Certified Treasury Professional Capital Structure and Funding Questions and Answers — Questions and Answers
Question 1: According to the pecking order theory of capital structure, which of the following funding sources would a company's management prefer to use first when financing a new investment?
- Using retained earnings (Correct answer)
- Issuing new long-term debt
- Issuing new common stock
- Issuing preferred stock
Correct answer: Using retained earnings
The pecking order theory suggests that firms prioritize their sources of financing, preferring internal financing (retained earnings) first. If external financing is required, they will then issue debt before finally resorting to issuing new equity, which is considered the most costly option due to asymmetric information and potential negative signals to the market.
Question 2: In a world with corporate taxes but no personal taxes or bankruptcy costs, what is the key implication of the Modigliani-Miller (M&M) Proposition I with taxes?
- A firm's weighted average cost of capital (WACC) is constant regardless of leverage.
- The value of a levered firm exceeds the value of an unlevered firm by the present value of the interest tax shield. (Correct answer)
- The value of a firm is unaffected by its capital structure.
- A firm's value is maximized at 100% equity financing.
Correct answer: The value of a levered firm exceeds the value of an unlevered firm by the present value of the interest tax shield.
M&M Proposition I with taxes states that because interest payments on debt are tax-deductible, leverage creates a 'tax shield' that adds value to the firm. The total value of the levered firm is equal to the value of an identical unlevered firm plus the present value of this tax shield.
Question 3: A manufacturing company is undergoing a review by a major credit rating agency. Which of the following events would most likely lead to a downgrade of the company's credit rating?
- A sustained increase in free cash flow.
- The strategic acquisition of a competitor financed entirely with new equity.
- A significant increase in its debt-to-EBITDA ratio beyond industry norms. (Correct answer)
- A successful refinancing of existing debt at a lower interest rate.
Correct answer: A significant increase in its debt-to-EBITDA ratio beyond industry norms.
Credit rating agencies focus on a company's ability to meet its debt obligations. A higher debt-to-EBITDA ratio is a key leverage metric that indicates the company has more debt relative to its earnings, which increases its default risk and makes a downgrade more likely.
Question 4: Which of the following statements best describes the primary effect of increasing a company's financial leverage?
- It decreases the company's business risk.
- It reduces the cost of equity due to tax shield benefits.
- It decreases the volatility of net income.
- It magnifies the impact of changes in EBIT on earnings per share (EPS). (Correct answer)
Correct answer: It magnifies the impact of changes in EBIT on earnings per share (EPS).
Financial leverage is the use of fixed-cost financing, like debt. These fixed interest payments must be made regardless of the level of Earnings Before Interest and Taxes (EBIT). This causes any change in EBIT to have a magnified, or amplified, effect on the net income available to shareholders and, consequently, on earnings per share (EPS).
Question 5: A company's CFO is evaluating a new project that has a similar risk profile to the company's existing operations. The company intends to maintain its target capital structure to fund the project. What is the most appropriate discount rate to use when calculating the Net Present Value (NPV) of this project?
- The company's after-tax cost of debt
- The company's cost of equity
- The company's Weighted Average Cost of Capital (WACC) (Correct answer)
- The current risk-free rate of return
Correct answer: The company's Weighted Average Cost of Capital (WACC)
The Weighted Average Cost of Capital (WACC) represents the blended, or average, cost of all the capital sources (debt, equity) a company uses, weighted by their respective proportions. For a project with an average risk profile that does not alter the firm's overall capital structure, the WACC is the correct hurdle rate or discount rate to use for evaluation.
Question 6: A mature company with stable cash flows and limited growth opportunities is reviewing its dividend policy. Management and the board believe that investors value the certainty of receiving cash returns now over the possibility of future capital gains. This belief is most consistent with which dividend theory?
- Dividend Irrelevance Theory
- Residual Theory of Dividends
- Signaling Theory
- Bird-in-the-Hand Theory (Correct answer)
Correct answer: Bird-in-the-Hand Theory
The 'bird-in-the-hand' theory argues that investors prefer the certainty of a current dividend (a 'bird in the hand') over the uncertainty of potential future capital gains ('two in the bush'). According to this theory, investors perceive a high dividend payout as less risky, and therefore, a company's stock price could be increased by a higher dividend payout ratio.
Certified Treasury Professional Capital Structure and Funding Questions and Answers
According to the pecking order theory of capital structure, which of the following funding sources would a company's management prefer to use first when financing a new investment?