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Corporate Finance【 Reading 29,Reading30】

Which of the following statements regarding how different capital structure theories impact managers’ capital structure decisions is most accurate? According to:
A)
the static trade-off theory, debt will not be used if a company is in a high corporate tax bracket.
B)
pecking order theory, issuing new debt is preferable to issuing new equity.
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.

According to pecking order theory, which of the following lists most accurately orders financing preferences from most to least preferred?
A)
Retained earnings, debt financing, and raising external equity.
B)
Debt financing, retained earnings, and raising external equity.
C)
Retained earnings, raising external equity, and debt financing.



Financing choices under pecking order theory follow a hierarchy based on visibility to investors with internally generated capital being the most preferred, debt being the next best choice, and external equity being the least preferred financing option.

TOP

Tad Bentley, CFA, is the chief financial officer (CFO) for Industrial Inc., a manufacturer and distributor of cleaning supplies designed for commercial applications. Industrial Inc.’s current target market spans the entire United States, and possesses a large percentage of the national market. Senior management has formulated a strategy for expansion into Europe and Asia in the near future. The success of the expansion plans lay in large part upon the firm’s ability to raise additional capital in the marketplace to finance the expansion. According to the preliminary time schedule for expansion into Europe and Asia, funds would need to be made available to the firm within the next eighteen to twenty four months.
Bentley is in charge of the team that is evaluating all financing options available to Industrial Inc. to determine which method would minimize the firm’s weighted average cost of capital (WACC) while providing a capital structure that will maximize firm value and that is attractive to outside investors. The firm is considering either issuing additional debt or issuing a secondary equity offering to finance the venture. The firm’s target capital structure will be utilized to determine what the specific advantages and disadvantages associated with the different methods of raising capital.
Industrial currently has $450 million of shareholders’ equity outstanding. The company also has $100 million of 10-year notes issued with 4 years remaining to maturity. Industrial Inc.’s current rating is Aa by Moody’s and AA by Standard and Poor’s (S&P). Bentley is aware that any financing strategy must be considered in light of the potential impact the decision could have upon the company’s current rating.
Any new acquisition of capital will be carefully analyzed in relation to Industrial Inc.’s current capital structure as well. Bentley is familiar with the different theories of capital structure and intends to determine which one is most applicable to Industrial Inc.’s current situation. Industrial Inc. is publicly traded on the New York Stock Exchange, and several analysts at large brokerage firms provide research on the stock. Bentley wants to ensure that the company’s approach to raising additional capital will be acceptable to analysts and investors alike.
Top management of Industrial, Bentley included, collectively own a 20% equity stake in the firm, through either direct purchase of the stock or the receipt of executive stock options. This group is placing pressure on Bentley to recommend a strategy that would not significantly dilute their ownership position. Bentley realizes that he must recommend a strategy that will most effectively utilize the company’s assets and that will be in the best interest of all of the company’s stakeholders.Under a strict set of assumptions, Modigliani and Miller (MM) proposed a capital structure theory in 1958 in which Proposition I proves that:
A)
capital markets are perfectly competitive.
B)
the cost of debt is lower than the cost of equity, so a firm should issue the maximum amount of debt before issuing equity.
C)
the value of a firm is unaffected by its capital structure.



MM’s underlying assumptions are that capital markets are perfectly competitive (no transaction costs) and that investors have homogenous expectations with respect to cash flows. Under these two “perfect world” assumptions, the value of a firm is unaffected by its capital structure because the value of a firm’s assets will always be the same regardless of its debt to equity ratio. (Study Session 8, LOS 29.a)


Under MM’s Proposition II of their capital structure theory, will a firm that increases its use of debt most likely affect default risk, cost of equity, or both?
A)
Increases both.
B)
Does not affect either.
C)
Increases only one.



The increased use of debt has no impact on expected default rates under MM, because it is assumed to be risk-free. The cost of equity does increase because the firm's business risk is concentrated on a smaller proportion of equity as leverage increases. (Study Session 8, LOS 29.a)


Bentley anticipates that whatever method of financing choice is utilized, it will be interpreted by investors as a signal of the firm’s strategy and overall economic health. In accordance with the pecking order theory, which of the following methods are least likely and most likely to send “signals” to investors?
Least LikelyMost Likely
A)
External equityDebt
B)
External equityInternally generated equity
C)
Internally generated equityExternal equity



Internally generated equity is the method least visible to investors, while external equity is the most visible. (Study Session 8, LOS 29.a)

Which of the following statements regarding the role of debt ratings is least accurate?
A)
Any rating Ba (from Moody’s) or BB (from S&P) or higher is considered to be “investment grade”.
B)
Historically, the difference in yield between an AAA-rated bond and a BBB-rated bond has averaged 100 basis points.
C)
The lower the debt rating, the higher the level of default risk for both shareholders and bondholders alike.



Bonds must be rated at least Baa (Moody’s) or BBB (S&P) to be considered investment grade. (Study Session 8, LOS 29.c)

As a result of Industrial expanding its operations into Europe and Asia, Bentley anticipates an increase in foreign investors in the firm. Which of the following statements regarding international differences in leverage is least accurate?
A)
Companies in Japan and France tend to have more debt in their capital structure than firms in the U.S.
B)
Companies operating in countries that have active institutional investors tend to have less financial leverage than firms in countries with less of an institutional presence.
C)
Companies in the U.S. tend to use shorter maturity debt than companies in Japan.



Debt levels vary by country. For example, companies in the U.S. tend to use longer maturity debt than companies in Japan. More generally, companies in developed countries tend to use more debt with longer maturities than firms in emerging markets. (Study Session 8, LOS 29.e)

In any firm, managers who do not have a stake in the company do not bear the costs of taking on too much or too little risk. The costs associated with the conflicts of interest between managers and owners are referred to as:
A)
bonding costs.
B)
agency costs of equity.
C)
monitoring costs.



Monitoring costs and bonding costs are components of the net agency cost of equity. (Study Session 8, LOS 29.a)

TOP

According to pecking order theory, which financing choice is most preferred, and which is least preferred?
Most preferredLeast preferred
A)
Internally generated fundsNew equity
B)
New debtNew equity
C)
Internally generated fundsNew debt



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.

TOP

John Harrison is discussing the implications for Modigliani and Miller (MM’s) propositions (assuming no corporate or personal taxes) for manager’s decisions regarding capital structure with his supervisor, Harriet Perry. In the conversation, Harrison makes the following statements:
Statement 1: According to MM’s propositions, increasing the use of cheaper debt financing will increase the cost of equity and the net change to the company’s weighted average cost of capital (WACC) will be zero.
Statement 2: Since MM’s propositions assume that there are no taxes, equity is the preferred method of financing.
What is the most appropriate response to Harrison’s statements?
A)
Agree with both.
B)
Agree with neither.
C)
Agree with one only.



Perry should agree with the first statement. MM asserts that the use of debt financing, although it is cheaper than equity, will increase in the cost of equity, resulting in a zero net change in the WACC. Perry should disagree with the second statement. Although MM’s propositions assume that there are no taxes, the conclusion is that the mix of debt and equity financing is irrelevant and that there is no preferred method of financing.

TOP

Global Development expects to earn $6 million next year. 40% of this amount, or $2.4 million, has been allocated for distribution to common shareholders. There are 2.4 million shares outstanding, and the market price is $30 a share. If Global uses the $2.4 million to repurchase shares at the current price of $30 per share, its share price after the repurchase will be closest to:
A)
$29.00.
B)
$31.00.
C)
$30.00.



Market value of equity before the repurchase is $30 × 2.4 million = $72 million.
Shares Repurchased = $2.4 million / $30 = 80,000 shares.
Shares remaining = Shares outstanding − Shares repurchased = 2,400,000 − 80,000 = 2,320,000.
Share price after the repurchase = ($72 million − $2.4 million) / 2,320,000 = $30.

TOP

Which of the following best describes the shape of the line depicting the value of a levered firm when plotted according to the static trade-off theory? Assume that the percentage of debt in the capital structure is the independent variable.
A)
U shaped.
B)
Always upward sloping.
C)
Upside down U shaped.



The line depicting the value of a levered firm according to the static trade-off theory looks like an upside down U. The value of the firm will initially increase due to the tax savings provided by taking on additional debt financing, and then will decline as the costs of financial distress exceed the tax benefits of taking on additional debt financing.

TOP

According to the static trade-off theory:
A)
new debt financing is always preferable to new equity financing.
B)
there is an optimal proportion of debt that will maximize the value of the firm.
C)
the amount of debt used by a company should decrease as the company’s corporate tax rate increases.



The static trade-off theory seeks to balance the costs of financial distress with the tax shield benefits from using debt. Under the static trade-off theory, there is an optimal capital structure that has an optimal proportion of debt that will maximize the value of the firm.

TOP

Katherine Epler, a self-employed corporate finance consultant, is working with another new client, Thurber Electronics. Epler is discussing the static trade-off capital structure theory with her client, and makes the following comments:
Comment 1: Under the static trade-off theory, the graph of a company’s weighted average cost of capital has a U shape.
Comment 2: According to the static trade-off theory, every firm will have the same optimal amount of debt that maximizes the value of the firm.With respect to Epler’s comments:
A)
only one is correct.
B)
both are correct.
C)
both are incorrect.



Epler’s first comment is correct. When graphing a company’s WACC according to the static trade-off theory, the WACC will initially decline as a company increases its tax savings through the use of debt. However, as more debt is added, the WACC will reach a point where it increases due to the increasing costs of financial distress. Note that when graphing the static trade-off theory, the WACC looks like a U shape, while the value of the firm looks like an upside down U shape. This makes sense because the value of the firm is maximized when the WACC is minimized. Epler’s second comment is incorrect. Every firm will have a different optimal capital structure that will depend on the firm’s operating risk, tax situation, industry influences, and other factors.

TOP

Bhairavi Patel, an analyst for major brokerage firm, is considering how to incorporate the static trade-off capital structure theory into her valuation models for companies she covers. Patel is discussing the static trade-off theory with her colleagues, and makes the following statements:
Statement 1: If a firm maintains a high debt rating, the firm cannot be at its optimal capital structure based on the static trade-off theory.
Statement 2: The static theory implies that differences in the optimal capital structure across similar firms in different countries must be the result of different tax rates in those countries.
With respect to Patel’s statements:
A)
both are correct.
B)
only one is correct.
C)
both are incorrect.



Neither of Patel’s statements is correct. Firms seek to maintain a high debt rating because it implies a lower probability of financial distress, which reduces the cost of debt and equity capital and leads to a higher value for the firm. Although a firm would not be at its optimal capital structure if it were not using enough debt, a firm can certainly have a large proportion of high quality debt that keeps the firm at its optimal capital structure while maintaining a high credit rating. The second statement is also incorrect. Although differences in tax rates can play a role in having different optimal capital structures for similar firms, differences in costs of financial distress will play a role as well. Differences in legal structure, liquidity, and other factors will result in different perceived costs of financial distress in different countries, which will in turn, contribute to different optimal capital structures according to the static trade-off theory.

TOP

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