CTP Capital Structure and Funding 3 — Questions and Answers
Question 1: Which bond covenant directly restricts a company from taking on additional debt beyond a specified level?
- Pari passu clause
- Negative pledge clause
- Debt incurrence covenant (Correct answer)
- Cross-default clause
Correct answer: Debt incurrence covenant
A debt incurrence covenant restricts the issuer from incurring additional indebtedness unless certain financial tests (e.g., fixed charge coverage ratio) are satisfied.
Question 2: What is 'mezzanine financing' in the context of capital structure?
- Short-term bridge loans for acquisitions
- Hybrid debt-equity instruments subordinated to senior debt but senior to equity (Correct answer)
- Government-guaranteed middle-market loans
- Revolving credit facilities for working capital
Correct answer: Hybrid debt-equity instruments subordinated to senior debt but senior to equity
Mezzanine financing occupies the middle of the capital structure, typically structured as subordinated debt with equity kickers like warrants, offering higher returns than senior debt.
Question 3: A company's book value of equity is $200M and market capitalization is $600M. Which value should a treasurer use when calculating WACC?
- Book value, because it reflects historical costs
- Market value, because it reflects current required returns (Correct answer)
- Average of book and market values
- Neither; use replacement cost instead
Correct answer: Market value, because it reflects current required returns
WACC should use market values for both debt and equity because they reflect current investor expectations and the opportunity cost of capital, not historical accounting figures.
Question 4: What is the 'debt capacity' concept in corporate treasury?
- The maximum credit line a bank will extend
- The amount of debt a firm can carry while maintaining its credit rating and financial flexibility (Correct answer)
- Total liabilities divided by total assets
- The face value of all outstanding bonds
Correct answer: The amount of debt a firm can carry while maintaining its credit rating and financial flexibility
Debt capacity is the optimal or maximum debt level a company can support given its cash flow stability, asset base, and need to maintain investment-grade status or financial flexibility.
Question 5: Which of the following is an advantage of issuing preferred stock over common equity?
- Preferred dividends are tax-deductible for the issuer
- Preferred stock does not dilute common shareholders' voting rights (Correct answer)
- Preferred shareholders have priority over bondholders in bankruptcy
- Preferred stock reduces the company's total equity
Correct answer: Preferred stock does not dilute common shareholders' voting rights
Preferred stock carries dividend and liquidation preference over common stock but typically carries no voting rights, preserving existing shareholders' control.
Question 6: A 'bullet maturity' bond structure means:
- Interest payments increase each year until maturity
- The entire principal is repaid in one lump sum at maturity (Correct answer)
- The bond can be called at any time by the issuer
- Coupon payments are made quarterly rather than semi-annually
Correct answer: The entire principal is repaid in one lump sum at maturity
A bullet maturity bond pays only interest during its life and repays the full principal as a single payment at the maturity date, creating refinancing risk at maturity.
Question 7: What does a 'make-whole call' provision protect in a bond?
- Bondholders, by requiring the issuer to pay a premium based on the present value of remaining cash flows if called early (Correct answer)
- Issuers, by allowing redemption at par regardless of market rates
- Bondholders from credit rating downgrades
- Issuers from interest rate increases after issuance
Correct answer: Bondholders, by requiring the issuer to pay a premium based on the present value of remaining cash flows if called early
A make-whole call requires issuers to pay bondholders the present value of remaining cash flows discounted at a low spread to Treasuries, making early calls very expensive.
CTP Capital Structure and Funding 3
Which bond covenant directly restricts a company from taking on additional debt beyond a specified level?