Capital Structure Quiz Corporate Finance Quiz بواسطة admin آخر تحديث أبريل 10, 2023 0 Capital Structure Quiz Capital Structure 1 / 44 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 : A) 25% debt-financed and 75% equity-financed B) 33% debt-financed and 66% equity-financed C) 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. 2 / 44 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 : A) managers cannot increase the value of the company by using tax-saving strategies B) managers cannot change the value of the company by changing the amount of debt C) 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 . 3 / 44 According to the static trade-off theory : A) companies have an optimal level of debt B) debt should be used only as a last resort C) the capital structure decision is irrelevant 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 . 4 / 44 Which of the following is least accurate with respect to debt-equity conflicts ? A) Management attempts to balance the interests of equityholders and debtholders B) Debt covenants can mitigate the conflict between debtholders and equityholders C) 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 . 5 / 44 To determine their target capital structures in practice, it is least likely that firms will : A) use the book value of their debt to make financing decisions B) match the maturities of their debt issues to specific firm investments C) 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. 6 / 44 Which of the following is not a reason why target capital structure and actual capital structure tend to differ ? A) Companies raise capital when the terms are attractive B) Target capital structure is set for a particular project, while actual capital structure is measured at the consolidated company level C) Financing is often tied to a specific investment 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. 7 / 44 Which of the following is least likely to be true with respect to agency costs and senior management compensation ? A) High cash compensation for senior management, without significant equity-based performance incentives, can lead to excessive caution and complacency B) A well-designed compensation scheme should eliminate agency costs C) 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 . 8 / 44 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. Check The cyclical nature of ISS’s revenues, which cause the company’s earnings and cash flows to vary considerably over the business cycle, would point to a relatively high cost of borrowing and low proportion of debt in the capital structure. Revenue and earnings streams subject to relatively high volatility, and consequently less predictability, are less favorable for supporting debt in the capital structure. Further, companies with pay-per-use business models, rather than subscription-based models, are likely to have a lower degree of revenue predictability and a lower ability to support debt in the capital structure. Another factor pointing to a relatively high cost of borrowing and low proportion of debt in the capital structure is the fact that most of the company’s assets are intangible and thus less likely to be accepted by lenders as collateral for secured financing. Asset-light companies with a lower proportion of tangible assets will have a lower ability to support debt in the capital structure. 9 / 44 A company is most likely to be financed only by equity during its : A) start-up stage B) growth stage C) mature 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 . 10 / 44 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. 11 / 44 Other factors being equal, in which of the following situations are debt-equity conflicts likely to arise ? A) The company’s debt is long-term B) Financial leverage is low C) 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 . 12 / 44 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. 13 / 44 According to the pecking order theory : A) new debt is preferable to new equity B) new debt is preferable to internally generated funds C) new equity is always preferable to other sources of capital According to the pecking order theory, internally generated funds are preferable to both new equity and new debt. If internal financing is insufficient, managers next prefer new debt, then new equity. Managers prefer forms of financing with the least amount of visibility to outsiders . 14 / 44 Which of the following is least accurate with respect to the market value and book value of a company’s equity ? A) Market value is more relevant than book value when measuring a company’s cost of capital B) Both market value and book value fluctuate with changes in the company’s share price C) 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. 15 / 44 Which of the following mature companies is most likely to use a high proportion of debt in its capital structure ? A) A mining company with a large, fixed asset base B) An electric utility C) A software company with very stable and predictable revenues and an asset-light business model 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 . 16 / 44 A company will typically use debt for the largest percentage of its financing during its : A) growth stage B) start-up stage C) maturity 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 . 17 / 44 The pecking order theory of financial structure decisions : A) is based on information asymmetry B) suggests that debt is the first choice for financing an investment of significant size C) suggests that debt is the riskiest and least preferred source of financing 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. 18 / 44 Which of the following statements most accurately characterizes how debt ratings may affect a firm's capital structure policy? A) Because credit ratings are based upon cash flow coverage of interest expense, they are not influenced by the firm’s capital structure B) Firms that have their credit ratings reduced below investment grade are not able to issue additional debt C) A firm may be deterred from increasing the use of debt to avoid having its credit rating reduced below some minimum acceptable level 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 . 19 / 44 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 : A) the company’s debt/equity has moved beyond the optimal range B) equity financing is cheaper than debt financing C) 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 . 20 / 44 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 : A) issuance of common stock B) greater firm risk C) 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. 21 / 44 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 . A) 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 B) Management believes the acquisition will be positive for shareholder value but negative for the value and interests of the company’s debtholders C) 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 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 . 22 / 44 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 ? A) 50% debt and 50% equity B) 100% equity C) 100% debt 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 . 23 / 44 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 : A) not affect the company’s cost of capital B) result in a lower cost of debt capital C) result in a higher cost of debt capital The after-tax cost of debt decreases as the marginal tax rate increases 24 / 44 According to Modigliani and Miller’s Proposition II without taxes : A) investment and capital structure decisions are interdependent B) the capital structure decision has no effect on the cost of equity C) the cost of equity increases as the use of debt in the capital structure increases The cost of equity rises with the use of debt in the capital structure (e.g., with increasing financial leverage) . 25 / 44 When interest rates have fallen to low levels that are expected to persist, firms are most likely to have a preference for : A) issuing debt B) issuing equity C) repurchasing 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. 26 / 44 Which of the following statements most correctly characterizes the pecking order theory of capital structure ? A) 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 B) 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 C) 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 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. 27 / 44 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 : A) weight debt = 0.185 ; weight equity = 0.815 B) weight debt = 0.200 ; weight equity = 0.800 C) weight debt = 0.223 ; weight equity = 0.777 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. 28 / 44 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 ? A) The firm decides to issue additional equity because management believes the firm’s stock is overpriced B) The firm decides to issue additional debt due to a temporary discount in underwriting fees for corporate debt C) The firm decides to finance a low risk project with 100% debt to improve the project’s profitability 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. 29 / 44 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. Check The fact that Tillett earns about half of its revenues from subscription-based service agreements would suggest that the company’s revenue stream is likely somewhat predictable. A high proportion of recurring revenues for a company is generally viewed as a positive for its ability to support debt, because the company’s revenue stream is likely to be more predictable and less sensitive to the ups and downs of the macro economy. Further, Tillett’s assets consist mostly of inventory and property, plant, and equipment, representing its production facilities. Tangible assets, such as inventory and property, plant, and equipment, are often deemed safer than intangible assets and can better serve as debt collateral. Finally, the fact that Tillett currently has no debt in its capital structure and has experienced improved profitability in recent years would also suggest that Tillett might be able to access debt capital at a reasonable cost to finance the additional growth. 30 / 44 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 ? A) Debt can be a significant portion of the optimal capital structure because of the tax-deductibility of interest B) The optimal capital structure minimizes WACC C) 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 31 / 44 Which of these statements is most accurate with respect to the use of debt by a start-up fashion retailer with negative cash flow and uncertain revenue prospects ? A) Debt financing will be unavailable or very costly B) The company will prefer to use equity rather than debt given its uncertain cash flow outlook C) Debt financing will be unavailable or very costly + The company will prefer to use equity rather than debt given its uncertain cash flow outlook 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. 32 / 44 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 ? A) The company relies on equity to finance its growth B) Leverage increases as the company needs more capital to support organic expansion C) 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 . 33 / 44 Which of the following is true of the growth stage in a company’s development ? A) Cash flow may be negative or positive B) Cash flow is positive and growing quickly C) Cash flow is negative, by definition, with investment outlays exceeding cash flow from operations Cash flow typically turns positive during the growth stage, but it may be negative, particularly at the beginning of this stage. 34 / 44 The conclusion of Modigliani and Miller's capital structure model with taxes is that : A) there is a trade off between tax savings on debt increased risk of bankruptcy B) capital structure decisions do not affect the value of a firm C) firms should be financed with all debt Because MM with taxes does not consider costs of financial distress, it concludes that tax savings of debt financing are maximized at 100% debt. 35 / 44 According to the static trade off theory : A) new debt financing is always preferable to new equity financing B) there is an optimal proportion of debt that will maximize the value of the firm C) 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. 36 / 44 Under the assumptions of Modigliani and Miller's Proposition I, the value of a firm : A) increases as the use of debt financing rises B) is not affected by its capital structure C) 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 . 37 / 44 Which of the following statements regarding Modigliani and Miller’s Proposition I is most accurate ? A) A firm’s cost of equity financing increases as the proportion equity in a firm’s capital structure is increased B) A firm’s weighted average cost of capital is not affected by its choice of capital structure C) 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 of debt in the capital structure is increased . 38 / 44 Which of the following is least likely an appropriate method for an analyst to estimate a firm’s target capital structure ? A) Use the firm’s current capital structure, based on market values of debt and equity B) Use the firm’s current proportions of debt and equity based on market values, with an adjustment for recent trends in its capital structure C) 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 . 39 / 44 A company’s optimal capital structure : A) maximizes expected earnings per share and maximizes the price per share of common stock B) minimizes the interest rate on debt and maximizes expected earnings per share C) maximizes firm value and minimizes the weighted average cost of capital The optimal capital structure minimizes the firm’s WACC and maximizes the firm’s value (stock price) 40 / 44 Companies moving from the start-up stage to the growth stage most likely exhibit increasing : A) business risk B) cash flow C) debt financing costs 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. 41 / 44 Which of the following is least likely to affect the capital structure of Longdrive Trucking Company ? Longdrive has moderate leverage today A) The acquisition of a major competitor for shares B) The payment of a stock dividend C) 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 . 42 / 44 According to pecking order theory, which of the following lists most accurately orders financing preferences from most to least preferred? A) Retained earnings, raising external equity, and debt financing B) Retained earnings, debt financing, and raising external equity C) 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 . 43 / 44 Which of the following statements regarding Modigliani and Miller's Proposition II with taxes is most accurate? A) The tax shield provided by debt causes the WACC to increase as leverage increases B) The value of the firm is maximized at the point where the WACC is minimized C) Companies should use a 50% equity /50% debt capital structure to maximize 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 . 44 / 44 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 : A) debt, internal financing, equity B) equity, debt, internal financing C) 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 . 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