CTP Capital Structure and Funding 4 — Questions and Answers
Question 1: Under Modigliani-Miller with taxes, the value of a levered firm equals the unlevered firm value plus:
- The present value of financial distress costs
- The tax shield on debt (tax rate × debt) (Correct answer)
- The equity risk premium multiplied by beta
- Free cash flow divided by WACC
Correct answer: The tax shield on debt (tax rate × debt)
MM with taxes shows that debt creates value through the interest tax shield, calculated as the corporate tax rate multiplied by the amount of debt outstanding.
Question 2: Which credit metric is most commonly used by rating agencies to assess leverage for industrial companies?
- Current ratio
- Net debt / EBITDA (Correct answer)
- Return on equity
- Asset turnover ratio
Correct answer: Net debt / EBITDA
Net debt-to-EBITDA is the primary leverage metric because it measures how many years of operating earnings are needed to repay net debt, adjusted for non-cash charges.
Question 3: A company wants to fund a long-term capital project but avoid balance sheet debt. Which off-balance sheet structure historically served this purpose?
- Revolving credit facility
- Commercial paper program
- Operating lease under old GAAP (pre-ASC 842) (Correct answer)
- Accounts receivable securitization
Correct answer: Operating lease under old GAAP (pre-ASC 842)
Before ASC 842, operating leases were kept off-balance sheet, allowing companies to use assets without recording associated debt, though rating agencies typically adjusted for this.
Question 4: What is the primary difference between investment-grade and high-yield (junk) bond markets in terms of investor base?
- High-yield bonds are only available to individual retail investors
- Investment-grade bonds attract more price-sensitive institutional buyers like pension funds and insurance companies (Correct answer)
- High-yield bonds have longer average maturities than investment-grade bonds
- Investment-grade issuers pay higher spreads than high-yield issuers
Correct answer: Investment-grade bonds attract more price-sensitive institutional buyers like pension funds and insurance companies
Investment-grade bonds are dominated by regulated institutions (pension funds, insurance companies) with mandated quality requirements, creating a deep, liquid market with tighter spreads.
Question 5: A company's optimal capital structure is BEST described as the point where:
- Debt equals equity on the balance sheet
- The marginal tax benefit of debt equals the marginal cost of financial distress (Correct answer)
- Total assets are maximized relative to liabilities
- The debt-to-equity ratio matches the industry average
Correct answer: The marginal tax benefit of debt equals the marginal cost of financial distress
Trade-off theory identifies the optimal capital structure where the tax shield benefit from the last dollar of debt exactly offsets the incremental financial distress costs it creates.
Question 6: Which of the following describes a 'rights offering' in equity capital markets?
- An IPO with priority given to institutional investors
- An offer allowing existing shareholders to buy new shares at a discount before they are offered to the public (Correct answer)
- A secondary market repurchase of shares from employees
- A mandatory dividend distribution to common shareholders
Correct answer: An offer allowing existing shareholders to buy new shares at a discount before they are offered to the public
A rights offering gives existing shareholders pre-emptive rights to purchase new shares at a discount, allowing them to maintain their proportional ownership and prevent dilution.
Question 7: What is 'negative leverage' in the context of real estate or corporate finance?
- When a company has more liabilities than assets
- When the cost of debt exceeds the return on assets, making borrowing value-destructive (Correct answer)
- When interest rates on floating-rate debt decline
- When equity returns are lower than the risk-free rate
Correct answer: When the cost of debt exceeds the return on assets, making borrowing value-destructive
Negative leverage occurs when the after-tax cost of debt exceeds the return generated by the assets financed, meaning borrowing reduces rather than amplifies equity returns.
CTP Capital Structure and Funding 4
Under Modigliani-Miller with taxes, the value of a levered firm equals the unlevered firm value plus: