Capital Structure & Debt Modeling Flashcards
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Read the first 7 Capital Structure & Debt Modeling flashcards as text
What does the Weighted Average Cost of Capital (WACC) represent?
Answer: The blended cost of all capital sources, weighted by their proportion in the capital structure
WACC blends the after-tax cost of debt and the cost of equity, each weighted by its proportion in the capital structure, reflecting the overall return required by all capital providers.
According to the Modigliani-Miller theorem in a world with no taxes, which statement is true?
Answer: A firm's total value is unaffected by its capital structure
MM Proposition I (no taxes) states that capital structure is irrelevant because investors can replicate any leverage on their own, leaving total firm value unchanged.
In a leveraged buyout (LBO) model, which tranche of debt typically carries the highest interest rate?
Answer: Mezzanine debt
Mezzanine debt is subordinated to all senior debt and carries greater default risk, so lenders demand a higher interest rate as compensation.
A company has $600M in total debt and $300M in total equity. What is its debt-to-equity ratio?
Answer: 2.0x
Debt-to-equity ratio = Total Debt / Total Equity = $600M / $300M = 2.0x.
Which metric is most commonly used to assess a company's ability to cover interest payments from operating earnings?
Answer: Interest coverage ratio
The interest coverage ratio (EBIT / Interest Expense) shows how many times operating earnings can cover interest obligations, indicating debt serviceability.
What is the primary purpose of building a debt schedule in a financial model?
Answer: To track outstanding debt balances, interest expense, and required repayments over time
A debt schedule tracks each debt tranche's opening balance, calculates periodic interest expense, models mandatory and optional repayments, and shows ending balances for each period.
Which of the following is NOT used when calculating the after-tax cost of debt?
Answer: The equity risk premium
The equity risk premium is an input for calculating the cost of equity via CAPM; the after-tax cost of debt uses only the pre-tax yield and the tax rate.