CPFM Corporate Finance Structure 3 — Questions and Answers
Question 1: The trade-off theory of capital structure balances the tax benefits of debt against what cost?
- Dividend payments
- Expected costs of financial distress and bankruptcy (Correct answer)
- Share repurchase premiums
- Audit fees
Correct answer: Expected costs of financial distress and bankruptcy
Trade-off theory weighs the debt tax shield against rising distress and bankruptcy costs.
Question 2: A firm's optimal capital structure is the mix of debt and equity that does what?
- Maximizes net income
- Minimizes WACC and maximizes firm value (Correct answer)
- Eliminates all financial risk
- Maximizes the dividend payout ratio
Correct answer: Minimizes WACC and maximizes firm value
The optimal structure minimizes the weighted average cost of capital, maximizing firm value.
Question 3: Issuing new equity when management believes the stock is overvalued sends what signal to the market?
- A positive signal of strong growth
- Often a negative signal that shares may be overpriced (Correct answer)
- No signal at all
- A guaranteed dividend increase
Correct answer: Often a negative signal that shares may be overpriced
Investors often interpret equity issuance as a sign management thinks shares are overvalued.
Question 4: Preferred stock is best described as a hybrid security because it combines features of what?
- Debt and common equity (Correct answer)
- Cash and inventory
- Options and futures
- Receivables and payables
Correct answer: Debt and common equity
Preferred stock pays fixed dividends like debt but represents ownership like equity.
Question 5: If a company increases financial leverage, what generally happens to the cost of equity?
- It falls because risk decreases
- It rises because equity holders bear more financial risk (Correct answer)
- It stays exactly constant
- It becomes negative
Correct answer: It rises because equity holders bear more financial risk
Higher leverage increases the financial risk borne by shareholders, raising their required return.
Question 6: Which of the following is a direct cost of bankruptcy?
- Lost sales from customer concerns
- Legal and administrative court fees (Correct answer)
- Reduced employee morale
- Supplier reluctance to extend credit
Correct answer: Legal and administrative court fees
Legal and administrative fees are direct, measurable costs of the bankruptcy process.
Question 7: The financial structure of a firm differs from its capital structure because financial structure also includes what?
- Only long-term debt
- Short-term liabilities such as accounts payable (Correct answer)
- Common equity only
- Goodwill
Correct answer: Short-term liabilities such as accounts payable
Financial structure covers all liabilities including short-term ones, while capital structure focuses on long-term financing.
CPFM Corporate Finance Structure 3
The trade-off theory of capital structure balances the tax benefits of debt against what cost?