Chapter 14

Question 1

capital structure

Answer 1

The combination of debt and equity used to finance a firm.

Question 2

target capital structure

Answer 2

The mix of debt, preferred stock, and common equity with which the firm plans to finance its investments.

Question 3

business risk

Answer 3

The risk associated with projections of a firm’s future ROA or ROE if the firm uses no debt.

Question 4

financial risk

Answer 4

The portion of stockholders’ risk, over and above basic business risk, resulting from the manner in which the firm is financed.

Question 5

financial leverage

Answer 5

The extent to which fixed-income securities (debt and preferred stock) are used in a firm’s capital structure.

Question 6

EPS indifference point

Answer 6

The level of sales at which EPS is the same whether the firm uses debt or common stock financing.

Question 7

times-interest-earned (TIE) ratio

Answer 7

A ratio that measures the firm’s ability to meet its annual interest obligations. It is calculated by dividing EBIT by interest charges.

Question 8

symmetric information

Answer 8

The situation in which investors and managers have identical information and managers have identical information about the firm’s prospects.

Question 9

asymmetric information

Answer 9

The situation in which mangers have different (better) information about their firm’s prospects than do outside investors.

Question 10

signal

Answer 10

An action taken by a firm’s management that provides clues to investors about how management views the firm’s prospects.

Question 11

reserve borrowing capacity

Answer 11

The ability to borrow money at a reasonable cost when good investment opportunities arise. Firms often use less debt than the optimal capital structure to ensure that they can obtain debt capital later if necessary.

Question 12

dividends

Answer 12

Distributions made to stockholders from the firm’s earnings, whether those earnings were generated in the current period or in previous periods.

Question 13

dividend irrelevance theory

Answer 13

The theory that a firm’s dividend policy has no effect on either its value or its cost of capital.

Question 14

optimal dividend policy

Answer 14

The dividend policy that strikes a balance between current dividends and future growth and maximizes the firm’s stock price.

Question 15

dividend relevance theory

Answer 15

The theory that the value of a firm is affected by its dividend policy, with the optimal dividend policy being the one that maximizes the firm’s value.

Question 16

information content (signaling) hypothesis

Answer 16

The theory that investors regard dividend changes as signals of management’s earnings forecasts.

Question 17

clientele effect

Answer 17

The tendency of a firm to attract the type of investor who likes its dividend policy.

Question 18

free cash flow hypothesis

Answer 18

All else being equal, firms that pay dividends from cash flows that cannot be reinvested in positive net present value projects, which are termed free cash flows, have higher values than firms that retain free cash flows.

Question 19

residual dividend policy

Answer 19

A policy in which the dividend paid is set equal to the actual earnings minus the amount of retained earnings necessary to finance the firm’s optimal capital budget.

Question 20

stable, predictable dividend policy

Answer 20

Payment of a specific dollar dividend each year, or periodically increasing the dividend at a constant rate; the annual dollar dividend is relatively predictable for investors.

Question 21

constant payout rate

Answer 21

Payment of a constant percentage of earnings as dividends each year.

Question 22

extra dividend

Answer 22

A supplemental dividend paid in ears when the firm does well and excess funds are available for distribution.

Question 23

declaration date

Answer 23

The date on which a firm’s board of directors issues a statement declaring a dividend.

Question 24

holder-of-record date (date of record)

Answer 24

The date on which the company opens the ownership books to determine who will receive the dividend. The stockholders of record on this date receive the dividend.

Question 25

ex-dividend date

Answer 25

The date on which the right to the next dividend no longer accompanies a stock. It is two working days prior to the holder-of-record date.

Question 26

payment date

Answer 26

The date on which a firm actually mails dividend checks.

Question 27

dividend reinvestment plan (DRIP)

Answer 27

A plan that enables a stockholder to automatically reinvest dividends received back into the stock of the paying firm.

Question 28

stock split

Answer 28

An action taken by a firm to increase the number of shares outstanding, such as doubling the number of shares outstanding by giving each stockholder two new shares for each one formerly held.

Question 29

stock dividend

Answer 29

A dividend paid in the form of additional shares of stock rather than in cash.