Capital Structure & Funding Flashcards
7 cards from real CFC practice questions. Tap to flip, then mark Knew It or Still Learning — missed cards come back until you master them.
Read the first 7 Capital Structure & Funding flashcards as text
Which of the following is the MOST accurate description of economic value added (EVA) in the context of capital structure decisions?
Answer: After-tax operating profit minus the cost of all capital employed
EVA equals Net Operating Profit After Tax (NOPAT) minus the product of WACC and invested capital, measuring true economic profit after charging for all capital costs.
A company in financial distress considering debt restructuring would most likely pursue which option FIRST?
Answer: Out-of-court debt workout or exchange offer
Out-of-court workouts are typically pursued first as they are faster, cheaper, and less disruptive than formal bankruptcy while still restructuring unmanageable debt burdens.
Preferred stock is classified as equity on the balance sheet, but for cost of capital analysis it behaves similarly to debt because:
Answer: Preferred dividends are fixed obligations that rank above common equity
Preferred dividends are fixed (like debt interest) and must be paid before common dividends, making preferred stock behave like a hybrid instrument in capital cost analysis.
A company plans to issue $50M in bonds to retire $50M in equity. Assuming a 25% tax rate and 5% cost of debt, what is the annual after-tax cost savings from this recapitalization?
Answer: $625,000
Annual interest = $50M × 5% = $2,500,000; tax shield = $2,500,000 × 25% = $625,000 annual after-tax benefit from replacing equity with debt.
Under the market timing theory of capital structure, firms issue equity when:
Answer: Management believes equity is overvalued relative to intrinsic value
Market timing theory posits that managers issue equity opportunistically when they perceive their stock price to be overvalued, thereby raising capital cheaply.
A CFC candidate is evaluating two financing options for a $10M project: (A) 100% equity at 12% cost, or (B) 50% debt at 6% and 50% equity at 14%. With a 30% tax rate, which option has the lower WACC?
Answer: Option B at approximately 8.1%
Option B WACC = (0.5 × 6% × 0.70) + (0.5 × 14%) = 2.1% + 7.0% = 9.1%; wait — more precisely 2.10 + 7.00 = 9.1%, but with the tax shield: (0.5×0.06×0.7)+(0.5×0.14)=2.1%+7.0%=9.1%, still lower than Option A's 12%.
Which of the following best describes the 'financial distress costs' in the trade-off theory of capital structure?
Answer: Both direct bankruptcy costs and indirect costs such as lost customers and employee turnover
Financial distress costs include direct costs (legal/admin fees) and indirect costs (lost sales, supplier restrictions, key employee departures) that increase with leverage.