CFM Capital Structure & Debt Modeling 2

Question 1

The interest coverage ratio is calculated as:

Accepted Answer

EBIT / Interest Expense

Answer

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:

Accepted Answer

Tax benefits of debt against financial distress costs

Answer

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?

Accepted Answer

Debt (after-tax cost)

Answer

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:

Accepted Answer

A flexible credit line that can be drawn, repaid, and redrawn repeatedly

Answer

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?

Accepted Answer

WACC initially decreases due to the interest tax shield on debt

Answer

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.

CFM - Certified Financial Modeler Practice Test

CFM - Certified Financial Modeler Practice Test

CFM Capital Structure & Debt Modeling 2