CFC Capital Structure & Funding 2 — Questions and Answers
Question 1: A company has a debt-to-equity ratio of 1.5 and a tax rate of 30%. If the cost of debt is 6%, what is the tax shield benefit per dollar of debt?
- $0.30
- $0.06
- $0.018 (Correct answer)
- $0.09
Correct answer: $0.018
The tax shield per dollar of debt equals the interest rate multiplied by the tax rate: 0.06 × 0.30 = $0.018.
Question 2: Which capital structure theory argues that in the absence of taxes and bankruptcy costs, capital structure is irrelevant to firm value?
- Trade-off theory
- Pecking order theory
- Modigliani-Miller theorem (Correct answer)
- Agency cost theory
Correct answer: Modigliani-Miller theorem
The Modigliani-Miller theorem (1958) proposes that under perfect market conditions without taxes or bankruptcy costs, capital structure does not affect firm value.
Question 3: A company's EBIT is $500,000 and it has $2,000,000 in debt at 8% interest. What is the degree of financial leverage (DFL)?
- 1.47 (Correct answer)
- 2.50
- 0.68
- 3.20
Correct answer: 1.47
DFL = EBIT / (EBIT - Interest) = $500,000 / ($500,000 - $160,000) = $500,000 / $340,000 ≈ 1.47.
Question 4: Under the pecking order theory, which funding source do firms prefer LAST?
- Internal retained earnings
- Short-term debt
- Long-term debt
- Equity issuance (Correct answer)
Correct answer: Equity issuance
Pecking order theory holds that firms prefer internal funds first, then debt, and finally external equity as a last resort due to information asymmetry costs.
Question 5: A mezzanine financing instrument that converts to equity if not repaid by maturity is best described as:
- Senior secured debt
- Convertible subordinated debenture (Correct answer)
- Preferred equity
- Commercial paper
Correct answer: Convertible subordinated debenture
A convertible subordinated debenture is a mezzanine instrument that starts as debt but can convert to equity, blending characteristics of both.
Question 6: When a company issues new common stock to fund operations, the primary cost that existing shareholders bear is:
- Flotation cost only
- Dilution of ownership and earnings per share (Correct answer)
- Increased interest expense
- Higher dividend obligations
Correct answer: Dilution of ownership and earnings per share
Issuing new common stock dilutes existing shareholders' ownership percentage and reduces earnings per share by spreading earnings over more shares.
Question 7: The weighted average cost of capital (WACC) is minimized at the point where:
- The firm uses 100% debt financing
- The marginal benefit of tax shields equals the marginal cost of financial distress (Correct answer)
- The firm uses 100% equity financing
- Debt-to-equity ratio equals 1.0
Correct answer: The marginal benefit of tax shields equals the marginal cost of financial distress
According to trade-off theory, optimal capital structure occurs where the tax shield benefit of additional debt exactly equals the increasing cost of financial distress.
CFC Capital Structure & Funding 2
A company has a debt-to-equity ratio of 1.5 and a tax rate of 30%.
If the cost of debt is 6%, what is the tax shield benefit per dollar of debt?