CFM Capital Structure & Debt Modeling 2 — Questions and Answers
Question 1: The interest coverage ratio is calculated as:
- Total Debt / Annual Interest Expense
- EBIT / Interest Expense (Correct answer)
- Net Income / Total Debt
- EBITDA / Total Liabilities
Correct answer: EBIT / Interest Expense
Interest coverage ratio = EBIT / Interest Expense, measuring how many times operating income covers interest obligations in a given period.
Question 2: The trade-off theory of capital structure argues that firms balance:
- Revenue growth against operating costs when setting leverage
- Tax benefits of debt against financial distress costs (Correct answer)
- Dividend payments against retained earnings to optimize capital
- Short-term debt against long-term debt to manage liquidity
Correct answer: Tax benefits of debt against financial distress costs
The trade-off theory states firms optimize capital structure by weighing the tax shield from interest deductibility against the expected costs of financial distress and potential bankruptcy.
Question 3: Which source of capital is generally the least expensive for a corporation on an after-tax basis?
- Common equity
- Preferred equity
- Debt (after-tax cost) (Correct answer)
- Mezzanine financing
Correct answer: Debt (after-tax cost)
After-tax debt is typically the cheapest capital source because interest payments are tax-deductible, reducing the effective cost, and debt holders bear less risk than equity holders.
Question 4: A revolving credit facility (revolver) is best described as:
- A long-term bond with a fixed maturity date and fixed amortization
- A flexible credit line that can be drawn, repaid, and redrawn repeatedly (Correct answer)
- A hybrid form of equity financing convertible into debt at maturity
- A fixed amortizing loan with equal scheduled principal payments
Correct answer: A flexible credit line that can be drawn, repaid, and redrawn repeatedly
A revolving credit facility allows borrowers to draw funds up to a committed limit, repay them, and borrow again, making it ideal for managing short-term working capital needs.
Question 5: In the presence of corporate taxes, how does adding moderate debt typically affect a firm's WACC?
- WACC increases due to higher financial risk from leverage
- WACC remains unchanged per MM Proposition I
- WACC initially decreases due to the interest tax shield on debt (Correct answer)
- WACC increases because equity becomes more expensive with no offsetting benefit
Correct answer: WACC initially decreases due to the interest tax shield on debt
With corporate taxes, debt creates an interest tax shield that lowers the effective after-tax cost of debt, so moderate leverage reduces WACC and increases firm value.
Question 6: What does a Debt Service Coverage Ratio (DSCR) of 1.2x indicate?
- The company has $1.20 in total debt for every $1.00 of equity
- Net operating income is 20% higher than total debt service obligations (Correct answer)
- The company pays 1.2 times its interest expense in income taxes
- Total assets are 1.2 times greater than total liabilities
Correct answer: Net operating income is 20% higher than total debt service obligations
A DSCR of 1.2x means net operating income is 1.2 times total debt service (principal + interest), providing a 20% cushion above the minimum required payment.
Question 7: In a corporate liquidation waterfall, which claim is satisfied first?
- Common equity shareholders
- Preferred equity shareholders
- Subordinated (junior) debt holders
- Senior secured debt holders (Correct answer)
Correct answer: Senior secured debt holders
Senior secured creditors have first priority claim on assets in liquidation, followed by other creditors in descending order of seniority, with equity holders receiving any residual value last.
CFM Capital Structure & Debt Modeling 2
The interest coverage ratio is calculated as: