Chapter 13 - Capital Structure

Question 1

What is capital structure?

Answer 1

Capital structure is the mix of debt and equity a company uses to finance its operations and investments.

Question 2

What is financial leverage?

Answer 2

Financial leverage refers to the proportion of debt relative to equity used in a company’s capital structure.

Question 3

What happens when financial leverage increases?

Answer 3

When financial leverage increases, the proportion of debt in the company’s capital structure becomes higher.

Question 4

What is operating leverage?

Answer 4

Operating leverage refers to the increased volatility in operating income caused by a high level of fixed costs.

Question 5

Why do companies with high operating leverage prefer lower financial leverage?

Answer 5

Companies with high operating leverage tend to use less debt because volatile operating income increases the risk of failing to meet debt obligations.

Question 6

What is optimal capital structure?

Answer 6

Optimal capital structure is the specific mix of debt and equity that minimizes a company’s weighted average cost of capital (WACC).

Question 7

Why is identifying optimal capital structure important?

Answer 7

Identifying the optimal capital structure helps a company achieve the lowest possible overall cost of capital and maximize firm value.

Question 8

What are the three main factors that determine optimal capital structure?

Answer 8

Optimal capital structure depends on the nature of operations and assets, the amount and cost of available debt, and how debt affects the cost of equity and debt.

Question 9

Why might small companies struggle to achieve an optimal capital structure?

Answer 9

Small companies may have limited financing options and difficulty raising equity, forcing them to rely more heavily on debt

Question 10

How do financial ratios measure financial leverage?

Answer 10

Financial ratios such as the debt-to-equity ratio and debt-to-assets ratio measure the degree of financial leverage used by a company.

Question 11

Why does higher financial leverage increase risk for investors?

Answer 11

Higher financial leverage increases risk because the company must meet fixed debt payments regardless of its financial performance.

Question 12

How can debt increase returns to shareholders?

Answer 12

Debt can increase shareholder returns when the company earns a return on borrowed funds that exceeds the cost of interest.

Question 13

What determines how much debt a company can obtain?

Answer 13

The amount of debt available depends on the company’s operating cash flow stability and the value of assets available as collateral.

Question 14

How do volatile operating cash flows affect a company’s ability to borrow?

Answer 14

Companies with volatile operating cash flows typically borrow less because lenders are concerned about repayment risk.

Question 15

What is business risk?

Answer 15

Business risk is the variability in a firm’s earnings caused by factors such as industry changes, competition, consumer preferences, and economic cycles.

Question 16

What is operating risk?

Answer 16

Operating risk is the volatility in earnings caused by a company’s cost structure, particularly the balance between fixed and variable costs.

Question 17

Why do high fixed costs increase operating leverage?

Answer 17

High fixed costs increase operating leverage because small changes in sales create larger changes in operating income.

Question 18

How does cost structure influence operating risk?

Answer 18

Companies with higher fixed costs experience greater changes in profit when sales fluctuate, increasing operating risk.

Question 19

How do companies with high variable costs differ from those with high fixed costs?

Answer 19

Companies with high variable costs have lower operating leverage because their costs adjust more easily when sales change.

Question 20

How do tangible assets influence borrowing capacity?

Answer 20

Companies with significant tangible assets can borrow more because those assets can be used as collateral for loans.

Question 21

Why is the cost of debt usually lower than the cost of equity?

Answer 21

Debt is less risky for investors because lenders are paid before shareholders and interest payments are contractually required.

Question 22

How do taxes affect the attractiveness of debt financing?

Answer 22

Interest payments on debt are tax-deductible, which reduces the effective cost of borrowing.

Question 23

What happens to the cost of debt as a company adds more debt to its capital structure?

Answer 23

As a company increases its debt level, lenders charge higher interest rates because the risk of financial distress rises.

Question 24

What is financial distress?

Answer 24

Financial distress occurs when a company cannot meet its debt obligations or violates lending agreements.

Question 25

What costs arise from financial distress?

Answer 25

Financial distress creates direct costs such as legal and accounting fees and indirect costs such as lost customers, employees, and reputation.