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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?

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.

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.

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.

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

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

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

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.

The firm's target capital structure is consistent with which of the following?

A)	Minimum risk.

B)	Minimum weighted average cost of capital (WACC).

C)	Maximum earnings per share (EPS).

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.

A)	return on equity but not default risk.

B)	return on equity and default risk.

C)	default risk but not return on equity.

Jayco, Inc. currently has a D/A ratio of 33.33% but feels its optimal D/A ratio should be 16.67%. Sales are currently $750,000, and the total assets turnover (Sales / Assets) is 7.5. If Jayco needs to raise $100,000 to expand, how should the expansion be financed so as to produce the desired debt ratio? Finance it with:

Sales / Assets = 7.5 = 750,000 / A, so A = $100,000, D / 100,000 = 33.33. Therefore, D must be 33,333. You want to change D/A to 16.67, so must double A so the 100,000 must be all equity.

A)	is the firm's target capital structure.

B)	minimizes risk.

C)	maximizes return.

The optimal debt ratio for a firm balances the influences of risk and return, leading to a maximization of share price. As such, the optimal debt ratio serves as a 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 a scenario is impossible.

Which of the following statements about a firm's capital structure is least accurate?

A)	The degree of total leverage equals the degree of operating leverage times the degree of financial leverage.

B)	Other things held constant, if you increase a firm's financial leverage you will increase the firm's beta coefficient.

C)	The firm's optimal capital structure occurs where the firm's earnings per share is maximized.

The firm's optimal capital structure occurs where the firm's stock price or value is maximized and the WACC is minimized.