysis is that this model focuses on the maximization of earnings rather than on the maximization of owner wealth as reflected in a firm's stock price. | T or F?

Answer 156

TRUE

Question 157

The basic shortcoming of EBIT-EPS analysis is that this model focuses on the maximization of stock returns rather than on the maximization of share price. | T or F?

Answer 157

FALSE ## Footnote earnings

Question 158

In the EBIT-EPS approach to capital structure, risk is represented by ________. A) the slope of the capital market line B) shifts in the cost of debt capital C) the slope of the capital structure line D) shifts in the times-interest-earned ratio

Answer 158

C

Question 159

The EBIT-EPS approach to capital structure proposes that an optimal capital structure be selected which ________. A) maximizes the weighted average cost of capital B) minimizes the cost of debt C) maximizes the EPS D) minimizes dividends

Answer 159

C

Question 160

The major shortcoming of the EBIT-EPS approach to capital structure is that ________. A) the technique does not promote the maximization of shareholder wealth B) the technique does not consider the cost of capital C) the technique only considers leverage-related risk D) the technique does not maximize earnings per share

Answer 160

A

Question 161

The basic shortcoming of the EBIT-EPS approach to capital structure is ________. A) that the optimal capital structure is difficult to compute B) its disregard for the presence of preferred stock in the capital structure C) its disregard for the firm's dividend policy D) that it concentrates on the maximization of EPS rather than the maximization of owner's wealth

Answer 161

D

Question 162

Minimizing the weighted average cost of capital allows management to undertake a larger number of profitable projects, thereby further increasing the value of a firm. | T or F?

Answer 162

TRUE

Question 163

Optimal capital structure is the capital structure at which the weighted average cost of capital is minimized, thereby maximizing a firm's value. | T or F?

Answer 163

TRUE

Question 164

An increase in fixed operating and financial cost results in an increase in risk, since the firm will have to achieve a higher level of sales just to break even. | T or F?

Answer 164

TRUE

Question 165

The cost of equity is greater than the cost of debt and increases with increasing financial leverage, but generally less rapidly than the cost of debt. | T or F?

Answer 165

FALSE

Question 166

The cost of equity increases with increasing financial leverage in order to compensate the stockholders for the higher degree of financial risk. | T or F?

Answer 166

TRUE

Question 167

As financial leverage increases, the cost of debt initially remains constant and then rises, while the cost of equity always rises. | T or F?

Answer 167

TRUE

Question 168

If we assume that EBIT is constant, the value of a firm is maximized by minimizing the weighted average cost of capital. | T or F?

Answer 168

TRUE

Question 169

In theory, a firm's optimal capital structure is that which minimized the firm's overall cost of capital resulting in a maximization of the market value of a firm. | T or F?

Answer 169

TRUE

Question 170

The overriding objective of the capital structure decision should be to choose the level of debt that results in the largest possible share price. | T or F?

Answer 170

TRUE

Question 171

The optimal capital structure is the one that balances ________. A) return and risk factors in order to maximize profits B) return and risk factors in order to maximize earnings per share C) return and risk factors in order to maximize market value D) return and risk factors in order to maximize dividends

Answer 171

C

Question 172

Beginning with a zero-leverage company, as debt is substituted for equity in the capital structure ________. A) the overall cost of capital first rises, reaches a maximum, and then declines B) the overall cost of capital declines C) the overall cost of capital first declines, reaches a minimum, and then rises D) the overall cost of capital rises

Answer 172

C

Question 173

Poor capital structure decisions can result in ________ the cost of capital, resulting in ________ acceptable investments. A) increasing; fewer B) decreasing; more C) increasing; more D) decreasing; fewer

Answer 173

A

Question 174

According to the traditional approach to capital structure, the value of a firm will be maximized when ________. A) the financial leverage is maximized B) the cost of debt is minimized C) the weighted average cost of capital is minimized D) the dividend payout is maximized

Answer 174

C

Question 175

In the traditional approach to capital structure, as the amount of debt increases in a firm's capital structure, ________. A) the cost of equity rises faster than the cost of debt B) the cost of debt rises faster than the cost of equity C) debt becomes less risky D) equity cost is unaffected

Answer 175

A

Question 176

The value of a firm at optimum capital structure is computed as ________. A) earnings before interest and taxes times one less tax rate divided by one plus weighted average cost of capital B) earnings before interest and taxes times one less tax rate divided by weighted average cost of capital C) operating cash flow divided by weighted average cost of capital D) operating cash flow divided by one plus weighted average cost of capital

Answer 176

B

Question 177

Firms having stable and predictable revenues can more safely employ highly leveraged capital structures than can firms with volatile patterns of sales revenue. | T or F?

Answer 177

TRUE

Question 178

The reason why maximizing share value and maximizing EPS do not give the same optimal capital structure is because ________. A) EPS maximization does not consider risk B) share value maximization does not consider risk C) EPS maximization considers cash flows D) EPS maximization does consider risk

Answer 178

A