4.Frank Collins, CFA, is managing director for Brisbane Capital Resources, an Australian fund manager. The firm has had great success through the years with its growth-oriented investment strategy, but has suffered when the markets change in favor of value investment strategies. Consequently, Collins is exploring how the firm might increase its presence in the value sector of the market.

Many of the firms that reside in the value sector are those that have fallen on hard times, and have underperformed their peers. During his examination of firms meeting various value criteria, Collins has noted that while falling sales and the lack of profits are sometimes the obvious causes of the substandard performance, in other cases sales and profits do not appear to be the root cause. He wonders if the way that these firms have been capitalized is having a negative impact on their values.

Collins recalls from his days of studying finance at the University of Queensland, that a Nobel Prize was awarded for one of the theories in the capital structure area. His recollection of the details is sketchy, so he has contacted Dr. Martin Gray from UQ’s Department of Commerce to discuss capital structure in theory and in practice.

Gray tells Collins that his memory is indeed correct, that a Nobel Prize was awarded to Miller and Modigliani for their work in explaining the capital structure decision. Interestingly, he notes that their theories say that, under the right circumstances, capital structure is irrelevant. Obviously, the key is whether or not the right circumstances are relevant to what is observed in the real world.

Gray continues to tell Collins that there are a variety of matters that complicate the MM theory in practice. Firms pay taxes, managers may be motivated by their own self-interests, and adjustments to a firm’s capital structure are not costless. All of these factors affect the MM theories, and have given rise to other theories that attempt to explain why firms finance themselves as they do.

Collins also wonders if capital structure decisions are affected in any way by the country in which the firm is domiciled. He knows that Australia tends to follow the Anglo-American financial model, but that firms in continental Europe, Japan, and other countries are more accustomed to relying upon banks for capital. He wonders if this affects the capital structures observed across firms, even when the firms have the same underlying business risk.

Finally, Collins asks Gray about corporate debt ratings. Gray tells him that ratings fall broadly across two classes—investment grade and speculative—with a variety of ratings within each class. Moreover, Gray advises that firms usually seek to maintain a credit rating in the investment grade class, since some fiduciary investors are precluded from holding debt in the speculative class. Collins wonders if a firm’s debt ratings have any bearing upon the choice of capital structure.

Which of the following statements most accurately characterizes the static trade-off theory of capital structure?

A)   Regardless of how the firm is financed, the overall value of the firm and aggregate value of the claims issued to finance it remain the same.

B)   Firms have a preference ordering for capital sources, preferring internally-generated equity first, new debt capital second, and externally-sourced equity as a last resort.

C)   Increasing the use of relatively lower cost debt causes the required return on equity to increase such that the overall cost of capital is unchanged.

D)   Firms will seek to use debt financing up to the point that the value of the tax shield benefit is outweighed by the costs of financial distress.

5.Which of the following statements most correctly characterizes the pecking order theory of capital structure?

A)   Regardless of how the firm is financed, the overall value of the firm and aggregate value of the claims issued to finance it remain the same.

B)   Firms have a preference ordering for capital sources, preferring internally-generated equity first, new debt capital second, and externally-sourced equity as a last resort.

C)   Increasing the use of relatively lower cost debt causes the required return on equity to increase such that the overall cost of capital is unchanged.

D)   Firms will seek to use debt financing up to the point that the value of the tax shield benefit is outweighed by the costs of financial distress.

6.When taxes are incorporated into the capital structure decision, the main result is that:

A)   the costs of financial distress become relevant to the analysis.

B)   firms should increase the use of equity financing because of its inherent tax advantages.

C)   the firm derives a tax shield benefit from using debt because the interest expense is tax-deductible.

D)   agency costs are increased because taxes reduce the cash flows available to equity holders.

7.Which of the following reasons is least accurate regarding why a firm’s actual capital structure may deviate from its target capital structure?

A)   The book values of outstanding debt and equity are different from their market values.

B)   Management may believe that now is an opportune time to issue equity.

C)   There may be economies of scale in issuing debt securities.

D)   The market values of outstanding debt and equity fluctuate.

8.Which of the following statements most accurately characterizes how debt ratings may affect a firm’s capital structure policy?

A)   Because credit ratings are based upon cash flow coverage of interest expense, they are not influenced by the firm’s capital structure.

B)   Firms that have their credit ratings reduced below investment grade are not able to issue additional debt.

C)   A firm may be deterred from increasing the use of debt to avoid having its credit rating reduced below some minimum acceptable level.

D)   Firms generally prefer to issue new equity over new debt because this ensures that they maintain the highest possible debt rating.

9.Which of the following statements concerning the use of leverage is most accurate?

A)   The use of leverage in capital structures is broadly consistent in most developed economies.

B)   Firms in emerging markets tend to use longer maturities than firms in developed markets because the issuance costs are greater.

C)   A high degree of information asymmetry tends to reduce the use of debt in the capital structure.

D)   Companies in countries where the use of bank debt (as opposed to issuing bonds) is more prevalent tend to use more leverage.

4.Frank Collins, CFA, is managing director for Brisbane Capital Resources, an Australian fund manager. The firm has had great success through the years with its growth-oriented investment strategy, but has suffered when the markets change in favor of value investment strategies. Consequently, Collins is exploring how the firm might increase its presence in the value sector of the market.

Many of the firms that reside in the value sector are those that have fallen on hard times, and have underperformed their peers. During his examination of firms meeting various value criteria, Collins has noted that while falling sales and the lack of profits are sometimes the obvious causes of the substandard performance, in other cases sales and profits do not appear to be the root cause. He wonders if the way that these firms have been capitalized is having a negative impact on their values.

Collins recalls from his days of studying finance at the University of Queensland, that a Nobel Prize was awarded for one of the theories in the capital structure area. His recollection of the details is sketchy, so he has contacted Dr. Martin Gray from UQ’s Department of Commerce to discuss capital structure in theory and in practice.

Gray tells Collins that his memory is indeed correct, that a Nobel Prize was awarded to Miller and Modigliani for their work in explaining the capital structure decision. Interestingly, he notes that their theories say that, under the right circumstances, capital structure is irrelevant. Obviously, the key is whether or not the right circumstances are relevant to what is observed in the real world.

Gray continues to tell Collins that there are a variety of matters that complicate the MM theory in practice. Firms pay taxes, managers may be motivated by their own self-interests, and adjustments to a firm’s capital structure are not costless. All of these factors affect the MM theories, and have given rise to other theories that attempt to explain why firms finance themselves as they do.

Collins also wonders if capital structure decisions are affected in any way by the country in which the firm is domiciled. He knows that Australia tends to follow the Anglo-American financial model, but that firms in continental Europe, Japan, and other countries are more accustomed to relying upon banks for capital. He wonders if this affects the capital structures observed across firms, even when the firms have the same underlying business risk.

Finally, Collins asks Gray about corporate debt ratings. Gray tells him that ratings fall broadly across two classes—investment grade and speculative—with a variety of ratings within each class. Moreover, Gray advises that firms usually seek to maintain a credit rating in the investment grade class, since some fiduciary investors are precluded from holding debt in the speculative class. Collins wonders if a firm’s debt ratings have any bearing upon the choice of capital structure.

Which of the following statements most accurately characterizes the static trade-off theory of capital structure?

A)   Regardless of how the firm is financed, the overall value of the firm and aggregate value of the claims issued to finance it remain the same.

B)   Firms have a preference ordering for capital sources, preferring internally-generated equity first, new debt capital second, and externally-sourced equity as a last resort.

C)   Increasing the use of relatively lower cost debt causes the required return on equity to increase such that the overall cost of capital is unchanged.

D)   Firms will seek to use debt financing up to the point that the value of the tax shield benefit is outweighed by the costs of financial distress.

The correct answer was D)

The static trade-off theory of capital structure states that firms will seek to use debt financing up to the point that the value of the tax shield benefit is outweighed by the costs of financial distress. In other words, the capital structure is determined by the trade-off between these two factors.

5.Which of the following statements most correctly characterizes the pecking order theory of capital structure?

A)   Regardless of how the firm is financed, the overall value of the firm and aggregate value of the claims issued to finance it remain the same.

B)   Firms have a preference ordering for capital sources, preferring internally-generated equity first, new debt capital second, and externally-sourced equity as a last resort.

C)   Increasing the use of relatively lower cost debt causes the required return on equity to increase such that the overall cost of capital is unchanged.

D)   Firms will seek to use debt financing up to the point that the value of the tax shield benefit is outweighed by the costs of financial distress.

The correct answer was B)

The pecking order theory of capital structure assumes that firms have a preference ordering for capital sources. They prefer to use internally-generated equity first. When the internally-generated equity is exhausted, they issue new debt capital. As a last resort they will rely on externally-sourced equity. The reason that new equity is the last resort is that the issuance of new stock is assumed to send a negative signal to investors regarding firm value.

6.When taxes are incorporated into the capital structure decision, the main result is that:

A)   the costs of financial distress become relevant to the analysis.

B)   firms should increase the use of equity financing because of its inherent tax advantages.

C)   the firm derives a tax shield benefit from using debt because the interest expense is tax-deductible.

D)   agency costs are increased because taxes reduce the cash flows available to equity holders.

The correct answer was C)

The main impact of incorporating corporate income taxes is that the firm derives a tax shield benefit because interest is a tax-deductible expense.

7.Which of the following reasons is least accurate regarding why a firm’s actual capital structure may deviate from its target capital structure?

A)   The book values of outstanding debt and equity are different from their market values.

B)   Management may believe that now is an opportune time to issue equity.

C)   There may be economies of scale in issuing debt securities.

D)   The market values of outstanding debt and equity fluctuate.

The correct answer was A)

The book values of equity and debt are generally not relevant to assessing a firm’s capital structure. It is the market values of equity and debt that determine the current capital structure.

8.Which of the following statements most accurately characterizes how debt ratings may affect a firm’s capital structure policy?

A)   Because credit ratings are based upon cash flow coverage of interest expense, they are not influenced by the firm’s capital structure.

B)   Firms that have their credit ratings reduced below investment grade are not able to issue additional debt.

C)   A firm may be deterred from increasing the use of debt to avoid having its credit rating reduced below some minimum acceptable level.

D)   Firms generally prefer to issue new equity over new debt because this ensures that they maintain the highest possible debt rating.

The correct answer was C)

Credit ratings can be factored into management’s capital structure policy if a firm has a minimum rating objective, and this is likely to be adversely affected by issuing additional debt.

9.Which of the following statements concerning the use of leverage is most accurate?

A)   The use of leverage in capital structures is broadly consistent in most developed economies.

B)   Firms in emerging markets tend to use longer maturities than firms in developed markets because the issuance costs are greater.

C)   A high degree of information asymmetry tends to reduce the use of debt in the capital structure.

D)   Companies in countries where the use of bank debt (as opposed to issuing bonds) is more prevalent tend to use more leverage.

The correct answer was D)

Companies in countries where the use of bank borrowing is relatively more prevalent than the issuance of corporate bonds tend to use more leverage. The other statements are incorrect, based upon observations across countries.