BU340 11/20/2024

A firm's business risk is largely determined by the financial characteristics of its industry, especially by the amount of debt the average firm in the industry uses.

• True

• False

Financial risk refers to the extra risk borne by stockholders as a result of a firm's use of debt as compared with their risk if the firm had used no debt.

• True

• False

Different borrowers have different risks of bankruptcy, and if a borrower goes bankrupt, its lenders will probably not get back the full amount of funds that they loaned. Therefore, lenders charge higher rates to borrowers judged to be more likely to go bankrupt.

• True

• False

According to the signaling theory of capital structure, firms first use common equity for their capital, then use debt if and only if they can raise no more equity on "reasonable" terms. This occurs because the use of debt financing signals to investors that the firm's managers think that the future does not look good.

• True

• False

A firm's treasurer likes to be in a position to raise funds to support operations whenever such funds are needed, even in "bad times". This is called "financial flexibility," and the lower the firm's debt ratio, the greater its financial flexibility, other things held constant.

• True

• False

The firm's target capital structure should do which of the following?

• Maximize the earnings per share (EPS).

• Minimize the cost of debt (r_d).

• Minimize the cost of equity (r_s).

• Minimize the weighted average cost of capital (WACC).

A major contribution of the Miller model is that it demonstrates, other things held constant, that

• personal taxes increase the value of using corporate debt.

• personal taxes lower the value of using corporate debt

• personal taxes have no effect on the value of using corporate debt.

• financial distress and agency costs reduce the value of using corporate debt.

Other things held constant, which of the following events would be most likely to encourage a firm to increase the amount of debt in its capital structure?

• Its sales are projected to become less stable in the future.

• The bankruptcy laws are changed in a way that would make bankruptcy more costly to the firm and its stockholders.

• Management believes that the firm's stock is currently overvalued.

• The corporate tax rate is increased.

The optimal distribution policy strikes that balance between current dividends and capital gains that maximizes the firm's stock price.

• True

• False

One advantage of dividend reinvestment plans is that they allow shareholders to delay paying taxes on the dividends that they choose to reinvest.

• True

• False