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Chapter 18: Capital Structure and the Cost of Capital

Multiple Choice
1. The optimum debt/equity mix is the __________________.
a. proportionate use of debt and equity that maximizes the firms cost of capital.
b. proportionate use of debt and equity that minimizes the firms cost of capital.
c. the disproportionate use of debt and equity that minimizes the firms cost of capital.
d. the inappropriate use of debt and equity that minimizes the firms cost of capital.
Answer: b
Level: medium
Section: Why Choose a Capital Structure
2. A firm has a non-optimal capital structure leads to what type of financing costs?
a. higher
b. lower
c. optimal
d. different
Answer: a
Level: easy
Section: Why Choose a Capital Structure
3. Which of the following is a trend in the corporate use of debt?
a. Most firms went public in the 1980s.
b. Many firms were unable to structure themselves financially in the 1980s.
c. The ratio of long term debt to GDP grew during the 1960s.
d. The relative use of debt fell until 1989.
Answer: c
Level: medium
Section: Trends in Corporate Use of Debt
4. What is the minimum acceptable rate of return in a given project?
a. A return that provides the investors the maximum amount of money on their investment
b. A return that provides the investors the lowest amount of money on their investment
c. A return that fails to generate sufficient cash flow to pay investors their expected rate
of return.
d. A return that generates sufficient cash flow to pay investors their expected rate or return
Answer: d
Level: difficult
Section: Required Rate of Return and the Cost of Capital

5. The minimum required rate of return is ____________________ average of the firms costs of
various sources of capital.
a. an equivalent
b. a weighted
c. an optimal solution
d. a maximum benefit
Answer: b
Level: easy
Section: Required Rate of Return and the Cost of Capital
6. What is a relevant cash flow?
a. a related cash flow
b. a necessary cash flow before taxes
c. an incremental after-tax cash flow
d. a nonrelated cash flow
Answer: c
Level: easy
Section: Cost of Capital
7. How is debt interest paid?
a. from after tax income
b. from pre-tax income
c. from residual income
d. from the optimal income
Answer: b
Level: medium
Section: Cost of Capital
8. How is the weighted average cost of capital (WACC) calculated?
a. Multiply the marginal cost of each capital structure component by its weight and then
add the terms.
b. Multiply the marginal cost of each capital structure component by its weight and then
subtract the terms.
c. Subtract the marginal cost of each capital structure component by its weight and add the
terms.
d. Add the marginal cost of each capital structure component by its weight and subtract
the terms.
Answer: a
Level: medium
Section: Weighted Average Cost of Capital
9. Why is the EBIT/EPS analysis important to a manager?

a. It allows managers to see how different capital structures affect the earnings and risk.
b. It allows managers to evaluate the profitability at a firm..
c. It allows managers to see how similar capital structures affect earnings and risk.
d. It allows managers to evaluate the firms operating earnings.
Answer: a
Level: difficult
Section: EBIT/EPS Analysis
10. Which of the following factors will not affect a firms capital structure decision?
a. the firms dividend payout ratio
b. the firms growth rate
c. the firms return on assets
d. the firms current ratio
Answer: d
Level: difficult
Section: Difficulty of Making Capital Structure Decisions
11. Competitive pricing pressures, input supply shocks, labor union contracts, and other cost
influences can cause the price-variable cost margin to vary over time. What type of risk then
results?
a. business risk
b. operating risk
c. marginal risk
d. sunk risk
Answer: a
Level: easy
Section: Combined Operating and Financial Leverage Effects
12. The Pecking Order Hypothesis predicts that which source of financing will most corporations
look to first when seeking to expand their operations?
a. issuing new stock
b. retained earnings
c. issuing new debt
d. issue hybrid securities, such as convertible bonds
Answer: b
Level: medium
Section: Pecking Order Hypothesis
13. A firm with greater business risk may be inclined to use _______________ in its capital
structure, while a firm with less business risk may use _______________ in its capital structure.
a. less debt; more debt
b. more debt; less debt

c. zero debt; less debt


d. more debt; less debt
Answer: a
Level: difficult
Section: Insights from Theory and Practice
14. Each of the following statements are true about taxes and nondebt tax shields except
a. Interest on debt is a tax deductible expense.
b. Stock dividends are not a tax deductible expense.
c. Stock dividends are a tax deductible expense.
d. Dividends are paid from after tax dollars.
Answer: c
Level: medium
Section: Taxes and Non-debt Tax Shields
15. As the debt to total asset ratio _____________, or as earnings become more volatile, the firm
will face ______________ borrowing costs.
a. rises; higher
b. decreases; higher
c. decreases; lower
d. rises; lower
Answer: a
Level: difficult
Section: Bankruptcy Costs