Capital Structure quiz Corporate Finance Quiz On Mar 11, 2024 Share /20 1234567891011121314151617181920 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 enter full-screen mode by pressing the icon located in the top- right comer of the exam 1 / 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 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 . 2 / 20 Identify two market conditions that can be characterized as favorable for companies wishing to add debt to their capital structures. Check A company’s cost of debt is equal to a risk-free rate plus a credit spread specific to the company. Lower interest rates and tighter credit spreads would make borrowing less costly and make debt financing relatively more attractive than when interest rates are high or credit spreads are wide. 3 / 20 A company’s optimal capital structure : maximizes firm value and minimizes the weighted average cost of capital maximizes expected earnings per share and maximizes the price per share of common stock 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) 4 / 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. 5 / 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 prospects are improving the company’s debt/equity has moved beyond the optimal range 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 . 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 25% debt-financed and 75% equity-financed 75% debt-financed and 25% 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 statements most correctly characterizes the pecking order theory of capital structure ? 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 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 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. 8 / 20 Which of the following is least likely to be true with respect to agency costs and senior management compensation ? Equity-based incentive compensation is the primary method to address the problem of agency costs 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 A well-designed management compensation scheme can reduce, but not eliminate, agency costs . 9 / 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 needs more capital to support organic expansion The company relies on equity to finance its growth Leverage increases as the company is able to support more debt 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 . 10 / 20 Which of the following is least accurate with respect to debt-equity conflicts ? Equityholders focus on potential upside and downside outcomes, while debtholders focus primarily on downside risk Debt covenants can mitigate the conflict between debtholders and equityholders Management attempts to balance the interests of equityholders and debtholders Management is generally focused on maximizing the value of equity . 11 / 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% equity 100% debt 50% debt and 50% equity If MM's other assumptions are maintained, removing the no tax assumption means that the value of the firm is maximized when the value of the tax shield is maximized, which occurs with a capital structure of 100% debt . 12 / 20 To determine their target capital structures in practice, it is least likely that firms will : determine an optimal capital structure based on the expected costs of financial distress use the book value of their debt to make financing decisions match the maturities of their debt issues to specific firm investments 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. 13 / 20 When interest rates have fallen to low levels that are expected to persist, firms are most likely to have a preference for : repurchasing equity issuing debt 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. 14 / 20 According to the static trade off theory : new debt financing is always preferable to new equity financing there is an optimal proportion of debt that will maximize the value of the firm the amount of debt used by a company should decrease as the company’s corporate tax rate increases The static trade-off theory seeks to balance the costs of financial distress with the tax shield benefits from using debt. Under the static trade-off theory, there is an optimal capital structure that has an optimal proportion of debt that will maximize the value of the firm. 15 / 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. 16 / 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 internal financing, debt, equity debt, internal financing, 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 . 17 / 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 The optimal capital structure is generally close to the target capital structure Debt can be a significant portion of the optimal capital structure because of the tax-deductibility of interest A company’s optimal and target capital structures may be different from each other 18 / 20 Which of the following statements regarding Modigliani and Miller's Proposition II with taxes is most accurate? 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 value of the firm is maximized at the point where the WACC is minimized 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 . 19 / 20 The pecking order theory of financial structure decisions : suggests that debt is the first choice for financing an investment of significant size suggests that debt is the riskiest and least preferred source of financing is based on information asymmetry 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. 20 / 20 According to Modigliani and Miller’s Proposition II without taxes : the cost of equity increases as the use of debt in the capital structure increases investment and capital structure decisions are interdependent the capital structure decision has no effect on the cost of equity The cost of equity rises with the use of debt in the capital structure (e.g., with increasing financial leverage) . 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