- Which of the following statements about debt contracts is most correct? a. Debt contracts have several different names. b. Debt contracts typically contain restrictive covenants c. All debt contracts name a trustee. d. Both a. and b. above are correct. e. a., b., and c. above are all correct. ___-32. A call provision allows bondholders to tender (turn in) their bonds at any time and receive the principal amount in return. a. True b. False _________33. Which of the following statements about debt ratings is most correct? a. The ratings reflect the probability of default. b. The ratings on outstanding debt are automatically reviewed and updated annually c. The ratings are important to investors, but unimportant to issuers. d. The ratings are based solely on a quantitative analysis of the issuer’s financial condition e. The ratings run from A (for the best) to F (for the worst). _______________34. Although the use of financial leverage (debt financing) can increase the return to the owners of a business, it also increases the riskiness of their equity investment. a. True b. False_____________ 35. Which of the following statements about the use of debt financing (financial leverage) is incorrect? a. In most situations, the use of debt financing increases the return to owners (say, as measured by ROE). b. In all situations, the use of debt financing increases the riskiness to owners. c. Capital structure theory allows managers to precisely determine the optimal capital structure for any for-profit business. d. Debt financing allows more of a business’s operating income to flow through to investors e. Because debt financing “levers up” (increases) owners’ returns, its use is called financial leverage.______ 36. Which of the following statements about the tradeoff theory of capital structure is most correct? a. The trade-off theory can be used to set a precise optimal structure for any given business b. The trade-off theory tells us that businesses should use almost 100 percent debt financing c. The trade-off theory tells us that businesses should use almost no debt financing. d. The trade-off theory tells us that businesses should use some debt financing, but not too much. e. The trade-off theory has no applicability at all to not-for-profit businesses. _______________37. To minimize the risk associated with debt financing, permanent assets (land, buildings, and equipment) should be financed with long-term debt while temporary assets (such as a seasonal buildup in inventories) should be financed with short-term debt. a. True b. False ________________38. The corporate cost of capital is a blend (weighted average) of the costs of all of a business’s financing sources. a. True b. False ___________-39. Which of the following statements regarding the cost of equity is most correct? a. The cost of debt is the interest rate set on debt financing, while the cost of equity is defined similarly; it is the rate of return required by equity investors. b. The debt cost plus risk premium method is one way to estimate the cost of equity. c. The cost of equity for a not-for-profit business is zero. d. Both a. and b. above are correct. e. a., b., and c. above are correct._________ 40. The corporate cost of capital provides a benchmark for determining a project’s cost of capital. In general, projects that are riskier than average must have a cost of capital that is higher than the corporate cost of capital, while projects that are less risky than average must have a cost of capital that is less than the corporate cost of capital. a. True b. False
The Correct Answer and Explanation is :
31. Correct Answer: d. Both a. and b. above are correct.
Explanation:
Debt contracts, such as bonds or loans, can indeed have several different names (e.g., bonds, promissory notes, mortgages, etc.). Additionally, it is common for debt contracts to contain restrictive covenants—conditions that protect the lender’s interests by restricting the borrower’s actions (such as limits on additional borrowing, dividend payments, etc.). While not all debt contracts name a trustee, many do, particularly for bonds, where a trustee is often appointed to protect bondholders’ interests. Therefore, the most accurate statement is that both a. and b. are correct.
32. Correct Answer: b. False
Explanation:
A call provision allows the issuer of the bond (not the bondholder) to redeem or “call” the bond before its maturity date, typically at a premium. This provides the issuer with the flexibility to pay off the bond early if interest rates drop, thus allowing them to refinance at a lower cost. On the other hand, the statement in the question describes a put provision, where bondholders have the option to tender (sell back) the bond to the issuer at a predetermined price. Hence, the correct answer is False.
33. Correct Answer: a. The ratings reflect the probability of default.
Explanation:
Debt ratings assess the creditworthiness of a bond issuer and reflect the probability that the issuer will default on its obligations. These ratings are crucial for investors to evaluate the risk associated with investing in a particular bond. While the ratings are reviewed periodically, they are not automatically updated annually. Additionally, ratings are important to both issuers and investors, and are based on a combination of qualitative and quantitative factors, not solely on the issuer’s financial condition.
34. Correct Answer: a. True
Explanation:
Financial leverage (using debt to finance a business) can indeed magnify the return to equity holders when the business performs well. However, it also increases the risk because debt requires fixed payments regardless of the business’s performance. If the business underperforms, it may struggle to meet these debt obligations, which increases the risk to equity holders.
35. Correct Answer: c. Capital structure theory allows managers to precisely determine the optimal capital structure for any for-profit business.
Explanation:
Capital structure theory provides insights into how the mix of debt and equity can influence a company’s value and cost of capital. However, it does not offer a precise, one-size-fits-all solution for every business. The optimal capital structure depends on various factors, including industry characteristics, the company’s risk tolerance, and market conditions. Therefore, the statement that capital structure theory can precisely determine the optimal structure for any business is incorrect.
36. Correct Answer: d. The trade-off theory tells us that businesses should use some debt financing, but not too much.
Explanation:
The trade-off theory of capital structure suggests that businesses should balance the benefits of debt (such as tax shields) with the costs of debt (such as bankruptcy risk). It posits that there is an optimal level of debt that minimizes the overall cost of capital. Using too much debt increases the risk of financial distress, while using too little might mean missing out on potential tax benefits.
37. Correct Answer: a. True
Explanation:
The principle behind matching the financing of assets with the duration of the financing (also known as the “matching principle”) suggests that permanent assets, which provide long-term benefits (e.g., land, buildings, equipment), should be financed with long-term debt, while temporary assets (e.g., seasonal inventory) should be financed with short-term debt. This helps to reduce the risk of financial distress by aligning the timing of cash flows and financing needs.
38. Correct Answer: a. True
Explanation:
The corporate cost of capital (WACC – weighted average cost of capital) represents the blended cost of a business’s financing sources, which include debt, equity, and possibly other sources such as preferred stock. It is the average rate of return a company must earn on its assets to satisfy all its capital providers (debt holders, equity investors, etc.). This helps a company evaluate investment projects and determine their feasibility.
39. Correct Answer: d. Both a. and b. above are correct.
Explanation:
The cost of equity is the rate of return required by equity investors, and it is typically higher than the cost of debt because equity investors take on more risk. One way to estimate the cost of equity is through the debt cost plus risk premium method, which adds a risk premium to the cost of debt to reflect the higher risk equity investors face. Therefore, both a. and b. are correct.
40. Correct Answer: a. True
Explanation:
The corporate cost of capital serves as a benchmark for evaluating the cost of capital for different projects. A project that is riskier than the company’s average will have a higher required return to compensate investors for taking on more risk, while a less risky project will have a lower required return. This helps to ensure that the company only accepts projects that will generate returns that exceed their cost of capital.