Podcast
Questions and Answers
The optimal capital structure maximizes a firm's stock price by balancing risk and return.
The optimal capital structure maximizes a firm's stock price by balancing risk and return.
True (A)
A firm's beta is unaffected by business risk and is solely determined by market conditions.
A firm's beta is unaffected by business risk and is solely determined by market conditions.
False (B)
Uncertainty in projections of future returns on equity can be described as financial risk when a firm uses no debt.
Uncertainty in projections of future returns on equity can be described as financial risk when a firm uses no debt.
False (B)
Financial flexibility refers to a firm's ability to maintain operations during adverse conditions.
Financial flexibility refers to a firm's ability to maintain operations during adverse conditions.
Financial flexibility becomes irrelevant once a firm is near its target capital structure.
Financial flexibility becomes irrelevant once a firm is near its target capital structure.
The degree of financial risk is the only factor that determines a firm’s capital structure.
The degree of financial risk is the only factor that determines a firm’s capital structure.
Increasing financial leverage will raise a firm's systematic risk, as reflected in its beta coefficient.
Increasing financial leverage will raise a firm's systematic risk, as reflected in its beta coefficient.
Operating leverage affects both EPS and EBIT, while financial leverage only affects EBIT.
Operating leverage affects both EPS and EBIT, while financial leverage only affects EBIT.
Flashcards
Optimal Capital Structure
Optimal Capital Structure
The optimal capital structure is the mix of debt and equity that maximizes a company's stock price by balancing risk and return.
How does Business Risk affect Beta?
How does Business Risk affect Beta?
Business risk is how much a company's earnings can fluctuate due to non-financial factors, like competition or product demand. It's inherent in the business itself and is influenced by its operations.
Business Risk with No Debt
Business Risk with No Debt
Business risk is about how much operational uncertainty exists, independent of any debt. It's how much a company's profits can vary because of its core business activity.
Financial Flexibility
Financial Flexibility
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Importance of Financial Flexibility When Near Target Capital Structure
Importance of Financial Flexibility When Near Target Capital Structure
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Is Financial Risk the Only Factor in Capital Structure?
Is Financial Risk the Only Factor in Capital Structure?
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Financial Leverage and Beta
Financial Leverage and Beta
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Financial vs Operating Leverage
Financial vs Operating Leverage
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Study Notes
Capital Structure
- Optimal capital structure balances risk and return to maximize stock price.
- This structure minimizes the cost of capital.
Business Risk and Beta
- Business risk affects a firm's beta.
- Beta reflects market risk and sensitivity to market conditions impacting business operations.
- Beta is not solely determined by the market.
Business Risk and Debt
- Uncertainty in future returns on equity, when a firm uses no debt, is considered business risk.
- Business risk relates to operational uncertainty and is independent of financial leverage.
Financial Flexibility
- Financial flexibility is a firm's ability to raise capital competitively and sustain operations under challenging conditions.
- Financial flexibility helps firms respond to unexpected events.
Target Capital Structure and Financial Flexibility
- Financial flexibility remains crucial regardless of the target capital structure.
- Unforeseen events can necessitate additional capital.
Financial Leverage and Market Risk
- Increasing financial leverage intensifies market risk (systematic risk), as measured by a higher beta.
- Leverage amplifies returns but escalates exposure to systematic risk.
Operating Leverage and EBIT/EPS
- Operating leverage affects EBIT (earnings before interest and taxes).
- Financial leverage impacts EPS (earnings per share), but also indirectly affects EBIT.
Total Leverage Management
- Management can influence total leverage through financial and operating leverage.
- Financial leverage pertains to debt levels; operating leverage relates to fixed versus variable costs.
Trade-Off Theory of Capital Structure
- Trade-off theory recognizes tax benefits of debt financing alongside costs (bankruptcy risk).
- The theory balances tax benefits with potential costs associated with bankruptcy.
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Description
This quiz explores the concepts of optimal capital structure, business risk, and financial flexibility. Learn how these elements interrelate to impact a firm's ability to manage capital effectively and respond to market fluctuations. Test your knowledge on how operational uncertainties and debt influence a company's risk profile.
