Chapter 13: Capital Structure Concepts

Question 1

Consists of the amounts of permanent short-term debt, long-term debt, preferred stock, and common equity used to finance a firm

Answer 1

Capital Structure

Capital structure is part of the financial structure representing the permanent sources of the firm’s financing

Question 2

Consists of the amounts of total current liabilities, long-term debt, preferred stock, and common equity used to finance a firm

Answer 2

Financial Structure

Question 3

The capital structure at which the firm ultimately plans to operate

Answer 3

Target Capital Structure

Question 4

How/why might Target Capital Structure change

Answer 4

• Alteration in a company’s asset mix (and a resulting change in its risk)
• Increase in competition that may imply more risk
• Government regulation

Question 5

The mix of debt, preferred stock, and common equity that minimizes the weighted cost to the firm of its employed capital.

When the capital structure is such that the weighted cost of capital is minimized, the total value of the firm’s securities (and hence the value of the firm) is maximized.

Answer 5

Optimal Capital Structure

Question 6

The amount of debt contained in a firm’s optimal capital structure

Answer 6

Debt Capacity

Question 7

Name Business Risks

Answer 7

• The variability of sales volume over the business cycle
• The variability of selling prices
• The variability of costs
• The existence of market power
• The extent of product diversification
• The level and rate of growth
• The degree of operating language (DOL)

Question 8

Which business risk is this?

Firms and industries whose sales fluctuate greatly over the business cycle have more risk than firms whose sales are more stable

Answer 8

• The variability of sales volume over the business cycle

Question 9

Which business risk is this?

Prices could be fairly stable (i.e. brand-name foods like Kraft) or they could be unstable (i.e. Airline companies that are influenced by fuel prices)

Answer 9

• The variability of selling prices

Question 10

Which business risk is this?

Companies that have more variable costs are more risky, like airline companies and their dependence on jet fuel

Answer 10

• The variability of costs

Question 11

Which business risk is this?

The dominant companies of the market have more control over the whole market than the less-dominant companies

Answer 11

• The existence of market power

Question 12

Which business risk is this?

More products can mean less risk
If a company with one main product has a decrease in sales of that product, they will struggle, where a company with more product diversification will take less of a hit

Answer 12

• The extent of product diversification

Question 13

Which business risk is this?

Rapid growth can cause many stresses and can lead to great variability in operating earnings

Answer 13

• The level and rate of growth

Question 14

Which business risk is this?

A type of leverage ratio summarizing the effect a particular amount of operating leverage has on a company’s earnings before interest and taxes (EBIT)

Answer 14

• The degree of operating language (DOL)