4.6 capital structure

Question 1

The cost of capital

Answer 1

the rate of return that is required as compensation by suppliers of capital

It can also be thought of as an opportunity cost

Question 2

The mix of capital sources used to finance a company’s assets

Answer 2

capital structure

Question 3

The pre-tax cost of debt

Answer 3

the rate of return that investors expect as compensation when lending to a company

Question 4

A company’s cost of equity

Answer 4

greater than its cost of debt because shareholders have the lowest priority claim to a company’s cash flows and assets.

Unlike a company’s borrowing costs, there is no historical snapshot of its cost of equity. Investors use various methods to determine the rate of return that they require as compensation for holding a company’s shares.

These various components can be combined to calculate a company’s overall weighted average cost of capital (WACC)

Question 5

weighted average cost of capital (WACC)

Answer 5

When making capital budgeting decisions, WACC is the hurdle rate that a project’s IRR must exceed in order to be accepted.

WACC is also the discount rate that should be used to determine a project’s NPV.

When a company has exhausted its positive NPV projects, any remaining capital should be returned to shareholders so that they can allocate these funds to other investments.

A company maximizes value for its shareholders by achieving the capital structure with the lowest WACC.

Question 6

A company’s capital structure

Answer 6

the combination of equity and debt that have been raised to finance its assets and facilitate its operations

Question 7

Capital structure decisions will be affected by several key factors, which can be classified into two categories

Answer 7

internal

external

Question 8

Key internal factors that influence a company’s capital structure decisions include:

Answer 8

Business model characteristics

Stage in corporate life cycle

Cash flows and profitability

Asset types and ownership

Question 9

External, or top-down, factors affecting capital structure choices include:

Answer 9

Capital markets and economic conditions

Regulatory constraints

Industry factors

Question 10

operating leverage

Answer 10

fixed costs / total costs

Question 11

Higher operating leverage

Answer 11

will increase the volatility of a company’s earnings and cash flows

Question 12

financial leverage

Answer 12

increases the riskiness of a company’s profits by creating fixed obligations that must be met regardless of sales

Question 13

Proposition I Without Taxes: Capital Structure Irrelevance

Franco Modigliani and Merton Miller were awarded a Nobel Prize for demonstrating that, under the following assumptions, a company’s capital structure would have no effect on its value:

Answer 13

1. investors have homogeneous expectations, which means they agree on the expected cash flows from an investment.
2. Capital markets are perfect. There are no transaction costs, no taxes, and no bankruptcy costs. Everyone has access to the same information.
3. Investors can borrow and lend at the risk-free rate.
4. There are no agency costs. Managers always act in the best interest of the investors, maximizing shareholder wealth.
5. Financing and investment decisions are independent.

Question 14

Which of the following mature companies is most likely to use a high proportion of debt in its capital structure?

A
An electric utility

B
A mining company with a large, fixed asset base

C
A software company with very stable and predictable revenues and an asset-light business model

Answer 14

A
An electric utility

An electric utility has the capacity to support substantial debt, with very stable and predictable revenues and cash flows

Question 15

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.

Answer 15

C
internal financing, debt, equity.

Question 16

he 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 prospects are improving.

B
equity financing is cheaper than debt financing.

C
the company’s debt/equity has moved beyond the optimal range.

Answer 16

C
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.

Question 17

An analyst made the following statement:

“All else equal, if Modigliani and Miller’s assumptions hold, adding more debt to TWP’s capital structure will result in a higher asset beta.”

Is the analyst’s claim in the statement most likely correct?

A
Yes

B
No, because adding debt will result in a lower asset beta

C
No, because adding debt will have no effect on the asset beta

Answer 17

C
No, because adding debt will have no effect on the asset beta

The asset beta is a measure of business risk, or the systematic risk that cannot be diversified away. Assuming no change in a company’s business risk, changes to its capital structure will have no effect on its asset beta. Rather, the higher risk associated with an increase in a company’s financial leverage would be captured by an increase in its equity beta. As a result of this change, shareholders are exposed to greater risk and will demand a higher return on equity, but (all else equal) the asset beta will remain constant.

Question 18

Which of the following companies in the mature stage will most likely utilize high levels of leverage in its capital structure?

A
A real estate company

B
A capital light business

C
A company in cyclical industry

Answer 18

A
A real estate company

Question 19

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.

Answer 19

A
Cash flow may be negative or positive.

Question 20

Which of the following is least likely to be true with respect to agency costs and senior management compensation?

A
A well-designed compensation scheme should eliminate agency costs.

B
Equity-based incentive compensation is the primary method to address the problem of agency costs.

C
High cash compensation for senior management, without significant equity-based performance incentives, can lead to excessive caution and complacency.

Answer 20

A
A well-designed compensation scheme should eliminate agency costs.

Question 21

Which of the following is most accurate with respect to Modigliani and Miller’s Proposition I without taxes?

A
The cost of equity increases linearly with the debt-to-equity ratio.

B
The market value of a company is not affected by the capital structure of the company.

C
The market value of a levered company is equal to the value of an unlevered company plus the value of the debt tax shied.

Answer 21

B
The market value of a company is not affected by the capital structure of the company.