Capital Structure and Financing Quiz

The combination of debt and equity a company uses to finance its operations.

The proportion of a company's total value that is financed by debt.

A hypothetical market where securities are priced fairly, there are no taxes or transaction costs, and investment cash flows are independent of financing choices.

Financing a project solely through equity, where the owner raises funds by selling shares of their business.

Financing a project using a combination of debt and equity, where the company borrows money and also issues equity.

The return required by investors for holding a company's stock.

The increase in risk to a company's equity holders when they take on more debt.

The act of using financial leverage to increase returns, but also potentially increasing risk.

In perfect capital markets, the total value of a firm remains the same regardless of its debt-to-equity ratio.

The cash flows to equity holders in a levered firm are the remaining cash flows after paying debt obligations (principal and interest).

The return to equity holders in a levered firm is calculated by dividing the cash flows to equity by the value of equity.

In perfect capital markets, while the total value of a firm is constant, the risk of equity increases with higher debt levels.

The difference between the expected return on equity in a levered firm and the return on equity in an unlevered firm is the debt's cost (interest) multiplied by the debt-to-equity ratio.

The expected return on leveraged equity can be calculated as the risk-free return plus the equity risk premium multiplied by the firm's beta. Beta is a measure of the firm's non-diversifiable risk.

The value of a firm's equity in a levered firm can be calculated by subtracting the value of its debt from the value of the firm's assets.

The risk of a levered firm's equity increases with higher debt levels because the firm's cash flows are more volatile due to the fixed debt obligations.

The increase in value to investors due to the tax deductibility of interest payments. It is calculated as the product of the corporate tax rate and the interest payments.

The tax savings that a company receives due to deducting interest expenses from its taxable income. This reduces the amount of taxes paid and increases the value of the company.

A measure of the cost of capital for a company's equity. It represents the expected return that investors require for holding the company's stock.

It suggests that the value of a company is independent of its capital structure. In other words, the value of the company is the same regardless of whether it has a lot of debt or not.

A financial statement that summarizes a company's revenues, expenses, and profits over a specific period of time.

The value of a firm's total cash flows remains constant regardless of the amount of debt financing used.

The cost of levered equity is equal to the cost of unlevered equity plus a premium proportional to the debt-equity ratio. This premium reflects the increased risk to equity holders due to debt financing.

The weighted average cost of capital (WACC) represents the average cost of financing a company's assets. It's calculated by weighting the cost of debt and the cost of equity by their respective proportions in the company's capital structure.

The cost of levered equity, calculated using Modigliani-Miller Proposition II, remains constant as the debt-equity ratio changes in a perfect capital market. This means that the risk premium for increased debt is offset by the lower cost of debt.

The cost of levered equity is calculated using the following formula: Cost of Levered Equity = Cost of Unlevered Equity + (Debt/Equity) * (Cost of Unlevered Equity - Cost of Debt)

In perfect capital markets, the WACC remains constant regardless of the firm's capital structure. This is because the benefits of lower cost debt are offset by the higher cost of equity due to increased risk.

In a real-world setting, the cost of debt is often lower because the interest payments are tax deductible. As a result, the WACC may decrease with increased leverage, although this effect is not always present and can vary based on the firm's specific circumstances.

The expected return to equity holders is calculated by dividing the expected cash flow to equity by the value of equity. It represents the rate of return investors anticipate from holding the company's equity.

Costs incurred by creditors when a borrower declares bankruptcy. These costs can be significant, and they can significantly impact the value of the firm.

A theory that explains the optimal level of debt a company should use. It considers the trade-off between the tax advantages of debt and the costs of financial distress.

The likelihood that a company will be unable to meet its financial obligations. It increases with higher levels of debt and volatility in cash flows.

The costs associated with a company facing financial distress. These costs can include lost customers, suppliers, and employees, as well as fire sales of assets.

The level of debt that maximizes the value of a levered firm. It considers the tax advantages of debt and the costs of financial distress.

Costs arising from conflicts of interest between stakeholders, such as managers and investors. This can arise when managers make decisions that benefit themselves at the expense of investors.

The separation of ownership (investors) from control (managers) in a company can lead to agency costs. Managers may make decisions that benefit themselves at the expense of investors.

Debt can help to align the interests of management and investors by creating incentives for managers to operate efficiently and reduce waste.

A conflict between equity and debt holders when a company borrows money. Equity holders may want to take risks to maximize their investments, but such actions can hurt debt holders who expect the company to stay stable and pay its debts.

Companies prioritize funding sources, starting with retained earnings, then debt, and finally equity as a last resort. This theory reflects the idea that internal funds are preferred, followed by borrowing, and equity is considered risky.

The optimal capital structure balances the tax benefits of debt with the costs of financial distress. It involves making careful trade-offs between these factors.

Using short-term debt can be beneficial when agency costs are significant because it allows for flexibility in financing and minimizes potential conflicts between managers and shareholders.

When a company increases its leverage, it signals confidence in its ability to meet its debt obligations. This strategy can improve the company's credit rating.

Factors that influence a company's optimal capital structure include profitability, growth, cash flow, size, industry characteristics, interest rates, tax structure, and assets tangibility.

A rising burden of debt can be a concern for companies, especially if they have a high debt-to-equity ratio. It can increase financial risk and affect the company's ability to make timely interest payments.

Company size can influence its capital structure. Larger companies often have access to a wider range of financing options and may prefer lower leverage than smaller companies.