Capital Structure Quiz

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

1 / 20

Which of the following statements regarding Modigliani and Miller's Proposition II with taxes is most accurate?

The tax shield provided by debt causes the WACC to increase as leverage increases

Companies should use a 50% equity /50% debt capital structure to maximize value

The value of the firm is maximized at the point where the WACC is minimized

2 / 20

Integrated Systems Solutions Inc. (ISS) is a technology company that sells software to companies in the building construction industry. The company’s assets consist mostly of intangible assets. Although the company is profitable, revenue growth and earnings growth have been slowing in recent years. The company’s business model is a pay-per-use model, and given the cyclical nature of the construction industry, the company’s revenues and earnings vary considerably over the business cycle.

Describe two factors that would point to ISS having a relatively high cost of borrowing and low proportion of debt in its capital structure.

3 / 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

Holding operating earnings constant, an increase in the marginal tax rate to 40 % would :

result in a higher cost of debt capital

result in a lower cost of debt capital

not affect the company’s cost of capital

4 / 20

Removing the assumption of no taxes, but keeping all of Modigliani and Miller's other assumptions, which of the following would be the optimal capital structure for maximizing the value of a firm ?

100% debt

100% equity

50% debt and 50% equity

5 / 20

According to the static trade-off theory :

debt should be used only as a last resort

the capital structure decision is irrelevant

companies have an optimal level of debt

6 / 20

According to Modigliani and Miller’s Proposition II without taxes :

the capital structure decision has no effect on the cost of equity

the cost of equity increases as the use of debt in the capital structure increases

investment and capital structure decisions are interdependent

7 / 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

8 / 20

Which of the following is least likely to be true with respect to agency costs and senior management compensation ?

A well-designed compensation scheme should eliminate agency costs

High cash compensation for senior management, without significant equity-based performance incentives, can lead to excessive caution and complacency

Equity-based incentive compensation is the primary method to address the problem of agency costs

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

Which of the following is least likely to be true with respect to optimal capital structure ?

Debt can be a significant portion of the optimal capital structure because of the tax-deductibility of interest

The optimal capital structure is generally close to the target capital structure

The optimal capital structure minimizes WACC

10 / 20

Other factors being equal, in which of the following situations are debt-equity conflicts likely to arise ?

The company’s debt is secured

The company’s debt is long-term

Financial leverage is low

11 / 20

A company will typically use debt for the largest percentage of its financing during its :

growth stage

start-up stage

maturity stage

12 / 20

Discuss two financial metrics that can be used to assess a company’s ability to service additional debt in its capital structure .

13 / 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 :

25% debt-financed and 75% equity-financed

33% debt-financed and 66% equity-financed

75% debt-financed and 25% equity-financed

14 / 20

Tillett Technologies is a manufacturer of high-end audio and video (AV) equipment. The company, with no debt in its capital structure, has experienced rapid growth in revenues and improved profitability in recent years. About half of the company’s revenues come from subscription-based service agreements. The company’s assets consist mostly of inventory and property, plant, and equipment, representing its production facilities. Now, the company seeks to raise new capital to finance additional growth.

Describe two factors that would support Tillett being able to access debt capital at a reasonable cost to finance the additional growth. Justify your response.

15 / 20

Companies moving from the start-up stage to the growth stage most likely exhibit increasing :

cash flow

debt financing costs

business risk

16 / 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

17 / 20

Which of the following is an example of agency costs? In each case, management is advocating a substantial acquisition and management compensation is heavily composed of stock options .

Management’s stock options are worthless at the current share price. The acquisition has a high (50%) risk of failure (with zero value) but substantial (30%) upside if it works out

Management believes the acquisition will be positive for shareholder value but negative for the value and interests of the company’s debtholders

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

18 / 20

Compared with managers who do not have significant compensation in the form of stock options, managers who have such compensation will be expected to favor :

issuance of common stock

less financial leverage

greater firm risk

19 / 20

The weighted average cost of capital (WACC) for Van der Welde is 10%. The company announces a debt offering that raises the WACC to 13%. The most likely conclusion is that for Van der Welde :

equity financing is cheaper than debt financing

the company’s debt/equity has moved beyond the optimal range

the company’s prospects are improving

20 / 20

A company is most likely to be financed only by equity during its :

start-up stage

mature stage

growth stage

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Capital Structure quiz

20 questions in 20 minutes

Answers at the end of the exam

Pass Score 70%

The questions change when you repeat the exam