Reading 30: Capital Structure-LOS d 习题精选 structure, following, statements, 2011, class

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Session 8: Corporate Finance
Reading 30: Capital Structure

LOS d: Explain the factors an analyst should consider in evaluating the impact of capital structure policy on valuation.

 

 

Which one of the following statements about a firm's capital structure is most accurate? The optimal capital structure:

A) maximizes expected earnings per share (EPS), maximizes the price per share of common stock.

B) maximizes the stock price, minimizes the weighted average cost of capital (WACC).

C) minimizes the required rate on equity, maximizes the stock price.

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The firm's optimal capital structure is the one that balances the influence of risk and return and thus maximizes the firm's stock price. Return: this optimal capital structure will maximize the firm's stock price. Risk: at the optimum level, the cost of capital (as reflected in WACC) is also minimized.

A firm’s target capital structure is the debt to equity ratio that the firm tries to maintain over time. Should the firm’s current debt ratio fall below the target level, new capital needs will be satisfied by issuing debt. On the other hand, if the debt ratio is greater than the target level, the firm will raise new capital by retaining earnings or issuing new equity. When setting its target capital structure, the firm must weigh the tradeoff between risk and return associated with the use of debt. The use of debt increases the risk borne by shareholders. However, using debt leads to higher expected rates of return by shareholders. The higher risk associated with debt will depress stock prices, while the higher expected return will increase stock prices. Thus, the firm’s optimal capital structure is the one that balances the influence of risk and return and thus maximizes the firm’s stock price. The optimal debt ratio will be the firm’s target capital structure.

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The optimal capital structure:

A) minimizes the required rate on equity maximizes the stock price.

B) maximizes the stock price minimizes the weighted average cost of capital.

C) maximizes expected EPS maximizes the price per share of common stock.

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At the optimal capital structure the firm will minimize the WACC, maximize the share price of the stock and maximize the value of the firm.

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Michael Sherman is a finance professor at the University of Tuskaloosa. In a recent lecture concerning the factors an analyst should consider when evaluating the impact of capital structure on the valuation of a firm, Sherman makes the following statements:

Statement 1: The changes that occur in a company’s capital structure over time are irrelevant for assessing the impact of capital structure on valuation because changes in market conditions mean that only the current capital structure is relevant for analysis.

Statement 2: If an analyst is comparing the capital structure of one firm to the capital structure of a competitor firm, it is important to adjust the analysis for differences in business risk.

Sherman’s students should agree with:

A) both statements.

B) neither statements.

C) only one statement.

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Sherman’s students should disagree with his first statement. Changes in capital structure for a firm over time is essential for evaluating whether or not management’s decisions have worked to improve the firm’s value. Sherman’s second statement is correct. Differences in capital structure could reflect differences in business risk, so the analyst should try to make comparisons based on similar business risk characteristics in order to have a true apples to apples comparison.

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Vernon Hurd is an analyst that is covering Oswald Technologies. Hurd does not have the privilege of knowing the firm’s exact target capital structure, but would like to determine whether or not the capital structure policies followed by Oswald’s management is maximizing the value of the firm. Which of the following approaches would be most useful to Hurd to determine whether management’s current capital structure policy is maximizing Oswald’s value?

A) Scenario analysis.

B) Cross-sectional ratio analysis with firms that have similar business risk to Oswald.

C) Dupont analysis.

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The topic review specifically mentions using scenario analysis to assess how changes in a firm’s debt ratio may impact the firm’s WACC and then evaluate what happens to a firm’s value if the company moves toward its optimal capital structure.

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Jeffery Pyle, a health care analyst for a major brokerage firm, is trying to determine how capital structure policy impacts the valuation of firms he covers. Which of the following factors is likely to be the least useful for his analysis?

A) Quality of corporate governance.

B) Differences in capital structure across firms in his coverage universe.

C) How often management uses internally generated capital versus raising new capital in the capital markets.

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The three main factors that a financial analyst must consider when evaluating how a firm’s capital structure impacts valuation are changes in the firm’s capital structure over time, differences in capital structure between competitors with similar business risk, and company specific factors such as quality of corporate governance that may impact agency costs.