CFC Capital Structure & Funding 4 — Questions and Answers
Question 1: A leveraged buyout (LBO) transaction is primarily financed by:
- Common equity from public shareholders
- A combination of acquisition debt secured by the target's assets and cash flows (Correct answer)
- Government-backed loans at below-market rates
- Convertible preferred stock issued by the acquirer
Correct answer: A combination of acquisition debt secured by the target's assets and cash flows
LBOs use significant debt (typically 60-90% of purchase price) secured by the target company's assets and future cash flows to acquire the business.
Question 2: Which covenant type in a debt agreement restricts the borrower from taking specific actions without lender consent?
- Affirmative covenant
- Negative covenant (Correct answer)
- Financial covenant
- Cross-default covenant
Correct answer: Negative covenant
Negative covenants (also called restrictive covenants) prohibit borrowers from taking specific actions such as incurring additional debt or paying dividends above set limits.
Question 3: A company's interest coverage ratio falls below 1.5x as specified in its loan agreement. This most likely triggers a:
- Mandatory prepayment of principal
- Covenant violation requiring lender waiver or amendment (Correct answer)
- Automatic conversion to equity
- Reduction in the interest rate
Correct answer: Covenant violation requiring lender waiver or amendment
When a financial covenant threshold is breached, the borrower is in technical default and must obtain a waiver or amendment from lenders to avoid acceleration of the debt.
Question 4: Under ASC 470, debt with a subjective acceleration clause that makes it callable upon a material adverse change must be classified as:
- Long-term debt on the balance sheet
- Current liability if the condition exists at the balance sheet date (Correct answer)
- Off-balance-sheet obligation
- Mezzanine equity
Correct answer: Current liability if the condition exists at the balance sheet date
ASC 470-10 requires debt with subjective acceleration clauses to be reclassified as current if conditions giving the lender the right to accelerate exist at the balance sheet date.
Question 5: A Special Purpose Vehicle (SPV) used in structured finance is designed primarily to:
- Consolidate parent company operations for tax efficiency
- Isolate financial risk and ring-fence specific assets from the sponsor (Correct answer)
- Obtain government subsidies for infrastructure projects
- Avoid disclosure requirements under SEC regulations
Correct answer: Isolate financial risk and ring-fence specific assets from the sponsor
SPVs are bankruptcy-remote entities that isolate specific assets and liabilities, protecting the sponsoring entity from the SPV's risks and vice versa.
Question 6: A company with a market value of equity of $80M and total debt of $20M has a debt-to-total capital ratio of:
- 25%
- 20% (Correct answer)
- 33%
- 40%
Correct answer: 20%
Debt-to-total capital = Debt / (Debt + Equity) = $20M / ($20M + $80M) = $20M / $100M = 20%.
Question 7: Which of the following best describes the signaling effect of a company announcing a large share repurchase program?
- Management believes the stock is overvalued
- Management believes the stock is undervalued and excess cash exists (Correct answer)
- The company plans to reduce its equity base to increase debt capacity
- The company is preparing for an imminent acquisition
Correct answer: Management believes the stock is undervalued and excess cash exists
Share repurchase announcements typically signal that management believes the stock is trading below intrinsic value and that surplus cash is available for distribution.
CFC Capital Structure & Funding 4
A leveraged buyout (LBO) transaction is primarily financed by: