Chapter13 GE

Principles of Managerial Finance, 13e, Global Edition (Gitman) Chapter 13 Leverage and Capital Structure

13.1 Discuss leverage, capital structure, breakeven analysis, the operating breakeven point, and the effect of changing costs the breakeven point. 1) Generally, increases in leverage result in increased return and risk. Answer: !"# opic: $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills ) (reakeven analysis is used by the fir* to deter*ine the level of operations necessary to cover co ver all fi+ed operating costs and to evaluate the profitability associated with various levels of sales. Answer: A$&# opic: o pic: (reakeven Analysis %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 3) he fir*-s operating breakeven point is the level of sales necessary to cover all fi+ed operating costs. Answer: A$&# opic: o pic: perating (reakeven /oint %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 0) $everage results fro* the use of fi+edcost assets or funds to *agnify returns to the fir*-s owners. Answer: !"# opic: $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 2) perating leverage is concerned with the relationship between the fir*-s sales revenue and its operating e+penses. Answer: A$&# opic: o pic: perating $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills ) inancial leverage is concerned with the relationship between the fir*-s earnings after interest and ta+es and its co**on stock earnings per share. Answer: A$&# opic: o pic: inancial $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills

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6) otal leverage is concerned with the relationship between the fir*-s sales revenue and its co**on stock earnings per share. Answer: !"# opic: otal $everage $evera ge %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 7) ir*-s capital structure is the *i+ of the shortter* debt, longter* debt, and e8uity *aintained by the fir*. Answer: A$&# opic: o pic: 'apital &tructure %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 9) he levels of fi+edcost assets and funds that *anage*ent selects affect the variability of returns. Answer: !"# opic: otal $everage $evera ge %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 15) he a*ount of leverage in the fir*-s capital structure the *i+ of longter* debt and e8uity *aintained by the fir* can significantly affect its value by affecting return and risk. Answer: !"# opic: o pic: inancial $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 

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11) &ales co**ission *ay be considered as a se*ivariable cost because it *ay be fi+ed for a certain volu*e of sales and then increase to higher levels for higher volu*es. Answer: !"# opic: o pic: perating $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 1) At the operating breakeven point, the sales revenue is e8ual e8u al to the su* of the fi+ed and variable operating costs. Answer: !"# opic: o pic: perating (reakeven /oint %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills

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13) #arnings before interest and ta+es are positive above the operating breakeven point, and a loss occurs below it. Answer: !"# opic: o pic: perating (reakeven /oint %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 10) or sales levels below the operating breakeven breakev en point, sales revenue e+ceeds total operating costs, and earnings before interest and ta+es is greater than ero. Answer: A$&# opic: o pic: perating (reakeven /oint %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 12) An increase in cost ;fi+ed cost or variable cost) tends to increase the operating breakeven point, whereas an increase in the sales price per unit will decrease the operating breakeven point. Answer: !"# opic: o pic: perating (reakeven /oint %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 1) he use of a dollar breakeven point is i*portant when a fir* has *ore than one product, especially when each product is selling at a different price. Answer: !"# opic: o pic: Dollar (reakeven /oint %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 16) he contribution *argin is defined as the percent of each sales dollar that re*ains after satisfying fi+ed operating costs. Answer: A$&# opic: o pic: 'ontribution
5) &ince the sales price per unit generally decreases with volu*e and the cost per unit generally increases with volu*e, the true breakeven point p oint *ay be different fro* those obtained using linear revenue and cost functions as assu*ed in the breakeven analysis. Answer: !"# opic: o pic: (reakeven Analysis %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 1) ne of the li*itations of breakeven analysis is its shortter* ti*e horion. A large outlay in the current financial period could significantly raise the fir*-s breakeven p oint, while the benefits *ay occur over a period of years. Answer: !"# opic: o pic: (reakeven Analysis %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills ) he cash breakeven point is used when certain noncash charges, such as depreciation, constitute an i*portant portion of the fir*-s fi+ed operating costs. Answer: !"# opic: o pic: 'ash perating perating (reakeven /oint %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 3) he operating breakeven point can be found by solving for the sales level that =ust covers total fi+ed and variable costs. Answer: !"# opic: o pic: perating (reakeven /oint %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 0) (oth operating and financial leverage result in the *agnification of return as well as risk. Answer: !"# opic: o pic: perating and inancial $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 2) >hile operating leverage results only in a *agnification of returns, financial leverage results only in a *agnification of risk. Answer: A$&# opic: o pic: perating and inancial $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills


) he dollar breakeven sales level can be solved for by dividing fi+ed costs by the contribution *argin ratio. Answer: !"# opic: o pic: perating (reakeven /oint %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 6) he dollar breakeven sales level can be solved for by dividing fi+ed costs by the dollar contribution *argin. Answer: A$&# opic: o pic: perating (reakeven /oint %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 7) ???????? analysis is a techni8ue used to assess the returns associated with various cost structures and levels of sales. A) i*eseries ()

31) ???????? costs are a function of volu*e, not ti*e. A) i+ed operating () &e*ivariable ') ariable D) i+ed financial Answer: ' opic: o pic: perating $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 3) he fir*-s ???????? is the level of sales necessary ne cessary to cover all operating costs, i.e., the point at which #(@ B C5. A) cash breakeven point () financial breakeven point ') operating breakeven point D) total breakeven point Answer: ' opic: o pic: perating (reakeven /oint %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 33) >hich of the following is  a variable costE A)
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32) At the operating breakeven point, ???????? e8uals ero. A) sales revenue () fi+ed operating costs ') variable operating costs D) earnings before interest and ta+es Answer: D opic: o pic: perating (reakeven /oint %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 3) A fir*-s operating breakeven point po int is sensitive to all of the following variables #F'#/ A) fi+ed operating costs. () sales price per unit. ') interest e+pense. D) variable operating cost per unit. Answer: ' opic: o pic: perating (reakeven /oint %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 36) (reakeven analysis is used by the fir* A) to deter*ine the level of operations necessary nece ssary to cover all operating costs. () to evaluate the profitability associated with various levels of sales. ') (oth A and (. D) none of the above. Answer: ' opic: o pic: (reakeven Analysis %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 37) @f a fir*-s fi+ed operating costs decrease, the fir*-s operating breakeven point will A) decrease. () increase. ') re*ain unchanged. D) change in an undeter*ined direction. Answer: A opic: o pic: perating (reakeven /oint %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills


39) @f a fir*-s variable costs per unit increase, the fir*-s operating breakeven point will A) decrease. () increase. ') re*ain unchanged. D) change in an undeter*ined direction. Answer: ( opic: o pic: perating (reakeven /oint %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 05) @f a fir*-s sale price per unit decreases, the fir*-s operating breakeven point will A) decrease. () increase. ') re*ain unchanged. D) change in an undeter*ined direction. Answer: ( opic: o pic: perating (reakeven /oint %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 01) @f a fir*-s fi+ed financial costs decrease, the fir*-s operating breakeven point will A) decrease. () increase. ') re*ain unchanged. D) change in an undeter*ined direction. Answer: ' opic: o pic: perating (reakeven /oint %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 0) he fir*-s operating breakeven point is the point at which A) total operating costs e8ual total fi+ed costs. () total operating costs are ero. ') #(@ is less than sales. D) #(@ is ero. Answer: D opic: o pic: perating (reakeven /oint %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills


03) oncash charges such as depreciation and a*ortiation ???????? the fir*-s breakeven point. A) do not affect () overstate ') understate D) decrease Answer: ( opic: o pic: perating (reakeven /oint %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 00) A fir* has fi+ed operating costs of C22,555, of which C12,555 is depreciation e+pense. he fir*-s sales price per unit is C32 and its variable cost per unit is C.25. he fir*-s cash operating breakeven point in units is A) 3,335. () 3,555. ') 0,555. D) 2,555. Answer: ( opic: o pic: 'ash perating perating (reakeven /oint %uestion &tatus: !evised AA'&( Guidelines: Guidelines: Analytic skills 02) >hich one of the following is considered a li*itation of breakeven analysisE A) @t assu*es that the fir* faces linear, or nonvarying, sales revenue and total op erating cost functions. () @t is difficult to break se*ivariable costs into fi+ed and variable co*ponents. ') @t has a shortter* ti*e horion. D) All of the above. Answer: D opic: o pic: $i*itations of (reakeven (reakeven Analysis Analysis %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 0) A *a=or assu*ption of breakeven analysis and one which causes severe li*itations in its use is that A) fi+ed costs really are fi+ed. () total revenue is nonlinear. ') revenues and operating costs are linear. D) all costs are really se*ivariable. Answer: ' opic: o pic: $i*itations of (reakeven (reakeven Analysis Analysis %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills


06) he per dollar contribution toward fi+ed operating costs and profits provided by each dollar of sales is the A) profit *argin. () contribution *argin. ') e+pense ratio. D) fi+ed coverage ratio. Answer: ( opic: o pic: 'ontribution

21) ne function of breakeven analysis is to A) create profits. () describe leverage. ') evaluate the profitability of various sales levels. D) deter*ine the a*ount of financing needed by the fir*. Answer: ' opic: o pic: (reakeven Analysis %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 2) he preferred approach to breakeven analysis for the *ultiproduct fir* is the A) breakeven point e+pressed in units. () breakeven point e+pressed in dollars. ') cash breakeven point. D) overall breakeven point. Answer: ( opic: o pic: Dollar perating perating (reakeven /oint %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 23) A fir* has fi+ed operating costs of C2,555, a per unit sales price of C2, and a variable cost per unit of C3. >hat is its operating operating breakeven point if it desires net operating inco*e of C15,555, not C5 ;ero)E A) 1,255 units () 12,555 units ') 16,255 units D) 2,555 units Answer: ' opic: o pic: perating (reakeven /oint %uestion &tatus: !evised AA'&( Guidelines: Guidelines: Analytic skills 20) ony-s ony-s (each &hirts &hirts has fi+ed annual operating costs of C62,555. C62,5 55. ony retails his shirts shirts for C10.99 each and the variable cost per shirt shirt is C0.99. (ased on this infor*ation, the breakeven sales level in dollars is A) C12,092. () C11,02. ') C157,992. D) none of the above. Answer: ( opic: o pic: Dollar perating perating (reakeven /oint %uestion &tatus: !evised AA'&( Guidelines: Guidelines: Analytic skills


22) ony-s ony-s (each &hirts &hirts has fi+ed annual operating costs of C62,555. C62,5 55. ony retails his shirts shirts for C10.99 each and the variable cost per shirt shirt is C0.99. (ased on this infor*ation, the breakeven sales level in units is A) 6,255. () 12,535. ') 2,553. D) none of the above. Answer: A opic: o pic: perating (reakeven /oint %uestion &tatus: !evised AA'&( Guidelines: Guidelines: Analytic skills 2)
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3) he relationship between operating and financial leverage is additive rather than *ultiplicative. Answer: A$&# opic: otal $everage $evera ge %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 0) perating leverage results fro* the e+istence of operating co sts in the fir*-s inco*e strea*. Answer: A$&# opic: o pic: perating $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 2) he total leverage *easures the co*bined effect of operating an d financial leverage on the fir*-s risk. Answer: !"# opic: otal $everage $evera ge %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills ) perating leverage *ay be defined d efined as the potential use of fi+ed operating costs to *agnify the effects of changes in sales on the fir*-s earnings before interest and ta+es ;#(@). Answer: !"# opic: o pic: perating $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 6) perating leverage is present when a fir* has fi+ed operating costs. Answer: !"# opic: o pic: perating $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 7) inancial leverage results fro* the presence of variable v ariable financial costs in the fir*-s inco*e strea*. Answer: A$&# opic: o pic: inancial $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 9) inancial leverage *ay be defined as the potential use of variable financial costs to *agnify the effects of changes in earnings before interest and ta+es ;#(@) on the fir*-s earnings per share ;#/&). Answer: A$&# opic: o pic: inancial $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 13 'opyright 4 51 /earson #ducation

15) >henever the percentage change in earnings before interest and ta+es resulting fro* a given g iven percentage change in sales is greater than the percentage change in sales, operating leverage e+ists. Answer: !"# opic: o pic: perating $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 11) he effect of financial leverage is such that an increase in the fir*-s earnings before interest and ta+es ;#(@) results in a *ore than proportional increase in the fir*-s earnings per share ;#/&), while a decrease in the fir*-s #(@ results in a less than proportional decrease in #/&. Answer: A$&# opic: o pic: inancial $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 1) >henever the percentage change in earnings per share ;#/&) resulting fro* a given percentage change in sales is greater than the percentage change in sales, financial leverage e+ists. Answer: A$&# opic: o pic: inancial $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 13) otal leverage e+ists whenever the percentage change in earnings per share ;#/&) resulting fro* a given percentage change in sales is greater than the percentage change in sales. Answer: !"# opic: otal $everage $evera ge %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 10) >hen a fir* has fi+ed operating costs, operating leverage is present. @n that case, an increase in sales results in a *orethanproportional increase in #(@, and a decrease in sales results in a *orethanproportional decrease in #(@. Answer: !"# opic: o pic: perating $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 12) >henever the percentage change in #(@ resulting fro* a given percentage change in sales is greater than the percentage change chang e in sales, operating leverage e+ists. Answer: !"# opic: o pic: perating $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills


1) he closer the base sales level used is to the operating breakeven point, the s*aller the operating leverage. Answer: A$&# opic: o pic: perating $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 16) he base level of #(@ *ust be held constant to co*pare the financial leverage associated with different levels of fi+ed financial costs. Answer: !"# opic: o pic: inancial $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 17) he base level of sales *ust be held he ld constant to co*pare the total leverage associated with different levels of fi+ed costs. Answer: !"# opic: otal $everage $evera ge %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 19) he degree of operating leverage will increase if a fir* decides to co*pensate its sales representatives with a fi+ed salary and bonus rather than with a pure percentofsales co**ission. Answer: !"# opic: o pic: perating $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 5) 'o*parison of the degree of operating leverage of two fir*s is valid only when the base level of sales used for each fir* is the sa*e. Answer: !"# opic: o pic: perating $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 1) he degree of operating leverage depends on the base level of sales used as a point of reference. he closer the base sales level used is to the operating breakeven point, the greater the operating leverage. Answer: !"# opic: o pic: perating $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills


) Holding all other factors constant, a fir* that is sub=ect to a greater level of business risk should e*ploy *ore total leverage than an otherwise e8uivalent fir* that is sub=ect to a lesser level of business risk. Answer: A$&# opic: o pic: (usiness !isk and o otal tal $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 3) @n general, the greater the fir*-s operating leverage, the higher its business risk. Answer: !"# opic: o pic: perating $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 0) he longter* funds of the fir* are called A) debt. () assets. ') capital. D) e8uity. Answer: ' opic: o pic: 'apital &tructure &tructure (asics %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 2) ???????? results fro* the use of fi+edcost assets or funds to *agnify returns to the fir*-s owners. A) $ongter* debt () #8uity ') $everage D) 'apital structure Answer: ' opic: o pic: 'apital &tructure &tructure (asics %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills ) ???????? leverage is concerned with the relationship between sales revenues and earnings before interest and ta+es. A) inancial () perating ') ariable D) otal Answer: ( opic: o pic: perating $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills

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6) ???????? is the risk to the fir* of being unable to cover operating o perating costs. A) otal risk () (usiness risk ') inancial risk D) Diversifiable risk Answer: ( opic: (usiness (usines s !isk %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 7) ???????? is the risk to the fir* of being unable to cover financial obligations. ob ligations. A) otal risk () (usiness risk ') inancial risk D) Diversifiable risk Answer: ' opic: o pic: inancial !isk %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 9) ???????? leverage is concerned with the relationship between sales revenue and earnings per share. A) inancial () perating ') ariable D) otal Answer: D opic: otal $everage $evera ge %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 35) (usiness risk is the risk to the fir* of being unable to cover operating costs. Answer: !"# opic: (usiness (usines s !isk %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 31) (usiness risk is the risk to the fir* of being unable to cover re8uired financial obligations. Answer: A$&# opic: (usiness (usines s !isk %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills


3) ???????? leverage is concerned with the relationship between earnings before interest and ta+es and earnings per share. A) inancial () perating ') ariable D) otal Answer: A opic: o pic: inancial $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 33) ???????? is the potential use of fi+ed operating costs to *agnify the effects of changes in sales on earnings before interest and ta+es. A) inancial leverage () perating leverage ') otal leverage D) !atio analysis Answer: ( opic: o pic: perating $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 30) ???????? is the potential use of fi+ed financial charges to *agnify the effects of changes in earnings before interest and ta+es on the fir*-s earnings per share. A) inancial leverage () perating leverage ') otal leverage D) Debt service Answer: A opic: o pic: inancial $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 32) i+ed financial charges include A) co**on stock dividends and bond interest e+pense. () co**on stock dividends and preferred stock dividends. ') bond interest e+pense and preferred stock dividends. D) stock repurchase e+pense. Answer: ' opic: o pic: inancial $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills


3) A decrease in fi+ed financial costs will result in ???????? ?????? ?? in financial risk. A) an increase () a decrease ') no change D) an undeter*ined change Answer: ( opic: o pic: inancial $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 36) he three basic types of leverage are A) operating, production, and financial. () operating, production, and total. ') production, financial, and total. D) operating, financial, and total. Answer: D opic: ypes ypes of $everage $evera ge %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 37) Higher financial leverage causes ???????? to increase *ore for a given increase in ????????. A) #(@ sales () #/& sales ') #/& #(@ D) #(@ #/& Answer: ' opic: o pic: inancial $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 39) ???????? is the potential use of fi+ed costs, both operating and financial, to *agnify the effect of changes in sales on the fir*-s earnings per share. A) Debt service () otal leverage ') perating leverage D) inancial leverage Answer: ( opic: otal $everage $evera ge %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills


05) As fi+ed operating costs increase and all other factors are held constant, the degree of operating leverage will A) increase. () decrease. ') re*ain unchanged. D) change in an undeter*ined direction. Answer: A opic: o pic: perating $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 01) hrough the effects of financial leverage, when #(@ increases, earnings per share will A) increase. () decrease. ') re*ain unchanged. D) change in an undeter*ined direction. Answer: A opic: o pic: inancial $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 0) >ith >ith the e+istence of fi+ed operating o perating costs, a decrease in sales will result in ???????? in #(@. A) a proportional increase () an e8ual increase ') a less than proportional decrease D) a *ore than proportional decrease Answer: D opic: o pic: perating $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 03) An increase in fi+ed operating costs will result in ???????? in the deg ree of operating leverage. A) a decrease () an increase ') no change D) an undeter*ined change Answer: ( opic: o pic: perating $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills

5 'opyright 4 51 /earson #ducation

00) A fir* has fi+ed operating costs of C25,555, a sales price per unit of C5, and a variable cost per unit of C13. At a base sales sales level of 255,555 units, the fir*-s degree of operating leverage is ????????. A) 1.56 () 1.11 ') 1.17 D) 1.3 Answer: D opic: o pic: Degree of perating $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: Analytic skills 02) A fir* has fi+ed operating costs of C162,555, total sales revenue of C3,555,555 and total variable costs of C,25,555. he fir*-s degree of operating leverage is ????????. A) 5.66 () 1.35 ') 5.71 D) 0.9 Answer: ( opic: o pic: Degree of perating $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: Analytic skills 0) A fir* has #(@ of C362,555, interest e+pense of C62,555, preferred dividends of C,555 and a ta+ rate of 05 percent. p ercent. he fir*-s degree of financial leverage at a base #(@ level of C362,555 is ????????. A) 5.96 () 1.9 ') 1.6 D) 1.59 Answer: ( opic: o pic: Degree of inancial $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: Analytic skills 06) A decrease in fi+ed operating costs will result in ???????? in the degree of financial leverage. A) a decrease () an increase ') no change D) an undeter*ined change Answer: D opic: o pic: Degree of inancial $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills


07) At a base sales level of C055,555, a fir* has a degree of operating leverage of  and a degree of financial leverage of 1.2. he fir*-s degree of total leverage is ????????. A) 3.2 () 3.5 ') 5.2 D) 1.3 Answer: ( opic: Degree of otal $everage $everag e %uestion &tatus: !evised AA'&( Guidelines: Guidelines: Analytic skills 09) Generally, ???????? in leverage result in ???????? return and ???????? risk. A) increases decreased increased () increases decreased decreased ') increases increased increased D) decreases increased decreased Answer: ' opic: o pic: $everage, !eturn, and !isk %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 25) >ith >ith the e+istence of fi+ed operating o perating costs, an increase in sales will result in ???????? increase in #(@. A) a proportional () an e8ual ') a less than proportional D) a *ore than proportional Answer: D opic: o pic: perating $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 21) (ecause the degree of total leverage is *ultiplicative and not additive, when a fir* has very high operating leverage it can *oderate its total risk by A) increasing sales. () using *ore financial leverage. ') increasing #(@. D) using a lower level of financial leverage. Answer: D opic: Degree of otal $everage $everag e %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills

 'opyright 4 51 /earson #ducation

2) inancial leverage *easures the effect of fi+ed financing costs on the relationship between A) &ales and #(@. () &ales and #/&. ') #(@ and #/&. D) none of the above. Answer: ' opic: o pic: inancial $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 23) perating leverage *easures the effect of fi+ed financing costs on the relationship between A) sales and #(@. () sales and #/&. ') #(@ and #/&. D) none of the above. Answer: D opic: o pic: perating $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 20) perating leverage *easures the effect of fi+ed operating costs on the relationship between A) sales and #(@. () sales and #/&. ') #(@ and #/&. D) none of the above. Answer: A opic: o pic: perating $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 22) inancial leverage *easures the effect of fi+ed operating op erating costs on the relationship between A) sales and #(@. () sales and #/&. ') #(@ and #/&. D) none of the above. Answer: D opic: o pic: inancial $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills


2) otal otal leverage *easures the effect of fi+ed costs on the relationship between A) sales and #(@. () sales and #/&. ') #(@ and #/&. D) none of the above. Answer: ( opic: otal $everage $evera ge %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 26) (a*boo *anufacturing sells its finished product for an average of C32 per unit with a variable cost per unit of C1. he co*pany has fi+ed operating costs of C1,525,555. ;a) 'alculate 'alculate the fir*-s fir*-s operating operating breakeven breakeven point in units. ;b) 'alculate the fir*-s fir*-s operating operating breakeven point in dollars. ;c) "sing 155,555 units as a base, what what is the fir*-s degree of operating leverageE Answer: ;a) % B

'

B

C1,525,555

B 62,555 units

C32 − C)1 A' C1,525,555 ' ;b) ;b) D B B B C,2,555) ;1  C1K32) ;1  A'K!) %;/  A')

/

−

;c) D$ at at base sales level level of 155,555 155,555 units B

%;/  A')  ' 155,555;C32  C1) B 155,555;C32  C1)  C1,525,555

B 0.5 opic: perating (reakeven /oint opic: %uestion &tatus: !evised AA'&( Guidelines: Guidelines: Analytic skills


27) (ei=ing (erings is considering purchasing a s*all fir* in the sa*e line of business. he purchase would be financed by the sale of co**on stock or a bond issue. he financial *anager needs to evaluate how the two alternative financing plans will affect the earnings potential of the fir*. otal financing re8uired is C0.2 *illion. he fir* currently has C5,555,555 of 1 percent bonds and 55,555 co**on shares outstanding. he fir* can arrange financing of the C0.2 *illion through a 10 percent bond bon d issue or the sale of 155,555 shares of co**on stock. he fir* has a 05 percent ta+ rate. ;a) >hat is the the degree of financial financial leverage for each plan at C6,555,555 of #(@E ;b) >hat is the financial financial breakeven breakeven point for each each planE Answer: 6,555,555 B 1.6 6,555,555  3,535,555 6,555,555 D$ at base level #(@ ;stock @ssue) B B 1.2 6,555,555  ,055,555

;a) D$ at base level level #(@ ;(ond @ssue) @ssue) B

;b) inancial inancial (reakeven (reakeven /oint ;(ond @ssue) @ssue) B C3,535,555 C3,535,555 inancial (reakeven /oint ;&tock @ssue) B C,055,555 opic: o pic: inancial $everage and inancial (reakeven %uestion &tatus: !evised AA'&( Guidelines: Guidelines: Analytic skills 29) Jong*an Jong*an #lectronics has decided to invest C15,555,555 in a new head8uarters and needs to deter*ine the best way to finance the construction. he fir* currently has C25,555,555 of 15 percent bonds and 0,555,555 co**on shares outstanding. he fir* can obtain the C15,555,555 of financing through a 15 percent bond issue or the sale of 1,555,555 shares of co**on stock. he fir* has a 05 percent ta+ rate. ;a) >hat is the degree of financial financial leverage leverage for each plan plan at C2,555,555 of #(@E #(@E ;b) >hat is the financial financial breakeven breakeven point for each each planE Answer: ;a) (ond issue issue interest interest B 15,555,555;5.1 15,555,555;5.15) 5) B C1,555,555 C1,555,555 2,555,555 3,555,555 2,555,555 D$ at base level #(@ ;(ond @ssue B B 1.3 2,555,555  ,555,555 2,555,555 D$ at base level #(@ ;stock @ssue) B B 1.2 2,555,555  2,555,555

'urrent interest B 25,555,555;5.15) B

;b) inancial inancial (reakeven (reakeven /oint ;(ond @ssue) @ssue) B C,555,555 C,555,555 inancial (reakeven /oint ;&tock @ssue) B C2,555,555 opic: o pic: inancial $everage and inancial (reakeven %uestion &tatus: !evised AA'&( Guidelines: Guidelines: Analytic skills


5) 'hina A*erica
;a) or each operating operating structur structure, e, calculate calculate ;a1)#(@ and #/& at 15,555, 5,555, and 35,555 units. ;a)the degree of operating leverage ;D$) and degree of total leverage ;D$) using 5,555 units as a base sales level. ;a3)the operating breakeven point in units. ;b) >hich operating structure structure has greater operating leverage and business business riskE ;c) @f 'hina A*erica A*erica pro=ects sales of 5,555 units, which operating structure structure is reco**endedE Answer: ;a1)

;a) and ;a3)

;b) perating structure  has greater fi+ed fi+ed costs, greater operating leverage, and greater greater business risk than operating structure 1. ;c) @f sales are pro=ected at 5,555 units, ri&tar ri&tar /roduction, /roduction, @nc. should choose operating structure  because it results in a higher #(@ and #/& for the fir*. perating structure  has a higher operating breakeven point, but with sales esti*ated at 5,555 units versus a breakeven point of 0,555 units, the fir* should take advantage of the added leverage. opic: o pic: $everage, !eturn, and !isk %uestion &tatus: !evised AA'&( Guidelines: Guidelines: Analytic skills

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13.3 Describe the types types of capital, e+ternal e+ternal assess*ent of capital structure, the capital structure structure of non".&. fir*s, and capital structure theory. 1) he probability that a fir* will beco*e bankrupt is largely dependent on its level of both business risk and financial risk. Answer: !"# opic: o pic: (usiness !isk and inancial !isk %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills ) he fir*-s capital structure is the *i+ of shortter* and longter* debt and e8uity *aintained by the fir*. Answer: A$&# opic: o pic: 'apital &tructure &tructure (asics %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 3) he fir*-s capital structure can significantly affect the fir*-s value by affecting its risk and return. Answer: !"# opic: o pic: 'apital &tructure &tructure (asics %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 0) All ite*s ite*s on the righthand side of the fir*-s balance sheet, e+cluding current liabilities are called capital. Answer: !"# opic: o pic: 'apital &tructure &tructure (asics %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 2) @n general, low debtpay*ent ratios are associated with high degrees of financial leverage. Answer: !"# opic: o pic: inancial $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills ) he *ore fi+ed cost financing a fir* has in its capital structure, the greater its financial leverage and risk. Answer: !"# opic: o pic: inancial $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills


6) Asy**etric Asy**etric infor*ation results when *anagers of a fir* have *ore infor*ation about abo ut operations and future prospects than do investors. Answer: !"# opic: Asy**etric @nfor*ation %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 7) @n general, non".&. co*panies have *uch higher debt ratios than do their ".&. counterparts because financial *arkets are *uch *ore developed in the "nited &tates than elsewhere and have played a *uch greater role in corporate financing than has been the case in other countries. Answer: !"# opic: o pic: @nternational Aspects Aspects of 'apital &tructure &tructure %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 9) #ffective capital structure decisions can lower the cost of capital, resulting in h igher /s and *ore acceptable pro=ects, thereby increasing the value of the fir*. Answer: !"# opic: o pic: 'apital &tructure &tructure (asics %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 15) /ecking order is a hierarchy of financing beginning with retained earnings followed by b y debt financing and finally e+ternal e8uity financing. Answer: !"# opic: o pic: /ecking rder heory %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 11) he relative ine+pensiveness of debt capital is due to the fact that the lenders take the least risk of any longter* contributors of capital. Answer: !"# opic: o pic: 'apital &tructure &tructure (asics %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 1) /oor capital structure decisions can result in a high cost of capital, thereby *aking so*e unacceptable invest*ents acceptable. Answer: A$&# opic: o pic: 'apital &tructure &tructure (asics %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills


13) Debt capital less risky than e8uity capital because the fir* is legally obligated to pay interest to bondholders but they are not legally obligated to pay dividends to preferred or co**on stockholders. Answer: !"# opic: o pic: 'apital &tructure &tructure (asics %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 10) Due to its secondary position relative to e8uity, e8u ity, suppliers of debt capital face greater risk and therefore *ust be co*pensated with higher e+pected returns than suppliers of e8uity capital. Answer: A$&# opic: o pic: 'apital &tructure &tructure (asics %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 12) "nder certain circu*stances, when the fir* is in default debtholders and preferred stockholders *ay receive a voice in *anage*ent otherwise, only co**on stockholders have voting rights. Answer: !"# opic: o pic: 'apital &tructure &tructure (asics %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 1) A shift toward *ore fi+ed costs co sts increases business risk, which in turn causes earnings before interest and ta+es to increase by less for a given increase in sales. Answer: A$&# opic: (usiness (usines s !isk %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 16) >hen considering fi+ed operating cost increases, the financial *anager *ust weigh the increased financial risk associated with greater operating leverage against the e+pected increase in returns. Answer: A$&# opic: o pic: (usiness !isk and inancial !isk %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 17) (ecause of the e+tensive research conducted in recent years in the area of capital structure theory, it is now possible for financial *anagers to pinpoint with great accuracy a fir*-s opti*al capital structure. Answer: A$&# opic: o pic: 'apital &tructure &tructure heory heory %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills


19) Despite the e+tensive research conducted in recent years in the area of capital structure theory, it is not yet possible to provide financial *anagers with a specified *ethodology for use in deter*ining a fir*-s opti*al capital structure. Answer: !"# opic: o pic: 'apital &tructure &tructure heory heory %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 5) @n general, a fir*-s theoretical opti*al capital structure is that which balances the ta+ benefits of debt financing against the increase probability of bankruptcy that result fro* its use. Answer: !"# opic: o pic: 'apital &tructure &tructure heory heory %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 1) @n general, a fir*-s theoretical opti*al capital structure is that which balances the ta+ disadvantage of debt financing against the increase probability of bankruptcy that results fro* its use. Answer: A$&# opic: o pic: 'apital &tructure &tructure heory heory %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills ) he pecking order e+planation of capital structure states that a hierarchy of financing e+ists for fir*s in which retained earnings are e*ployed first, followed by debt financing and finally by e+ternal e8uity financing. Answer: !"# opic: o pic: /ecking rder heory %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 3) he pecking order e+planation of capital structure states that a hierarchy of financing e+ists for fir*s in which new e+ternal debt financing is e*ployed first, followed by retained earnings and finally by e+ternal e8uity financing. Answer: A$&# opic: o pic: /ecking rder heory %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 0) he asy**etric infor*ation e+planation of capital structure suggests that fir*s will issue new e8uity only when the *anagers believe the fir*-s stock is overvalued as a result, issuing new e8uity is considered a negative signal that will result in a decline in share price. Answer: !"# opic: Asy**etric @nfor*ation %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills


2) he asy**etric infor*ation e+planation of capital structure suggests that fir*s will issue new debt only when the *anagers believe the fir*-s stock is overvalued as a result, issuing new debt is considered a negative signal that will result in a decline in share price. Answer: A$&# opic: Asy**etric @nfor*ation %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills ) he fir*-s ???????? is the *i+ of longter* debt and e8uity utilied by the fir*, which *ay significantly affect its value by affecting return and risk. A) dividend policy () capital budget ') capital structure D) working capital Answer: ' opic: o pic: 'apital &tructure &tructure (asics %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 6) Holding all other factors constant, a fir* that is sub=ect to a greater level of business risk should e*ploy less operating leverage than an otherwise e8uivalent fir* that is sub=ect to a lesser level of business risk. Answer: !"# opic: o pic: (usiness !isk and perating $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 7) Holding all other factors constant, a fir* that is sub=ect to a greater level of business risk should e*ploy *ore operating leverage than an otherwise e8uivalent fir* that is sub=ect to a lesser level of business risk. Answer: A$&# opic: o pic: (usiness !isk and perating $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 9) Holding all other factors constant, a fir* that is sub=ect to a greater level of business risk should e*ploy less financial leverage than an otherwise e8uivalent fir* that is sub=ect to a lesser level of business risk. Answer: !"# opic: o pic: (usiness !isk and inancial $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills


35) Holding all other factors constant, a fir* that is sub=ect to a greater level of business risk should e*ploy *ore financial leverage than an otherwise e8uivalent fir* that is sub=ect to a lesser level of business risk. Answer: A$&# opic: o pic: (usiness !isk and inancial $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 31) Holding all other factors constant, a fir* that is sub=ect to a greater level of business risk should e*ploy less total leverage than an otherwise e8uivalent fir* that is sub=ect to a lesser level of business risk. Answer: !"# opic: o pic: (usiness !isk and o otal tal $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 3) he basic sources of capital for a fir* include all of the following #F'#/ A) longter* debt. () preferred stock. ') current liabilities. D) co**on stock. Answer: ' opic: o pic: 'apital &tructure &tructure (asics %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 33) @n theory, the fir* should *aintain financial leverage consistent with a capital structure that A) *eets the industry standard. () *a+i*ies the earnings per share. ') *a+i*ies the owner-s wealth. D) *a+i*ies dividends. Answer: ' opic: o pic: 'apital &tructure &tructure (asics %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 30) ???????? risk is the risk of being unable to cover operating costs. co sts. A) (usiness () inancial ') $everage D) otal Answer: A opic: (usiness (usines s !isk %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills


32) (usiness risk is affected by all of the following #F'#/ A) revenue stability. stability. () cost stability. ') operating leverage. D) earnings per share. Answer: D opic: (usiness (usines s !isk %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 3) All of the following affect business risk #F'#/ A) operating leverage. () interest rate stability. stability. ') cost stability. D) revenue stability. stability. Answer: ( opic: (usiness (usines s !isk %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 36) ???????? risk is the risk of being unable to cover financial costs. A) (usiness () inancial ') otal D) $everage Answer: ( opic: o pic: inancial !isk %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 37) After satisfying satisfying obligations to creditors, the govern*ent, and preferred stockholders, any re*aining earnings will *ost likely be allocated to any of the following #F'#/ A) co**on shareholders as cash dividends. () co**on shareholders as stock dividends. ') retained by the fir* for future invest*ent. D) a co*bination of retained earnings and cash dividends. Answer: ( opic: o pic: 'oncept of 'apital &tructure %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills


39) he lower risk nature of longter* debt in a fir*-s capital structure is due to the fact that A) the e8uity holders are the true owners of the fir*. () e8uity capital has a fi+ed return. ') creditors have a higher position in the priority of clai*s. D) dividend pay*ents are ta+deductible. Answer: ' opic: o pic: 'oncept of 'apital &tructure %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 05) >hich of the following is  a reason why debt capital is considered to be the least risky source of capitalE A) @t has a high priority clai* against assets and earnings. () @t has a strong legal position. ') @t is a low cost source of capital because interest pay*ents are ta+ deductible. D) @t does not nor*ally have to be repaid at a specific future date. Answer: D opic: o pic: 'oncept of 'apital &tructure %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 01) /robability of bankruptcy is deter*ined by A) financial risk. () total risk. ') business risk. D) interest rate risk. Answer: ( opic: o pic: inancial !isk %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 0) he ine+pensive nature of longter* debt in a fir*-s capital structure is due to the fact that A) the e8uity holders are the true owners of the fir*. () e8uity capital has a fi+ed return. ') creditors have a higher position in the priority of clai*s. D) dividend pay*ents are ta+deductible. Answer: ' opic: o pic: 'oncept of 'apital &tructure %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills


03) he ine+pensive nature of longter* debt in a fir*-s capital structure is due to the fact that A) the e8uity holders are the true owners of the fir*. () e8uity capital has a fi+ed return. ') interest pay*ents are ta+deductible. D) e8uity holders have a higher position in the priority of clai*s. Answer: ' opic: o pic: 'oncept of 'apital &tructure %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 00) he key differences between debt and e8uity capital include all of the following #F'#/ A) voice in *anage*ent. () *aturity. ') ta+ treat*ent. D) effect on operating leverage. Answer: D opic: o pic: 'oncept of 'apital &tructure %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 02) he cost of debt financing results fro* A) the increased profitability of bankruptcy caused by b y debt obligations. () the agency costs of the lender-s *onitoring and controlling the fir*-s actions. ') the costs associated with *anagers having *ore infor*ation abo ut the fir*-s prospects than do investors. D) all of the above. Answer: D opic: o pic: 'ost of Debt inancing %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 0) A corporation borrows C1,555,555 at 15 percent annual rate of interest. he fir* has a 05 05 percent ta+ rate. he yearly, yearly, afterta+ cost of this this debt is A) C 05,555. () C 5,555. ') C155,555. D) C1,6. Answer: ( opic: o pic: 'ost of Debt inancing %uestion &tatus: !evised AA'&( Guidelines: Guidelines: Analytic skills


06) A corporation has C2,555,555 of 7 percent preferred stock outstanding and a 05 percent ta+ rate. he afterta+ cost of the preferred stock is A) C055,555. () C05,555. ') C,6. D) C15,555. Answer: A opic: o pic: 'ost of /referred /referred &tock inancing %uestion &tatus: !evised AA'&( Guidelines: Guidelines: Analytic skills 07) A corporation has C15,555,555 of 15 percent preferred stock outstanding and a 05 percent ta+ rate. he a*ount of earnings before interest and ta+es ;#(@) re8uired to pay the preferred dividends is A) C1,555,555. () C 055,555. ') C 55,555. D) C1,,6. Answer: D opic: o pic: 'ost of /referred /referred &tock inancing %uestion &tatus: !evised AA'&( Guidelines: Guidelines: Analytic skills 09) A corporation has C2,555,555 of 15 percent bonds and C3,555,555 of 1 percent preferred stock outstanding. he fir*-s financial breakeven ;assu*ing a 05 percent ta+ rate) is A) C75,555. () C61,555. ') C1,155,555. D) C1,055,555. Answer: ' opic: o pic: inancial (reakeven /oint %uestion &tatus: !evised AA'&( Guidelines: Guidelines: Analytic skills 25) he conflict resulting fro* a *anager-s desire to increase the fir*-s risk without increasing current borrowing costs and lenders- desire to li*it lending is one effect of the ???????? proble*. A) agency () leverage ') capital D) variable cost Answer: A opic: o pic: pti*al 'apital &tructure &tructure %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills


21) perating and financial constraints placed on a corporation by loan provision are A) agency costs to the lender. () agency costs to the fir*. ') interest rate costs to the fir*. D) necessary to control the risk of the fir*. Answer: ( opic: o pic: Agency 'osts and 'apital &tructure %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 2) he risk of the debt capital is less than that of other longter* contributors of capital because A) they have a higher priority of clai* against any earnings or assets available for pay*ent. () they have a far stronger legal pressure against the co*pany to *ake pay*ent than do preferred and co**on stockholders. ') the ta+deductibility of interest pay*ents lowers the debt cost to the fir* substantially. D) all of the above. Answer: D opic: o pic: 'ost of Debt inancing %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 23)
3) pti*al capital structure is the capital structure at which the weighted average cost of capital is *ini*ied, thereby *a+i*iing the fir*-s value. Answer: !"# opic: o pic: pti*al 'apital &tructure &tructure %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 0) An increase in fi+ed operating and financial cost results in an increase in risk, since the fir* will have to achieve a higher level of sales =ust to break even. Answer: !"# opic: o pic: (usiness !isk and inancial !isk %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 2) he cost of e8uity is greater than the cost of debt and increases with increasing financial leverage, but generally less rapidly than the cost of debt. Answer: A$&# opic: o pic: 'ost of #8uity #8uity and inancial $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills ) he cost of e8uity increases with increasing financial leverage in order to co*pensate the stockholders for the higher degree of financial risk. Answer: !"# opic: o pic: 'ost of #8uity #8uity and inancial $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 6) As financial leverage increases, the cost of debt initially re*ains constant and then rises, while the cost of e8uity always rises. Answer: !"# opic: o pic: 'ost of Debt and inancial $everage %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 7) @f we assu*e that #(@ is constant, the value of the fir* is *a+i*ied by *ini*iing the weighted average cost of capital. Answer: !"# opic: 'apital &tructure and ir* alue alue %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 9) @n theory, a fir*-s opti*al capital structure is that which *ini*ied the fir*-s overall cost of capital resulting in a *a+i*iation of the *arket value of the fir*. Answer: !"# opic: o pic: pti*al 'apital &tructure &tructure %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 37 'opyright 4 51 /earson #ducation

15) he overriding ob=ective of the capital structure decision should be to choose the level of debt that results in the largest possible share price. Answer: !"# opic: o pic: pti*al 'apital &tructure &tructure %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 11) @n order to enhance the wealth of stockholders and to send positive signals to the *arket, corporations generally raise funds using the following order: A) !etained earnings, e8uity e8 uity,, debt. () !etained earnings, debt, d ebt, e8uity. ') Debt, retained earnings, e8uity. D) #8uity, retained earnings, debt. Answer: ( opic: o pic: Asy**etric Asy**etric @nfor*ation and 'apital &tructure &tructure %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 1) he opti*al capital structure is the one that balances A) return and risk factors in order to *a+i*ie profits. () return and risk factors in order to *a+i*ie earnings per share. ') return and risk factors in order to *a+i*ie *arket value. D) return and risk factors in order to *a+i*ie dividends. Answer: ' opic: o pic: pti*al 'apital &tructure &tructure %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 13) As debt is substituted substituted for e8uity in the capital structure and the debt ratio increases, all of the following state*ents about the co*ponent costs of capital are true #F'#/ A) the cost of e8uity continually increases. () the cost of debt continually increases. ') the overall cost of capital first declines, reaches a *ini*u*, and then rises again. D) the overall cost of capital continually increases. Answer: D opic: o pic: pti*al 'apital &tructure &tructure %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills


10) /oor capital structure decisions can result in ???????? ????? ??? the cost of capital, resulting in ???????? acceptable invest*ents. #ffective capital structure decisions can ???????? the cost of capital, resulting in ???????? acceptable invest*ents. A) increasing fewer lower *ore () decreasing *ore higher fewer ') increasing *ore lower, fewer D) decreasing fewer higher *ore Answer: A opic: o pic: pti*al 'apital &tructure &tructure %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 12) According to the traditional approach to capital structure, the value of the fir* will be *a+i*ied when A) the financial leverage is *a+i*ied. () the cost of debt is *ini*ied. ') the weighted average cost of capital is *ini*ied. D) the dividend payout is *a+i*ied. Answer: ' opic: o pic: raditional raditional Approach to 'apital &tructure &tructure %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 1) @n the traditional approach to capital structure, as the a*ount of debt increases in a fir*-s capital structure, A) the cost of e8uity rises faster than the cost of debt. () the cost of debt rises faster than the cost of e8uity. ') debt beco*es less risky. D) e8uity cost is unaffected. Answer: A opic: o pic: raditional raditional Approach to 'apital &tructure &tructure %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 16) As debt is substituted substituted for e8uity in the capital structure and the debt ratio increases, the behavior of the overall cost of capital is partially e+plained by A) the ta+deductibility of interest pay*ents. () the increase in the nu*ber of co**on shares outstanding. ') the reduction in risk as perceived by the co**on shareholders. D) the decrease in the cost of o f e8uity. Answer: A opic: o pic: raditional raditional Approach to 'apital &tructure &tructure %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills


17) he controversy over the e+istence of an opti*al capital structure is debated between those ???????? who believe a traditional approach e+ists and those ????????, who do not believe one e+ists. @n the ???????? approach to capital structure, the opti*al capital structure occurs where the ???????? is *ini*ied. A) supporters of

3) he higher the financial breakeven point and the steeper the slope of the capital structure line, the greater the financial risk. Answer: !"# opic: #(@#/& Analysis %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 0) (ecause risk pre*iu*s increase with increases in financial leverage, *a+i*iing #/& does not assure owners- wealth *a+i*iation. Answer: !"# opic: #(@#/& Analysis %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 2) he higher the degree of financial leverage ;D$), the greater the leverage a given financing plan has, and the steeper its slope when plotted on #(@#/& #(@#/& a+es. Answer: !"# opic: #(@#/& Analysis %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills ) he steeper the slope of the #(@#/& #(@#/& capital structure line, the lower the financial risk. Answer: A$&# opic: #(@#/& Analysis %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 6) inancial breakeven point represents the level of earnings before interest and ta+es necessary for the fir* to cover its fi+ed operating and financial changes that is, the point at which earnings per share ;#/&) is e8ual to ero. Answer: A$&# opic: #(@#/& Analysis %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 

7) he basic shortco*ing of o f #(@#/& #(@#/& analysis is that this *odel focuses on the *a+i*iation of earnings rather than on the *a+i*iation of share price. Answer: !"# opic: #(@#/& Analysis %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills


9) he basic shortco*ing of o f #(@#/& #(@#/& analysis is that this *odel focuses on the *a+i*iation of stock returns rather than on the *a+i*iation of share price. Answer: A$&# opic: #(@#/& Analysis %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 15) @n the #(@#/& #(@#/& approach to capital structure, risk is represented by A) shifts in the cost of e8uity capital. () shifts in the cost of debt capital. ') the slope of the capital structure line. D) shifts in the ti*esinterestearned ratio. Answer: ' opic: #(@#/& Analysis %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 11) @n the #(@#/& #(@#/& approach to capital structure, a constant level of #(@ is assu*ed A) to ease the calculations of owners- e8uity. () to isolate the i*pact on returns of the financing costs associated with alternative capital structures. ') to e*phasie the relationship between interest e+penses and ta+es. D) to concentrate on the effect e ffect of revenue and e+pense on capital structure decisions. Answer: ( opic: #(@#/& Analysis %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 1) A fir* has interest e+pense of C102,555, preferred dividends of C2,555, and a ta+ rate of 05 percent. he fir*-s financial breakeven point is A) C 2,555. () C165,555. ') C17,6. D) C102,555. Answer: ' opic: o pic: inancial (reakeven /oint %uestion &tatus: !evised AA'&( Guidelines: Guidelines: Analytic skills


13) A fir* has a current capital structure consisting of C055,555 of 1 percent annual interest debt and 25,555 shares of co**on stock. he fir*-s ta+ rate is 05 percent on ordinary inco*e. @f the #(@ is e+pected to be C55,555, C55, 555, the fir*-s earnings per share will be ????????. ???? ????. A) C.05 () C3.50 ') C6.50 D) C1.7 Answer: D opic: #(@#/& Analysis %uestion &tatus: !evised AA'&( Guidelines: Guidelines: Analytic skills 10) he *a=or shortco*ing of the #(@#/& #(@#/& approach to capital structure is that A) the techni8ue does not pro*ote p ro*ote the *a+i*iation of shareholder wealth. () the techni8ue does not consider the cost of capital. ') the techni8ue only considers leveragerelated risk. D) the techni8ue does not *a+i*ie earnings per share. Answer: A opic: #(@#/& Analysis %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 12) he ???????? approach to capital structure proposes that an opti*al capital structure be selected which ????????. A) < and < *a+i*ies the weighted average cost of capital () traditional *ini*ies the cost of debt ') #(@#/& #(@#/& *a+i*ies the #/& D) residual theory *ini*ies dividends Answer: ' opic: #(@#/& Analysis %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 1) A fir* has a current capital structure consisting of C055,555 of 1 percent annual interest debt and 25,555 shares of co**on stock. he fir*-s ta+ rate is 05 percent on ordinary inco*e. @f the #(@ is e+pected to be C55,555, C55, 555, two #(@#/& #(@#/& coordinates for the fir*-s e+isting capital structure are A) ;C3,555, C5) and ;C55,555, C3.50). () ;C07,555, C5) and ;C55,555, C1.7). ') ;C5, C07,555) and ;C55,555, C1.7). D) ;C12,555, C3.25) and ;C125,555, C1.7). Answer: ( opic: #(@#/& Analysis %uestion &tatus: !evised AA'&( Guidelines: Guidelines: Analytic skills


16) he basic shortco*ing of the #(@#/& #(@#/& approach to capital structure is A) that the opti*al capital structure is difficult to co*pute. () its disregard for the presence of preferred stock in the capital structure. ') its disregard for the fir*-s dividend policy. D) that it concentrates on the *a+i*iation of #/& rather than the *a+i*iation of owner-s wealth. Answer: D opic: #(@#/& Analysis %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 17) A fir* is analying two possible capital structures 35 and 25 percent debt ratios. he fir* has total assets of C2,555,555 and co**on stock valued at C25 per share. he fir* has a *arginal ta+ rate of 05 percent on ordinary inco*e. he nu*ber of co**on shares outstanding for each of the capital structures would be A) 35 percent debt ratio: 35,555 shares and 25 percent debt ratio: 25,555 shares. () 35 percent debt ratio: 25,555 shares and 25 percent debt ratio: 65,555 shares. ') 35 percent debt ratio: 65,555 shares and 25 percent debt ratio: 155,555 shares. D) 35 percent debt ratio: 65,555 shares and 25 percent debt ratio: 25,555 shares. Answer: D opic: o pic: 'apital &tructure Analysis %uestion &tatus: !evised AA'&( Guidelines: Guidelines: Analytic skills 

19) A fir* is analying two possible capital structures 35 and 25 percent debt ratios. he fir* has total assets of C2,555,555 and co**on stock valued at C25 per share. he fir* has a *arginal ta+ rate of 05 percent on ordinary inco*e. @f the interest rate on debt is 6 percent and 9 percent for the 35 percent and the 25 percent debt ratios, respectively, the a*ount of interest on the debt under each of the capital structures being considered would be A) 35 percent debt ratio: C152,555 and 25 percent debt ratio: C2,555. () 35 percent debt ratio: C02,555 and 25 percent debt ratio: C2,555. ') 35 percent debt ratio: C152,555 and 25 percent debt ratio: C25,555. D) 35 percent debt ratio: C132,555 and 25 percent debt ratio: C162,555. Answer: A opic: o pic: 'apital &tructure Analysis %uestion &tatus: !evised AA'&( Guidelines: Guidelines: Analytic skills 


Table 13.1

5) Assu*ing Assu*ing a 05 percent ta+ rate, what is the financial breakeven point for each planE ;&ee able 13.1) Answer: inancial breakeven point B C@nterest M /referred DividendsK;1  t) inancing /lan 1: (/ B C2,555 M 3,555K;1  5.05) B C35,555 inancing /lan : (/ B C25,555 M 1,255K;1  5.05) B C2,255 opic: o pic: inancial (reakeven /oint %uestion &tatus: !evised AA'&( Guidelines: Guidelines: Analytic skills 1) >hat is the degree of financial leverage at a base level #(@ of C15,555 for both financing plansE he fir* has a 05 percent ta+ rate. ;&ee able able 13.1) Answer: Degree of financial leverage for /lan 1 at base level of #(@ #(@ B

C15 ,555 B 1.33 C15 ,555  C2,555  C3,555K;1  5.05)

Degree of financial leverage for /lan  at base level of #(@ B

C15 ,555 B 1.67 C15 ,555  C25,555  C1,255K;1  5.05)

opic: Degree of inancial $everage opic: %uestion &tatus: !evised AA'&( Guidelines: Guidelines: Analytic skills ) >hat is the #/& under inancing /lan 1, if the fir* pro=ects #(@ of C55,555 and has a ta+ rate of 05 percentE ;&ee able 13.1) Answer: 'alculate the #/& with the for*ula: ; #(@  @nterest);1  ta+ rate) /D of co**on shares outstanding C55 ,555  C2,555);1  5.05)  C3,555 #/& B B 5.21 55 ,555

#/& B

=

opic: inancial (reakeven opic: %uestion &tatus: !evised AA'&( Guidelines: Guidelines: Analytic skills


3) At about what #(@ level should the financial *anager be indifferent to either planE ;&ee able 13.1) Answer:

; #(@  2,555);1  5.05)  3,555 ; #(@  25,555);1  5.05)  1,255 B 55,555 155,555

At #(@ B C62,555. opic: o pic: inancial (reakeven %uestion &tatus: !evised AA'&( Guidelines: Guidelines: Analytic skills 0) >hich plan has a higher degree of financial leverage and financial riskE ;&ee able 13.1) Answer: inancing /lan  opic: o pic: inancial $everage and inancial !isk %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills 2) rankline 'oin, @nc. is considering two capital c apital structures. he key infor*ation follows. Assu*e a 05 percent ta+ rate and e+pected #(@ of C25,555.

;a) 'alculate two #(@#/& #(@#/& coordinates coordinates for each of the structures. ;b) @ndicate over what #(@ range, range, if any, any, each structure is preferred. Answer: ;a)

;b) 'alculatio 'alculation n of indiffer indifference ence point point #/& ;&tructure 1) B #/& ;&tructure ) ;#(@  C05,555);1  5.05)K15,555 B ;#(@  C0,255);1  5.05)K5,555 @f #(@ is e+pected to be less than C22,255, C22,25 5, structure  will *a+i*ie #/&. @f #(@ is e+pected to be greater than C22,255, &tructure 1 will *a+i*ie #/&. opic: #(@#/& Analysis %uestion &tatus: !evised AA'&( Guidelines: Guidelines: Analytic skills


13. !eview the return and risk of alternative capital structures, their linkage to *arket *arket value, and other i*portant considerations related to capital structure. 1) ir*s having stable and predictable revenues can *ore safely e*ploy highly leveraged capital structures than can fir*s with volatile patterns of sales revenue. Answer: !"# opic: o pic: (usiness !isk and 'apital &tructure &tructure %uestion &tatus: !evised AA'&( Guidelines: Guidelines: !eflective thinking thinking skills skills ) he reason why *a+i*iing share value and *a+i*iing #/& do not give the sa*e opti*al capital structure is because A) #/& *a+i*iation does not consider risk. () share value *a+i*iation does not consider risk. ') #/& *a+i*iation considers cash flows. D) #/& *a+i*iation does consider risk. Answer: A opic: o pic: pti*al 'apital &tructure and &hareholder >ealth >ealth ealth >ealth

0) angshan angshan hat is the value per share share for angshan angshan hat is the value per share share for angshan angshan ealth >ealth

Chapter13 GE

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