Capital Structure and Leverage. Ch 13

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CHAPTER 13
CAPITAL STRUCTURE AND LEVERAGE
(Difficulty: E = Easy, M = Medium, and T = Tough)

Multiple Choice: Conceptual

Easy:

Business riskAnswer: c Diff: E
[i].A decrease in the debt ratio will generally have no effect on .

a.Financial risk.
b.Total risk.
c.Business risk.
d.Market risk.
e.None of the above is correct. (It will affect each type of risk above.)

Business riskAnswer: d Diff: E
[ii].Business risk is concerned with the operations of the firm. Which of the following is not associated with (or not a part of) business risk?

a.Demand variability.
b.Sales price variability.
c.The extent to which operating costs are fixed.
d.Changes in required returns due to financing decisions. e.The ability to change prices as costs change.

Business riskAnswer: d Diff: E N
[iii].Which of the following factors would affect a company’s business risk?

a.The level of uncertainty regarding the demand for its product. b.The degree of operating leverage.
c.The amount of debt in its capital structure.
d.Statements a and b are correct.
e.All of the statements above are correct.

Business and financial riskAnswer: d Diff: E

[iv].Which of the following statements is most correct?

a.A firm’s business risk is solely determined by the financial characteristics of its industry. b.The factors that affect a firm’s business risk are determined partly by industry characteristics and partly by economic conditions. Unfortunately, these and other factors that affect a firm’s business risk are not subject to any degree of managerial control. c.One of the benefits to a firm of being at or near its target capital structure is that financial flexibility becomes much less important. d.The firm’s financial risk may have both market risk and diversifiable risk components. e.None of the statements above is correct.

Optimal capital structureAnswer: e Diff: E
[v].Which of the following statements is most correct?

a.As a rule, the optimal capital structure is found by determining the debt-equity mix that maximizes expected EPS. b.The optimal capital structure simultaneously maximizes EPS and minimizes the WACC. c.The optimal capital structure minimizes the cost of equity, which is a necessary condition for maximizing the stock price. d.The optimal capital structure simultaneously minimizes the cost of debt, the cost of equity, and the WACC. e.None of the statements above is correct.

Optimal capital structureAnswer: c Diff: E
[vi].From the information below, select the optimal capital structure for Minnow Entertainment Company.

a.Debt = 40%; Equity = 60%; EPS = $2.95; Stock price = $26.50. b.Debt = 50%; Equity = 50%; EPS = $3.05; Stock price = $28.90. c.Debt = 60%; Equity = 40%; EPS = $3.18; Stock price = $31.20. d.Debt = 80%; Equity = 20%; EPS = $3.42; Stock price = $30.40. e.Debt = 70%; Equity = 30%; EPS = $3.31; Stock price = $30.00.

Optimal capital structureAnswer: e Diff: E

[vii].Which of the following statements best describes the optimal capital structure?

a.The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company’s earnings per share (EPS). b.The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company’s stock price. c.The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company’s weighted average cost of capital (WACC). d.Statements a and b are correct.

e.Statements b and c are correct.

Target capital structureAnswer: e Diff: E

[viii].The firm’s target capital structure is consistent with which of the following?

a.Maximum...
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