Capital Structure quiz Corporate Finance Quiz On Mar 11, 2024 Share /20 1234567891011121314151617181920 Capital Structure 20 questions in 20 minutes Answers at the end of the exam Pass Score 70% The questions change when you repeat the exam enter full-screen mode by pressing the icon located in the top- right comer of the exam 1 / 20 If investors have homogeneous expectations, the market is efficient, and there are no taxes, no transaction costs, and no bankruptcy costs, Modigliani and Miller’s Proposition I states that : managers cannot increase the value of the company by using tax-saving strategies managers cannot change the value of the company by changing the amount of debt bankruptcy risk rises with more leverage Proposition I, or the capital structure irrelevance theorem, states that in perfect markets the level of debt versus equity in the capital structure has no effect on company value . 2 / 20 A company will typically use debt for the largest percentage of its financing during its : start-up stage maturity stage growth stage Mature companies are able to support more debt than start-up companies or growth stage companies because they typically have predictable positive cash flows, lower business risk, and significant liquid assets . 3 / 20 The pecking order theory of financial structure decisions : is based on information asymmetry suggests that debt is the riskiest and least preferred source of financing suggests that debt is the first choice for financing an investment of significant size Pecking order theory is based on information asymmetry and the resulting signals that different financing choices send to investors. It suggests that retained earnings are the first choice for financing an investment and issuing new equity is the least preferred choice. 4 / 20 Which of the following is least accurate with respect to the market value and book value of a company’s equity ? Market value is more relevant than book value when measuring a company’s cost of capital Both market value and book value fluctuate with changes in the company’s share price Book value is often used by lenders and in financial ratio calculations Share price changes will cause the market value of the company’s equity to change; book value is unaffected. Statements A and B are accurate. 5 / 20 A company is most likely to be financed only by equity during its : mature stage start-up stage growth stage During the start-up stage a firm is unlikely to have positive earnings and cash flows or significant assets that can be pledged as debt collateral, so firms in this stage are typically financed by equity only . 6 / 20 Discuss two financial metrics that can be used to assess a company’s ability to service additional debt in its capital structure . Check Leverage ratios and interest coverage ratios are commonly used to determine whether a company can service additional debt. Regarding leverage ratios, a company’s ratio of total debt to total assets measures the proportion of total assets funded by debt capital, and its ratio of total debt to EBITDA provides an estimate of how many years it would take to repay its total debt based on EBITDA (a proxy for operating cash flow). The interest coverage ratio (EBIT to interest expense) measures the number of times a company’s EBIT could cover its interest payments. 7 / 20 Identify two market conditions that can be characterized as favorable for companies wishing to add debt to their capital structures. Check A company’s cost of debt is equal to a risk-free rate plus a credit spread specific to the company. Lower interest rates and tighter credit spreads would make borrowing less costly and make debt financing relatively more attractive than when interest rates are high or credit spreads are wide. 8 / 20 The conclusion of Modigliani and Miller's capital structure model with taxes is that : there is a trade off between tax savings on debt increased risk of bankruptcy capital structure decisions do not affect the value of a firm firms should be financed with all debt Because MM with taxes does not consider costs of financial distress, it concludes that tax savings of debt financing are maximized at 100% debt. 9 / 20 Nailah Mablevi is an equity analyst who covers the entertainment industry for Kwame Capital Partners, a major global asset manager. Kwame owns a significant position, with a large unrealized capital gain, in Mosi Broadcast Group (MBG). On a recent conference call, MBG’s management stated that they plan to increase the proportion of debt in the company’s capital structure. Mablevi is concerned that any changes in MBG’s capital structure will negatively affect the value of Kwame’s investment. To evaluate the potential impact of such a capital structure change on Kwame’s investment, she gathers the information about MBG given in below : Current Selected Financial Information on MBG 8.00 % Yield to maturity on debt USD 100 million Market value of debt 10 million Number of shares of common stock USD 30 Market price per share of common stock 10.30 % Cost of capital if all equity-financed 35 % Marginal tax rate MBG is best described as currently : 75% debt-financed and 25% equity-financed 25% debt-financed and 75% equity-financed 33% debt-financed and 66% equity-financed The market value of equity is (USD30)(10,000,000) = USD 300,000,000 With the market value of debt equal to USD 100,000,000 the market value of the company is USD 100,000,000 + USD 300,000,000 = USD 400,000,000. Therefore, the company is USD 100,000,000/USD 400,000,000 = 0.25, or 25% debt-financed. 10 / 20 When interest rates have fallen to low levels that are expected to persist, firms are most likely to have a preference for : issuing debt repurchasing equity issuing equity When interest rates have fallen to low levels that are expected to persist, firms often increase their target proportion of debt to reflect its lower cost. Firms may issue equity when they perceive the market price of their stock to be temporarily high or repurchase their stock when they judge the price to be low. 11 / 20 Fran McClure of Alba Advisers is estimating the cost of capital of Frontier Corporation as part of her valuation analysis of Frontier. McClure will be using this estimate, along with projected cash flows from Frontier’s new projects, to estimate the effect of these new projects on the value of Frontier. McClure has gathered the following information on Frontier Corporation: Forecasted for Next Year (USD) Current Year (USD) 50 50 Book value of debt 63 62 Market value of debt 58 55 Book value of shareholders’ equity 220 210 Market value of shareholders’ equity The weights that McClure should apply in estimating Frontier’s cost of capital for debt and equity are, respectively : weight debt = 0.223 ; weight equity = 0.777 weight debt = 0.200 ; weight equity = 0.800 weight debt = 0.185 ; weight equity = 0.815 wd = 63 / ( 220 + 63) = 0.223. we = 220 / (220 + 63) = 0.777. Market values should be used in cost of capital calculations, and forecasted market values should be used in this case given that the cost of capital will be applied to projected cash flows in McClure’s analysis. 12 / 20 According to the static trade-off theory : the capital structure decision is irrelevant debt should be used only as a last resort companies have an optimal level of debt The static trade-off theory indicates that there is a trade-off between the tax shield for interest on debt and the costs of financial distress, leading to an optimal amount of debt in a company’s capital structure . 13 / 20 According to the pecking order theory : new equity is always preferable to other sources of capital new debt is preferable to new equity new debt is preferable to internally generated funds According to the pecking order theory, internally generated funds are preferable to both new equity and new debt. If internal financing is insufficient, managers next prefer new debt, then new equity. Managers prefer forms of financing with the least amount of visibility to outsiders . 14 / 20 Nailah Mablevi is an equity analyst who covers the entertainment industry for Kwame Capital Partners, a major global asset manager. Kwame owns a significant position, with a large unrealized capital gain, in Mosi Broadcast Group (MBG). On a recent conference call, MBG’s management stated that they plan to increase the proportion of debt in the company’s capital structure. Mablevi is concerned that any changes in MBG’s capital structure will negatively affect the value of Kwame’s investment. To evaluate the potential impact of such a capital structure change on Kwame’s investment, she gathers the information about MBG given in below : Current Selected Financial Information on MBG 8.00 % Yield to maturity on debt USD 100 million Market value of debt 10 million Number of shares of common stock USD 30 Market price per share of common stock 10.30 % Cost of capital if all equity-financed 35 % Marginal tax rate Which of the following is least likely to be true with respect to optimal capital structure ? The optimal capital structure is generally close to the target capital structure The optimal capital structure minimizes WACC Debt can be a significant portion of the optimal capital structure because of the tax-deductibility of interest A company’s optimal and target capital structures may be different from each other 15 / 20 Which of these statements is most accurate with respect to the use of debt by a start-up fashion retailer with negative cash flow and uncertain revenue prospects ? Debt financing will be unavailable or very costly + The company will prefer to use equity rather than debt given its uncertain cash flow outlook The company will prefer to use equity rather than debt given its uncertain cash flow outlook Debt financing will be unavailable or very costly For a start-up company of this nature, debt financing is likely to be unattractive to lenders—and therefore very expensive or difficult to obtain. Debt financing is also unappealing to the company, because it commits the company to interest and principal payments that might be difficult to manage given the company’s uncertain cash flow outlook. 16 / 20 Which of the following statements most correctly characterizes the pecking order theory of capital structure ? Firms will seek to use debt financing up to the point that the value of the tax shield benefit is outweighed by the costs of financial distress Regardless of how the firm is financed, the overall value of the firm and aggregate value of the claims issued to finance it remain the same Firms have a preference ordering for capital sources, preferring internally-generated equity first, new debt capital second, and externally-sourced equity as a last resort The pecking order theory of capital structure assumes that firms have a preference ordering for capital sources. They prefer to use internally-generated equity first. When the internally-generated equity is exhausted, they issue new debt capital. As a last resort they will rely on externally-sourced equity. The reason that new equity is the last resort is that the issuance of new stock is assumed to send a negative signal to investors regarding firm value. 17 / 20 Which of the following is least likely an appropriate method for an analyst to estimate a firm’s target capital structure ? Use the firm’s current proportions of debt and equity based on market values, with an adjustment for recent trends in its capital structure Use average capital structure weights for the firm’s industry, based on book values of debt and equity Use the firm’s current capital structure, based on market values of debt and equity For an analyst, target capital structure should always be based on market values of debt and equity. The other two choices are appropriate methods for estimating a firm’s capital structure for analysis . 18 / 20 Which of the following is least likely to be a reason why a firm's actual capital structure may vary from the target capital structure ? The firm decides to issue additional equity because management believes the firm’s stock is overpriced The firm decides to issue additional debt due to a temporary discount in underwriting fees for corporate debt The firm decides to finance a low risk project with 100% debt to improve the project’s profitability A firm should always finance a project based on the firm's weighted average cost of capital, although when evaluating a project, the firm may apply a risk factor to adjust the risk of the project. A corporate manager generally cannot deem some projects as being financed by debt and some by equity as all projects are effectively financed proportionately based on the firm's capital structure. In practice, a firm's actual capital structure will float around its target. For a firm that does have a target capital structure, the actual structure may vary from the target due to market value fluctuations, or management's desire to exploit an opportunity in a particular financing source. 19 / 20 Which of the following statements most accurately characterizes how debt ratings may affect a firm's capital structure policy? A firm may be deterred from increasing the use of debt to avoid having its credit rating reduced below some minimum acceptable level Because credit ratings are based upon cash flow coverage of interest expense, they are not influenced by the firm’s capital structure Firms that have their credit ratings reduced below investment grade are not able to issue additional debt Credit ratings can be factored into management's capital structure policy if a firm has a minimum rating objective, and this is likely to be adversely affected by issuing additional debt . 20 / 20 Which of the following mature companies is most likely to use a high proportion of debt in its capital structure ? A mining company with a large, fixed asset base An electric utility A software company with very stable and predictable revenues and an asset-light business model An electric utility has the capacity to support substantial debt, with very stable and predictable revenues and cash flows. The software company also has these attributes, but it would have been much less likely to have raised debt during its development and may have raised equity. The mining company has fixed assets, which it would have needed to finance, but the cyclical nature of its business would limit its debt capacity . Your score is LinkedIn Facebook Twitter VKontakte 0% Send feedback factors affecting capital structure the Modigliani–Miller propositions regarding capital structure Target capital structure Pecking order theory stakeholder interests in capital structure decisions "capital structure question"capital structure arbitragecapital structure decision