Chapter 10

Question 1

Lower cost of capital maximizes the value of the firm in 2 ways:

Answer 1

1. lower discount rate yields higher present value of existing cash flows.
2. firm value goes up because it can implement more projects at a lower cost of capital.

Question 2

financial leverage:

Answer 2

Share of debt in capital structure of the firm.

Question 3

Financial leverage can be calculated in 2 ways:

Answer 3

1. debt-to-equity ratio = debt/MCAP
2. weight of debt = debt/firm value

Question 4

If debt-to-equity ratio is 1:2 then weight of debt is?

Answer 4

1/(1+2)= 1/3
- the two equations are directly related.

Question 5

The choice of share of debt is referred to as:

Answer 5

Capital structure decision

Question 6

What are the three explanations to rationalize firms capital structure choices?

Answer 6

Static trade-off theory, pecking order theory, and market timing (path dependency).

Question 7

Static trade-off theory rationalizes modest debt ratios through what equation?

Answer 7

Firm value = value of unlevered firm + tax shield - bankruptcy cost

Question 8

Larger tax shield pushes firm value ____

Answer 8

up

Question 9

Higher costs of financial distress _______ firm value

Answer 9

lower

Question 10

V(levered) = ?

Answer 10

V(unlevered) + tax shield - bankruptcy cost

Question 11

Companies in industries with marketable tangible assets will have ___________ due to ___________

Answer 11

larger share in capital structure, lower bankruptcy cost

Question 12

Companies with a high share of research and development spending tend to _________ to avoid additional ____________

Answer 12

borrow less (less debt), disclosures regarding their products

Question 13

Regulated firms will have _________

Answer 13

Higher levels of debt.

Question 14

Firms operating in fast-paced environments require __________ and operate at _________ that minimizes ____ in static trade-off theory.

Answer 14

a higher degree of financial flexibility, below-optimal share of debt, WACC

Question 15

Pecking order theory revolves around:

Answer 15

The concept of information asymmetry (unequal distribution of information)

Question 16

In pecking order theory 3 sources of financing are used:

Answer 16

1. reinvested earnings
2. debt
3. new equity

Question 17

Market timing suggests that:

Answer 17

Firm managers take into account market conditions to raise capital. They issue equity when stock valuations are high, or debt when interest rates are low.

Question 18

Path dependency is viewed as:

Answer 18

market timing over long periods of time.

Question 19

High share of marketable tangible assets and low level of research and development suggest:

Answer 19

Higher level of leverage relative to other industries.

Question 20

Sharp increase in retained earnings coupled with decrease in the number of shares outstanding point to:

Answer 20

Pecking order explanation.