Capital Structure quiz

For companies entering the growth stage, revenue and cash flow are typically increasing. Both debt financing costs and business risk tend to be somewhat reduced compared to the start-up stage.

Management is generally focused on maximizing the value of equity .

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.

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 .

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.

While it is a useful theoretical concept, in practice determining an optimal capital structure based on the cost savings of debt and the expected costs of financial distress is not feasible. Because debt rating companies often use book values of debt, firms use book values of debt when choosing financing sources. It is common for firms to match debt maturities to the economic lives of specific investments.

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.

A well-designed management compensation scheme can reduce, but not eliminate, agency costs .

Stock dividends, like stock splits, have no impact on the value of a company’s equity. Issuing shares to acquire a competitor would increase equity relative to debt in the capital structure. Share price appreciation would also increase the market value of equity, thus increasing equity relative to debt .

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 .

Companies generally raise capital when it is needed, such as for investment spending or when market pricing and terms are favorable for debt or equity issuance.

Management is advocating an acquisition that is likely to be positive for the value of the company’s options but negative for equityholders, given the substantial risk.

(Management believes the acquisition will be positive for shareholder value but negative for the value and interests of the company’s debtholders ) is an example of a debt-equity conflict.

(The acquisition is positive for equityholders and does not significantly impair the position of debtholders. However, the acquisition puts the company into a new business where labor practices are harsh and the production process is environmentally damaging ) is an example of stakeholder interests that are not being considered by management .

The after-tax cost of debt decreases as the marginal tax rate increases

Long-term debt is more exposed than short-term debt to the risk of a management decision that is not debtholder-friendly. Secured debt is less exposed than unsecured debt to such a risk, and with low leverage, the risk of a debt-equity conflict is reduced, not increased, relative to high leverage .

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 .

According to Modigliani and Miller's Proposition I, under certain assumptions, including the absence of taxes and bankruptcy costs, the value of a firm is unaffected by its capital structure .

If the company’s WACC increases as a result of taking on additional debt, the company has moved beyond the optimal capital range. The costs of financial distress may outweigh any tax benefits from the use of debt .

Cash flow typically turns positive during the growth stage, but it may be negative, particularly at the beginning of this stage.