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 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
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
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.
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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.
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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.
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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.
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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.
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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.
