Reading 32- LOS m ～ Q1－5

1.Katherine Epler, a self-employed corporate finance consultant, is conducting a seminar for executive management teams regarding issues related to a company’s capital structure. In the morning session of the seminar, Epler makes the following two statements:

Statement 1: Management teams will have a target capital structure for their firm because of an awareness of how competing firms finance their operations and a desire to keep their financial ratios close to industry averages.

Statement 2: In order to reap the benefits that come with having a target capital structure, management must always raise capital in the exact proportions called for by the target.

Are the statements made by Epler CORRECT?

A)              No                                     No

B)              Yes                                        Yes

C)                                        No        Yes

D)                                        Yes       No

The correct answer was A)

Both of Epler’s statements are incorrect. Management teams will have a target capital structure because they are aware that their firm as an optimal capital structure that will maximize the value of the firm. It is the desire to keep the capital structure close to the optimal structure that leads to a target capital structure, not a desire to keep financial ratios close to industry averages. The second statement is also incorrect. The target capital structure is more of a floating range, and the firm may deviate slightly from the target when raising capital to exploit short-term opportunities in a particular financing source.

2.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)   Fluctuations in debt or equity market prices may cause the capital structure to vary from the target.

B)   The firm decides to finance a low risk project with 100 percent debt to improve the project’s profitability.

C)   The firm decides to issue additional equity because management believes the firm’s stock is overpriced.

D)   The firm decides to issue additional debt due to a temporary discount in underwriting fees for corporate debt.

The correct answer was B)

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.

3.Zoltan DeJainus is the Chief Financial Officer of Hilliard Veterinary Products (HVP). In a discussion with HVP’s management team about the firm’s capital structure, DeJainus makes the following comments:

Comment 1: HVP’s target capital structure is the same as its optimal capital structure.

Comment 2: If market value fluctuations cause the firm’s actual capital structure to vary from the target capital structure, HVP should buy or sell its own stock or bonds as necessary to make sure that the capital structure remains at its optimal level.

Should the members of HVP’s management team agree or disagree with each of DeJainus’ comments?

A)          Agree                                 Disagree

B)          Agree                                    Agree

C)         Disagree                                 Disagree

D)         Disagree                                 Agree

The correct answer was A)

The management team should agree with DeJainus’ first comment. For managers trying to maximize the value of the firm, the target capital structure will be the same as the optimal capital structure. The management team should disagree with the second comment. In practice, a firm’s actual capital structure will float around its target. One of the reasons for floating around the target is market value fluctuations. The target capital structure serves as a guide for making decisions about how to raise additional capital, but unless there is an extreme circumstance, there is no need for a firm to make transactions to keep the capital structure exactly on target.

4.Katherine Epler, a self-employed corporate finance consultant, is preparing a new seminar concerning debt ratings and how they impact capital structure policy. As she is working on her presentation, Epler prepares two presentation slides that contain the following:

Slide 1: Lower debt ratings will increase the cost of debt as well as the cost of equity financing.

Slide 2: Managers will always prefer to have the highest possible debt ratings.

Is the information contained on Epler’s slides CORRECT?

A)              Yes                                    Yes

B)               No                                         No

C)               Yes                                        No

D)               No                                         Yes

The correct answer was A)

The information on both of Epler’s slides is correct. Lower debt ratings signifies higher risk to both debt and equity capital providers and will cause both to demand higher returns on their investment. Also, managers will always prefer the highest possible debt rating because higher debt ratings will result in lower costs of capital.

5.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 most likely increase in the cost of debt for Oswald Technologies?

A)   10 basis points.

B)   1000 basis points.

C)   500 basis points.

D)   100 basis points.

The correct answer was D)

Historically, the average spread between AAA rated bonds and BBB rated bonds has been 100 basis points, so 100 basis points is the most likely answer. Note however that the actual spread may fluctuate due to market conditions, and may be wider in recessions.