1.Fixed cost sources of financing include both debt and common stock.

True

False

2.The desire to maintain high bond ratings will tend to increase the use of debt financing in a firmâs capital structure.

True

False

3. Financial risk is the basic risk inherent in the operations of a firm. It can be viewed as the volatility of a firmâs EBIT.

True

False

4. As a firm increases its use of debt financing, what is the impact upon the cost of equity?

The cost of equity decreases.

The cost of equity remains the same.

The cost of equity increases.

None of the above.

5.An investment banking firm has estimated the following after-tax cost of debt and cost of equity for Marquez Luxury Travel Tours.

Proportion of Debt After-tax Cost of Debt Cost of Equity

30% 3.5% 10.5%

40% 3.8% 11.3%

50% 5.0% 12.9%

60% 7.2% 14.5%

What is the cost of capital at Marquezâ optimal capital structure given the above information?

8.95%

8.40%

8.30%

8.15%

6. How does high business risk affect firm risk?

Higher business risk increases the volatility of capital structure.

Higher business risk increases the volatility of EBIT.

Higher business risk increases the volatility of financial costs.

Higher business risk increases the volatility of the firmâs asset structure.

Question

1.Fixed cost sources of financing include both debt and common stock.

True

False

2.The desire to maintain high bond ratings will tend to increase the use of debt financing in a firmâs capital structure.

True

False

3. Financial risk is the basic risk inherent in the operations of a firm. It can be viewed as the volatility of a firmâs EBIT.

True

False

4. As a firm increases its use of debt financing, what is the impact upon the cost of equity?

The cost of equity decreases.

The cost of equity remains the same.

The cost of equity increases.

None of the above.

5.An investment banking firm has estimated the following after-tax cost of debt and cost of equity for Marquez Luxury Travel Tours.

Proportion of Debt After-tax Cost of Debt Cost of Equity

30% 3.5% 10.5%

40% 3.8% 11.3%

50% 5.0% 12.9%

60% 7.2% 14.5%

What is the cost of capital at Marquezâ optimal capital structure given the above information?

8.95%

8.40%

8.30%

8.15%

6. How does high business risk affect firm risk?

Higher business risk increases the volatility of capital structure.

Higher business risk increases the volatility of EBIT.

Higher business risk increases the volatility of financial costs.

Higher business risk increases the volatility of the firmâs asset structure.

		If a firm is exposed to a high degree of business risk as a result of its high operating leverage, then it probably should offset this risk by using a larger-than-average amount of financial leverage. This follows because debt has a lower after-tax cost than equity.
		Financial risk can be reduced by replacing common equity with preferred stock.
		The Hamada equation specifies the effect of financial leverage on beta. It shows how increases in the debt/equity ratio lowers beta.
		In the textbook, it was stated that the capital structure that minimizes the WACC also maximizes the firmâs stock price and its total value, but generally not its expected EPS. One reason given for why debt is beneficial is that it shelters operating income from taxes, while it was stated that a disadvantage of excessive debt has to do with costs associated with bankruptcy and financial distress generally.
		All of the above statements are false.

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