pacmandefense

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.

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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.

pacmandefense

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.

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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)

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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.

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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)

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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.

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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)

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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.

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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)

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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.

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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)

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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.

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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)

pacmandefense

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.

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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.

pacmandefense

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.

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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

pacmandefense

Which of the following statements about a firm's capital structure is least accurate?

A) The optimal capital structure is the one that minimizes the weighted average cost of capital and consequently maximizes the value of the firm's share price.

B) The firm's share price is maximized when the firm maximizes its earnings per share while it minimizes its cost of capital.

C) If bankruptcy costs were included into the M&M analysis of capital structure in a tax world there would be an optimal capital structure between no debt and all debt.

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The optimal capital structure is the one that maximizes stock price and minimizes the WACC. The optimal capital structure is not the one that maximizes the firm’s EPS.

pacmandefense

Which of the following statements about capital structure theories is most accurate?

A) Based on signaling theory, if a firm issues new common stock it means that the firm thinks future investment prospects are better than normal.

B) In a Modigliani and Miller (MM) world with taxes, but no bankruptcy cost, you would expect to see firms taking on very little debt.

C) In a world with taxes and bankruptcy costs one would expect there to be an optimal capital structure where the cost of capital is minimized and share price is maximized.

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It is true that in a world with taxes and bankruptcy costs there will be an optimal capital structure where the cost of capital is minimized and share price is maximized. The other statements are false. In a tax world without bankruptcy the optimal capital structure is 100% debt. When firms issue new equity, it may suggest investment prospects look poor

pacmandefense

Katherine Epler, a self-employed corporate finance consultant, is working with her newest client, Harbor Machinery. Epler is discussing various capital structure theories with her client, and makes the following comments.
Comment 1: If we remove the assumption of no taxes from Modigliani and Miller’s theory regarding capital structure, and if the firm holds some proportion of debt, increases in the corporate tax rate will increase the value of the firm.
Comment 2: If we also include the costs of financial distress in Modigliani and Miller’s assumptions, the optimal capital structure will not contain any debt financing.With respect to Epler’s comments:

A) both are correct.

B) both are incorrect.

C) only one is correct.

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Epler’s first comment is correct. The tax deductibility of interest payments provides a tax shield that adds value to the firm. The value of a tax shield is equal to the marginal tax rate times the amount of debt in the capital structure, so the higher the tax rate, the greater the value of the tax shield and the value of the firm, all else equal. Epler’s second comment is incorrect. If the costs of financial distress are also included in MM’s assumptions, we get the static-tradeoff theory, where the firm will have debt in its capital structure up to the point where the marginal cost of financial distress exceeds the marginal value provided by the tax shield.

pacmandefense

Davis Streng, the corporate controller for the Cannizaro Corporation has been researching Modigliani and Miller’s (MM) theories on capital structure. Streng would like to apply the theories to his firm’s capital structure, but does not agree with MM’s assumption of no taxes, since Cannizaro has a 40% tax rate. If Streng removes the assumption of no taxes, but keeps all of MM’s other assumptions, which of the following would be the optimal capital structure for maximizing the value of the firm?

A) The capital structure Streng chooses is irrelevant.

B) 100% equity.

C) 100% debt.

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If MM’s other assumptions are maintained, removing the no tax assumption means that the value of the firm is maximized when the value of the tax shield is maximized, which occurs with a capital structure of 100% debt.

pacmandefense

Joseph Palmer is discussing the impact of the tax shield provided by debt with his supervisor, Ming Chou. During the course of their discussion, Palmer makes the following statements:

Statement 1:	The value of the tax shield provided by debt can be calculated by multiplying the pre-tax cost of debt by (1 – tax rate).
Statement 2:	If a company is profitable, the value of its tax shield will be positive and its value will increase as its leverage increases, all else equal.

With respect to Palmer’s statements:

A) both are correct.

B) both are incorrect.

C) only one is correct.

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Palmer’s first statement is incorrect. The calculation Palmer describes is the calculation for the after-tax cost of debt. The value of a tax shield is equal to the marginal tax rate times the amount of debt in the capital structure. Palmer’s second statement is correct. The tax shield adds value to the firm so that the value of a levered firm is greater than the value of an unlevered firm, all else equal.

pacmandefense

Modigliani and Miller demonstrated that if corporate taxes and bankruptcy costs are introduced into an otherwise perfect world the weighted average cost of capital (WACC) will:

A) fall continuously as more debt is added to the capital structure.

B) fall, then bottom out, and finally start to rise.

C) rise, then plateau, and finally start to fall.

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The WACC first falls because bondholders take less risk and, consequently, have a lower required rate of return. In addition, interest expenses are tax deductible. However, as the amount of debt rises, financial risk rises, and the chance for bankruptcy increases. If there are positive bankruptcy costs, both bondholders and stockholders will require increasingly higher rates of return as financial risk increases causing the WACC to rise. This rise offsets the benefits of using the cheaper source of financing.