pacmandefense

A firm's optimal debt ratio:

A) minimizes risk.

B) maximizes return.

C) is the firm's target capital structure.

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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.

pacmandefense

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 would prefer to have the highest possible debt ratings.
With respect to Epler’s slides:

A) both are incorrect.

B) both are correct.

C) only one is correct.

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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.

pacmandefense

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) 100 basis points.

B) 500 basis points.

C) 10 basis points.

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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.

pacmandefense

Gervase Jackson is a student in corporate finance class. Jackson is unsure how debt ratings tie into a company’s capital structure and decides to talk to his professor after class. In their discussion, the professor makes the following statements:
Statement 1: The most common way that firms use debt ratings in conjunction with capital structure is to set a certain minimum debt rating that the firm strives to stay above at all times.
Statement 2: A change in debt rating from investment grade to speculative grade will significantly increase the firm’s cost of debt capital.
With respect to the statements made by Jackson’s professor:

A) both are incorrect.

B) both are correct.

C) only one is correct.

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Both of the statements made by Jackson’s professor are correct. Managers generally want to maintain the highest debt rating possible because higher debt ratings will result in lower costs of capital. Managers are aware that a drop in debt rating may increase capital costs, so that is generally something the managers will avoid. Also, a change in debt rating from investment grade to speculative grade is particularly harmful for the firm’s cost of capital because a drop to speculative grade will classify the debt as “junk” which will generally result in a significant increase in capital costs.

pacmandefense

Which of the following changes in debt ratings is most likely to have the greatest negative impact on a firm’s weighted average cost of capital (WACC)? A change in debt rating from:

A) AA to A.

B) BBB to BB.

C) BB to BBB.

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Since the cost of capital is tied to debt ratings, many managers have goals for maintaining certain minimum debt ratings when determining their capital structure policies. Lower debt ratings mean higher level of credit risk, and a higher cost of capital. Managers want to avoid drops in bond ratings in any case, but a bond rating drop from investment grade to speculative grade (BBB to BB) tends to cause a significant increase in the cost of debt and the WACC.

pacmandefense

Steve Cooley, the Chief Financial Officer for Canberra Corporation, decides that he wants to use as much debt as possible in his firm’s capital structure. Cooley knows that to use more debt, he will need to make a persuasive argument to his board. Which of the following arguments used by Cooley to help with his goal of raising large amounts of additional debt is least supported by empirical evidence?

A) The cost of debt is always cheaper than the cost of equity.

B) Increasing the amount of debt has an insignificant impact on our credit risk premium.

C) Raising additional debt provides a signal to our shareholders that our firm’s future prospects are positive.

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Athough it is not the only factor, increasing the amount of debt will put downward pressure on the company’s credit rating, resulting in an increase in the credit risk premium. This will in turn increase the costs of both debt and equity capital. Note that raising additional debt does provide a positive signal about future prospects. Also, saying that the cost of debt is always cheaper than the cost of equity is an accurate statement, but the static trade-off theory shows how balancing debt and equity capital can lead to lower costs for both components

pacmandefense

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

B) Quality of corporate governance.

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

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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.

pacmandefense

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) Dupont analysis.

C) Scenario 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.

pacmandefense

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) only one statement.

C) neither statements.

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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.

JoeyDVivre

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

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

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

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.