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Reading 29: Capital Structure and Leverage LOS g~ Q1-10

 

LOS g: Describe the objective of the capital structure decision.

Q1. Which of the following is likely to encourage a firm to increase the amount of debt in its capital structure?

A)   The personal tax rate increases.

B)   The firm's earnings become more volatile.

C)   The corporate tax rate increases.

 

Q2. The firm's target capital structure is consistent with which of the following?

A)   Minimum risk.

B)   Maximum earnings per share (EPS).

C)   Minimum weighted average cost of capital (WACC).

 

Q3. A firm’s capital structure affects:

A)   return on equity but not default risk.

B)   default risk but not return on equity.

C)   return on equity and default risk.

 

Q4. Jayco, Inc. currently has a D/A ratio of 33.33% but feels its optimal D/A ratio should be 16.67%. Sales are currently $750,000, and the total assets turnover (Sales / Assets) is 7.5. If Jayco needs to raise $100,000 to expand, how should the expansion be financed so as to produce the desired debt ratio? Finance it with:

A)   25% debt, 75% equity.

B)   all equity.

C)   all debt.

 

Q5. A firm's optimal debt ratio:

A)   minimizes risk.

B)   is the firm's target capital structure.

C)   maximizes return.

 

Q6. Which of the following statements about a firm's capital structure is least accurate?

A)   The degree of total leverage equals the degree of operating leverage times the degree of financial leverage.

B)   The firm's optimal capital structure occurs where the firm's earnings per share is maximized.

C)   Other things held constant, if you increase a firm's financial leverage you will increase the firm's beta coefficient.

 

Q7. The capital structure that:

A)   minimizes the required rate on equity maximizes the stock price.

B)   maximizes the stock price minimizes the weighted average cost of capital.

C)   maximizes expected EPS maximizes the price per share of common stock.

 

Q8. Which one of the following statements about a firm's capital structure is most accurate? The optimal capital structure:

A)   maximizes expected earnings per share (EPS), maximizes the price per share of common stock.

B)   minimizes the required rate on equity, maximizes the stock price.

C)   maximizes the stock price, minimizes the weighted average cost of capital (WACC).

 

Q9. Which of the following firms is most likely to utilize additional debt the next time it raises capital? The firm:

A)   in a high tax bracket.

B)   that has many new fixed assets.

C)   firm that has experienced significant losses in recent years.

 

Q10. Which of the following firms is likely to have a higher debt ratio?

A)   Bath & Books, which produces toiletries and other consumer staples that are in demand regardless of economic conditions.

B)   Critter Care, which has a low debt rating due to the prior financial mismanagement by the chief executive officer.

C)   Egg Harbor Furs, which serves as a wholesaler of fine furs and garments.

[2009] Session 8 -Reading 29: Capital Structure and Leverage LOS g~ Q1-10

 

 

LOS g: Describe the objective of the capital structure decision. fficeffice" />

Q1. Which of the following is likely to encourage a firm to increase the amount of debt in its capital structure?

A)   The personal tax rate increases.

B)   The firm's earnings become more volatile.

C)   The corporate tax rate increases.

Correct answer is C)

An increase in the corporate tax rate will increase the tax benefit to the corporation, because interest expense is not taxable. An increase in the personal tax rate will not impact the firm’s cost of capital. More volatile earnings increase the risk of the firm and therefore the firm would not desire to increase financial risk as a result of these changes.

 

Q2. The firm's target capital structure is consistent with which of the following?

A)   Minimum risk.

B)   Maximum earnings per share (EPS).

C)   Minimum weighted average cost of capital (WACC).

Correct answer is C)

At the optimal capital structure the firm will minimize the WACC, maximize the share price of the stock and maximize the value of the firm.

 

Q3. A firm’s capital structure affects:

A)   return on equity but not default risk.

B)   default risk but not return on equity.

C)   return on equity and default risk.

Correct answer is C)

A firm’s capital structure affects both its return on equity and its risk of default.

 

Q4. Jayco, Inc. currently has a D/A ratio of 33.33% but feels its optimal D/A ratio should be 16.67%. Sales are currently $750,000, and the total assets turnover (Sales / Assets) is 7.5. If Jayco needs to raise $100,000 to expand, how should the expansion be financed so as to produce the desired debt ratio? Finance it with:

A)   25% debt, 75% equity.

B)   all equity.

C)   all debt.

Correct answer is B)

Sales / Assets = 7.5 = 750,000 / A, so A = $100,000, D / 100,000 = 33.33. Therefore, D must be 33,333. You want to change D/A to 16.67, so must double A so the 100,000 must be all equity.

 

Q5. A firm's optimal debt ratio:

A)   minimizes risk.

B)   is the firm's target capital structure.

C)   maximizes return.

Correct answer is B)

The optimal debt ratio for a firm balances the influences of risk and return, leading to a maximization of share price. As such, the optimal debt ratio serves as a target level of debt financing for the value-maximizing firm. A debt ratio of 1.0 would be possible only if one hundred percent of the firm were financed with debt, eliminating equity ownership. Such a scenario is impossible.

 

Q6. Which of the following statements about a firm's capital structure is least accurate?

A)   The degree of total leverage equals the degree of operating leverage times the degree of financial leverage.

B)   The firm's optimal capital structure occurs where the firm's earnings per share is maximized.

C)   Other things held constant, if you increase a firm's financial leverage you will increase the firm's beta coefficient.

Correct answer is B)

The firm's optimal capital structure occurs where the firm's stock price or value is maximized and the WACC is minimized.

 

Q7. The capital structure that:

A)   minimizes the required rate on equity maximizes the stock price.

B)   maximizes the stock price minimizes the weighted average cost of capital.

C)   maximizes expected EPS maximizes the price per share of common stock.

Correct answer is B)

At the optimal capital structure the firm will minimize the WACC, maximize the share price of the stock and maximize the value of the firm.

 

Q8. Which one of the following statements about a firm's capital structure is most accurate? The optimal capital structure:

A)   maximizes expected earnings per share (EPS), maximizes the price per share of common stock.

B)   minimizes the required rate on equity, maximizes the stock price.

C)   maximizes the stock price, minimizes the weighted average cost of capital (WACC).

Correct answer is C)

The firm's optimal capital structure is the one that balances the influence of risk and return and thus maximizes the firm's stock price. Return: this optimal capital structure will maximize the firm's stock price. Risk: at the optimum level, the cost of capital (as reflected in WACC) is also minimized.

A firm’s target capital structure is the debt to equity ratio that the firm tries to maintain over time. Should the firm’s current debt ratio fall below the target level, new capital needs will be satisfied by issuing debt. On the other hand, if the debt ratio is greater than the target level, the firm will raise new capital by retaining earnings or issuing new equity. When setting its target capital structure, the firm must weigh the tradeoff between risk and return associated with the use of debt. The use of debt increases the risk borne by shareholders. However, using debt leads to higher expected rates of return by shareholders. The higher risk associated with debt will depress stock prices, while the higher expected return will increase stock prices. Thus, the firm’s optimal capital structure is the one that balances the influence of risk and return and thus maximizes the firm’s stock price. The optimal debt ratio will be the firm’s target capital structure.

 

Q9. Which of the following firms is most likely to utilize additional debt the next time it raises capital? The firm:

A)   in a high tax bracket.

B)   that has many new fixed assets.

C)   firm that has experienced significant losses in recent years.

Correct answer is A)

The value of tax deductibility rises with tax rates. Of course, there are other ways to reduce taxes. Firms with many new assets are probably also benefiting from high levels of depreciation. Firms with recent losses may be avoiding taxes by writing off those losses.

 

Q10. Which of the following firms is likely to have a higher debt ratio?

A)   Bath & Books, which produces toiletries and other consumer staples that are in demand regardless of economic conditions.

B)   Critter Care, which has a low debt rating due to the prior financial mismanagement by the chief executive officer.

C)   ffice:smarttags" />laceName w:st="on">EgglaceName> laceType w:st="on">HarborlaceType> Furs, which serves as a wholesaler of fine furs and garments.

Correct answer is A)

Bath & Books appears to have relatively little business risk, especially in relation to Egg Harbor Furs, which is likely to be a much more cyclical business. Creditors will be less willing to lend funds to Critter Care whose managers have shown poor money management skills in the past.

 

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回复:(youzizhang)[2009] Session 8 -Reading 29: ...

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