Capital Structure quiz Corporate Finance QuizFinancial Analysis Quiz Share 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 value of the firm is maximized at the point where the WACC is minimized Companies should use a 50% equity /50% debt capital structure to maximize value The tax shield provided by debt causes the WACC to increase as leverage increases 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 . 2 / 20 According to pecking order theory, which of the following lists most accurately orders financing preferences from most to least preferred? Retained earnings, raising external equity, and debt financing Retained earnings, debt financing, and raising external equity Debt financing, retained earnings, and raising external equity Financing choices under pecking order theory follow a hierarchy based on visibility to investors with internally generated capital being the most preferred, debt being the next best choice, and external equity being the least preferred financing option . 3 / 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. 4 / 20 To determine their target capital structures in practice, it isleast likelythat firms will : use the book value of their debt to make financing decisions match the maturities of their debt issues to specific firm investments determine an optimal capital structure based on the expected costs of financial distress 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. 5 / 20 Vega Company has announced that it intends to raise capital next year, but it is unsure as to the appropriate method of raising capital. White, the CFO, has concluded that Vega should apply the pecking order theory to determine the appropriate method of raising capital. Based on White’s conclusion, Vega should raise capital in the following order : equity, debt, internal financing debt, internal financing, equity internal financing, debt, equity According to the pecking order theory, managers prefer internal financing. If internal financing is insufficient, managers next prefer debt, then equity—in order of increasing visibility to outsiders . 6 / 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 : 33% debt-financed and 66% equity-financed 75% debt-financed and 25% equity-financed 25% debt-financed and 75% 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. 7 / 20 Which of the following isleast likelyan appropriate method for an analyst to estimate a firm’s target 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 Use the firm’s current proportions of debt and equity based on market values, with an adjustment for recent trends in its capital structure 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 . 8 / 20 A company ismost likelyto 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 . 9 / 20 Under the assumptions of Modigliani and Miller's Proposition I, the value of a firm : is not affected by its capital structure increases as the use of debt financing rises decreases as the use of equity financing rises 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 . 10 / 20 Other factors being equal, in which of the following situations are debt-equity conflicts likely to arise ? The company’s debt is long-term Financial leverage is low The company’s debt is secured 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 . 11 / 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 finance a low risk project with 100% debt to improve the project’s profitability The firm decides to issue additional debt due to a temporary discount in underwriting fees for corporate debt The firm decides to issue additional equity because management believes the firm’s stock is overpriced 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. 12 / 20 Which of the following statements regarding Modigliani and Miller’s Proposition I ismost accurate? A firm’s cost of equity financing increases as the proportion equity in a firm’s capital structure is increased A firm’s weighted average cost of capital is not affected by its choice of capital structure A firm’s cost of debt financing increases a firm’s financial leverage increases 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 ofdebtin the capital structure is increased . 13 / 20 Which of the following is least likely to affect the capital structure of Longdrive Trucking Company ? Longdrive has moderate leverage today The acquisition of a major competitor for shares The payment of a stock dividend A substantial increase in share price 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 . 14 / 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 = 0.185 ; weight equity = 0.815 weight debt = 0.223 ; weight equity = 0.777 weight debt = 0.200 ; weight equity = 0.800 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. 15 / 20 Which of the following statements most accurately characterizes how debt ratings may affect a firm's capital structure policy? Firms that have their credit ratings reduced below investment grade are not able to issue additional debt 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 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 . 16 / 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. 17 / 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 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 . 18 / 20 A company will typically use debt for the largest percentage of its financing during its : maturity stage growth stage start-up 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 . 19 / 20 Which of the following mature companies is most likely to use a high proportion of debt in its capital structure ? A software company with very stable and predictable revenues and an asset-light business model A mining company with a large, fixed asset base An electric utility 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 . 20 / 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 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 . 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
