CFM Capital Structure & Debt Modeling 1 — Questions and Answers
Question 1: What does the Weighted Average Cost of Capital (WACC) represent?
- The average interest rate a company pays on its outstanding debt
- The blended cost of all capital sources, weighted by their proportion in the capital structure (Correct answer)
- The return required by equity shareholders only
- The risk-free rate adjusted for company-specific risk
Correct answer: The blended cost of all capital sources, weighted by their proportion in the capital structure
WACC blends the after-tax cost of debt and the cost of equity, each weighted by its proportion in the capital structure, reflecting the overall return required by all capital providers.
Question 2: According to the Modigliani-Miller theorem in a world with no taxes, which statement is true?
- A firm's value increases as it takes on more debt due to reduced equity risk
- An optimal capital structure exists at 100% equity financing
- A firm's total value is unaffected by its capital structure (Correct answer)
- Debt reduces the firm's cost of equity by lowering operating risk
Correct answer: A firm's total value is unaffected by its capital structure
MM Proposition I (no taxes) states that capital structure is irrelevant because investors can replicate any leverage on their own, leaving total firm value unchanged.
Question 3: In a leveraged buyout (LBO) model, which tranche of debt typically carries the highest interest rate?
- Senior secured Term Loan A
- Revolving credit facility
- Mezzanine debt (Correct answer)
- Investment-grade bonds
Correct answer: Mezzanine debt
Mezzanine debt is subordinated to all senior debt and carries greater default risk, so lenders demand a higher interest rate as compensation.
Question 4: A company has $600M in total debt and $300M in total equity. What is its debt-to-equity ratio?
- 0.5x
- 1.0x
- 2.0x (Correct answer)
- 3.0x
Correct answer: 2.0x
Debt-to-equity ratio = Total Debt / Total Equity = $600M / $300M = 2.0x.
Question 5: Which metric is most commonly used to assess a company's ability to cover interest payments from operating earnings?
- Return on equity (ROE)
- EBITDA-to-revenue ratio
- Interest coverage ratio (Correct answer)
- Price-to-earnings ratio
Correct answer: Interest coverage ratio
The interest coverage ratio (EBIT / Interest Expense) shows how many times operating earnings can cover interest obligations, indicating debt serviceability.
Question 6: What is the primary purpose of building a debt schedule in a financial model?
- To calculate the company's market capitalization over the forecast period
- To track outstanding debt balances, interest expense, and required repayments over time (Correct answer)
- To determine the optimal dividend payout ratio for shareholders
- To project future revenue growth rates by financing period
Correct answer: To track outstanding debt balances, interest expense, and required repayments over time
A debt schedule tracks each debt tranche's opening balance, calculates periodic interest expense, models mandatory and optional repayments, and shows ending balances for each period.
Question 7: Which of the following is NOT used when calculating the after-tax cost of debt?
- The coupon rate on outstanding bonds
- The marginal corporate tax rate
- The equity risk premium (Correct answer)
- The yield to maturity on newly issued debt
Correct answer: The equity risk premium
The equity risk premium is an input for calculating the cost of equity via CAPM; the after-tax cost of debt uses only the pre-tax yield and the tax rate.
CFM Capital Structure & Debt Modeling 1
What does the Weighted Average Cost of Capital (WACC) represent?