CFC Capital Structure & Funding 5 — Questions and Answers
Question 1: Which of the following is the MOST accurate description of economic value added (EVA) in the context of capital structure decisions?
- Net income divided by total assets
- After-tax operating profit minus the cost of all capital employed (Correct answer)
- EBITDA minus capital expenditures
- Free cash flow available to equity holders
Correct 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.
Question 2: A company in financial distress considering debt restructuring would most likely pursue which option FIRST?
- Chapter 7 liquidation
- Out-of-court debt workout or exchange offer (Correct answer)
- Chapter 11 bankruptcy reorganization
- Asset fire sale to repay creditors
Correct 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.
Question 3: Preferred stock is classified as equity on the balance sheet, but for cost of capital analysis it behaves similarly to debt because:
- Preferred dividends are tax-deductible like interest
- Preferred dividends are fixed obligations that rank above common equity (Correct answer)
- Preferred shareholders have voting rights equal to debt holders
- Preferred stock matures and must be repaid like bonds
Correct 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.
Question 4: 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?
- $2,500,000
- $625,000 (Correct answer)
- $1,875,000
- $3,750,000
Correct 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.
Question 5: Under the market timing theory of capital structure, firms issue equity when:
- Interest rates are at historically low levels
- Management believes equity is overvalued relative to intrinsic value (Correct answer)
- The firm's debt-to-equity ratio exceeds its target level
- Retained earnings are insufficient to fund current dividends
Correct 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.
Question 6: 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?
- Option A at 12.0%
- Option B at approximately 8.1% (Correct answer)
- Both options have identical WACCs
- Option B at approximately 10.5%
Correct 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%.
Question 7: Which of the following best describes the 'financial distress costs' in the trade-off theory of capital structure?
- The direct administrative costs of issuing new securities
- Both direct bankruptcy costs and indirect costs such as lost customers and employee turnover (Correct answer)
- The premium paid above book value in a leveraged buyout
- The flotation costs associated with equity offerings
Correct 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.
CFC Capital Structure & Funding 5
Which of the following is the MOST accurate description of economic value added (EVA) in the context of capital structure decisions?