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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 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.

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

B)	Scenario analysis.

C)	Dupont analysis.

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.

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.

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.

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

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

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

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

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

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.

Schwarzwald Industries recently issued new equity to help fund a new capital project. What type of signal is Schwarzwald’s choice of financing sending to investors about the future prospects of the firm under the information asymmetry signaling theory and pecking order theory respectively?

A)	Positive signal under both theories.

B)	Positive signal under only one theory.

C)	Negative signal under both theories.

Signaling theory results from asymmetric information, which refers to the fact that managers have more information about a company’s future prospects than the firm’s owners and creditors. Since managers are reluctant to sell new stock if they think the stock is undervalued, but very willing to sell stock if they think the stock is overvalued, selling stock sends a negative signal about a firm’s future prospects. Pecking order theory, which is related to signaling theory, suggests that managers choose methods of financing based on the visibility of signals they send. Raising equity is the least preferred method of financing under pecking order theory, and it sends a negative signal.

Which of the following statements regarding how different capital structure theories impact managers’ capital structure decisions is most accurate? According to:

A)	pecking order theory, issuing new debt is preferable to issuing new equity.

B)	the static trade-off theory, debt will not be used if a company is in a high corporate tax bracket.

C)	MM’s propositions (assuming no taxes), companies have an optimal level of debt financing.

Pecking order theory is related to the signals management sends to investors through its financing choices. Financing choices follow a hierarchy based on visibility to investors with internally generated funds being the least visible and most preferred, and issuing new equity as the most visible and least preferred. Under static trade-off theory, higher tax brackets result in greater tax savings from using debt financing. Under MM’s propositions (assuming no taxes), capital structure is irrelevant and there is no optimal level of debt financing.