Answer the given five questions on a separate document. Describe how you reached the answer or show your work if a mathematical calculation is required, or both.
1. The firm's target capital structure should be consistent with which of the following statements?
a. Minimize the cost of debt (rd).
b. Obtain the highest possible bond rating.
c. Minimize the cost of equity (rs).
d. Minimize the weighted average cost of capital (WACC).
e. Maximize the earnings per share (EPS).
2. Which of the following statements is CORRECT?
a. The factors that affect a firm's business risk are affected by industry characteristics and economic conditions. Unfortunately, these factors are generally beyond the control of the firm's management.
b. One of the benefits to a firm of being at or near its target capital structure is that this eliminates any risk of bankruptcy.
c. A firm's financial risk can be minimized by diversification.
d. The amount of debt in its capital structure can under no circumstances affect a company's business risk.
e. A firm's business risk is determined solely by the financial characteristics of its industry.
3. Which of the following statements is CORRECT? As a firm increases the operating leverage used to produce a given quantity of output, this will
a. normally lead to a decrease in its business risk.
b. normally lead to a decrease in the standard deviation of its expected EBIT.
c. normally lead to a decrease in the variability of its expected EPS.
d. normally lead to a reduction in its fixed assets turnover ratio.
e. normally lead to an increase in its fixed assets turnover ratio.
4. If debt financing is used, which of the following is CORRECT?
a. The percentage change in net operating income will be equal to a given percentage change in net income.
b. The percentage change in net income relative to the percentage change in net operating income will depend on the interest rate charged on debt.
c. The percentage change in net income will be greater than the percentage change in net operating income.
d. The percentage change in sales will be greater than the percentage change in EBIT, which in turn will be greater than the percentage change in net income.
e. The percentage change in net operating income will be greater than a given percentage change in net income.
5. Which of the following statements is CORRECT, holding other things constant?
a. An increase in the personal tax rate is likely to increase the debt ratio of the average corporation.
b. If changes in the bankruptcy code make bankruptcy less costly to corporations, then this would likely reduce the debt ratio of the average corporation.
c. An increase in the company's degree of operating leverage is likely to encourage a company to use more debt in its capital structure.
d. An increase in the corporate tax rate is likely to encourage a company to use more debt in its capital structure.
e. Firms whose assets are relatively liquid tend to have relatively low bankruptcy costs, hence they tend to use relatively little debt.