Question 1

If a firm has an exceptionally good year and grows as a result, then

Accepted Answer

If a firm has an exceptionally good year and grows as a result, it is likely to generate additional profits, which can be reinvested back into the business. This can lead to an increase in the value of the equity portion of the firm, as more earnings will be retained in the business to support growth. It is less likely that the debt-equity or debt ratios will increase, as these ratios depend on the proportion of debt financing used by the firm, rather than its profitability or growth. If a firm has an exceptionally good year and grows as a result, it will generate more profits and have the opportunity to reinvest those profits back into the business, leading to an increase in retained earnings and equity. The debt ratio and debt-equity ratio may remain the same or decrease if the firm chooses not to take on additional debt to finance its growth.

Question 2

Empirical evidence suggests that

Accepted Answer

Managers often try to time the market to repurchase shares when they believe the stock is undervalued, which aligns with empirical evidence.

Question 3

Which of the following statements is true?

Accepted Answer

Management tends to favor issuing debt over equity because debt allows for tax deductions on interest payments, has lower cost of capital than equity, and does not dilute current shareholder ownership. Additionally, issuing senior debt securities does not necessarily mean that a firm's value will decrease since it is dependent on the overall financial health and potential of the company. Junior securities may have a lower cost of capital, but they are riskier and can lead to a higher cost of capital in the future if the company's financial health declines. Management tends to favor issuing debt over equity because debt typically has a lower cost of capital than equity, which can increase the firm's value. However, if the debt ratio increases too much, it can negatively impact the firm's value. Therefore, management must carefully consider the optimal balance between debt and equity financing to maximize the firm's value. Option A is incorrect because issuing senior debt securities will increase the debt ratio but may also have a lower cost of capital, which could increase the firm's value if the benefits of lower cost of capital outweigh the costs of higher leverage. Option B is incorrect because management may prefer to issue equity if they believe the stock is overvalued or if they want to maintain control over the firm. Option D is incorrect because junior securities have a higher cost of capital, not a lower cost of capital.

Question 4

Your firm has an excessive amount of cash and no good project opportunities on the
horizon. One of your colleagues suggests it be invested in Treasury bills in order to
earn at least a little more return for your shareholders. How would you respond to
this suggestion?

Accepted Answer

The answer of Your firm has an excessive amount of...

Question 5

Which of the following actions would necessarily result in a higher firm value, all else equal?

Accepted Answer

The answer of Which of the following actions would necessarily...

Question 6

A firm has $5 million in debt , $1 million of which is convertible to shares of common stock, and $10 million in equity. If all the firm's convertible bondholders convert, what will happen
To the debt-equity ratio of the firm?

Accepted Answer

Initially, the debt-equity ratio is $5 million / $10 million = 0.5 or 50%. If $1 million of debt is converted into equity, the new debt is $4 million, and the new equity is $11 million. The new debt-equity ratio is $4 million / $11 million ≈ 0.364 or 36.4%.

Question 7

Arrange the following in the correct pecking order, from highest to lowest: I. Short-term debt
II. New equity financing
III. Long-term debt
IV. Retained earnings

Accepted Answer

The correct pecking order, from highest to lowest priority in financing preferences, is: Retained earnings (IV), short-term debt (I), long-term debt (III), and new equity financing (II). This reflects the pecking order theory, which suggests companies prefer to finance first with internal funds (retained earnings), then with debt, and finally with issuing new equity, due to the costs and implications associated with each financing option.

Question 8

A firm is currently financed with $2 million in debt and $6 million in equity. What will happen to its debt-equity ratio if it simultaneously issues another $2 million in debt and $2 million in
Equity?

Accepted Answer

The answer of A firm is currently financed with $2...

Question 9

Which of the following is the most senior claim in the pecking order?

Accepted Answer

Retained earnings represent profits that have been earned and kept within the company, meaning that they are not owed to any external creditors. Therefore, retained earnings are the most senior claim in the pecking order. Retained earnings represent profits that have been retained in the company rather than being paid out as dividends to shareholders. Therefore, they are considered the most senior claim as they have already been earned by the company and are not owed to any external creditors.

Question 10

Which of the following statements about the financing pyramid is true?

Accepted Answer

The answer of Which of the following statements about the...

Question 11

A firm that is worth $2 million and is financed with 40% risk-free debt and 60% equity grows in value to $3 million. What is its new debt-equity ratio?

Accepted Answer

Initial debt = $2 million x 40% = $0.8 million
Initial equity = $2 million x 60% = $1.2 million
New equity = $3 million x 60% = $1.8 million
New debt = $3 million - $1.8 million = $1.2 million
New debt-equity ratio = $1.2 million / $1.8 million = 0.67
The ratio expressed as a percentage is 67%. However, the question asks for the new debt-equity ratio as a percentage of debt. Therefore, the answer is:
New debt proportion = $1.2 million / $3 million = 0.4 or 40%
New equity proportion = $1.8 million / $3 million = 0.6 or 60%
New debt-equity ratio = 40% / 60% = 0.6667 or 0.67
The ratio expressed as a percentage is 66.67% or rounded to 36.4%. Therefore, the answer is choice C.

Question 12

A firm in a declining industry has not been able to identify any positive NPV projects in which to invest. In such a case, firm's management should

Accepted Answer

If the firm has not been able to identify any positive NPV projects in which to invest, then it is best for the firm to return excess cash to its shareholders by increasing dividends and/or share repurchases. This will help maximize shareholder wealth without investing in negative NPV projects. Additionally, it will improve the financial health of the firm by reducing excess cash balances and making the firm less vulnerable to economic downturns. If a firm cannot identify any positive NPV projects in a declining industry, it is best to return the excess cash to shareholders through dividends and/or share repurchases. This will increase the shareholders' wealth and reduce the risk of holding cash in the declining industry. Looking for a firm to buy in an entirely different industry (choice A) may not be feasible or may not result in positive returns. Increasing the use of debt to decrease the cost of capital (choice B) may result in financial distress if the firm is unable to generate sufficient returns to cover the increased debt payments. Investing in U.S. Treasury securities (choice C) may provide a small return, but it does not address the issue of declining industry and does not generate higher returns for shareholders.

Question 13

Which of the following theories provides a reason that issuing debt may be favored over issuing equity?

Accepted Answer

All three theories provide reasons why a company may favor debt over equity.

- Inside information: if management believes that their company is undervalued by the public market, they may prefer to issue debt rather than equity in order to avoid diluting their ownership stake. 
- Agency considerations: debt can provide a greater degree of control over a company's capital structure, as debt holders typically do not have voting rights and therefore cannot influence management decisions. Equity holders, on the other hand, can vote on important matters, potentially leading to conflicts of interest between management and shareholders. 
- Issuing costs: issuing equity can be more expensive than issuing debt, as the underwriting fees and expenses related to an equity issuance can be substantial. All of the above theories provide a reason that issuing debt may be favored over issuing equity.

- Inside information: If managers have inside information that indicates the company is undervalued, they may prefer to issue debt rather than equity to avoid diluting the value of existing shares.
- Agency considerations: Issuing debt creates a contractual obligation to repay the lender, which can reduce agency costs by aligning the interests of managers and creditors. On the other hand, issuing equity can create agency problems if managers prioritize their own interests over the interests of shareholders.
- Issuing costs: Issuing debt typically involves lower transaction costs than issuing equity, since debt does not require extensive disclosures or shareholder approval. This can make debt a more attractive option for smaller companies or those with limited resources.

Question 14

Which of the following would be the most senior security?

Accepted Answer

The answer of Which of the following would be the...

Question 15

Assume a perfect M&M world. A firm is currently valued at $500 million, $200 million of which is debt (including non-financial debt). It pays out $10 million in dividends and $20
Million to service its existing debt. It also raises another $60 million in debt and uses some of it
To repurchase $50 million of its common shares. What is the new value of the firm, and what is
Its new debt-equity ratio?

Accepted Answer

In a perfect M&M world, the firm's value is unaffected by its capital structure. The firm raises $60 million in debt and uses $50 million to repurchase shares, so the net increase in firm value is $10 million. The new value is $500 million + $10 million = $510 million. However, the debt increases by $60 million, making total debt $260 million. The equity is $250 million (original $300 million - $50 million repurchase). The debt-equity ratio is $260 million / $250 million = 104%, closest to 100% in the options.

Question 16

Which of the following actions would necessarily result in a lower firm value, all else equal?

Accepted Answer

The answer of Which of the following actions would necessarily...

Question 17

Which of the following statements about leveraged buyout firms (LBOs)is true?

Accepted Answer

None of the statements are true.

Explanation for each option:
A) This statement is false as LBOs typically focus on acquiring one company at a time rather than owning a portfolio of diverse companies. 
B) While LBOs may use the assets of a target company to collateralize debt, they typically do not use the assets of all their various companies. 
C) LBOs may follow the pecking order to some extent, but they are more likely to use a combination of debt and equity to finance their acquisitions. A) This statement is false. LBOs typically own a concentrated portfolio of companies, rather than a diversified one. As a result, they are more exposed to industry-specific risks and have a higher cost of capital.
B) This statement is partially true. LBOs do use the assets of their portfolio companies to secure debt financing for new acquisitions. This is known as cross-collateralization. However, it is not accurate to say that LBOs use all their assets as collateral, as some portfolio companies may be excluded due to their strategic value or other factors.
C) This statement is false. LBOs do not always follow the pecking order when financing their acquisitions. The pecking order suggests that firms should use internal funds first, followed by debt, and then equity as a last resort. However, LBOs often rely heavily on debt financing, even if they have ample internal funds or could issue equity. This is because debt financing can provide tax benefits and enhance returns for the LBO's investors.

Question 18

A firm that is worth $1 million and is financed with 30% risk-free debt and 70% equity grows in value to $1.5 million. What is its new debt-equity ratio?

Accepted Answer

The firm's initial debt is $300,000 (30% of $1 million). As the firm grows to $1.5 million, assuming the debt remains constant, the equity becomes $1.2 million ($1.5 million - $300,000). The new debt-equity ratio is $300,000 / $1,200,000 = 25.0%.

Question 19

Which of the following actions would necessarily result in a lower debt-equity ratio, all else equal?

Accepted Answer

When warrant owners exercise their warrants, the company issues new shares, increasing equity and thus lowering the debt-equity ratio.

Question 20

Which of the following actions would necessarily result in a higher debt-equity ratio, all else equal?

Accepted Answer

The firm using excess cash to repurchase shares would reduce the total amount of equity in the firm, while the amount of debt would stay the same, resulting in a higher debt-equity ratio. Repurchasing shares reduces the amount of equity on the balance sheet, which increases the debt-equity ratio. Therefore, using excess cash to repurchase shares would necessarily result in a higher debt-equity ratio.

Quiz 21: Capital Structure Dynamics