Chapter 15 - Long-Term Financing: An Introduction

Chapter 15
Long-Term Financing: An Introduction

Multiple Choice Questions

1. The book capital of a corporation is determined by:

A. the sum of the capital in excess of par and the retained earnings.
B. the par value of preferred stock.
C. the sum of the treasury stock and the preferred stock.
D. the number of shares issued multiplied by the par value of each share.
E. the market price of the company's debt.

2. Retained earnings are:

A. the amount of cash that the firm has saved up.
B. the difference between the net income earned and the dividends paid.
C. the difference between the market price of the stock and the book value.
D. the amount of stock repurchased.
E. None of the above.

3. The book value of the shareholders' ownership is represented by:

A. the sum of the par value of common stock, the capital surplus and the accumulated retained
earnings.
B. the total assets minus the net worth.
C. the sum of the preferred stock, debt and the capital surplus.
D. the sum of the total assets minus the current liabilities.
E. None of the above.

4. Shares of stock that have been repurchased by the corporation are called:
A. treasury stock.
B. undistributed capital stock.
C. retained equity.
D. capital surplus shares.
E. None of the above.

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Chapter 15 - Long-Term Financing: An Introduction

5. The market value of the ownership of the firm equals:

A. the market price of the stock times the number of shares outstanding.
B. the sum of the market price of the bonds and the stock.
C. the par value of the stock times the number of shares outstanding.
D. the market price of the stock minus the retained earnings.
E. None of the above.

6. A grant of authority allowing someone else to vote shares of stock that you own is called:
A. a power-of-share authorization.
B. a proxy.
C. a share authority grant (SAG).
D. a restricted conveyance.
E. None of the above.

7. Unsecured corporate debt is called a(n):

A. indenture.
B. debenture.
C. bond.
D. mortgage.
E. None of the above.

8. A standard arrangement for the orderly retirement of long-term debt calls for the
corporation to make regular payments into a(n):
A. custodial account.
B. sinking fund.
C. retirement fund.
D. irrevocable trustee fund.
E. None of the above

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Chapter 15 - Long-Term Financing: An Introduction

9. Debt that may be extinguished before maturity is referred to as:

A. sinking-fund debt.
B. debentures.
C. callable debt.
D. indenture debt.
E. None of the above.

10. If a long-term debt instrument is perpetual, it is called a(n):

A. secured debt issue.
B. subordinated debt issue.
C. consol.
D. capital debt issue.
E. indenture.

11. The amount of loan a person or firm borrows from a lender is the:
A. creditor.
B. indenture.
C. debenture.
D. principal.
E. amortization.

12. The written agreement between a corporation and its bondholders is called:
A. the collateral agreement.
B. the deed.
C. the indenture.
D. the deed of conveyance.
E. None of the above.

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Chapter 15 - Long-Term Financing: An Introduction

13. If cumulative voting is permitted:

A. the total number of votes a shareholder has is equal to the number of shares owned.
B. the total number of votes a shareholder has is equal to the number of shares owned times
the average number of years the shareholder has owned the shares.
C. the total number of votes a shareholder has can be calculated as the number of shares
owned times the number of directors to be elected.
D. the total number of votes a shareholder has is equal to the number of shares times the
number of board meetings the shareholder has attended.
E. None of the above.

14. The market-to-book value ratio is implies growth and success when it is:
A. greater than 0.
B. less than 10.
C. less than 0.
D. less than 1.
E. greater than 1.

15. There are 3 directors' seats up for election. If you own 1,000 shares of stock and you can
cast 3,000 votes for a particular director, this is illustrative of:
A. cumulative voting.
B. absolute priority voting.
C. sequential voting.
D. straight voting.
E. None of the above.

16. If you own 1,000 shares of stock and you can cast only 1,000 votes for a particular
director, then the stock features:
A. cumulative voting.
B. absolute priority voting.
C. sequential voting.
D. straight voting.
E. None of the above.

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Chapter 15 - Long-Term Financing: An Introduction

17. If a group other than management solicits the authority to vote shares to replace
management, a _____ is said to occur.
A. proxy fight
B. stockholder derivative action
C. tender offer
D. vote of confidence
E. None of the above.

18. Shareholders usually have which of the following right(s)?

A. To elect board members, the authorizing of new shares and other matters of great
importance to shareholders such as being acquired.
B. To share proportionally in regular and liquidating dividends.
C. To share proportionally in any new stock sold.
D. All of the above.
E. None of the above.

19. Different classes of stock usually are issued to:

A. maintain ownership control by holding the class of stock with greater voting rights.
B. pay less in dividends between the classes of stock.
C. fool investors into thinking that equity is equity and there is no difference in control or
value features.
D. extract perquisites without the other class of stockholders knowing.
E. None of the above.

20. Which of the following statements is false?

A. Creditors do not have voting power.
B. Payment on interest on debt in considered an expense, while payment of dividends is a
return on capital.
C. Unpaid debt is a liability of the firm, and if not paid, can result in liquidation of the firm.
Unpaid common stock dividends cannot force liquidation.
D. One of the costs of issuing equity is the possibility of financial distress, while no financial
distress is associated with debt.
E. None of the above.

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Chapter 15 - Long-Term Financing: An Introduction

21. Corporations try to create hybrid securities that look like equity but are called debt
because:
A. debt interest expense is tax deductible.
B. bankruptcy costs are eliminated or reduced.
C. these securities have lower risk than debt.
D. Both A and C.
E. Both A and B.

22. Technically speaking, a long-term corporate debt offering that features a specific
attachment to corporate property is generally called:
A. a debenture.
B. a bond.
C. a long-term liability.
D. a preferred liability.
E. None of the above.

23. If a firm retires or extinguishes a debt issue before maturity, the specific amount they pay
is:
A. the amortization amount.
B. the call price.
C. the sinking fund amount.
D. the spread premium.
E. None of the above.

24. If a debenture is subordinated, it:

A. has a higher priority status than specified creditors.
B. is secondary to equity.
C. must give preference to the specified creditor in the event of default.
D. has been issued because the company is in default.
E. None of the above.

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Chapter 15 - Long-Term Financing: An Introduction

25. Not paying the dividends on a cumulative preferred issue may result in:
A. preferred dividend arrears that can be eliminated by the common shareholders only after
common dividends are paid.
B. voting rights are granted to preferred stockholders if preferred dividends are in arrears.
C. no payment of dividends to common shareholders.
D. Both A and B.
E. Both B and C.

26. Preferred stock has both a tax advantage and a tax disadvantage. These two are:
A. in default there are no taxes and dividends are taxed in corporate hands at 70%.
B. corporate dividends are taxed on 30% of the dividends received and expenses are
deductible.
C. dividends are not a tax-deductible expense but are 70% exempt from corporate taxation.
D. dividends are fully tax deductible but are not equity capital.
E. None of the above.

27. Preferred stock may be desirable to issue for which of the following reason(s)?
A. If there is no taxable income, preferred stock does not impose a tax penalty.
B. The failure to pay preferred dividends, cumulative or noncumulative, will not cause
bankruptcy.
C. Preferred dividends are not tax deductible and therefore will not provide a tax shield but
will reduce net income.
D. Both B and C.
E. Both A and B.

28. Preferred stock may exist because:

A. losses before income taxes prevent a company from enjoying the tax advantages of debt
interest while there is no tax advantage for preferred dividends.
B. an advantage exists for the firm; preferred shareholders can not force the company into
bankruptcy because of unpaid dividends.
C. corporations get a 70% tax exemption on preferred dividends received.
D. All of the above.
E. None of the above.

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Chapter 15 - Long-Term Financing: An Introduction

29. The written agreement between a corporation and its bondholders might contain a
prohibition against paying dividends in excess of current earnings. This prohibition is an
example of a(n):
A. maintenance of security provision.
B. collateral restriction.
C. affirmative indenture.
D. restrictive covenant.
E. None of the above.

30. What percentage of the dividends received by one corporation from another is taxable?
A. 15%
B. 30%
C. 34%
D. 70%
E. 100%

31. Which of the following statements about preferred stock is true?

A. Unlike dividends paid on common stock, dividends paid on preferred stock are a tax-
deductible expense.
B. Unpaid dividends on preferred stock are a debt of the corporation.
C. If preferred dividends are non-cumulative, then preferred dividends not paid in a particular
year will be carried forward to the next year.
D. There is no difference in the voting rights of preferred and common stockholders.
E. None of the above.

32. If a debt issue is callable, the call price is generally ____ par.
A. greater than
B. less than
C. equal to
D. unrelated to
E. It varies widely based on the risk of the firm.

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Chapter 15 - Long-Term Financing: An Introduction

33. There was an upward trend in the ratio of the book value of debt to the book value of debt
and equity throughout the 1990s. Some of this was due to the repurchasing of stock. The
market value ratio of debt to debt and equity exhibited no upward trend. This can be explained
by:
A. the change in the accounting rules of the period.
B. the difference between tax accounting and accounting for financial accounting purposes.
C. a large increase in the market value of equity that was greater than the increase in debt.
D. All of the above.
E. None of the above.

34. Based on historical experience, which of the following best describes the "pecking order"
of long-term financing strategy in the U.S.?
A. Long-term debt first, new common equity, internal financing last.
B. Long-term debt first, internal financing, new common equity last.
C. Internal financing first, new common equity, long-term borrowing last.
D. Internal financing first, long-term borrowing, new common equity last.
E. None of the above.

35. Financial deficits are created when:

A. profits and retained earnings are greater than the capital-spending requirement.
B. profits and retained earnings are less than the capital-spending requirement.
C. profits and retained earnings are equal to the capital-spending requirement.
D. All of the above.
E. None of the above.

36. Financial economists prefer to use market values when measuring debt ratios because:
A. market values are more stable than book values.
B. market values are a better reflection of current value than historical value.
C. market values are readily available and do not have to be calculated like book values.
D. market values are more difficult to calculate which makes financial economists more
valuable.
E. None of the above.

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Chapter 15 - Long-Term Financing: An Introduction

37. Corporate financial officers prefer to use book values when measuring debt ratios
because:
A. book values are more stable than market values.
B. debt covenant restriction are usually expressed in book value terms.
C. rating agencies measure debt ratios in book values terms.
D. All of the above.
E. None of the above.

38. Rockwell Corporation had net income of $150,000 for the year ending 2008. The
company decided to payout 40% of earnings per share as a dividend. Rockwell has 120,000
shares issued and outstanding. What are the retained earnings for 2008?
A. $40,000
B. $60,000
C. $90,000
D. $150,000
E. None of the above

39. Nelson Company had equity accounts in 2008 as follows:

Projected income is $150,000 and 40% of this amount will be paid out immediately as
dividends. What will the ending retained earnings account be?
A. $90,000
B. $92,000
C. $122,000
D. $210,000
E. $242,000

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Chapter 15 - Long-Term Financing: An Introduction

40. Holden Bicycles has 1,000 shares outstanding each with a par value of $0.10. If they are
sold to shareholders at $10 each, what would the capital surplus be?
A. $100
B. $900
C. $9,900
D. $10,000
E. $11,000

41. The Lory Bookstore used internal financing as a source of long-term financing for 80% of
its total needs in 2008. The company borrowed an additional 27% of its total needs in the
long-term debt markets in 2008. What were Lory's net new stock issues in that year?
A. -20%
B. -7%
C. 7%
D. 20%
E. 27%

42. David's Building Equipment (DBE) had net income of $200,000 for the year ending 2008.
The company decided to payout 30% of earnings per share as a dividend. DBE has 50,000
shares issued and outstanding. What are the retained earnings for 2008?
A. $60,000
B. $140,000
C. $150,000
D. $200,000
E. None of the above.

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Chapter 15 - Long-Term Financing: An Introduction

43. Alexandra Investments had equity accounts in 2008 as follows:

Projected income is $200,000 and 20% of this amount will be paid out immediately as
dividends. What will the ending retained earnings account be?
A. $160,000
B. $250,000
C. $270,000
D. $410,000
E. $470,000

44. Michael's Motor Scooters has 1,000 shares outstanding each with a par value of $0.05. If
they are sold to shareholders at $5 each, what would the capital surplus be?
A. $4,400
B. $4,500
C. $4,750
D. $4,950
E. $5,000

45. Calhoun Computech used internal financing as a source of long-term financing for 80% of
its total needs in 2008. The company borrowed an additional 15% of its total needs in the
long-term debt markets in 2008. What were Calhoun's net new stock issues, in percentage
terms, for 2008?
A. -10%
B. -5%
C. 5%
D. 10%
E. 15%

Essay Questions

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Chapter 15 - Long-Term Financing: An Introduction

Information on shareholder's equity as currently shown on the books of the Eaton

Corporation is given as:

46. From this information, calculate Eaton's book value per share.

47. Rework the shareholder's equity as it appears on the books if the company issues 40,000
new shares of common at $70 per share.

48. Preferred Stock, as a hybrid security, presents somewhat of a puzzle as to why they are
issued. What elements give rise to the puzzle and how is it explained?

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Chapter 15 - Long-Term Financing: An Introduction

49. Different countries have different sources of funds. For example, in the United States,
internally generated funds count for over 4/5 of all funds while in Japan, it is about ½ with
externally generated funds making up the remainder. The disparities are less in the United
Kingdom and Germany, with about 2/3 of funds coming from internal sources. Discuss this
disparity and why it might exist.

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Chapter 15 - Long-Term Financing: An Introduction

Chapter 15 Long-Term Financing: An Introduction Answer Key

Multiple Choice Questions

1. The book capital of a corporation is determined by:

A. the sum of the capital in excess of par and the retained earnings.
B. the par value of preferred stock.
C. the sum of the treasury stock and the preferred stock.
D. the number of shares issued multiplied by the par value of each share.
E. the market price of the company's debt.

Difficulty level: Easy

Topic: BOOK CAPITAL
Type: DEFINITIONS

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Chapter 15 - Long-Term Financing: An Introduction

2. Retained earnings are:

A. the amount of cash that the firm has saved up.
B. the difference between the net income earned and the dividends paid.
C. the difference between the market price of the stock and the book value.
D. the amount of stock repurchased.
E. None of the above.

Difficulty level: Easy

Topic: RETAINED EARNINGS
Type: DEFINITIONS

3. The book value of the shareholders' ownership is represented by:

A. the sum of the par value of common stock, the capital surplus and the accumulated retained
earnings.
B. the total assets minus the net worth.
C. the sum of the preferred stock, debt and the capital surplus.
D. the sum of the total assets minus the current liabilities.
E. None of the above.

Difficulty level: Medium

Topic: BOOK VALUE
Type: DEFINITIONS

4. Shares of stock that have been repurchased by the corporation are called:
A. treasury stock.
B. undistributed capital stock.
C. retained equity.
D. capital surplus shares.
E. None of the above.

Difficulty level: Easy

Topic: TREASURY STOCK
Type: DEFINITIONS

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Chapter 15 - Long-Term Financing: An Introduction

5. The market value of the ownership of the firm equals:

A. the market price of the stock times the number of shares outstanding.
B. the sum of the market price of the bonds and the stock.
C. the par value of the stock times the number of shares outstanding.
D. the market price of the stock minus the retained earnings.
E. None of the above.

Difficulty level: Easy

Topic: MARKET VALUE OF EQUITY
Type: DEFINITIONS

6. A grant of authority allowing someone else to vote shares of stock that you own is called:
A. a power-of-share authorization.
B. a proxy.
C. a share authority grant (SAG).
D. a restricted conveyance.
E. None of the above.

Difficulty level: Easy

Topic: PROXY
Type: DEFINITIONS

7. Unsecured corporate debt is called a(n):

A. indenture.
B. debenture.
C. bond.
D. mortgage.
E. None of the above.

Difficulty level: Easy

Topic: DEBENTURE
Type: DEFINITIONS

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Chapter 15 - Long-Term Financing: An Introduction

8. A standard arrangement for the orderly retirement of long-term debt calls for the
corporation to make regular payments into a(n):
A. custodial account.
B. sinking fund.
C. retirement fund.
D. irrevocable trustee fund.
E. None of the above

Difficulty level: Easy

Topic: SINKING FUND
Type: DEFINITIONS

9. Debt that may be extinguished before maturity is referred to as:

A. sinking-fund debt.
B. debentures.
C. callable debt.
D. indenture debt.
E. None of the above.

Difficulty level: Easy

Topic: CALLABLE DEBT
Type: DEFINITIONS

10. If a long-term debt instrument is perpetual, it is called a(n):

A. secured debt issue.
B. subordinated debt issue.
C. consol.
D. capital debt issue.
E. indenture.

Difficulty level: Easy

Topic: CONSOL OR PERPETUAL DEBT
Type: DEFINITIONS

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Chapter 15 - Long-Term Financing: An Introduction

11. The amount of loan a person or firm borrows from a lender is the:
A. creditor.
B. indenture.
C. debenture.
D. principal.
E. amortization.

Difficulty level: Easy

Topic: LOAN PRINCIPAL
Type: DEFINITIONS

12. The written agreement between a corporation and its bondholders is called:
A. the collateral agreement.
B. the deed.
C. the indenture.
D. the deed of conveyance.
E. None of the above.

Difficulty level: Easy

Topic: INDENTURE
Type: DEFINITIONS

13. If cumulative voting is permitted:

A. the total number of votes a shareholder has is equal to the number of shares owned.
B. the total number of votes a shareholder has is equal to the number of shares owned times
the average number of years the shareholder has owned the shares.
C. the total number of votes a shareholder has can be calculated as the number of shares
owned times the number of directors to be elected.
D. the total number of votes a shareholder has is equal to the number of shares times the
number of board meetings the shareholder has attended.
E. None of the above.

Difficulty level: Easy

Topic: CUMULATIVE VOTING
Type: CONCEPTS

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Chapter 15 - Long-Term Financing: An Introduction

14. The market-to-book value ratio is implies growth and success when it is:
A. greater than 0.
B. less than 10.
C. less than 0.
D. less than 1.
E. greater than 1.

Difficulty level: Medium

Topic: MARKET-TO-BOOK RATIO
Type: CONCEPTS

15. There are 3 directors' seats up for election. If you own 1,000 shares of stock and you can
cast 3,000 votes for a particular director, this is illustrative of:
A. cumulative voting.
B. absolute priority voting.
C. sequential voting.
D. straight voting.
E. None of the above.

Difficulty level: Easy

Topic: CUMULATIVE VOTING
Type: CONCEPTS

16. If you own 1,000 shares of stock and you can cast only 1,000 votes for a particular
director, then the stock features:
A. cumulative voting.
B. absolute priority voting.
C. sequential voting.
D. straight voting.
E. None of the above.

Difficulty level: Easy

Topic: STRAIGHT VOTING
Type: CONCEPTS

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Chapter 15 - Long-Term Financing: An Introduction

17. If a group other than management solicits the authority to vote shares to replace
management, a _____ is said to occur.
A. proxy fight
B. stockholder derivative action
C. tender offer
D. vote of confidence
E. None of the above.

Difficulty level: Easy

Topic: PROXY FIGHT
Type: CONCEPTS

18. Shareholders usually have which of the following right(s)?

A. To elect board members, the authorizing of new shares and other matters of great
importance to shareholders such as being acquired.
B. To share proportionally in regular and liquidating dividends.
C. To share proportionally in any new stock sold.
D. All of the above.
E. None of the above.

Difficulty level: Easy

Topic: SHAREHOLDER RIGHTS
Type: CONCEPTS

19. Different classes of stock usually are issued to:

A. maintain ownership control by holding the class of stock with greater voting rights.
B. pay less in dividends between the classes of stock.
C. fool investors into thinking that equity is equity and there is no difference in control or
value features.
D. extract perquisites without the other class of stockholders knowing.
E. None of the above.

Difficulty level: Medium

Topic: CLASSES OF STOCK
Type: CONCEPTS

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Chapter 15 - Long-Term Financing: An Introduction

20. Which of the following statements is false?

A. Creditors do not have voting power.
B. Payment on interest on debt in considered an expense, while payment of dividends is a
return on capital.
C. Unpaid debt is a liability of the firm, and if not paid, can result in liquidation of the firm.
Unpaid common stock dividends cannot force liquidation.
D. One of the costs of issuing equity is the possibility of financial distress, while no financial
distress is associated with debt.
E. None of the above.

Difficulty level: Medium

Topic: COSTS OF LONG TERM FINANCING
Type: CONCEPTS

21. Corporations try to create hybrid securities that look like equity but are called debt
because:
A. debt interest expense is tax deductible.
B. bankruptcy costs are eliminated or reduced.
C. these securities have lower risk than debt.
D. Both A and C.
E. Both A and B.

Difficulty level: Medium

Topic: HYBRID SECURITIES
Type: CONCEPTS

22. Technically speaking, a long-term corporate debt offering that features a specific
attachment to corporate property is generally called:
A. a debenture.
B. a bond.
C. a long-term liability.
D. a preferred liability.
E. None of the above.

Difficulty level: Easy

Topic: BOND
Type: CONCEPTS

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Chapter 15 - Long-Term Financing: An Introduction

23. If a firm retires or extinguishes a debt issue before maturity, the specific amount they pay
is:
A. the amortization amount.
B. the call price.
C. the sinking fund amount.
D. the spread premium.
E. None of the above.

Difficulty level: Easy

Topic: CALLABLE DEBT
Type: CONCEPTS

24. If a debenture is subordinated, it:

A. has a higher priority status than specified creditors.
B. is secondary to equity.
C. must give preference to the specified creditor in the event of default.
D. has been issued because the company is in default.
E. None of the above.

Difficulty level: Medium

Topic: SUBORDINATED DEBENTURE
Type: CONCEPTS

25. Not paying the dividends on a cumulative preferred issue may result in:
A. preferred dividend arrears that can be eliminated by the common shareholders only after
common dividends are paid.
B. voting rights are granted to preferred stockholders if preferred dividends are in arrears.
C. no payment of dividends to common shareholders.
D. Both A and B.
E. Both B and C.

Difficulty level: Medium

Topic: PREFERRED STOCK AND DIVIDENDS
Type: CONCEPTS

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Chapter 15 - Long-Term Financing: An Introduction

26. Preferred stock has both a tax advantage and a tax disadvantage. These two are:
A. in default there are no taxes and dividends are taxed in corporate hands at 70%.
B. corporate dividends are taxed on 30% of the dividends received and expenses are
deductible.
C. dividends are not a tax-deductible expense but are 70% exempt from corporate taxation.
D. dividends are fully tax deductible but are not equity capital.
E. None of the above.

Difficulty level: Medium

Topic: PREFERRED STOCK
Type: CONCEPTS

27. Preferred stock may be desirable to issue for which of the following reason(s)?
A. If there is no taxable income, preferred stock does not impose a tax penalty.
B. The failure to pay preferred dividends, cumulative or noncumulative, will not cause
bankruptcy.
C. Preferred dividends are not tax deductible and therefore will not provide a tax shield but
will reduce net income.
D. Both B and C.
E. Both A and B.

Difficulty level: Challenge

Topic: PREFERRED STOCK
Type: CONCEPTS

28. Preferred stock may exist because:

A. losses before income taxes prevent a company from enjoying the tax advantages of debt
interest while there is no tax advantage for preferred dividends.
B. an advantage exists for the firm; preferred shareholders can not force the company into
bankruptcy because of unpaid dividends.
C. corporations get a 70% tax exemption on preferred dividends received.
D. All of the above.
E. None of the above.

Difficulty level: Medium

Topic: PREFERRED STOCK
Type: CONCEPTS

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Chapter 15 - Long-Term Financing: An Introduction

29. The written agreement between a corporation and its bondholders might contain a
prohibition against paying dividends in excess of current earnings. This prohibition is an
example of a(n):
A. maintenance of security provision.
B. collateral restriction.
C. affirmative indenture.
D. restrictive covenant.
E. None of the above.

Difficulty level: Easy

Topic: RESTRICTIVE COVENANT
Type: CONCEPTS

30. What percentage of the dividends received by one corporation from another is taxable?
A. 15%
B. 30%
C. 34%
D. 70%
E. 100%

Difficulty level: Easy

Topic: TAXABLE CORPORATE DIVIDENDS
Type: CONCEPTS

31. Which of the following statements about preferred stock is true?

A. Unlike dividends paid on common stock, dividends paid on preferred stock are a tax-
deductible expense.
B. Unpaid dividends on preferred stock are a debt of the corporation.
C. If preferred dividends are non-cumulative, then preferred dividends not paid in a particular
year will be carried forward to the next year.
D. There is no difference in the voting rights of preferred and common stockholders.
E. None of the above.

Difficulty level: Medium

Topic: PREFERRED STOCK
Type: CONCEPTS

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Chapter 15 - Long-Term Financing: An Introduction

32. If a debt issue is callable, the call price is generally ____ par.
A. greater than
B. less than
C. equal to
D. unrelated to
E. It varies widely based on the risk of the firm.

Difficulty level: Easy

Topic: CALLABLE DEBT
Type: CONCEPTS

33. There was an upward trend in the ratio of the book value of debt to the book value of debt
and equity throughout the 1990s. Some of this was due to the repurchasing of stock. The
market value ratio of debt to debt and equity exhibited no upward trend. This can be explained
by:
A. the change in the accounting rules of the period.
B. the difference between tax accounting and accounting for financial accounting purposes.
C. a large increase in the market value of equity that was greater than the increase in debt.
D. All of the above.
E. None of the above.

Difficulty level: Easy

Topic: DEBT FINANCING TRENDS
Type: CONCEPTS

34. Based on historical experience, which of the following best describes the "pecking order"
of long-term financing strategy in the U.S.?
A. Long-term debt first, new common equity, internal financing last.
B. Long-term debt first, internal financing, new common equity last.
C. Internal financing first, new common equity, long-term borrowing last.
D. Internal financing first, long-term borrowing, new common equity last.
E. None of the above.

Difficulty level: Easy

Topic: PECKING ORDER
Type: CONCEPTS

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Chapter 15 - Long-Term Financing: An Introduction

35. Financial deficits are created when:

A. profits and retained earnings are greater than the capital-spending requirement.
B. profits and retained earnings are less than the capital-spending requirement.
C. profits and retained earnings are equal to the capital-spending requirement.
D. All of the above.
E. None of the above.

Difficulty level: Medium

Topic: FINANCIAL DEFICITS
Type: CONCEPTS

36. Financial economists prefer to use market values when measuring debt ratios because:
A. market values are more stable than book values.
B. market values are a better reflection of current value than historical value.
C. market values are readily available and do not have to be calculated like book values.
D. market values are more difficult to calculate which makes financial economists more
valuable.
E. None of the above.

Difficulty level: Medium

Topic: MARKET VALUE OF DEBT
Type: CONCEPTS

37. Corporate financial officers prefer to use book values when measuring debt ratios
because:
A. book values are more stable than market values.
B. debt covenant restriction are usually expressed in book value terms.
C. rating agencies measure debt ratios in book values terms.
D. All of the above.
E. None of the above.

Difficulty level: Medium

Topic: BOOK VALUE OF DEBT
Type: CONCEPTS

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Chapter 15 - Long-Term Financing: An Introduction

38. Rockwell Corporation had net income of $150,000 for the year ending 2008. The
company decided to payout 40% of earnings per share as a dividend. Rockwell has 120,000
shares issued and outstanding. What are the retained earnings for 2008?
A. $40,000
B. $60,000
C. $90,000
D. $150,000
E. None of the above

RE = NI (1 - payout ratio) = $150,000 (1 - .4) = $90,000.

Difficulty level: Medium

Topic: RETAINED EARNINGS
Type: PROBLEMS

39. Nelson Company had equity accounts in 2008 as follows:

Projected income is $150,000 and 40% of this amount will be paid out immediately as
dividends. What will the ending retained earnings account be?
A. $90,000
B. $92,000
C. $122,000
D. $210,000
E. $242,000

RE0 = NI (1 - payout ratio) = $150,000 (.6) = $90,000.

RE1 = RE-1 + RE0 = $32,000 + $90,000 = $122,000.

Difficulty level: Medium

Topic: RETAINED EARNINGS
Type: PROBLEMS

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Chapter 15 - Long-Term Financing: An Introduction

40. Holden Bicycles has 1,000 shares outstanding each with a par value of $0.10. If they are
sold to shareholders at $10 each, what would the capital surplus be?
A. $100
B. $900
C. $9,900
D. $10,000
E. $11,000

Capital Surplus: ($10.00 - $0.10) * 1,000 = $9,900.

Difficulty level: Medium

Topic: CAPITAL SURPLUS
Type: PROBLEMS

41. The Lory Bookstore used internal financing as a source of long-term financing for 80% of
its total needs in 2008. The company borrowed an additional 27% of its total needs in the
long-term debt markets in 2008. What were Lory's net new stock issues in that year?
A. -20%
B. -7%
C. 7%
D. 20%
E. 27%

Net new issues = - 7%, as more stock was repurchased than issued. (100% - (80 + 27)) = (100
- 107) = -7%.

Difficulty level: Medium

Topic: NET NEW ISSUE
Type: PROBLEMS

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Chapter 15 - Long-Term Financing: An Introduction

42. David's Building Equipment (DBE) had net income of $200,000 for the year ending 2008.
The company decided to payout 30% of earnings per share as a dividend. DBE has 50,000
shares issued and outstanding. What are the retained earnings for 2008?
A. $60,000
B. $140,000
C. $150,000
D. $200,000
E. None of the above.

RE = NI (1 - payout ratio) = $200,000 (1 - .3) = $140,000.

Difficulty level: Medium

Topic: RETAINED EARNINGS
Type: PROBLEMS

43. Alexandra Investments had equity accounts in 2008 as follows:

Projected income is $200,000 and 20% of this amount will be paid out immediately as
dividends. What will the ending retained earnings account be?
A. $160,000
B. $250,000
C. $270,000
D. $410,000
E. $470,000

RE0 = NI (1 - payout ratio) = $200,000 (.8) = $160,000.

RE1 = RE-1 + RE0 = $250,000 + $160,000 = $410,000.

Difficulty level: Medium

Topic: RETAINED EARNINGS
Type: PROBLEMS

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Chapter 15 - Long-Term Financing: An Introduction

44. Michael's Motor Scooters has 1,000 shares outstanding each with a par value of $0.05. If
they are sold to shareholders at $5 each, what would the capital surplus be?
A. $4,400
B. $4,500
C. $4,750
D. $4,950
E. $5,000

Capital Surplus: ($5.00 - $0.05) * 1,000 = $4,950.

Difficulty level: Medium

Topic: CAPITAL SURPLUS
Type: PROBLEMS

45. Calhoun Computech used internal financing as a source of long-term financing for 80% of
its total needs in 2008. The company borrowed an additional 15% of its total needs in the
long-term debt markets in 2008. What were Calhoun's net new stock issues, in percentage
terms, for 2008?
A. -10%
B. -5%
C. 5%
D. 10%
E. 15%

Net new issues = 5%, as 100% - (80% + 15%) = 5%.

Difficulty level: Medium

Topic: NET NEW ISSUE
Type: PROBLEMS

Essay Questions

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Chapter 15 - Long-Term Financing: An Introduction

Information on shareholder's equity as currently shown on the books of the Eaton

Corporation is given as:

46. From this information, calculate Eaton's book value per share.

Book Value per Share = $8,150,000/175,000 = $46.57

Topic: BOOK VALUE

Type: ESSAYS

47. Rework the shareholder's equity as it appears on the books if the company issues 40,000
new shares of common at $70 per share.

Topic: BOOK VALUE

Type: ESSAYS

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Chapter 15 - Long-Term Financing: An Introduction

48. Preferred Stock, as a hybrid security, presents somewhat of a puzzle as to why they are
issued. What elements give rise to the puzzle and how is it explained?

There are two offsetting tax effects to consider in evaluating preferred stock. First, dividends
are not deducted from corporate income in computing the tax liability of the issuing
corporation. Second, when a corporation purchases preferred stock, 70% of the dividends
received are exempt from corporate taxation.
The three reasons why preferred stock is issued are: regulated public utilities can pass the tax
disadvantage of issuing preferred stock on to their customers, companies reporting losses to
the IRS may issue preferred stock, and firms issuing preferred stock can avoid the threat of
bankruptcy that exists with debt financing.

Topic: PREFERRED STOCK

Type: ESSAYS

49. Different countries have different sources of funds. For example, in the United States,
internally generated funds count for over 4/5 of all funds while in Japan, it is about ½ with
externally generated funds making up the remainder. The disparities are less in the United
Kingdom and Germany, with about 2/3 of funds coming from internal sources. Discuss this
disparity and why it might exist.

Firms in the United States generate more funding from internally generated cash than firms
in other countries. Firms in Japan, Canada and the United Kingdom rely more on externally
generated equity than American firms. This provides support for the pecking order theory in
which firms will first make use of internally generated funds before moving to the more
expensive external equity markets. It is possible that American firms have more internally
generated funds available, thereby making them more able to use less expensive funds for
capital investment.

Topic: INTERNATION AND DOMESTIC CASH FLOWS

Type: ESSAYS

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