Reading 34: capital structure Flashcards
A company is most likely to be financed only by equity during its:
start-up stage.
growth stage.
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. (LOS 34.b)
A company’s optimal capital structure:
maximizes firm value and minimizes the weighted average cost of capital.
minimizes the interest rate on debt and maximizes expected earnings per share.
maximizes expected earnings per share and maximizes the price per share of common stock.
The optimal capital structure minimizes the firm’s WACC and maximizes the firm’s value (stock price). (LOS 34.c)
Which of the following statements regarding Modigliani and Miller’s Proposition II with no taxes is most accurate?
A firm’s cost of equity financing increases as the proportion equity in a firm’s capital structure is increased.
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.
MM’s Proposition II (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. (LOS 34.c)
Which of the following is least likely an 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 average capital structure weights for the firm’s industry, based on book values of debt and equity.
Use the firm’s current capital structure, based on market 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. (LOS 34.d)
To determine their target capital structures in practice, it is least likely that firms will:
use the book value of their debt to make financing decisions.
match the maturities of their debt issues to specific firm investments.
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. (LOS 34.d)
The pecking order theory of financial structure decisions:
is based on information asymmetry.
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.
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. (LOS 34.d)
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:
less financial leverage.
greater firm risk.
issuance of common stock.
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. (LOS 34.e)
