Capital Structure quiz

w_d =  63 / ( 220 +  63) = 0.223.

w_e =  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.

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.

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.

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.

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 .

Because MM with taxes does not consider costs of financial distress, it concludes that tax savings of debt financing are maximized at 100% debt.

A company’s optimal and target capital structures may be different from each other

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 .

The tax shield provided by debt causes the WACC to decrease as leverage increases. The value of the firm is maximized at the point where the WACC is minimized, which is 100% debt under the MM assumptions .

MM’s Proposition I (with no taxes) states that capital structure is irrelevant because the decrease in a firm’s WACC from additional debt financing is just offset by the increase in WACC from a decrease in equity financing. The cost of debt is held constant and the cost of equity financing increases as the proportion of debt in the capital structure is increased .

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.

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 .

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 .

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.

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.

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.

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.

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 .