1) A corporation has concluded that its financial risk premium is too high. In o

Question

1) A corporation has concluded that its financial risk premium is too high. In order to decrease this, the firm can

A) increase the proportion of long-term debt to decrease the cost of capital.

B) increase short-term debt to decrease the cost of capital.

C) decrease the proportion of common stock equity to decrease financial risk.

D) increase the proportion of common stock equity to decrease financial risk.

2) Which of the following is not typically a feature of common stock?

A) Most common stock is callable.

B) Most common stock is cumulative.

C) Common stock may or may not pay dividends.

D) More than one of the above statements is not true of common stock.

3)The decision to refund a callable bond

A) should be made only if interest rates have increased.

B) is a net working capital decision.

C) is a capital budgeting decision.

D) is a financing decision.

Explanation / Answer

1) D

A firm has high financial risk premium when markets think that they have a higher risk of defaulting on their bonds/loans and are leveraged

Firm should increase equity stake to decrease the leverage and hence the financial premium

Q2) D

Common stocks are assumed perpetual and in case of share repurchase it is at the discretion of shareholder to surrender his share or not.

Common stocks are not cumulative as they have residual rights and all other stakeholders are paid first and then common stock migh and might not get dividend

3) D is a financing decision

If interest rate decreases it is better to not refund the debt as refinancing would be costlier; net working capital deals with operations and not with source of funds and financing. Capital budgeting is used to determine if a project is worth taking or not [ NPV, IRR etc]

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