Chapter 18
Capital Structure and the Cost of Capital

TRUE-FALSE QUESTIONS

1. The firm’s capital structure is the mix of debt and equity used to finance its assets.

Difficulty Level: Easy

Subject Heading: Why Choose a Capital Structure?

L.O. 18.1

2. Firm value is calculated by adding expected cash flow to the firm’s cost of capital under each capital structure.

Difficulty Level: Medium

Subject Heading: Why Choose a Capital Structure?

L.O. 18.1

3. A nonoptimal capital structure may lead to higher financing costs.

Difficulty Level: Medium

Subject Heading: Why Choose a Capital Structure?

L.O. 18.1

4. A nonoptimal capital structure may lead the firm to reject some capital budgeting projects that could have increased shareholder wealth with an optimal financing mix.

Difficulty Level: Medium

Subject Heading: Why Choose a Capital Structure?

L.O. 18.1

5. The firm’s optimum debt/equity mix minimizes the firm’s cost of capital, which in turn will help the firm to maximize shareholder wealth.

Difficulty Level: Medium

Subject Heading: Why Choose a Capital Structure?

L.O. 18.1

6. The ratio of long-term debt to GDP for non-financial U.S. corporations declined drastically during the late 1990s.

Difficulty Level: Medium

Subject Heading: Trends in Corporate Use of Debt

L.O. 18.1

7. The ratio of debt to stock market equity has generally been lowest for the largest of U.S. firms.

Difficulty Level: Medium

Subject Heading: Trends in Corporate Use of Debt

L.O. 18.1

8. Repurchasing common stock decreases a firm’s debt to equity ratio.

Difficulty Level: Medium

Subject Heading: Trends in Corporate Use of Debt

L.O. 18.1

9. A lower weighted average cost of capital gives lower project NPVs.

Difficulty Level: Easy

Subject Heading: Why Choose a Capital Structure?

L.O. 18.1

10. The firm’s optimum debt/equity mix maximizes the firm’s cost of capital, which in turn will help the firm to maximize shareholder wealth.

Difficulty Level: Easy

Subject Heading: Why Choose a Capital Structure?

L.O. 18.2

11. The minimum acceptable rate of return for a project is the return that generates sufficient cash flow to pay investors their expected return.

Difficulty Level: Medium

Subject Heading: Required Rate of Return and The Cost of Capital

L.O. 18.2

12. The required return, the cost of capital, and the discount rate are actually three distinctively different concepts.

Difficulty Level: Medium

Subject Heading: Required Rate of Return and The Cost of Capital

L.O. 18.2

13. The minimum required rate of return is a weighted average of the firm’s cost of various sources of capital.

Difficulty Level: Easy

Subject Heading: Required Rate of Return and The Cost of Capital

L.O. 18.2

14. Minimum cash flow ∕ Investment = Maximum rate of return.

Difficulty Level: Easy

Subject Heading: Required Rate of Return and The Cost of Capital

L.O. 18.2

15. The weighted average cost of capital is used so project acceptance is not subject to how it is to be financed.

Difficulty Level: Easy

Subject Heading: Required Rate of Return and The Cost of Capital

L.O. 18.2

16. The cost of debt represents the minimum acceptable rate of return to a firm on a project of average risk.

Difficulty Level: Medium

Subject Heading: Cost of Debt

L.O. 18.3

17. There is no opportunity cost associated with retained earnings.

Difficulty Level: Easy

Subject Heading: Cost of Common Equity

L.O. 18.3

18. The cost of capital should be estimated from the historical cost of raising debt and equity capital.

Difficulty Level: Medium

Subject Heading: Cost of Capital

L.O. 18.3

19. The firm’s unadjusted cost of debt financing equals the yield to maturity on new debt issues.

Difficulty Level: Medium

Subject Heading: Cost of Debt

L.O. 18.3

20. Firms have three sources of common equity, retained earnings, new stock issues, and new bond issues.

Difficulty Level: Medium

Subject Heading: Cost of Common Equity

L.O. 18.3

21. Retained earnings are not directly related to net income.

Difficulty Level: Medium

Subject Heading: Cost of Common Equity

L.O. 18.3

22. Retained earnings represent cost-free financing to the firm.

Difficulty Level: Medium

Subject Heading: Cost of Common Equity

L.O. 18.3

23. Issuance costs are costs of issuing stock; includes accounting, legal, and printing costs of offering shares to the public, as well as the commission or fees earned by the investment bankers.

Difficulty Level: Medium

Subject Heading: Cost of New Common Stock

L.O. 18.3

24. Similar to the net present value method, there is a formula to determine the proportions of debt and equity a firm should use to finance its assets.

Difficulty Level: Easy

Subject Heading: Difficulty of Making Capital Structure Decisions

L.O. 18.4

25. The weighted average cost of capital represents the maximum required rate of return on a capital-budgeting project and is found by multiplying the cost of each capital structure component by its appropriate weight and summing the terms.

Difficulty Level: Medium

Subject Heading: Weighted Average Cost of Capital

L.O. 18.4

26. For any firm’s given growth strategy, its dividend decision directly affects its capital structure decision.

Difficulty Level: Medium

Subject Heading: Difficulty of Making Capital Structure Decisions

L.O. 18.4

27. Financial theory favors the method using the market values of the firm’s debt and equity to compare target and actual weights.

Difficulty Level: Medium

Subject Heading: Measuring The Target Weights

L.O. 18.4

28. The basic capital structure of a firm may include debt, preferred equity, common equity, and bonds.

Difficulty Level: Medium

Subject Heading: Measuring The Target Weights

L.O. 18.4

29. Surveys of U.S. firms find that most firms use before-tax WACC as their required rate of return for projects.

Difficulty Level: Hard

Subject Heading: What Do Businesses Use as Their Cost of Capital?

L.O. 18.4

30. Corporate bond yields are extremely stable over time.

Difficulty Level: Hard

Subject Heading: What Do Businesses Use as Their Cost of Capital?

L.O. 18.4

31. Corporate stock prices are extremely stable over time.

Difficulty Level: Hard

Subject Heading: What Do Businesses Use as Their Cost of Capital?

L.O. 18.4

32. The internal growth rate measures how quickly a firm can increase its asset base over the next year without raising outside funds.

Difficulty Level: Medium

Subject Heading: Internal Growth Rate

L.O. 18.5

33. The sustainable growth rate measures how quickly a firm can increase its asset base over the next year without raising outside funds.

Difficulty Level: Medium

Subject Heading: Sustainable Growth Rate

L.O. 18.5

34. The sustainable growth rate measures how quickly a firm can grow when it uses both internal equity and debt financing to keep its capital structure constant over time.

Difficulty Level: Medium

Subject Heading: Sustainable Growth Rate

L.O. 18.5

35. The internal growth rate measures how quickly a firm can grow when it uses both internal equity and debt financing to keep its capital structure constant over time.

Difficulty Level: Medium

Subject Heading: Internal Growth Rate

L.O. 18.5

36. The retained earnings rate is the proportion of each dollar of earnings per share that is retained by the firm.

Difficulty Level: Medium

Subject Heading: Internal Growth Rate

L.O. 18.5

37. The dividend payout ratio is the proportion of each dollar of earnings that is paid to shareholders as a dividend; equals one minus the retention rate.

Difficulty Level: Medium

Subject Heading: Internal Growth Rate

L.O. 18.5

38. The green growth rate is the estimate of how quickly a firm can grow when it uses internal equity and debt financing to keep its capital structure constant over time.

Difficulty Level: Medium

Subject Heading: Internal Growth Rate

L.O. 18.5

39. A reduction in the dividend payout ratio implies a higher retention rate.

Difficulty Level: Easy

Subject Heading: Effects of Unexpectedly Higher (or Lower) Growth

L.O. 18.5

40. ROA = Profit margin / Total asset turnover.

Difficulty Level: Easy

Subject Heading: Effects of Unexpectedly Higher (or Lower) Growth

L.O. 18.5

41. EBIT/EPS analysis allows managers to see how different capital structures affect the earnings levels of their firms.

Difficulty Level: Easy

Subject Heading: EBIT/EPS Analysis

L.O. 18.6

42. EBIT/EPS analysis shows the ranges of EBIT where a firm may prefer one capital structure over another.

Difficulty Level: Easy

Subject Heading: Implications of EBIT/EPS Analysis

L.O. 18.6

43. The EPS/EBIT indifference level represents the level of EBIT at which the firm would be indifferent between two different capital structures because they both result in the same level of EPS.

Difficulty Level: Medium

Subject Heading: Indifference Level

L.O. 18.6

44. A firm’s financial risk is measured by its variability in EBIT over time.

Difficulty Level: Easy

Subject Heading: Implications of EBIT/Eps Analysis

L.O. 18.6

45. Business risk is measured by the degree of financial leverage.

Difficulty Level: Easy

Subject Heading: Implications of EBIT/Eps Analysis

L.O. 18.6

46. A firm’s business risk is measured by its variability in EBIT over time.

Difficulty Level: Medium

Subject Heading: Implications of EBIT/Eps Analysis

L.O. 18.6

47. Variations in EBIT will produce changes in earnings per share.

Difficulty Level: Easy

Subject Heading: Implications of EBIT/Eps Analysis

L.O. 18.6

48. EBIT/eps analysis inadequately captures the risk facing investors and how it affects shareholder wealth.

Difficulty Level: Easy

Subject Heading: Implications of EBIT/Eps Analysis

L.O. 18.6

49. Operating leverage affects the top portion of a firm’s income statement whereas financial leverage affects the bottom half of the income statement.

Difficulty Level: Easy

Subject Heading: Fixed Costs

L.O. 18.7

50. Financial risk affects the bottom half of the income statement.

Difficulty Level: Easy

Subject Heading: Combined Operating and Financial Leverage Effects

L.O. 18.7

51. The greater the total fixed operating costs of a firm, the greater the degree of operating leverage and the greater the degree of combined leverage.

Difficulty Level: Medium

Subject Heading: Combined Operating and Financial Leverage Effects

L.O. 18.7

52. The degree of financial leverage measures the sensitivity of earnings per share to changes in EBIT.

Difficulty Level: Easy

Subject Heading: Degree of Financial Leverage

L.O. 18.7

53. The degree of financial leverage may be measured by taking the firm’s earnings before interest and taxes and dividing by earnings before taxes.

Difficulty Level: Medium

Subject Heading: Degree of Financial Leverage

L.O. 18.7

54. When the interest expense is zero, the percentage change in earnings per share will be the same as the percentage change in EBIT.

Difficulty Level: Medium

Subject Heading: Degree of Financial Leverage

L.O. 18.7

55. The degree of combined leverage is measured by adding the degree of operating leverage and degree of financial leverage.

Difficulty Level: Medium

Subject Heading: Total Risk

L.O. 18.7

56. The degree of financial leverage measures the sensitivity of earnings per share to sales.

Difficulty Level: Easy

Subject Heading: Degree of Financial Leverage

L.O. 18.7

57. The degree of combined leverage is the percentage change in earnings per share that results from a one percent change in EBIT.

Difficulty Level: Easy

Subject Heading: Degree of Financial Leverage

L.O. 18.7

58. Leverage does not affect EPS for most firms.

Difficulty Level: Medium

Subject Heading: Degree of Financial Leverage

L.O. 18.7

59. A firm’s degree of combined leverage is the product of its degree of operating leverage and its degree of financial leverage

Difficulty Level: Easy

Subject Heading: Combined Operating and Financial Leverage Effects

L.O. 18.7

60. Operating leverage is affected by such items as rental payments, contractual employee salaries, and general and administrative overhead expenses.

Difficulty Level: Medium

Subject Heading: Fixed Costs

L.O. 18.7

61. Some classes of common equity may have superior voting rights.

Difficulty Level: Medium

Subject Heading: Beyond Debt and Equity

L.O. 18.8

62. The pecking order hypothesis implies that firm’s have no optimal debt/equity ratios.

Difficulty Level: Medium

Subject Heading: The Pecking Order Hypothesis

L.O. 18.8

63. All classes of common equity may have the same voting rights.

Difficulty Level: Medium

Subject Heading: Beyond Debt and Equity

L.O. 18.8

64. All classes of common equity may have the same dividends.

Difficulty Level: Medium

Subject Heading: Beyond Debt and Equity

L.O. 18.8

65. Preferred stock has a claim on the firm that is senior to the bondholder claim and also senior to the common shareholder claim.

Difficulty Level: Medium

Subject Heading: Beyond Debt and Equity

L.O. 18.8

66. The static trade-off hypothesis states that firms will balance the advantages of debt with its disadvantages.

Difficulty Level: Easy

Subject Heading: Bankruptcy Costs

L.O. 18.8

67. The probability of financial distress and bankruptcy rises as a firm’s bond ratings decline.

Difficulty Level: Easy

Subject Heading: Bankruptcy Costs

L.O. 18.8

68. Firms prefer to issue stock when earnings expectations by the market are overly optimistic.

Difficulty Level: Easy

Subject Heading: Market Timing

L.O. 18.8

69. An implication of the pecking order and market timing hypotheses is that the firm has no optimal capital structure.

Difficulty Level: Medium

Subject Heading: Market Timing

L.O. 18.8

70. A firm’s DOL affects the amount of debt it can issue.

Difficulty Level: Easy

Subject Heading: Guidelines for Financing Strategy

L.O. 18.8

71. Firms with highly variable EBIT can afford to issue large amounts of debt.

Difficulty Level: Easy

Subject Heading: Guidelines for Financing Strategy

L.O. 18.8

MULTIPLE-CHOICE QUESTIONS

72. A firm’s mix of debt and equity defines the firm’s:

a. capital structure

b. working capital

c. net working capital

d. degree of operating leverage

Difficulty Level: Easy

Subject Heading: Why Choose a Capital Structure?

L.O. 18.1

73. What should be the relation between the target capital structure for a firm and the firm’s optimum capital structure?

a. Target and optimum capital structures should be the same.

b. Target capital structure is more conservative overall.

c. Target capital structure contains more debt.

d. Target capital structure excludes preferred stock.

Difficulty Level: Medium

Subject Heading: Why Choose a Capital Structure?

L.O. 18.1

74. Which of the following is a different concept from the other three?

a. required rate of return

b. cost of capital

c. discount rate

d. net profit margin

Difficulty Level: Medium

Subject Heading: Why Choose a Capital Structure?

L.O. 18.1

75. All of the following statements are correct except:

a. The firm’s optimum debt/equity mix maximizes the firm’s cost of capital, which in turn helps the firm to maximize shareholder wealth

b. A firm’s mix of debt and equity used to finance its assets defines the firm’s capital structure.

c. A non-optimal capital structure with either too much or too little debt leads to higher financing costs, and the firm will likely reject some capital budgeting projects that could have increased shareholder wealth with an optimal financing mix.

d. A project’s NPV represents the increase in shareholders’ wealth from undertaking a project; thus, a lower weighted average cost of capital gives higher project net present values and results in higher levels of shareholder wealth.

Difficulty Level: Hard

Subject Heading: Mixed

L.O. 18.1

76. All of the following statements are correct, except:

a. The firm’s optimum debt/equity mix minimizes the firm’s cost of capital, which in turn helps the firm to maximize shareholder wealth

b. A firm’s mix of debt and equity used to finance its assets is not the firm’s capital structure.

c. A non-optimal capital structure with either too much or too little debt leads to higher financing costs, and the firm will likely reject some capital budgeting projects that could have increased shareholder wealth with an optimal financing mix.

d. A project’s NPV represents the increase in shareholders’ wealth from undertaking a project; thus, a lower weighted average cost of capital gives higher project net present values and results in higher levels of shareholder wealth.

Difficulty Level: Hard

Subject Heading: Mixed

L.O. 18.1

77. All of the following statements are correct except:

a. Venture capitalists usually are members of partnerships that consist of a few general partners.

b. The typical venture capital partnership manages between $500 million and $1billion in assets.

c. It is common to organize a venture capital fund as a limited partnership in which the venture capitalist is the general partner and the other investors are limited investors.

d. At the end of a fund’s life, cash and securities are distributed to the investors.

Difficulty Level: Hard

Subject Heading: Venture Capital as a Source of Financing for the Small Business

L.O. 18.2

78. To compensate the firm’s investors adequately, the project should generate an annual pretax expected cash flow equal to which of the following:

a. Lender’s interest - Shareholders’ return

b. Lender’s interest + Shareholders’ return

c. Minimum cash flow x Investment

d. Minimum cash flow ∕ Investment

Difficulty Level: Easy

Subject Heading: Required Rate of Return and The Cost of Capital

L.O. 18.2

79. The project’s pre-tax minimum rate of return must equal which of the following:

a. Lender’s interest - Shareholders’ return

b. Lender’s interest + Shareholders’ return

c. Minimum cash flow x Investment

d. Minimum cash flow ∕ Investment

Difficulty Level: Easy

Subject Heading: Required Rate of Return and The Cost of Capital

L.O. 18.2

80. Of the components shown below, which is least likely to be of value in calculating the cost of preferred stock?

a. flotation costs per share

b. book value of a preferred share

c. dividends per share

d. market price per share

Difficulty Level: Easy

Subject Heading: Cost of Preferred Stock

L.O. 18.3

81. In calculating the cost of new common stock using the constant dividend growth model, it is important that the __________ are subtracted from the price of the stock.

a. flotation costs

b. par value

c. cost of retained earnings

d. proceeds of the sale

Difficulty Level: Easy

Subject Heading: Cost of Common Equity

L.O. 18.3

82. When retained earnings are used up and new common stock is issued, we know that the cost of:

a. equity has increased

b. equity has dropped

c. equity is unaffected

d. both common and preferred stock are affected

Difficulty Level: Easy

Subject Heading: Cost of New Common Stock

L.O. 18.3

83. Flotation costs include all of the following, except:

a. cost of printing shares

b. legal and accounting costs

c. investment banker fees

d. management expense

Difficulty Level: Easy

Subject Heading: Cost of New Common Stock

L.O. 18.3

84. The cost of debt:

a. is typically higher than the cost of preferred stock

b. must be adjusted to an after-tax cost

c. is higher than the cost of retained earnings

d. is the lowest component cost because corporations can deduct 70 percent of the interest expense

Difficulty Level: Easy

Subject Heading: Cost of Debt

L.O. 18.3

85. The cost of retained earnings is:

a. the cheapest component cost

b. zero because the firm does not have to pay interest or dividend to itself

c. always less than the cost of new common stock

d. typically cheaper than the cost of preferred stock

Difficulty Level: Easy

Subject Heading: Cost of Common Equity

L.O. 18.3

86. The cost of capital for retained earnings:

a. cannot be determined

b. may be determined by more than method

c. is greater than the cost of capital for common stock

d. is higher than the cost issuing bonds

Difficulty Level: Medium

Subject Heading: Cost of New Common Stock

L.O. 18.3

87. The after-tax cost of debt for a firm in the 35% tax bracket with a before-tax cost of debt of 6% is:

a. 6%

b. 2.1%

c. 3.9%

d. 5.8%

Difficulty Level: Medium

Subject Heading: Cost of Debt

L.O. 18.3

88. Ningbo Shipping has issued preferred stock at its $125 per share par value. The stock will pay a $15 annual dividend. The cost of issuing and selling the stock was $4 per share. The cost of Ningbo Shipping preferred stock is:

a. 7.2%.

b. 12.0%.

c. 12.4%.

d. 15%.

Difficulty Level: Medium

Subject Heading: Cost of Preferred Stock

L.O. 18.3

89. Ningbo Shipping, which has an average tax rate of 40 percent, would like to estimate the after-tax cost of debt for a 15-year, 12 percent, $1,000 par value bond, selling at $950. Based on this information, the after-tax cost of debt is:

a. 7.7%.

b. 12.0%.

c. 12.8%.

d. 15%.

Difficulty Level: Medium

Subject Heading: Cost of Debt

L.O. 18.3

90. Ningbo Shipping has common stock with a market price of $25 per share and an expected dividend of $2 per share at the end of the coming year. The growth rate in dividends has been 5 percent and this growth is expected to continue indefinitely. Based on this information, the cost of the firm's common stock equity is

a. 5%.

b. 8%.

c. 10%.

d. 13%.

Difficulty Level: Medium

Subject Heading: Cost of Preferred Stock

L.O. 18.3

91. Ningbo Shipping has determined it can issue preferred stock at $115 per share par value. The stock will pay a $12 annual dividend. The cost of issuing and selling the stock is $3 per share. The cost of the preferred stock is

a. 6.4%.

b. 9.4%.

c. 10.7%.

d. 14.7%.

Difficulty Level: Medium

Subject Heading: Cost of Preferred Stock

L.O. 18.3

92. All of the following methods can be used to estimate the cost of debt except:

a. If the firm targets an “A” rating (or any other bond rating), a review of the yields to maturity on A-rated bonds in Standard & Poor’s Bond Guide can provide an estimate of the firm’s current borrowing costs.

b. The firm can solicit the advice of investment bankers on the cost of issuing new debt.

c. If the firm has debt currently trading, it can use public market prices and yields to estimate its current cost of debt.

d. A firm can seek long-term debt financing from a bank or a consortium of banks; preliminary discussions with the bankers will not indicate a ballpark interest rate the firm can expect to pay on its borrowing.

Difficulty Level: Hard

Subject Heading: Cost of Debt

L.O. 18.3

93. All of the following methods can be used to estimate the cost of debt except:

a. If the firm targets an “A” rating (or any other bond rating), a review of the yields to maturity on A-rated bonds in Standard & Poor’s Bond Guide can provide an estimate of the firm’s current borrowing costs.

b. The firm can solicit the advice of personal financial planners on the cost of issuing new debt.

c. If the firm has debt currently trading, it can use public market prices and yields to estimate its current cost of debt.

d. A firm can seek long-term debt financing from a bank or a consortium of banks; preliminary discussions with the bankers will indicate a ballpark interest rate the firm can expect to pay on its borrowing.

Difficulty Level: Hard

Subject Heading: Cost of Debt

L.O. 18.3

94. Which of the following costs must be adjusted to an after-tax cost?

a. cost of debt

b. cost of preferred stock

c. cost of common stock

d. cost of retained earnings

Difficulty Level: Medium

Subject Heading: Cost of Debt

L.O. 18.3

95. Using the constant dividend growth model, which of the following components is not considered?

a. current stock price

b. dividend growth rate

c. risk-free rate

d. the Treasury bond rate

Difficulty Level: Medium

Subject Heading: Cost of Common Equity

L.O. 18.3

96. All of the following are correct except:

a. Unlike debt and preferred stock, cash flows from common equity are not fixed or known beforehand and their risk is harder to evaluate.

b. Firms have three sources of common equity, retained earnings, treasury stock, and new stock issues, and thus two costs of common equity.

c. From the shareholders’ perspective, the opportunity cost of retained earnings is the return the shareholders could earn by investing the funds in assets whose risk is similar to that of the firm.

d. If the firm cannot invest its retained earnings to achieve a sufficient risk-adjusted return, shareholders would be better off receiving 100 percent of its net income as dividends.

Difficulty Level: Hard

Subject Heading: Mixed

L.O. 18.3

97. All of the following methods are correct except:

a. Like debt and preferred stock, cash flows from common equity are fixed.

b. Firms have two sources of common equity, retained earnings and new stock issues, and thus two costs of common equity.

c. From the shareholders’ perspective, the opportunity cost of retained earnings is the return the shareholders could earn by investing the funds in assets whose risk is similar to that of the firm.

d. If the firm cannot invest its retained earnings to achieve a sufficient risk-adjusted return, shareholders would be better off receiving 100 percent of its net income as dividends.

Difficulty Level: Hard

Subject Heading: Mixed

L.O. 18.3

98. Which of the following is not potentially used in the weighted average cost of capital equation?

a. cost of retained earnings

b. weight of debt

c. average corporate income tax rate

d. marginal tax rate

Difficulty Level: Easy

Subject Heading: Weighted Average Cost of Capital

L.O. 18.4

99. The initial impact of increasing the use of debt for a firm which had no prior debt financing is to:

a. lower the cost of capital

b. lower the weight of the debt component

c. increase the cost of capital

d. lower the cost of retained earnings

Difficulty Level: Easy

Subject Heading: Weighted Average Cost of Capital

L.O. 18.4

100. Finance theory favors the use of ____________ value weights in the calculation of the weighted average cost of capital.

a. book

b. future

c. market

d. GAAP

Difficulty Level: Medium

Subject Heading: Measuring The Target Weights

L.O. 18.4

101. What is Ningbo Shipping’s WACC if it’s after tax cost of debt is 3.5%, it’s cost of retained earnings is 14%, and the firm’s market value of debt is $40 million while the market value of its equity is $60 million?

a. 9.8%.

b. 3.5%.

c. 11.8%.

d. 14.7%.

Difficulty Level: Medium

Subject Heading: Weighted Average Cost of Capital

L.O. 18.4

102. All of the following statements are correct except:

a. Relevant cash flows are incremental after-tax cash flows, which must be discounted using an incremental after-tax cost of capital.

b. The firm’s relevant cost of capital is computed from before-tax financing costs.

c. A project’s incremental cash flows must be discounted at a cost of capital that represents the incremental or marginal cost to the firm of financing the project, that is, the cost of raising one additional dollar of capital.

d. In estimating the cost of capital, the firm’s analysts need to evaluate investors’ expected returns under likely market conditions and then use these expected returns to compute the firm’s marginal future cost of raising funds.

Difficulty Level: Hard

Subject Heading: Mixed

L.O. 18.4

103. All of the following statements are correct except:

a. Relevant cash flows are incremental before-tax cash flows, which must be discounted using an incremental after-tax cost of capital.

b. The firm’s relevant cost of capital is computed from after-tax financing costs.

c. A project’s incremental cash flows must be discounted at a cost of capital that represents the incremental or marginal cost to the firm of financing the project, that is, the cost of raising one additional dollar of capital.

d. In estimating the cost of capital, the firm’s analysts need to evaluate investors’ expected returns under likely market conditions and then use these expected returns to compute the firm’s marginal future cost of raising funds.

Difficulty Level: Hard

Subject Heading: Mixed

L.O. 18.4

104. All of the following statements regarding capital structure weights in the WACC equation are correct except:

a. The weights represent a variable financing mix.

b. These target weights represent a mix of debt and equity that the firm will try to achieve or maintain over the planning horizon.

c. As much as possible, the target weights should reflect the combination of debt and equity that management believes will minimize the firm’s weighted average cost of capital.

d. The firm should make an effort over time to move toward and maintain its target capital structure mix of debt and equity.

e. All of the above statements are correct.

Difficulty Level: Hard

Subject Heading: Mixed

L.O. 18.4

105. All of the following statements regarding capital structure weights in the WACC equation are correct except:

a. The weights represent a specific intended financing mix.

b. These target weights represent a mix of debt and equity that the firm will try to achieve or maintain over the planning horizon.

c. As much as possible, the target weights should reflect the combination of debt and equity that management believes will maximize the firm’s weighted average cost of capital.

d. The firm should make an effort over time to move toward and maintain its target capital structure mix of debt and equity.

Difficulty Level: Hard

Subject Heading: Mixed

L.O. 18.4

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

a. minimum risk

b. maximum earnings per share

c. minimum weighted average cost of capital

d. minimum cost of equity

Difficulty Level: Medium

Subject Heading: Weighted Average Cost of Capital

L.O. 18.4

107. As a general rule, the capital structure that:

a. minimizes the cost of equity also maximizes the stock price

b. maximizes the stock price also minimizes the weighted average cost of capital

c. minimizes the cost of debt also maximizes the expected earnings per share

d. increases operating leverage for a given quantity of output, increases business risk

Difficulty Level: Medium

Subject Heading: Weighted Average Cost of Capital

L.O. 18.4

108. Which of the following statements is correct?

a. All component costs in a firm’s weighted average cost of capital must reflect after-tax costs, but the only component that requires an adjustment for taxes is the cost of new common stock.

b. An increase in the marginal corporate tax rate would lower the weighted average cost of capital for the firm, other things held constant.

c. The cost of debt is equal to one minus the marginal tax rate multiplied by the coupon rate on outstanding debt.

d. The WACC is the sum of the Fed Funds rate and the firm’s bond coupon rate.

Difficulty Level: Medium

Subject Heading: Weighted Average Cost of Capital

L.O. 18.4

109. All of the following components are needed to calculate the internal growth rate except:

a. return on assets

b. retention rate

c. return on equity

d. earnings on assets

Difficulty Level: Medium

Subject Heading: Internal Growth Rate

L.O. 18.5

110. All of the following components are needed to calculate the sustainable growth rate except:

a. return on assets

b. retention rate

c. return on equity

d. earnings on assets

Difficulty Level: Medium

Subject Heading: Sustainable Growth Rate

L.O. 18.5

111. The internal and sustainable growth rate relationships suggest that there are three measurable influences on growth. These include all of the following except:

a. asset policy

b. dividend policy

c. profitability

d. the firm’s capital structure

Difficulty Level: Medium

Subject Heading: Mixed

L.O. 18.5

112. The estimate of how quickly a firm may grow by maintaining a constant mix of debt and equity is called:

a. the retention growth rate

b. dividend growth rate

c. sustainable growth rate

d. the internal growth rate

Difficulty Level: Medium

Subject Heading: Sustainable Growth Rate

L.O. 18.5

113. If a firm pays out 30% of its earnings as dividends and has averaged a 20 percent return on assets, how quickly can the firm grow without needing to secure outside funding sources?

a. 6.4%.

b. 10.2%.

c. 16.3%.

d. 20.0%.

Difficulty Level: Medium

Subject Heading: Internal Growth Rate

L.O. 18.5

114. If a firm pays out 20% of its earnings as dividends and has averaged a 20 percent return on equity, how quickly can the firm grow while maintaining a constant debt to equity mix?

a. 6.4%.

b. 10.2%.

c. 16.3%.

d. 19.0%.

Difficulty Level: Medium

Subject Heading: Sustainable Growth Rate

L.O. 18.5

115. All of the following statements are correct except:

a. The internal growth rate measures how quickly a firm can increase its asset base over the next year without raising outside funds.

b. The retention rate represents the proportion of every $1 of earnings per share that is retained by the firm; in other words, it is equal to one plus the dividend payout ratio.

c. The sustainable growth rate measures how quickly the firm can grow when it uses both internal equity and debt financing to keep its capital structure constant over time.

d. The internal and sustainable growth rate relationships suggest that there are three measurable influences on growth: dividend policy (as reflected in the retention rate), profitability (as measured by ROA), and the firm’s capital structure (as measured by the equity multiplier).

Difficulty Level: Hard

Subject Heading: Mixed

L.O. 18.5

116. All of the following statements are correct except:

a. The internal growth rate measures how quickly a firm can increase its asset base over the next year without raising outside funds.

b. The retention rate represents the proportion of every $1 of earnings per share that is retained by the firm; in other words, it is equal to one minus the dividend payout ratio.

c. The sustainable growth rate measures how quickly the firm can grow when it uses only debt financing to keep its capital structure constant over time.

d. The internal and sustainable growth rate relationships suggest that there are three measurable influences on growth: dividend policy (as reflected in the retention rate), profitability (as measured by ROA), and the firm’s capital structure (as measured by the equity multiplier).

Difficulty Level: Hard

Subject Heading: Mixed

L.O. 18.5

117. This is a measure of how quickly a firm can increase its asset base over the next year without raising outside funds,

a. Internal rate of return

b. Internal growth rate

c. Retention rate

d. Dividend payout ratio

Difficulty Level: Easy

Subject Heading: Planning Growth Rates

L.O. 18.5

118. It is equal to the ratio of the expected increase in retained earnings over the next year to the current asset base.

a. Internal rate of return

b. Internal growth rate

c. Retention rate

d. Dividend payout ratio

Difficulty Level: Easy

Subject Heading: Planning Growth Rates

L.O. 18.5

119. (RR)(ROA) / [1 – (RR)(ROA)]

a. Internal rate of return

b. Internal growth rate

c. Retention rate

d. Dividend payout ratio

Difficulty Level: Medium

Subject Heading: Planning Growth Rates

L.O. 18.5

120. This is the proportion of each dollar of earnings per share that is retained by the firm.

a. Internal rate of return

b. Internal growth rate

c. Retention rate

d. Dividend payout ratio

Difficulty Level: Easy

Subject Heading: Planning Growth Rates

L.O. 18.5

121. This is the proportion of each dollar of earnings that is paid to shareholders as a dividend; equals one minus the retention rate.

a. Internal rate of return

b. Internal growth rate

c. Retention rate

d. Dividend payout ratio

Difficulty Level: Easy

Subject Heading: Planning Growth Rates

L.O. 18.5

122. All of the following statements are correct except:

a. EBIT/EPS analysis allows managers to see how different capital structures affect the earnings and risk levels of their firms.

b. EBIT/EPS analysis shows the graphical relationship between a firm’s operating earnings, or earnings before interest and taxes (EBIT), and earnings per share (EPS).

c. EBIT/EPS analysis suggests that at no EBIT level, will a firm will be indifferent between the two capital structures.

d. EBIT/eps analysis shows the ranges of EBIT where a firm may prefer one capital structure over another so that the firm may decide to increase or decrease its financial leverage depending on whether its expected EBIT is above or below the indifference EBIT level.

Difficulty Level: Hard

Subject Heading: EBIT/EPS Analysis

L.O. 18.6

123. A firm’s business risk is measured by the variability in which one of the following over time:

a. net sales

b. total assets

c. operating income (EBIT)

d. net income

Difficulty Level: Medium

Subject Heading: Implications of EBIT/Eps Analysis

L.O. 18.6

124. The degree of combined leverage shows us to what degree a percentage change in sales will cause a percentage change in:

a. earnings before interest and taxes

b. pre-tax earnings

c. earnings per share

d. gross profit

Difficulty Level: Easy

Subject Heading: Total Risk

L.O. 18.7

125. Which of the following is a correct way to calculate degree of combined leverage?

a. divide DFL by DOL

b. multiply DOL by DFL

c. divide DOL by DFL

d. add DOL and DFL

Difficulty Level: Easy

Subject Heading: Total Risk

L.O. 18.7

126. A firm’s degree of combined leverage can be measured as degree of operating leverage __________ the degree of financial leverage:

a. plus

b. minus

c. times

d. divided by

Difficulty Level: Medium

Subject Heading: Total Risk

L.O. 18.7

127. A decrease in the debt ratio will normally have no effect on:

a. financial risk

b. business risk

c. total risk

d. systematic risk

Difficulty Level: Medium

Subject Heading: Combined Operating and Financial Leverage Effects

L.O. 18.7

128. Which of the following statements is correct?

a. The degree of combined leverage measures the sensitivity of earnings per share into changes in EBIT.

b. A firm’s business risk is measured by its variability in earnings per share over time.

c. A firm’s degree of combined leverage is the product of its degree of operating leverage and its degree of financial leverage.

d. Total leverage does not consider financial leverage.

Difficulty Level: Medium

Subject Heading: Total Risk

L.O. 18.7

129. Which of the following statements is false?

a. Combined leverage is the effect on earnings produced by the operating and financial leverage.

b. There is strong empirical evidence that firms adjust their degrees of operating leverage and degrees of financial leverage to match some standard degree of combined leverage.

c. Financial risk is the additional risk, above business risk, resulting from substituting debt into the capital structure.

d. A firm’s degree of combined leverage is the product of its degree of operating leverage and its degree of financial leverage.

Difficulty Level: Medium

Subject Heading: Multiple Topics

L.O. 18.7

130. A company with a DCL of 12 and a DFL of 2 has a DOL of?

a. 24

b. 14

c. 6

d. 3

Difficulty Level: Medium

Subject Heading: Total Risk

L.O. 18.7

131. A firm with a DOL of 2, and no preferred stock, and no long-term debt will have a DCL of:

a. 0

b. 2

c. 1

d. -1

Difficulty Level: Medium

Subject Heading: Total Risk

L.O. 18.7

132. A high degree of financial leverage means that a small change in sales will result in:

a. a small change in earnings per share

b. a large change in earnings per share

c. no change in earnings per share

d. always a negative change in earnings per share

Difficulty Level: Medium

Subject Heading: Degree of Financial Leverage

L.O. 18.7

133. A decrease in contractual managers’ salaries will result in:

a. an increase in the degree of financial leverage

b. a decrease in the degree of financial leverage

c. no change in the degree of financial leverage

d. an increase in operational leverage

Difficulty Level: Medium

Subject Heading: Degree of Financial Leverage

L.O. 18.7

134. A firm’s business risk is affected by all of the following, except:

a. business cycle

b. the firm’s operating leverage

c. competitive pressures

d. the interest rate on previously issued bonds

Difficulty Level: Medium

Subject Heading: Combined Operating and Financial Leverage Effects

L.O. 18.7

135. A decrease in contractual managers’ salaries will result in:

a. an increase in the degree of combined leverage

b. a decrease in the degree of combined leverage

c. no change in the degree of combined leverage

d. an increase in the degree of financial leverage

Difficulty Level: Medium

Subject Heading: Degree of Financial Leverage

L.O. 18.7

136. If a firm has current earnings per share of $2 and a degree of combined leverage of 4, a 10% increase in sales would result in earnings per share of:

a. $2.80

b. $8.00

c. $2.20

d. $6.00

Difficulty Level: Medium

Subject Heading: Degree of Financial Leverage

L.O. 18.7

137. If a firm has current earnings per share of $2 and a degree of financial leverage of 4, a 10% increase in sales would result in earnings per share of:

a. $2.80

b. $8

c. $2.20

d. cannot tell from this information

Difficulty Level: Medium

Subject Heading: Degree of Financial Leverage

L.O. 18.7

138. If a firm has current earnings per share of $2 and a degree of operating leverage of 4, a 10% increase in sales would result in earnings per share of:

a. $2.80

b. $8

c. $2.20

d. cannot tell from this information

Difficulty Level: Medium

Subject Heading: Degree of Financial Leverage

L.O. 18.7

139. If a firm has current earnings before interest and taxes of $100,000 and interest expense of $10,000, its degree of financial leverage would be:

a. 10

b. 1.11

c. .10

d. 1.10

Difficulty Level: Medium

Subject Heading: Degree of Financial Leverage

L.O. 18.7

140. The degree of financial leverage measures the sensitivity of __________ to changes in __________.

a. net sales, EBIT

b. EBIT, net sales

c. EBIT, eps

d. eps, EBIT

Difficulty Level: Medium

Subject Heading: Degree of Financial Leverage

L.O. 18.7

141. All of the following statements are correct except:

a. A firm’s business risk is measured by its variability in EBIT over time and is affected by several factors, including the business cycle, competitive pressures, and the firm’s operating leverage or its level of fixed operating costs.

b. The degree of financial leverage measures the sensitivity of earnings per share to changes in EBIT.

c. The degree of combined leverage is the percentage change in gross profit that results from a 1 percent change in sales volume.

d. The degree of combined leverage is simply the product of its degree of operating leverage and its degree of financial leverage.

Difficulty Level: Hard

Subject Heading: Degree of Financial Leverage

L.O. 18.7

142. Other factors being constant, higher fixed operating costs mean:

a. higher financial leverage

b. higher operating leverage

c. lower combined leverage

d. the degree of financial leverage is equal to 1.0

Difficulty Level: Easy

Subject Heading: Fixed Costs

L.O. 18.7

143. Smith Company has a degree of operating leverage of 5, while an industry competitor, Johnson Company, has a degree of operating leverage of 2. Supplied with this knowledge, pick the response below that is most typical of Johnson Company.

a. high fixed costs

b. conservative

c. large commitment to plant facilities

d. low sales.

Difficulty Level: Medium

Subject Heading: Degree of Financial Leverage

L.O. 18.7

144. A company experienced a 12 % increase in earnings before interest and taxes and a 3 % increase in sales. What is the degree of operating leverage for this company?

a. 36

b. 6

c. 4

d. 9

Difficulty Level: Medium

Subject Heading: Fixed Costs

L.O. 18.7

145. Other factors being constant, higher fixed financial costs mean:

a. higher financial leverage

b. higher operating leverage

c. lower combined leverage

d. the degree of financial leverage is equal to 1.0

Difficulty Level: Medium

Subject Heading: Combined Operating and Financial Leverage Effects

L.O. 18.7

146. Which of the following is not an influence affecting a firm’s capital structure choices?

a. corporate control

b. maturity matching

c. timing

d. distribution channels

Difficulty Level: Medium

Subject Heading: Guidelines for Financing Strategy

L.O. 18.8

147. The hypotheses that states that firm’s try to time the market by issuing stocks when stock prices are high and repurchasing shares when prices are low is called:

a. the market theory hypothesis

b. the market timing hypothesis

c. the market value hypothesis

d. the market pricing hypothesis

Difficulty Level: Medium

Subject Heading: Market Timing

L.O. 18.8

148. All of the following affects a firm’s choice of capital structures, except:

a. flexibility

b. timing

c. corporate control

d. management compensation

Difficulty Level: Medium

Subject Heading: Guidelines for Financing Strategy

L.O. 18.8

149. All of the following statements are correct except:

a. The tax deductibility of debt becomes more important to firms with large non-debt tax shields such as foreign tax credits granted by the U.S. government to firms that pay taxes to foreign governments.

b. As the debt/total asset ratio rises, or as earnings become more volatile, the firm will face higher borrowing costs, driven upward by bond investors requiring higher yields to compensate for additional risk.

c. The static tradeoff hypothesis states that firms will balance the advantages of debt (its lower cost and tax-deductibility of interest) with its disadvantages (greater possibility of bankruptcy and the value of explicit and implicit bankruptcy costs).

d. Agency costs reduce the optimal level of debt financing for a firm below the level that would be appropriate if agency costs were zero.

Difficulty Level: Hard

Subject Heading: Mixed

L.O. 18.8

150. Which of the following statements are correct?

a. The tax deductibility of debt becomes more important to firms with large non-debt tax shields such as foreign tax credits granted by the U.S. government to firms that pay taxes to foreign governments.

b. As the debt/total asset ratio falls, or as earnings become less volatile, the firm will face lower borrowing costs, driven down by bond investors requiring lower yields to compensate for less risk.

c. The static tradeoff hypothesis states that firms will balance the advantages of equity (its lower cost and tax-deductibility of dividends) with its disadvantages (greater possibility of bankruptcy and the value of explicit and implicit bankruptcy costs).

d. Agency costs increase the optimal level of debt financing for a firm above the level that would be appropriate if agency costs were zero.

Difficulty Level: Hard

Subject Heading: Mixed

L.O. 18.8

151. All of the following statements are correct except:

a. The pecking order hypothesis is a theory that states managers prefer to use new debt to finance the firm, then retained earnings, and (as a final resort) new equity.

b. The market timing hypothesis states that firms try to time the equity market by issuing stock when their stock prices are high and repurchasing shares when stock values are low.

c. The static tradeoff hypothesis states that firms will balance the advantages of debt (its lower cost and tax-deductibility of interest) with its disadvantages (greater possibility of bankruptcy and the value of explicit and implicit bankruptcy costs).

d. Agency costs reduce the optimal level of debt financing for a firm below the level that would be appropriate if agency costs were zero.

Difficulty Level: Hard

Subject Heading: Mixed

L.O. 18.8

152. Which of the following securities have voting rights?

a. convertible bond

b. preferred stock

c. common stock

d. treasury stock

Difficulty Level: Easy

Subject Heading: Beyond Debt and Equity

L.O. 18.8

153. This is a theory that states firms will balance the advantages of debt with its disadvantages.

a. Rational decision maker hypothesis

b. Static trade-off hypothesis

c. Pecking order hypothesis

d. Market timing hypothesis

Difficulty Level: Medium

Subject Heading: Insights From Theory and Practice

L.O. 18.8

154. This is a theory that managers prefer to use additions to retained earnings to finance the firm, then debt, and as a final resort, new equity.

a. Rational decision maker hypothesis

b. Static trade-off hypothesis

c. Pecking order hypothesis

d. Market timing hypothesis

Difficulty Level: Medium

Subject Heading: Insights From Theory and Practice

L.O. 18.8

155. A theory that firms time the market by issuing stock when their stock prices are high and repurchasing shares when their stock values are low.

a. Rational decision maker hypothesis

b. Static trade-off hypothesis

c. Pecking order hypothesis

d. Market timing hypothesis

Difficulty Level: Medium

Subject Heading: Insights From Theory and Practice

L.O. 18.8