Test ID: 7440553
Capital Structure
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SteveCooley, theChief Financial OfficerforCanberraCorporation, decidesthat he wantstouseas much debtaspossiblein hisfirm'scapitalstructure. Cooley knowsthattouse more debt, he willneed to makeapersuasiveargumentto his board. Which ofthefollowing argumentsused by Cooley to help with his goalofraising largeamountsofadditional debtisleast supported by empiricalevidence?
The cost of debt is always cheaper than the cost of equity.
Raising additional debtprovidesasignaltoourshareholdersthatourfirm'sfuture prospectsarepositive.
Increasing theamountof debt hasaninsignificantimpactonourcreditrisk premium.
Explanation
Athough itisnottheonly factor, increasing theamountof debt willput downward pressureonthecompany'screditrating, resulting inanincreaseinthecreditrisk premium. This willinturnincreasethecostsof both debtand equity capital. Notethat raising additional debt doesprovideapositivesignalaboutfutureprospects. Also, saying thatthecostof debtisalways cheaperthanthecostofequity isanaccuratestatement, butthestatictrade-offtheory shows how balancing debtand equity capitalcanlead tolowercostsfor both components.
Rupert Jones, a manager with Oswald Technologies, isconfused aboutagency costsofequity and how they can be managed at hisfirm. Totry to gaina betterunderstanding aboutagency costs, Jonesasks KarrieConverse, a well knownconsultantfor anexplanation. Intheirconversation, Converse makesthefollowing statements:
Statement1:Costsrelated totheconflictofinterest between managersand ownersofa businesscan beeliminated through a combinationof bonding provisionsand adequate monitoring through aquality corporate governancestructure.
Statement 2:Thelessacompany dependson debtinitscapitalstructure, thelowertheagency coststhecompany willtend to have.
AreConverse'sstatementsconcerning theagency costsofequity correct?
Both are correct. Both areincorrect. Only oneiscorrect.
Explanation
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leveragetocorrespond toareductioninagency costs.
Modiglianiand Miller demonstrated thatifcorporatetaxesand bankruptcy costsareintroduced intoanotherwiseperfect world the weighted averagecostofcapital (WACC) will:
fall, then bottom out, and finally start to rise.
fallcontinuously as more debtisadded tothecapitalstructure. rise, thenplateau, and finally starttofall.
Explanation
The WACCfirstfalls because bondholderstakelessrisk and, consequently, havealowerrequired rateofreturn. Inaddition, interestexpensesaretax deductible. However, astheamountof debtrises, financialrisk rises, and thechancefor bankruptcy increases. Iftherearepositive bankruptcy costs, both bondholdersand stockholders willrequireincreasingly higherratesof returnasfinancialrisk increasescausing the WACCtorise. Thisriseoffsetsthe benefitsofusing thecheapersourceof financing.
Thefirm'stargetcapitalstructureisconsistent with which ofthefollowing?
Minimumweighted average cost of capital (WACC).
Maximum earningspershare (EPS). Minimum risk.
Explanation
Attheoptimalcapitalstructurethefirm will minimizethe WACC, maximizethesharepriceofthestock and maximizethe valueofthe firm.
Katherine Epler, aself-employed corporatefinanceconsultant, is working with hernewestclient, Harbor Machinery. Epleris discussing variouscapitalstructuretheories with herclient, and makesthefollowing comments.
Comment1:If weremovetheassumptionofnotaxesfrom Modiglianiand Miller'stheory regarding capitalstructure, and ifthe firm holdssomeproportionof debt, increasesinthecorporatetax rate willincreasethe valueofthefirm.
Comment 2:If wealsoincludethecostsoffinancial distressin Modiglianiand Miller'sassumptions, theoptimalcapital structure willnotcontainany debtfinancing.
With respectto Epler'scomments:
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both areincorrect. both arecorrect.
Explanation
Epler'sfirstcommentiscorrect. Thetax deductibility ofinterestpaymentsprovidesatax shield thatadds valuetothefirm. The valueofatax shield isequaltothe marginaltax ratetimestheamountof debtinthecapitalstructure, sothe higherthetax rate, the greaterthe valueofthetax shield and the valueofthefirm, allelseequal. Epler'ssecond commentisincorrect. Ifthe costsoffinancial distressarealsoincluded in MM'sassumptions, we getthestatic-tradeofftheory, wherethefirm will have debtinitscapitalstructureuptothepoint wherethe marginalcostoffinancial distressexceedsthe marginal valueprovided by thetax shield.
Which ofthefollowing best describestheshapeoftheline depicting the valueofalevered firm whenplotted according tothe statictrade-offtheory? Assumethatthepercentageof debtinthecapitalstructureistheindependent variable.
U shaped.
Upside downUshaped. Alwaysupward sloping.
Explanation
Theline depicting the valueofalevered firm according tothestatictrade-offtheory lookslikeanupside downU. The valueof thefirm willinitially increase duetothetax savingsprovided by taking onadditional debtfinancing, and then will declineasthe costsoffinancial distressexceed thetax benefitsoftaking onadditional debtfinancing.
Joseph Palmeris discussing theimpactofthetax shield provided by debt with hissupervisor, Ming Chou. During thecourseof their discussion, Palmer makesthefollowing statements:
Statement1: The valueofthetax shield provided by debtcan becalculated by multiplying thepre-tax costof debt by (1 - tax rate).
Statement 2: Ifacompany isprofitable, the valueofitstax shield will bepositiveand its value willincreaseasitsleverage increases, allelseequal.
With respectto Palmer'sstatements:
both are incorrect. both arecorrect. only oneiscorrect.
Explanation
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correct. Thetax shield adds valuetothefirm sothatthe valueofalevered firm is greaterthanthe valueofanunlevered firm, allelseequal.
Jayco, Inc. currently hasaDebt/Assetsratioof33.33% butfeelsitsoptimalDebt/Assetsratioshould be16.67%. Salesarecurrently $750,000, and thetotalassetsturnover (Sales / Assets)is7.5. If Jayconeedstoraise $100,000toexpand, how should theexpansion be financed soastoproducethe desired debtratio? Financeit with:
all equity.
25% debt, 75% equity.
all debt.
Explanation
Sales / Assets = 7.5 = 750,000 / Assets, soAssets = 100,000. Debt / 100,000 = 33.33%. Therefore, Debt must be33,333. You wantto changeDebt/Assetsto16.67%, so you must doubleAssets (withoutincreasing Debt) by adding 100,000toequity.
According topecking ordertheory, which ofthefollowing listsmostaccurately ordersfinancing preferencesfrom mosttoleast preferred?
Retained earnings,debt financing, and raising external equity. Debtfinancing, retained earnings, and raising externalequity. Retained earnings, raising externalequity, and debtfinancing.
Explanation
Financing choicesunderpecking ordertheory follow a hierarchy based on visibility toinvestors with internally generated capital being the mostpreferred, debt being thenext bestchoice, and externalequity being theleastpreferred financing option.
Financialleverageratiostend to betolow incountriesthat have: inefficient legal systems.
alargeinstitutionalinvestorpresence.
a high relianceonthe banking system forraising debtcapital.
Explanation
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tend to have higher debtratios.
Schwarzwald Industriesrecently issued new equity to helpfund anew capitalproject. WhattypeofsignalisSchwarzwald's choiceoffinancing sending toinvestorsaboutthefutureprospectsofthefirm undertheinformationasymmetry signaling theory and pecking ordertheory respectively?
Negative signal under both theories. Positivesignalunderonly onetheory. Positivesignalunder both theories.
Explanation
Signaling theory resultsfrom asymmetricinformation, which referstothefactthat managers have moreinformationabouta company'sfutureprospectsthanthefirm'sownersand creditors. Since managersarereluctanttosellnew stock ifthey think thestock isundervalued, but very willing tosellstock ifthey think thestock isovervalued, selling stock sendsanegativesignal aboutafirm'sfutureprospects. Pecking ordertheory, which isrelated tosignaling theory, suggeststhat managerschoose methodsoffinancing based onthe visibility ofsignalsthey send. Raising equity istheleastpreferred method offinancing underpecking ordertheory, and itsendsanegativesignal.
The maturity structureforcorporate debtistypically shorterincountriesthat have: lower rates of inflation.
moreliquid stock and bond markets. low ratesof GDP growth.
Explanation
Firmsoperating incountries with higher GDP growth tend touselonger maturity debt, sofirms with weakereconomic growth willtend touseshorter maturity debt, allelseequal. Notethatlow inflation meansthatlonger maturity debt will doa better job holding its value, and thatcountries with highly liquid stock and bond markets willtend touselong maturity debt.
Which ofthefollowing statementsaboutcapitalstructuretheoriesismostaccurate? In a Modigliani andMiller (MM) worldwith taxes,but no bankruptcy cost,you would expect to see firms taking on very little debt.
Based onsignaling theory, ifafirm issuesnew commonstock it meansthatthefirm thinksfutureinvestmentprospectsare betterthannormal.
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Itistruethatina world with taxesand bankruptcy coststhere will beanoptimalcapitalstructure wherethecostofcapitalis minimized and sharepriceis maximized. Theotherstatementsarefalse. Inatax world without bankruptcy theoptimalcapital structureis100% debt. Whenfirmsissuenew equity, it may suggestinvestmentprospectslook poor.
John Harrisonis discussing theimplicationsfor Modiglianiand Miller (MM's)propositions (assuming nocorporateorpersonal taxes)for manager's decisionsregarding capitalstructure with hissupervisor, Harriet Perry. Intheconversation, Harrison makesthefollowing statements:
Statement1:According to MM'spropositions, increasing theuseofcheaper debtfinancing willincreasethecostofequity and thenetchangetothecompany's weighted averagecostofcapital (WACC) will be zero.
Statement 2:Since MM'spropositionsassumethattherearenotaxes, equity isthepreferred method offinancing. Whatisthemostappropriateresponseto Harrison'sstatements?
Agree with neither. Agree with both. Agree with oneonly.
Explanation
Perry should agree with thefirststatement. MM assertsthattheuseof debtfinancing, although itischeaperthanequity, will increaseinthecostofequity, resulting ina zeronetchangeinthe WACC. Perry should disagree with thesecond statement. Although MM'spropositionsassumethattherearenotaxes, theconclusionisthatthe mix of debtand equity financing is irrelevantand thatthereisnopreferred method offinancing.
Katherine Epler, aself-employed corporatefinanceconsultant, isconducting aseminarconcerning differencesinfinancial leverageacross differentcountries. In herseminar, Epler makesthefollowing statements:
Statement1:Companiesin developed countriestend touselesslong-term debt whenfinancing theiroperationscompared with companiesinemerging markets.
Statement 2:Companiesoperating in Japantend to havea greaterrelianceonshorterterm debtfinancing thancompanies operating intheUnited States.
With respectto Epler'sstatements:
both are incorrect. both arecorrect. only oneiscorrect.
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Epler'sfirststatementisincorrect. Companiesin developed countriestend touse morelong-term debtthanemerging market countries. This makessense becausecountries with moreliquid capital markets (which would favor developed markets)tend touse morelong-term debt. Epler'ssecond statementiscorrect. Japanrelieson moreshort-term debtthantheUnited States, which makessenseasthelegalsystem and institutionalinvestorpresencetendsto be greaterintheU.S., which favorslonger maturity debt.
MichaelShermanisafinanceprofessorattheUniversity ofTuskaloosa. Inarecentlectureconcerning thefactorsananalyst should consider whenevaluating theimpactofcapitalstructureonthe valuationofafirm, Sherman makesthefollowing statements:
Statement1:Thechangesthatoccurinacompany'scapitalstructureovertimeareirrelevantforassessing theimpactof capitalstructureon valuation becausechangesin marketconditions meanthatonly thecurrentcapitalstructureisrelevantfor analysis.
Statement 2:Ifananalystiscomparing thecapitalstructureofonefirm tothecapitalstructureofacompetitorfirm, itis importanttoadjusttheanalysisfor differencesin businessrisk.
Sherman'sstudentsshould agree with:
both statements. only onestatement. neitherstatements.
Explanation
Sherman'sstudentsshould disagree with hisfirststatement. Changesincapitalstructureforafirm overtimeisessentialfor evaluating whetherornot management's decisions have worked toimprovethefirm's value. Sherman'ssecond statementis correct. Differencesincapitalstructurecould reflect differencesin businessrisk, sotheanalystshould try to make
comparisons based onsimilar businessrisk characteristicsinorderto haveatrueapplestoapplescomparison.
Which ofthefollowing changesin debtratingsismostlikelyto havethe greatestnegativeimpactonafirm's weighted average costofcapital (WACC)? Achangein debtrating from:
BBB to BB. AAtoA. BBtoBBB.
Explanation
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Vernon Hurd isananalystthatiscovering Oswald Technologies. Hurd doesnot havetheprivilegeof knowing thefirm'sexact targetcapitalstructure, but would liketo determine whetherornotthecapitalstructurepoliciesfollowed by Oswald's
managementis maximizing the valueofthefirm. Which ofthefollowing approaches would be mostusefulto Hurd to determine whether management'scurrentcapitalstructurepolicy is maximizing Oswald's value?
Cross-sectional ratio analysis with firms that have similar business risk to Oswald.
Dupontanalysis. Scenarioanalysis.
Explanation
Thetopicreview specifically mentionsusing scenarioanalysistoassess how changesinafirm's debtratio may impactthe firm's WACCand thenevaluate what happenstoafirm's valueifthecompany movestoward itsoptimalcapitalstructure.
DavisStreng, thecorporatecontrollerfortheCannizaroCorporation has beenresearching Modiglianiand Miller's (MM) theoriesoncapitalstructure. Streng would liketoapply thetheoriesto hisfirm'scapitalstructure, but doesnotagree with MM'sassumptionofnotaxes, sinceCannizaro hasa40% tax rate. IfStreng removestheassumptionofnotaxes, but keeps allof MM'sotherassumptions, which ofthefollowing would betheoptimalcapitalstructurefor maximizing the valueofthe firm?
The capital structure Streng chooses is irrelevant. 100% debt.
100% equity.
Explanation
If MM'sotherassumptionsare maintained, removing thenotax assumption meansthatthe valueofthefirm is maximized whenthe valueofthetax shield is maximized, which occurs with acapitalstructureof100% debt.
Which ofthefollowing isleastlikelyto beareason why afirm'sactualcapitalstructure may vary from thetargetcapital structure?
The firmdecides to finance a low risk project with 100%debt to improve the project's profitability.
Thefirm decidestoissueadditionalequity because management believesthefirm's stock isoverpriced.
Thefirm decidestoissueadditional debt duetoatemporary discountinunderwriting feesforcorporate debt.
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Afirm should alwaysfinanceaproject based onthefirm's weighted averagecostofcapital, although whenevaluating a project, thefirm may apply arisk factortoadjusttherisk oftheproject. Acorporate manager generally cannot deem some projectsas being financed by debtand some by equity asallprojectsareeffectively financed proportionately based onthe firm'scapitalstructure. Inpractice, afirm'sactualcapitalstructure willfloataround itstarget. Forafirm that does haveatarget capitalstructure, theactualstructure may vary from thetarget dueto market valuefluctuations, or management's desireto exploitanopportunity inaparticularfinancing source.
Jeffery Pyle, a health careanalystfora major brokeragefirm, istrying to determine how capitalstructurepolicy impactsthe valuationoffirms hecovers. Which ofthefollowing factorsislikely to betheleastusefulfor hisanalysis?
How often management uses internallygenerated capital versus raising new capital in the capital markets.
Quality ofcorporate governance.
Differencesincapitalstructureacrossfirmsin hiscoverageuniverse.
Explanation
Thethree mainfactorsthatafinancialanalyst mustconsider whenevaluating how afirm'scapitalstructureimpacts valuation arechangesinthefirm'scapitalstructureovertime, differencesincapitalstructure betweencompetitors with similar business risk, and company specificfactorssuch asquality ofcorporate governancethat may impactagency costs.
Bhairavi Patel, ananalystfor major brokeragefirm, isconsidering how toincorporatethestatictrade-offcapitalstructure theory into her valuation modelsforcompaniesshecovers. Patelis discussing thestatictrade-offtheory with hercolleagues, and makesthefollowing statements:
Statement1:Ifafirm maintainsa high debtrating, thefirm cannot beatitsoptimalcapitalstructure based onthestatictrade -offtheory.
Statement 2:Thestatictheory impliesthat differencesintheoptimalcapitalstructureacrosssimilarfirmsin differentcountries must betheresultof differenttax ratesinthosecountries.
With respectto Patel'sstatements:
both are incorrect. both arecorrect. only oneiscorrect.
Explanation
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alsoincorrect. Although differencesintax ratescanplay arolein having differentoptimalcapitalstructuresforsimilarfirms, differencesincostsoffinancial distress willplay aroleas well. Differencesinlegalstructure, liquidity, and otherfactors will resultin differentperceived costsoffinancial distressin differentcountries, which willinturn, contributeto differentoptimal capitalstructuresaccording tothestatictrade-offtheory.
Which ofthefollowing islikely toencourageafirm toincrease theamount of debt in its capital structure? The personal tax rate increases.
The corporate tax rate increases.
The firm'searnings become more volatile.
Explanation
An increase in the corporate tax rate will increase the tax benefit to the corporation, because interest expense is not taxable. An increase in the personal tax rate will not impact the firm's cost of capital. More volatileearnings increase therisk of the firm and therefore the firm would not desire to increase financial risk asaresult of these changes.
Assume that the debt rating given by Standard and Poor's for Oswald Technologies drops from AAA to BBB. Which of the following reflects the mostlikely increase in the cost of debt for Oswald Technologies?
10 basis points. 100 basis points. 500 basis points.
Explanation
Historically, theaveragespread between AAA rated bondsand BBB rated bonds has been 100 basis points, so 100 basis points is the most likely answer. Note however that theactual spread may fluctuate due to market conditions, and may be wider in recessions.
Which of the following isleastlikely to be categorized asa cost of financial distress? Legal fees paid to bankruptcy lawyers.
Premiums paid for bonding insurance to guarantee management performance. Having a potential merger partner pull out of a proposed deal.
Explanation
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that fact. Costs of financial distress can be direct or indirect. Direct costs would include cash expensesassociated with bankruptcy, such as legal and administrative fees, while indirect costs would include foregone business opportunities, inability to access capital markets, or loss of trust from customers, suppliers, oremployees.
Frank Collins, CFA, is managing director for Brisbane Capital Resources, an Australian fund manager. The firm has had great success through the years with its growth-oriented investment strategy, but hassuffered when the markets change in favor of value investment strategies. Consequently, Collins isexploring how the firm might increase its presence in the valuesector of the market.
Many of the firms that reside in the valuesectorare those that have fallen on hard times, and have underperformed their peers. During hisexamination of firms meeting various value criteria, Collins has noted that while falling salesand the lack of profitsaresometimes the obvious causes of thesubstandard performance, in other casessalesand profits do not appear to be theroot cause. He wonders if the way that these firms have been capitalized is having a negative impact on their values. Collinsrecalls from his days of studying financeat the University of Queensland, that a Nobel Prize wasawarded for one of the theories in the capital structurearea. Hisrecollection of the details issketchy, so he has contacted Dr. Martin Gray from UQ's Department of Commerce to discuss capital structure in theory and in practice.
Gray tells Collins that his memory is indeed correct, that a Nobel Prize wasawarded to Millerand Modigliani for their work in explaining the capital structure decision. Interestingly, he notes that their theoriessay that, under theright circumstances, capital structure is irrelevant. Obviously, the key is whether or not theright circumstancesarerelevant to what is observed in thereal world.
Gray continues to tell Collins that therearea variety of matters that complicate the MM theory in practice. Firms pay taxes, managers may be motivated by their own self-interests, and adjustments to a firm's capital structureare not costless. All of these factorsaffect the MM theories, and have given rise to other theories that attempt to explain why firms finance themselvesas they do.
Collinsalso wonders if capital structure decisionsareaffected in any way by the country in which the firm is domiciled. He knows that Australia tends to follow the Anglo-American financial model, but that firms in continental Europe, Japan, and other countriesare moreaccustomed to relying upon banks for capital. He wonders if thisaffects the capital structures observed across firms, even when the firms have thesame underlying businessrisk.
Finally, Collinsasks Gray about corporate debt ratings. Gray tells him that ratings fall broadly across two classes-investment gradeand speculative-with a variety of ratings within each class. Moreover, Gray advises that firms usually seek to maintain a credit rating in the investment grade class, sincesome fiduciary investorsare precluded from holding debt in thespeculative class. Collins wonders if a firm's debt ratings haveany bearing upon the choice of capital structure.
Which of the following statements mostaccurately characterizes thestatic trade-off theory of capital structure? Increasing the use of relatively lower cost debt causes the required return on
equity to increase such that the overall cost of capital is unchanged. Regardless of how the firm is financed, the overall value of the firm and aggregate value of the claims issued to finance it remain thesame.
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Thestatic trade-off theory of capital structurestates that 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. In other words, the capital structure is determined by the trade-off between these two factors. (Study Session 8, LOS 26.a)
Which of the following statements most correctly characterizes the pecking order theory of capital structure? 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.
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 havea preference ordering for capital sources, preferring internally-generated equity first, new debt capital second, and externally-sourced equity asa last resort.
Explanation
The pecking order theory of capital structureassumes that firms havea preference ordering for capital sources. They prefer to use internally-generated equity first. When the internally-generated equity isexhausted, they issue new debt capital. Asa last resort they will rely on externally-sourced equity. Thereason that new equity is the last resort is that the issuance of new stock isassumed to send a negativesignal to investorsregarding firm value. (Study Session 8, LOS 26.a)
When taxesare incorporated into the capital structure decision, the main result is that: firms should increase the use of equity financing because of its inherent tax advantages.
the costs of financial distress becomerelevant to theanalysis.
the firm derivesa tax shield benefit from using debt because the interest expense is tax-deductible.
Explanation
The main impact of incorporating corporate income taxes is that the firm derivesa tax shield benefit because interest isa ta x-deductibleexpense. (Study Session 8, LOS 26.a)
Which of the following reasons isleastaccurateregarding why a firm'sactual capital structure may deviate from its target capital structure?
The book values of outstanding debt and equity are different from their market values.
Management may believe that now isan opportune time to issueequity. There may beeconomies of scale in issuing debt securities.
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The book values of equity and debt are generally not relevant to assessing a firm's capital structure. It is the market values of equity and debt that determine the current capital structure. (Study Session 8, LOS 26.b)
Which of the following statements mostaccurately characterizes how debt ratings may affect a firm's capital structure policy? A firmmay be deterred from increasing the use of debt to avoid having its
credit rating reduced below some minimum acceptable level.
Firms that have their credit ratingsreduced below investment gradeare not able to issueadditional debt.
Because credit ratingsare based upon cash flow coverage of interest expense, they are not influenced by the firm's capital structure.
Explanation
Credit ratings can be factored into management's capital structure policy if a firm hasa minimum rating objective, and this is likely to beadversely affected by issuing additional debt. (Study Session 8, LOS 26.c)
Which of the following statements concerning the use of leverage is mostaccurate? Companies in countries where the use of bank debt (as opposed to issuing bonds) is more prevalent tend to use more leverage.
A high degree of information asymmetry tends to reduce the use of debt in the capital structure.
The use of leverage in capital structures is broadly consistent in most developed economies.
Explanation
Companies in countries where the use of bank borrowing isrelatively more prevalent than the issuance of corporate bonds tend to use more leverage. The otherstatementsare incorrect, based upon observationsacross countries. (Study Session 8, LOS 26.e)
Katherine Epler, aself-employed corporate finance consultant, is working with another new client, Thurber Electronics. Epler is discussing thestatic trade-off capital structure theory with her client, and makes the following comments:
Comment 1: Under thestatic trade-off theory, the graph of a company's weighted average cost of capital hasa U shape. Comment 2: According to thestatic trade-off theory, every firm will have thesame optimal amount of debt that maximizes the value of the firm.
With respect to Epler's comments:
both are correct.
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Explanation
Epler's first comment is correct. When graphing a company's WACC according to thestatic trade-off theory, the WACC will initially declineasa company increases its tax savings through the use of debt. However, as more debt isadded, the WACC will reach a point where it increases due to the increasing costs of financial distress. Note that when graphing thestatic trade -off theory, the WACC looks likea U shape, while the value of the firm looks likean upside down U shape. This makessense because the value of the firm is maximized when the WACC is minimized. Epler'ssecond comment is incorrect. Every firm will havea different optimal capital structure that will depend on the firm's operating risk, tax situation, industry influences, and other factors.
A firm's optimal debt ratio: maximizes return. minimizesrisk.
is the firm's target capital structure.
Explanation
The optimal debt ratio fora firm balances the influences of risk and return, leading to a maximization of share price. Assuch, the optimal debt ratio servesasa target level of debt financing for the value-maximizing firm. A debt ratio of 1.0 would be possible only if one hundred percent of the firm were financed with debt, eliminating equity ownership. Such ascenario is impossible.
According to thestatic trade-off theory:
there is an optimal proportion of debt that will maximize the value of the firm. new debt financing isalways preferable to new equity financing.
theamount of debt used by a company should decreaseas the company's corporate tax rate increases.
Explanation
Thestatic trade-off theory seeks to balance the costs of financial distress with the tax shield benefits from using debt. Under thestatic trade-off theory, there isan optimal capital structure that hasan optimal proportion of debt that will maximize the value of the firm.
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pecking order theory, issuing new debt is preferable to issuing new equity. thestatic trade-off theory, debt will not be used if a company is in a high corporate tax bracket.
MM's propositions (assuming no taxes), companies havean optimal level of debt financing.
Explanation
Pecking order theory isrelated to thesignals management sends to investors through its financing choices. Financing choices follow a hierarchy based on visibility to investors with internally generated funds being the least visibleand most preferred, and issuing new equity as the most visibleand least preferred. Understatic trade-off theory, higher tax bracketsresult in greater tax savings from using debt financing. Under MM's propositions (assuming no taxes), capital structure is irrelevant and there is no optimal level of debt financing.
Katherine Epler, aself-employed corporate finance consultant, is having a discussion with friends that arealso in the corporate finance field. After talking about their families, the discussion turns to factors that tend to impact capital structure. During the course of the conversation, Epler makes two statements.
Statement 1: Favorable tax rates on dividend incomerelative to interest income will reduce the value of the tax shield provided by debt in thestatic trade-off theory of capital structure.
Statement 2: Evidence indicates that reductions in the net agency costs of equity tend to lead to lower financial leverageratios. With respect to Epler'sstatements:
only one is correct. both are incorrect. both are correct.
Explanation
Epler's first statement is correct. Miller (of Modigliani and Miller) concluded that if investors face different tax rates on dividend and interest income, theadvantage for debt financing may bereduced somewhat. This conclusion issupported by
international capital structure differencesas countries with favorable dividend tax rates tend to use less debt in their capital structure. Epler'ssecond comment isalso correct. When looking at international differences in capital structure, countries that have factors in placesuch asstronger legal systemsand a greater presence of analystsand auditors tend to reduceagency costsand thereforealso have lower financial leverageratios. Note that higher leverageratios tend to reduceagency costs, but reducing agency costs does not lead to higher leverageratios.
Which of the following firms is mostlikely to utilizeadditional debt the next time it raises capital? The firm: firm that has experienced significant losses in recent years.
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that has many new fixed assets.
Explanation
The value of tax deductibility rises with tax rates. Of course, thereare other ways to reduce taxes. Firms with many new assets are probably also benefiting from high levels of depreciation. Firms with recent losses may beavoiding taxes by writing off those losses.
The optimal capital structure:
minimizes the required rate on equitymaximizes the stock price. maximizes thestock price minimizes the weighted average cost of capital. maximizesexpected EPS maximizes the price pershare of common stock.
Explanation
At the optimal capital structure the firm will minimize the WACC, maximize theshare price of thestock and maximize the value of the firm.
Which of the following statementsabout a firm's capital structure isleastaccurate? The optimal capital structure is the one that minimizes the weighted average cost of capital and consequentlymaximizes the value of the firm's share price. If bankruptcy costs were included into the M&M analysis of capital structure in a tax world there would bean optimal capital structure between no debt and all debt. The firm'sshare price is maximized when the firm maximizes itsearnings pershare while it minimizes its cost of capital.
Explanation
The optimal capital structure is the one that maximizesstock priceand minimizes the WACC. The optimal capital structure is not the one that maximizes the firm's EPS.
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Bentley is in charge of the team that isevaluating all financing optionsavailable to Industrial Inc. to determine which method would minimize the firm's weighted average cost of capital (WACC) while providing a capital structure that will maximize firm valueand that isattractive to outside investors. The firm is considering either issuing additional debt or issuing asecondary equity offering to finance the venture. The firm's target capital structure will be utilized to determine what thespecific advantagesand disadvantagesassociated with the different methods of raising capital.
Industrial currently has $450 million of shareholders' equity outstanding. The company also has $100 million of 10-year notes issued with 4 yearsremaining to maturity. Industrial Inc.'s current rating is Aa by Moody'sand AA by Standard and Poor's (S&P). Bentley isaware that any financing strategy must be considered in light of the potential impact the decision could have upon the company's current rating.
Any new acquisition of capital will be carefully analyzed in relation to Industrial Inc.'s current capital structureas well. Bentley is familiar with the different theories of capital structureand intends to determine which one is most applicable to Industrial Inc.'s current situation. Industrial Inc. is publicly traded on the New York Stock Exchange, and several analystsat large brokerage firms provideresearch on thestock. Bentley wants to ensure that the company'sapproach to raising additional capital will be acceptable to analystsand investorsalike.
Top management of Industrial, Bentley included, collectively own a 20% equity stake in the firm, through either direct purchase of thestock or thereceipt of executivestock options. This group is placing pressure on Bentley to recommend astrategy that would not significantly dilute their ownership position. Bentley realizes that he must recommend astrategy that will most effectively utilize the company'sassetsand that will be in the best interest of all of the company'sstakeholders.
Underastrict set of assumptions, Modigliani and Miller (MM) proposed a capital structure theory in 1958 in which Proposition I proves that:
the cost of debt is lower than the cost of equity, so a firm should issue the maximum amount of debt before issuing equity.
capital marketsare perfectly competitive.
the value of a firm is unaffected by its capital structure.
Explanation
MM's underlying assumptionsare that capital marketsare perfectly competitive (no transaction costs) and that investors have homogenousexpectations with respect to cash flows. Under these two "perfect world" assumptions, the value of a firm is unaffected by its capital structure because the value of a firm'sassets will always be thesameregardless of its debt to equity ratio. (Study Session 8, LOS 26.a)
Under MM's Proposition II of their capital structure theory, will a firm that increases its use of debt most likely affect default risk, cost of equity, or both?
Does not affect either. Increases both.
Increases only one.
Explanation
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of equity does increase because the firm's businessrisk is concentrated on asmaller proportion of equity as leverage increases. (Study Session 8, LOS 26.a)
Bentley anticipates that whatever method of financing choice is utilized, it will be interpreted by investorsasasignal of the firm'sstrategy and overall economic health. In accordance with the pecking order theory, which of the following methodsare least likely and most likely to send "signals" to investors?
Least Likely Most Likely
External equity Internally generated equity
External equity Debt Internally generated
equity External equity
Explanation
Internally generated equity is the method least visible to investors, whileexternal equity is the most visible. (Study Session 8, LOS 26.a)
Which of the following statementsregarding therole of debt ratings isleastaccurate? Any rating Ba (from Moody's) or BB (from S&P) or higher is considered to be "investment grade".
Historically, the difference in yield between an AAA-rated bond and a BBB-rated bond hasaveraged 100 basis points.
The lower the debt rating, the higher the level of default risk for both shareholdersand bondholdersalike.
Explanation
Bonds must berated at least Baa (Moody's) or BBB (S&P) to be considered investment grade. (Study Session 8, LOS 26.c)
Asaresult of Industrial expanding its operations into Europeand Asia, Bentley anticipatesan increase in foreign investors in the firm. Which of the following statementsregarding international differences in leverage isleastaccurate?
Companies in the U.S. tend to use shorter maturity debt than companies in Japan.
Companies in Japan and France tend to have more debt in their capital structure than firms in the U.S.
