The Pecking Order Theory of capital structure implies a unique optimum capital structure.

True
False
**False.** The Pecking Order Theory of capital structure does **not** imply a unique optimum capital structure.

Instead, the Pecking Order Theory suggests that firms follow a hierarchy of financing preferences: they prefer to use internal funds first, then debt, and issue equity only as a last resort¹²³⁴. This behavior is driven by concerns about information asymmetry and the relative costs of different financing sources, not by a search for a specific, unique optimal mix of debt and equity¹³⁴. As a result, the actual capital structure observed in a company is the outcome of cumulative financing decisions over time, rather than the result of targeting a precise, optimal capital structure¹⁵³⁴.

In contrast, theories like the Trade-off Theory explicitly seek an optimal capital structure that minimizes the cost of capital and maximizes firm value³⁶. The Pecking Order Theory, however, does not provide a quantitative rule or target ratio for debt and equity, and therefore does not imply a unique optimum capital structure⁵³⁴.

A company has net income of $20,000 and a tax rate of 35 percent. Its total debt is $25,000, with principal payments of $5,000 due at the end of each year and an annual interest rate of 8%. What will be the company’s interest tax shield in the upcoming year?

$8,750
$700
$9,450
$2,450
The **interest tax shield** is calculated as the **interest expense multiplied by the tax rate**[^2_1][^2_3][^2_5][^2_7].

Given:

• Total debt: $25,000
• Annual interest rate: 8%
• Tax rate: 35%

First, calculate the annual interest expense:

Now, calculate the interest tax shield:

So, the company’s interest tax shield in the upcoming year will be $700⁷⁸⁹.

The cost of capital for an all-equity-financed company that pays no dividends is zero.

True
False
**False.** The cost of capital for an all-equity-financed company that pays no dividends is **not zero**.

Even if a company does not pay dividends, equity investors still require a return for investing their capital, reflecting the opportunity cost and risk of their investment. This required return is known as the cost of equity, which can be estimated using models such as the Capital Asset Pricing Model (CAPM)^10111213. The absence of dividend payments does not eliminate the cost of equity, as investors may expect returns through capital gains or future dividends.

Therefore, an all-equity-financed, no-dividend company still has a positive cost of capital, not zero.

A company has net working capital of $0, current liabilities of $25 and total assets equal to $100. What is its current ratio?

0.0
1.0
0.5
4.0
The **current ratio** is calculated as:

Given:

• Net working capital = Current Assets – Current Liabilities = $0
• Current Liabilities = $25

So, Current Assets must also be $25.

The correct answer is 1.0¹⁴¹⁵¹⁶.

A company has net working capital of $0, current liabilities of $25 and total assets equal to $100. What is its current ratio?

0.0
1.0
0.5
4.0
The **current ratio** is calculated as:

Given:

• Net working capital = Current Assets – Current Liabilities = $0
• Current Liabilities = $25

So, Current Assets = $25.

The correct answer is 1.0^17181920.

The item that roughly divides “real” from “financial” activities on an income statement is:

EBIT
Interest Expense
SG&A Expense
None of the above
The item that roughly divides **"real" (operating)** from **"financial" (financing)** activities on an income statement is **EBIT (Earnings Before Interest and Taxes)**.

• EBIT represents profit from the company’s core operations, before deducting interest (a financing cost) and taxes.
• Items above EBIT (such as revenue, cost of goods sold, and SG\&A expense) are considered part of the company’s real, operating activities.
• Items below EBIT (such as interest expense) relate to financial activities, like the cost of borrowing²¹²²²³.

Correct answer: EBIT

The higher the opportunity cost of capital the higher the NPV.

True
False
**False.** The higher the **opportunity cost of capital**, the **lower** the Net Present Value (NPV) of a project, not higher.

This is because NPV is calculated by discounting future cash flows at the opportunity cost of capital. As the discount rate increases, the present value of future cash flows decreases, resulting in a lower NPV²⁴²⁵²⁶.

You are saving money for a down payment on a house. Suppose you want to have total savings of $20,000 in 10 years time and you have currently $5,000. What annual interest rate do you need to earn on your initial investment, assuming you contribute no additional savings?

10.0%
18.5%
12.5%
15.0%
To find the **annual interest rate** needed to grow your savings from **\$5,000** to **\$20,000** in **10 years** with no additional contributions, use the **future value formula**:

Where:

• $FV = 20,000$
• $PV = 5,000$
• $n = 10$
• $r =$ annual interest rate

Plug in the values:

Take the 10th root of both sides:

The closest answer choice is 15.0%^27282930.

Analysis of Claims for Grandma’s Applesauce, Inc.

Given Data

• Probability of Good Year: 0.60
  • Operating Cash Flow (Good Year): $50,000
• Probability of Bad Year: 0.40
  • Operating Cash Flow (Bad Year): $30,000
• Debt Outstanding: $35,000
• Interest Rate: 8%
• Interest Due Next Year: $2,800 ($35,000 × 8%)
• Total Due to Creditors Next Year: $37,800 ($35,000 + $2,800)
• Tax Rate: 0%
• No other means to service debt except operating cash flow

Step-by-Step Calculation

• Expected Creditors’ Claim:

\((0.60 \times 37,800) + (0.40 \times 30,000) = 22,680 + 12,000 = \$34,680\)

• Expected Shareholders’ Claim:
  • Expected Operating Cash Flow:

\((0.60 \times 50,000) + (0.40 \times 30,000) = 30,000 + 12,000 = \$42,000\)

• Less: Expected Creditors’ Claim ($34,680)
• \[\$42,000 - \$34,680 = \$7,320\]

Correct Answer

• Creditors expected claim is $34,680.

This matches the third answer choice. The other options are not correct based on the calculations above.

Which is a commonly used proxy for the “risk-free rate”?

The average historical interest rate on long-term government bonds
The current market rate interest rate on a government-insured savings account
The current yield to maturity on a long-term government bond
The rate of return on a low volatility stock
The **current yield to maturity on a long-term government bond** is a commonly used proxy for the "risk-free rate"[^10_3][^10_4][^10_7][^10_8]. This is because government bonds, especially those issued by stable governments (such as U.S. Treasury bonds), are considered to have negligible default risk and are widely accepted as the closest practical approximation of a risk-free investment.

What is the risk premium for a stock where

the risk free rate is 5.1%;
the equity market risk premium is 5.0%; and
the beta of the stock is 1.2.

11.1%
6.1%
6.0%
12.1%
The **risk premium** for a stock, according to the Capital Asset Pricing Model (CAPM), is calculated as:

Given:

• Beta = 1.2
• Equity Market Risk Premium = 5.0%

So,

The correct answer is 6.0%³¹³²³³.

The sustainable growth rate is the maximum growth rate achievable over an extended period of time.

True
False
**True.** The sustainable growth rate is defined as the **maximum growth rate that a company can sustain over an extended period of time** without needing to raise additional external financing (debt or equity), relying only on internally generated resources[^12_2][^12_5][^12_6]. This rate reflects how quickly a company can grow while maintaining its current capital structure and financial policies.

What is the expected return on a risky investment where

the risk free rate is 5.1%;
the investment's beta is 1.4;
the equity market risk premium is 5.0%; and
the cost of debt is 4.5%.

10.8%
9.6%
12.1%
9.2%
To find the **expected return** on a risky investment using the Capital Asset Pricing Model (CAPM), use the formula:

Given:

• Risk-free rate: 5.1%
• Beta: 1.4
• Equity market risk premium: 5.0%

Plug in the values:

The correct answer is 12.1%^343536373839.

Note: The cost of debt is not relevant to this CAPM calculation.

Which of the following are sources of funds in a statement of sources and uses?

 I. Collection of accounts receivables
 II. Reduction of long-term debt
 III. Payment of dividends
 IV. Reduction in the cash account

I only
II and III
III and IV
I and IV
Among the options provided, the **collection of accounts receivables** is a source of funds, because it represents cash inflow from customers paying their outstanding balances[^14_2][^14_6][^14_7].

• Reduction of long-term debt and payment of dividends are uses of funds, as they represent outflows.
• Reduction in the cash account is also a use of funds, as it means cash is being spent or moved out.

Therefore, the correct answer is:

I only

The Pecking Order Theory of capital structure rests on an assumption of

agency costs.
barriers to entry.
asymmetric information.
tax shields and cost of financial distress.
The Pecking Order Theory of capital structure rests on an assumption of **asymmetric information**. This theory proposes that managers have more information about the firm's prospects and value than outside investors, leading to a hierarchy in financing choices: internal funds first, then debt, and equity as a last resort[^15_1][^15_2][^15_3][^15_5].

Common-size financial statements are constructed in order to:

Adjust for inflation and risk
Facilitate comparisons of different-sized companies
To comply with SEC requirements
All of the above
Common-size financial statements are constructed primarily to **facilitate comparisons of different-sized companies**. By expressing each line item as a percentage of a common base figure (such as total assets or total revenue), these statements allow analysts and investors to compare the financial structure and performance of companies regardless of their absolute size, and to identify trends over time or benchmark against industry peers[^16_1][^16_3][^16_5][^16_6].

There is no requirement to use common-size statements for SEC compliance, and they are not designed to adjust for inflation or risk⁴⁰⁴¹.

The correct answer is: Facilitate comparisons of different-sized companies

41.

Common-size financial statements are constructed in order to:

Adjust for inflation and risk
Facilitate comparisons of different-sized companies
To comply with SEC requirements
All of the above
The primary purpose of **common-size financial statements** is to **facilitate comparisons of different-sized companies** by expressing each line item as a percentage of a common base (such as total assets or total sales). This standardization allows analysts and investors to compare financial performance and structure across companies of varying sizes and over time, identify trends, and benchmark against industry averages.

• They do not adjust for inflation or risk.
• They are not required by the SEC.
• Their main benefit is enabling meaningful comparisons and trend analysis.

Therefore, the correct answer is:

Facilitate comparisons of different-sized companies^424344454647.

The cost of debt is generally lower than the cost of equity.

True
False
**True.** The cost of debt is generally lower than the cost of equity. This is because debt holders take on less risk than equity investors, have priority in repayment, and because interest payments on debt are often tax-deductible, reducing the effective cost to the company[^18_1][^18_3][^18_5][^18_7][^18_9]. Equity investors require a higher return to compensate for their higher risk and residual claim on assets.

39.

Which of the following is commonly forecasted as a percent of sales:

Common stock
Gross profit
Long-term debt
Revolving credit
The item that is **commonly forecasted as a percent of sales** is **gross profit**. The percentage-of-sales method is typically applied to items like **cost of goods sold, gross profit, accounts receivable, accounts payable, inventory, and various expenses** that vary with sales[^19_1][^19_2][^19_3][^19_5][^19_7]. Common stock and long-term debt are generally not forecasted as a percent of sales, as they do not directly correlate with sales volume.

The correct answer is:

Gross profit

The cash cycle measures the days required to produce finished goods or delivered services.

True
False
**False.** The cash cycle (or cash conversion cycle) does **not** measure just the days required to produce finished goods or delivered services. Instead, it measures the total number of days it takes for a company to convert its investment in inventory and other resources into cash flows from sales. This includes:

• The time to produce or acquire inventory,
• The time to sell inventory,
• The time to collect accounts receivable,
• Minus the time the company takes to pay its suppliers.

So, the cash cycle tracks the entire process from paying for inventory to collecting cash from customers, not just production or service delivery days^4849505152.

An increase in financial leverage generally results in a higher return on equity (ROE).

True
False
**False.** An increase in financial leverage does **not always** result in a higher return on equity (ROE). While using more debt can increase ROE if the company's return on assets exceeds the cost of debt (a positive leverage effect), it also increases the risk and the variability of both net income and ROE. If the cost of debt exceeds the returns generated, leverage can actually decrease ROE[^21_1][^21_2][^21_9]. Therefore, the relationship depends on the relative returns and costs, not simply on the use of leverage.

A company builds a new plant and finances its construction by issuing stock. Which ratio is least likely to be affected, all else being equal?

Current ratio
Debt to equity ratio
Debt to asset ratio
Net fixed assets to total assets
When a company builds a new plant and finances it by **issuing stock**, the following changes occur:

• Current ratio: Issuing stock increases cash (a current asset), but building a plant converts that cash into fixed assets (non-current). Ultimately, current assets return to their original level, so the current ratio is least likely to be affected.
• Debt to equity ratio: Equity increases due to the new stock, so this ratio changes.
• Debt to asset ratio: Total assets increase (the new plant), and equity increases, so this ratio changes.
• Net fixed assets to total assets: Net fixed assets increase (the plant), and total assets increase, so this ratio changes.

Therefore, the current ratio is least likely to be affected, all else being equal.

The owners of a firm facing a high probability of bankruptcy prefer to invest in __ projects, because ____.

safer; riskier projects make bankruptcy more likely
no new; the firm is likely to go bankrupt anyway
risky; the shareholders have little to lose and might win if successful
risky; creditors prefer taking a gamble rather than having the company default
The correct answer is:

risky; the shareholders have little to lose and might win if successful

Owners (shareholders) of a firm facing a high probability of bankruptcy prefer to invest in risky projects because if the project succeeds, they benefit from the upside, but if it fails, their losses are limited to what they have already invested. This is due to the asymmetric payoff structure in bankruptcy situations: creditors are paid first, and shareholders only get what remains (if anything). Thus, shareholders have an incentive to “gamble for resurrection” when bankruptcy is likely, as they have little left to lose and could gain substantially if the risky project succeeds⁵³⁵⁴.

In general, an increase in a liability is a source of funds.

True
False
**True.** An increase in a liability is generally considered a **source of funds** because it means the company has obtained additional financing or credit without immediately using cash. For example, borrowing money or increasing accounts payable increases liabilities and provides cash or resources, thus serving as a source of funds[^24_1][^24_5][^24_7].

This is consistent with the accounting and cash flow principles where:

• An increase in liabilities (like loans or accounts payable) brings in cash or resources.
• A decrease in liabilities (repayment of debt or payables) uses cash and is a use of funds.

Therefore, an increase in a liability is generally a source of funds.

A project with an internal rate of return greater than the cost of capital should always be accepted.

True
False
**False.** A project with an internal rate of return (IRR) greater than the cost of capital is generally considered acceptable because it indicates the project is expected to generate returns above the minimum required by investors[^25_1][^25_4][^25_5][^25_6]. However, it should **not always be accepted** without further analysis. There are several important limitations to relying solely on IRR:

• Mutually exclusive projects: The project with the highest IRR may not have the highest net present value (NPV), so NPV should also be considered⁵⁵⁵⁶.
• Non-conventional cash flows: Projects with multiple changes in cash flow direction can result in multiple IRRs, making interpretation difficult⁵⁷⁵⁶.
• Scale of investment: IRR does not account for the size of the project, which can lead to misleading decisions when comparing projects of different scales⁵⁵⁵⁶.

Thus, while IRR > cost of capital is a useful rule of thumb, it is not an absolute rule and should be used alongside other investment appraisal methods.

Biases can and should always be eliminated in financial forecasts.

True
False
**False.** Biases in financial forecasts can be **reduced** through structured processes, data-driven methods, and technology, but they **cannot always be completely eliminated**. Human judgment, incentives, and external pressures can introduce bias, and even with advanced tools and best practices, some level of subjectivity or error may persist[^26_1][^26_3][^26_5][^26_7]. The goal is to minimize bias as much as possible, not to expect its total elimination.

The Static Tradeoff theory of capital structure implies that firms with higher business risk should have lower leverage.

True
False
**True.** The Static Tradeoff theory of capital structure states that firms balance the tax benefits of debt (the interest tax shield) against the costs of financial distress, including bankruptcy and agency costs, to determine their optimal capital structure[^27_1][^27_2][^27_5]. Firms with **higher business risk** (greater variability in operating income) face a higher probability of financial distress for any given level of debt. As a result, the optimal capital structure for these firms involves **lower leverage** compared to firms with lower business risk, since the costs of financial distress rise more quickly for them[^27_2][^27_5].

GoodTimes, Inc. has asset turnover of 0.5 times, a net profit margin of 10% and average total assets of $100, what is its net income (assuming no unusual items)?

$50
$500
$5
The answer cannot be determined with the information provided.
Given:

• Asset turnover = 0.5 times
• Net profit margin = 10%
• Average total assets = $100

Let’s break down the calculation:

1. Asset turnover = Revenue / Average total assets Revenue = Asset turnover × Average total assets = 0.5 × $100 = $50
2. Net profit margin = Net income / Revenue Net income = Net profit margin × Revenue = 10% × $50 = $5

So, the net income is $5.

Correct answer: $5

An optimal current ratio should be greater than 1.0.

True
False
**True.** An optimal current ratio is generally considered to be **greater than 1.0**, as this indicates that a company's current assets exceed its current liabilities and it should be able to meet its short-term obligations[^29_1][^29_3][^29_7]. Most financial experts and banks consider a current ratio above 1.0 (often in the range of 1.2 to 2.0 or higher, depending on the industry) to be acceptable or optimal, as it provides a cushion against liquidity risk[^29_1][^29_2][^29_5][^29_7]. However, the ideal ratio can vary by industry, and a very high current ratio may signal inefficient use of assets[^29_1][^29_2][^29_7].

Which of the following are equivalent under M\&M proposition I?

Maximizing firm value and maximizing firm profit
Maximizing firm value and minimizing the cost of capital
Minimizing firm's cost of capital and minimizing firm's debt burden
Maximizing profit and minimizing taxes
Under **M\&M Proposition I** (Modigliani-Miller Proposition I), the key insight is that **the value of a firm is independent of its capital structure**—that is, it does not matter whether the firm is financed by debt, equity, or a mix of both; the firm's value remains the same in perfect markets without taxes, bankruptcy costs, or asymmetric information[^30_1][^30_2][^30_3][^30_4][^30_5][^30_7][^30_9][^30_10].

This means that:

• Maximizing firm value and minimizing the cost of capital are equivalent under M\&M Proposition I, because the firm’s value is maximized when its cost of capital is minimized, and vice versa^5859606162.

Therefore, the correct answer is:

Maximizing firm value and minimizing the cost of capital.

What is the present value of a growing perpetuity that makes a payment of $100 in the first year, which thereafter grows at 3% per year? Apply a discount rate of 7%.

$ 2,000
$ 3,500
$ 2,500
$ 4,000
To calculate the **present value of a growing perpetuity**, use the formula:

Where:

• $ C $ = payment in the first year = $100
• $ r $ = discount rate = 7% (0.07)
• $ g $ = growth rate = 3% (0.03)

Plug in the values:

The present value is $2,500^63646566.