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 isleast likelyan 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 the firm’s current capital structure, based on market values of debt and equity Use average capital structure weights for the firm’s industry, based on book 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 . 2 / 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 minimizes WACC 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 A company’s optimal and target capital structures may be different from each other 3 / 20 Which of the following is least accurate with respect to debt-equity conflicts ? Debt covenants can mitigate the conflict between debtholders and equityholders Management attempts to balance the interests of equityholders and debtholders Equityholders focus on potential upside and downside outcomes, while debtholders focus primarily on downside risk Management is generally focused on maximizing the value of equity . 4 / 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 lower cost of debt capital not affect the company’s cost of capital result in a higher cost of debt capital The after-tax cost of debt decreases as the marginal tax rate increases 5 / 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. 6 / 20 Which of the following is least likely to be true with respect to agency costs and senior management compensation ? High cash compensation for senior management, without significant equity-based performance incentives, can lead to excessive caution and complacency A well-designed compensation scheme should eliminate agency costs Equity-based incentive compensation is the primary method to address the problem of agency costs A well-designed management compensation scheme can reduce, but not eliminate, agency costs . 7 / 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 : the company’s debt/equity has moved beyond the optimal range the company’s prospects are improving equity financing is cheaper than debt financing 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 . 8 / 20 A company’s optimal capital structure : maximizes expected earnings per share and maximizes the price per share of common stock maximizes firm value and minimizes the weighted average cost of capital minimizes the interest rate on debt and maximizes expected earnings per share The optimal capital structure minimizes the firm’s WACC and maximizes the firm’s value (stock price) 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 : 25% debt-financed and 75% equity-financed 75% debt-financed and 25% 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 A company will typically use debt for the largest percentage of its financing during its : growth stage maturity 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 . 11 / 20 The pecking order theory of financial structure decisions : suggests that debt is the riskiest and least preferred source of financing is based on information asymmetry 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. 12 / 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 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 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 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. 13 / 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 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 . 14 / 20 Which of the following statements regarding Modigliani and Miller’s Proposition I ismost accurate? A firm’s cost of debt financing increases a firm’s financial leverage increases A firm’s weighted average cost of capital is not affected by its choice of capital structure A firm’s cost of equity financing increases as the proportion equity in a firm’s capital structure is increased 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 . 15 / 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 greater firm risk less financial leverage Given the asymmetric returns on stock options, we would expect managers with significant stock options in their compensation to favor greater financial leverage and issuance of debt to increase potential stock price gains. Issuing common stock could decrease the market price of shares, which would decrease the value of stock options. 16 / 20 Which of the following is true of the growth stage in a company’s development ? Cash flow is negative, by definition, with investment outlays exceeding cash flow from operations Cash flow is positive and growing quickly Cash flow may be negative or positive Cash flow typically turns positive during the growth stage, but it may be negative, particularly at the beginning of this stage. 17 / 20 The conclusion of Modigliani and Miller's capital structure model with taxes is that : firms should be financed with all debt capital structure decisions do not affect the value of a firm there is a trade off between tax savings on debt increased risk of bankruptcy Because MM with taxes does not consider costs of financial distress, it concludes that tax savings of debt financing are maximized at 100% debt. 18 / 20 Which of the following is most likely to occur as a company evolves from growth stage to maturity and seeks to optimize its capital structure ? Leverage increases as the company is able to support more debt The company relies on equity to finance its growth Leverage increases as the company needs more capital to support organic expansion As cash flows become more predictable, the company is able to support more debt in its capital structure; the optimal capital structure includes a higher proportion of debt. While mature companies do borrow to support growth, this action would typically not occur because the company is optimizing its capital structure. Likewise, while a mature company might issue equity to finance growth, this action would not be the typical approach for a company optimizing its capital structure . 19 / 20 Companies moving from the start-up stage to the growth stage most likely exhibit increasing : cash flow debt financing costs business risk 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. 20 / 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. 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