CPFM Corporate Finance Structure 2 — Questions and Answers
Question 1: A firm's weighted average cost of capital (WACC) will most likely decrease when it does which of the following?
- Replaces low-cost debt with new equity
- Adds a modest amount of tax-deductible debt to an all-equity structure (Correct answer)
- Increases its corporate tax rate to zero
- Issues equity to retire all outstanding debt
Correct answer: Adds a modest amount of tax-deductible debt to an all-equity structure
Adding tax-deductible debt lowers WACC because debt is cheaper than equity and interest provides a tax shield.
Question 2: Under Modigliani-Miller with corporate taxes, the value of a levered firm equals the value of an unlearvered firm plus what?
- The market value of equity
- The present value of the debt tax shield (Correct answer)
- The firm's retained earnings
- The cost of financial distress
Correct answer: The present value of the debt tax shield
MM with taxes adds the present value of the interest tax shield to the unlevered firm value.
Question 3: Which capital component typically carries the highest required rate of return for investors?
- Senior secured debt
- Subordinated debt
- Preferred stock
- Common equity (Correct answer)
Correct answer: Common equity
Common equity is the most junior claim and bears the most risk, so it demands the highest return.
Question 4: A company with highly volatile, cyclical cash flows should generally maintain what type of capital structure?
- A high proportion of fixed-rate debt
- A more conservative, equity-heavy structure (Correct answer)
- Maximum leverage to amplify returns
- Entirely short-term debt
Correct answer: A more conservative, equity-heavy structure
Volatile cash flows raise default risk, so lower leverage reduces the chance of distress.
Question 5: The 'pecking order theory' of capital structure predicts that firms prefer to finance investments first with which source?
- New common equity
- External debt
- Internal funds (retained earnings) (Correct answer)
- Preferred stock
Correct answer: Internal funds (retained earnings)
Pecking order theory ranks internal funds first, then debt, then equity as a last resort.
Question 6: Financial leverage refers to the use of what to finance a firm's assets?
- Fixed-cost financing such as debt (Correct answer)
- Operating fixed costs like rent
- Equity issued to insiders
- Variable production costs
Correct answer: Fixed-cost financing such as debt
Financial leverage is the use of fixed-cost debt financing to magnify returns to equity.
Question 7: Which ratio best measures the proportion of a company's capital that comes from creditors?
- Current ratio
- Debt-to-total-capital ratio (Correct answer)
- Gross margin
- Inventory turnover
Correct answer: Debt-to-total-capital ratio
The debt-to-total-capital ratio shows debt as a share of the firm's total financing.
CPFM Corporate Finance Structure 2
A firm's weighted average cost of capital (WACC) will most likely decrease when it does which of the following?