CPFM Corporate Finance Structure 3

Question 1

The trade-off theory of capital structure balances the tax benefits of debt against what cost?

Accepted Answer

Expected costs of financial distress and bankruptcy

Answer

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?

Accepted Answer

Minimizes WACC and maximizes firm value

Answer

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?

Accepted Answer

Often a negative signal that shares may be overpriced

Answer

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?

Accepted Answer

Debt and common equity

Answer

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?

Accepted Answer

It rises because equity holders bear more financial risk

Answer

Higher leverage increases the financial risk borne by shareholders, raising their required return.

CPFM Practice Test