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

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

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

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

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.

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

pacmandefense

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).

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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.

pacmandefense

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.

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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.

pacmandefense

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.

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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.

pacmandefense

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.

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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.

pacmandefense

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.

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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.