© 2000 John Petroff
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© 2000 John Petroff |
Questions for Chapter 11 Capital Structure
Review questions
Q-11.1
Is there a general consensus on level of debt that all can agree
as appropriate for all companies? Comment.
Q-11.2 What is the proportion
of debt and equity in the aggregate funds flows in the United
States?
Q-11.3 What is the aggregate
proportion of debt and equity used by all US nonfinancial businesses
put together?
Q-11A.1
Is the liability/equity side of the balance sheet as distorted
as the asset side? Explain.
Q-11A.2 Can the distortion
in the equity be accurately compared to the stock capitalization
in the stock market?
Q-11A.3 Are there items
on the liability/equity side of the balance sheet that are neither
liability nor equity? If so, name some.
Q-11A1.1
Are the amounts in current liabilities likely to be distorted?
Discuss.
Q-11A1.2 Is it true that,
under the American accounting method of defined contribution,
the pension liability recorded on the balance sheet is only based
on the number of employees currently employed? Discuss.
Q-11A1.3 Give examples of
deferred revenue. Argue whether that is a real liability.
Q-11A1.4 Can the current
liabilities expand significantly as a result of conditional contractual
commitments? Give examples, and comment.
Q-11A2.1
Why is deferred income tax not a real liability?
Q-11A2.2 Does deferred income
tax appear only in current liabilities? Explain.
Q-11A2.3 When studying the
capital structure of a company, is it common to remove items such
as deferred revenue and deferred taxes from liability/equity?
Q-11A3.1
What type of contractual arrangements or business accepted practices
a company may have to avoid non-payment of current obligations
from becoming a major problem?
Q-11A3.2 Are obligations
under operating leases included in long term debt? Explain why
or why not?
Q-11A3.3 Are obligations
under capital leases included in long term debt? Explain why or
why not.
Q-11A3.4 Is the amount of
principal paid to bondholders different from that shown on the
balance sheet? In which case not and in which case yes?
Q-11A3.5 Is the amount of
long term debt on the balance sheet likely to be in line with
the funding requirement for replacement of fixed assets? Explain.
Q-11A4.1
What is the name given to the amounts set aside to cover potential
liabilities in case of product or performance warranty, or other
such obligations stemming from past decisions or operations? Where
are such amounts classified?
Q-11A4.2 What is the name
given to amounts set aside for the purpose of expansion or future
improvements in company operations (in some countries required
by law)? Where are these amounts appearing in the balance sheet?
Q-11A5.1
What are the type of obligations found in other non-current liabilities?
Are these amounts a relative small size?
Q-11A6.1
Does the sum of capital plus paid-in surplus usually stay in step
with the market value of the stock? Comment.
Q-11A6.2 What is the name
given to stock that a corporation repurchases? What are some of
the reasons for doing so?
Q-11A6.3 Is there a significant
likelihood that the treasury stock amount be distorted? Explain.
Q-11A6.4 Is there a significant
likelihood that the retained earnings amount be distorted? Explain.
Q-11A6.5 Where is the account
of reevaluation of assets located in the balance sheet? What is
its purpose? Does it increase the potential for balance sheet
distortion, or reduces it?
Q-11A6.6 What are some of
the off balance sheet liabilities that must concern an analyst?
Q-11A6.7 How (i.e. with
which contractual arrangement) can a company reduce the amount
of equity it ought to have?
Q-11A6.8 Should an analyst
correct the liability/equity side of the balance sheet for all
the potential distortions found? Explain.
Q-11B.1
Which type of companies should avoid using debt?
Q-11B.2 Will increasing
debt increase total profits of a company, or earnings per share
(assuming initial moderate use of debt)?
Q-11B.3 Will increasing
debt causes the price of the stock to rise (assuming initial moderate
use of debt)?
Q-11B1.1Give the three
reasons why debt increases earnings per share.
Q-11B2.1
Give formula for degree of financial leverage. Explain what is
the ratio intended to show.
Q-11B2.2 Can the degree
of financial leverage compare among different companies? Why.
Q-11B2.3 Give formula for
financial leverage index. Explain what the ratio intended to show
and whether it actually does that.
Q-11B2.4 What are the simpler
measure of financial leverage that are recommended instead of
degree of financial leverage and financial leverage index?
Q-11B2.5 Why is short term
obligations sometimes omitted from the debt to total assets and
debt to equity ratios?
Q-11B3.1
Is it reasonable to assume that the interest paid on debt is less
than the return expected by shareholders? Is there historical
evidence to support your position?
Q-11B3.2 Does financial
leverage apply to long term debt or to use of short term debt
as well? Is short term debt costing a firm even less than long
term debt?
Q-11B3.3 Does the ability
to retire debt when it is no longer needed, reduce the cost of
financing compared to equity? How?
Q-11B3.4 Is long term debt
financing most beneficial when the yield curve is downsloping,
and is it most easy time to arrange it?
Q-11B4.1
Does the empirical data in the United States show that the use
of debt was greater when taxes were higher prior to the 1980's?
Is the evidence onvincing?
Q-11B4.2 Is international
comparative evidence supporting the greater use of debt in countries
with higher corporate income taxes?
Q-11C1.1
What does it mean to service debt?
Q-11C1.2 Is there a greater
potential for profit variability as financial leverage is increased?
Explain how the variability comes about.
Q-11C1.3 Does the variability
in profits translates necessarily in lower market stock price?
Explain why.
Q-11C1.4 Does higher profit
variability with higher financial leverage imply a higher cost
of borrowing as well?
Q-11C1.5 Is the increase
in profit variability the most serious consequence of financial
leverage? If not, what is?
Q-11C2.1
Is financial leverage directly responsible for potential default?
If not, what is?
Q-11C2.2 Is the increased
potential for default adding restrictions of company strategies?
Give examples of these restrictions.
Q-11C3.1
Is the potential for bankruptcy more burdensome than the potential
for default?
Q-11C3.2 How does the potential
for bankruptcy affect employees, suppliers and customers of the
firm?
Q-11C3.3 Is the outcome
of bankruptcy proceeding always detrimental to the firm? Give
examples when it is and when it is not.
Q-11C3.4 Is the dissolution
of a firm usually beneficial to owners?
Q-11C4.1
Is profit variability more difficult to measure than potential
for bankruptcy?
Q-11C4.2 What are the measures
of company profit volatility?
Q-11C4.3 What are coverage
ratios intended to measure?
Q-11C4.4 Give formula for
times interest earned ratio.
Q-11c4.5 Should interest
expense be net of interest income in the TIE formula?
Q-11C4.6 Should implicit
interest on operating leases be include in coverage ratios? Explain
how.
Q-11C4.7 Give formula for
cash flow coverage ratio. Explain why is it used.
Q-11C4.8 Why is the repayment
of principal converted to a pre-tax equivalent?
Q-11C4.9 Give formula for
fixed charges coverage ratio.
Q-11C4.10 Should preferred
stock dividend be considered as a fixed charge? When?
Q-11C4.11 Should minority
interest share of profits be included as a fixed charge?
Q-11C4.12 What other amounts
are also deducted as fixed charges?
Q-11C5.1
What is the bankruptcy predictor proposed by Hickman?
Q-11C5.2 What is the bankruptcy
predictor proposed by Beaver?
Q-11C5.3 What is the name
given to Altman's bankruptcy predictor?
Q-11C5.3 What are some
of the ratios included in Altman's measure?
Q-11C5.4 How accurate have
the bankruptcy predictor been?
Q-11C6.1
What mathematical method allows to construct a probabilistic distribution
of the potential of earnings difficulties?
Q-11D1.1
When can the use of debt be considered as benign? Give examples
of benign uses of debt.
Q-11D1.2 When must the
purpose of contracting more debt not considered as benign? Give
examples.
Q-11D2.1
Does the combination of financial and operating leverages aggravates
variability and potential for default?
Q-11D2.2 Does the combination
of financial and operating leverages results in the need to increase
sales? Does this constitute commercial risk? Explain.
Q-11D3.1
How is the combination of financial and operating leverages assessed?
Q-11D3.2 Give formula for
fixed to worth. What common adjustments are made in the ratio?
Q-11D4.1
What can management do to reduce the potential for default other
than reduce debt and operating leverage?
Q-11D4.2 What are hybrid
securities? How are they reducing potential for default?
Q-11E1.1
What limits the number of projects that a firm can undertake?
When is the selection of project decided?
Q-11E1.2 What is the measure
that is used to select projects? Why is this measure also the
determinant indicator for an optimum debt level?
Q-11E1.3 Give formula for
weighted average cost of capital. What should be the weights used
in the formula? Why is the interest stated aft-tax in the formula?
Q-11E1.4 Explain reasons
why the rate of return on equity increases.
Q-11E1.5 Explain reason
why WACC decrease as debt proportion is increased, then increases
as even more debt is added.
Q-11E1.6 What does the
presence of minimum WACC prove?
Q-11E1.7 Does the minimum
WACC affect earning per share and stock price? Explain.
Q-11E1.8 What are some
of the practical limitations of the formulation of a minimum WACC?
Q-11E1.9 What mathematical
procedure is useful to test out different combinations of type
of debt to use?
Q-11E1.10 Can studying
the terms offered in recent bond issues by the corporation indicative
if the firm has or not exceeded its optimum debt level? Explain.
Q-11E1.11 What other methods
can be used in practice to estimate if debt proportion becomes
a burden for the company strategy?
Q-11E2.1
What proportion of debt should be used when a firm starts?
Q-11E2.2 What proportion
and type of debt should be used by a firm that experiences a fast
product expansion?
Q-11E2.3 What proportion
of debt should be used by a maturing product company?
Q-11E2.4 What proportion
of debt should be use by a company with highly standardized products?
Q-11E2.5 How does the corporate
life cycle model predicts corporate restructuring?
Q-11E3.1
Why is it argued that the proportion of debt a company uses is
irrelevant to investors?
Q-11E3.2 Under what assumptions
the proposition of irrelevance of debt proportion valid?
Q-11E3.3 For what group
of companies is the Modigliani-Miller propositions valid?
Q-11E4.1
What proportion of small businesses fail each year on average
in the United States?
Q-11E4.2 What proportion
of the business population is considered small business?
Q-11E4.3 What proportion
of business population is threatened by financial distress?
Q-11F.1
What are the four factors that a company should consider in choosing
to use debt financing?
Q-11F1.1
List as many (up to eight) reasons as possible for using debt
financing.
Q-11F1.2 List up to 13
reasons for not using debt financing.
Q-11F3.1
What are the US nonfinancial industries that the most leveraged?
What special circumstance explains their situation?
Q-11F4.1
What is the US sector that is the least leveraged? What explains
this?
Q-11F4.2 Is there empirical
evidence that suggests that a correlation exists between size
of fixed assets and size of equity?
Q-11F4.3 Is there empirical
evidence that suggests that a correlation exists between size
of equity and sales instability?
Q-11F4.4 Is there empirical
evidence that suggests that a correlation exists between times
interest earned and sales instability?
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