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Which of the following firms is most likely to utilize additional debt the next time it raises capital? The firm:
A)
that has many new fixed assets.
B)
firm that has experienced significant losses in recent years.
C)
in a high tax bracket.



The value of tax deductibility rises with tax rates. Of course, there are other ways to reduce taxes. Firms with many new assets are probably also benefiting from high levels of depreciation. Firms with recent losses may be avoiding taxes by writing off those losses

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Which of the following is likely to encourage a firm to increase the amount of debt in its capital structure?
A)
The personal tax rate increases.
B)
The corporate tax rate increases.
C)
The firm's earnings become more volatile.



An increase in the corporate tax rate will increase the tax benefit to the corporation, because interest expense is not taxable. An increase in the personal tax rate will not impact the firm’s cost of capital. More volatile earnings increase the risk of the firm and therefore the firm would not desire to increase financial risk as a result of these changes.

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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)
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.
B)
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.
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.



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. (Study Session 8, LOS 29.a)

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 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.
C)
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.



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. (Study Session 8, LOS 29.a)

When taxes are incorporated into the capital structure decision, the main result is that:
A)
the firm derives a tax shield benefit from using debt because the interest expense is tax-deductible.
B)
firms should increase the use of equity financing because of its inherent tax advantages.
C)
the costs of financial distress become relevant to the analysis.



The main impact of incorporating corporate income taxes is that the firm derives a tax shield benefit because interest is a tax-deductible expense. (Study Session 8, LOS 29.a)

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.



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. (Study Session 8, LOS 29.b)

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.



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. (Study Session 8, LOS 29.c)

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)
Companies in countries where the use of bank debt (as opposed to issuing bonds) is more prevalent tend to use more leverage.
C)
A high degree of information asymmetry tends to reduce the use of debt in the capital structure.



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. (Study Session 8, LOS 29.e)

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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)
Negative signal under both theories.
B)
Positive signal under both theories.
C)
Positive signal under only one theory.



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.

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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 finance a low risk project with 100% debt to improve the project’s profitability.
C)
The firm decides to issue additional debt due to a temporary discount in underwriting fees for corporate debt.



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.

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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.
With respect to Epler's statements:
A)
both are correct.
B)
only one is correct.
C)
both are incorrect.



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.

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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?
A)
Agree with both.
B)
Disagree with both.
C)
Agree with only one.



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.

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Jayco, Inc. currently has a Debt/Assets ratio of 33.33% but feels its optimal Debt/Assets 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:
A)
all equity.
B)
25% debt, 75% equity.
C)
all debt.



Sales / Assets = 7.5 = 750,000 / Assets, so Assets = 100,000. Debt / 100,000 = 33.33%. Therefore, Debt must be 33,333. You want to change Debt/Assets to 16.67%, so you must double Assets (without increasing Debt) by adding 100,000 to equity.

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The firm's target capital structure is consistent with which of the following?
A)
Minimum risk.
B)
Maximum earnings per share (EPS).
C)
Minimum weighted average cost of capital (WACC).



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.

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firm’s capital structure affects:
A)
return on equity but not default risk.
B)
default risk but not return on equity.
C)
return on equity and default risk.



A firm’s capital structure affects both its return on equity and its risk of default.

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