CTP Capital Structure and Funding 2 — Questions and Answers
Question 1: Which metric best measures a company's ability to service its debt obligations from operating cash flow?
- Debt-to-equity ratio
- Interest coverage ratio (Correct answer)
- Current ratio
- Price-to-earnings ratio
Correct answer: Interest coverage ratio
The interest coverage ratio (EBIT divided by interest expense) directly measures how many times operating earnings can cover interest payments.
Question 2: A company issues $500 million in convertible bonds at a 2% coupon versus 5% for straight debt. What is the primary reason investors accept the lower coupon?
- Tax advantages of convertible bonds
- The embedded equity conversion option has value (Correct answer)
- Convertible bonds have senior priority in bankruptcy
- Lower coupon signals higher credit quality
Correct answer: The embedded equity conversion option has value
Investors accept a below-market coupon on convertible bonds because the option to convert to equity has intrinsic value, compensating for the yield sacrifice.
Question 3: Under the pecking order theory of capital structure, what is a firm's FIRST preferred source of financing?
- Public equity issuance
- Bank debt
- Internal retained earnings (Correct answer)
- Convertible securities
Correct answer: Internal retained earnings
Pecking order theory holds that firms prefer internal funds first because they avoid information asymmetry costs and flotation expenses associated with external financing.
Question 4: A leveraged buyout (LBO) typically uses what financing structure?
- Primarily equity with minimal debt
- Equal proportions of debt and equity
- Primarily debt secured by the target's assets and cash flows (Correct answer)
- Mezzanine financing only
Correct answer: Primarily debt secured by the target's assets and cash flows
LBOs are characterized by high leverage, using the target company's assets as collateral and its future cash flows to service debt, maximizing equity returns.
Question 5: What is the primary purpose of a shelf registration (SEC Rule 415) in corporate finance?
- To delay tax payments on equity issuance
- To allow pre-registered securities to be issued quickly when market conditions are favorable (Correct answer)
- To register securities for employee stock options only
- To obtain FDIC insurance for corporate bonds
Correct answer: To allow pre-registered securities to be issued quickly when market conditions are favorable
Shelf registration pre-approves securities with the SEC so companies can access capital markets rapidly without a full registration process each time.
Question 6: Which of the following best describes 'financial distress costs' in capital structure theory?
- The cost of raising equity during a bull market
- Direct and indirect costs incurred when a firm cannot meet its debt obligations (Correct answer)
- Fees paid to investment banks for bond issuance
- The opportunity cost of holding excess cash
Correct answer: Direct and indirect costs incurred when a firm cannot meet its debt obligations
Financial distress costs include direct costs like legal and restructuring fees, and indirect costs like lost customers and supplier credit, which offset the tax benefits of debt.
Question 7: A company with a WACC of 8% evaluates a project returning 6%. What should the treasurer recommend?
- Accept the project as it generates positive cash flow
- Reject the project because it destroys shareholder value (Correct answer)
- Accept if funded entirely with equity
- Defer the decision until interest rates decline
Correct answer: Reject the project because it destroys shareholder value
A project returning less than the WACC destroys value because it earns less than the blended cost of capital provided by investors.
CTP Capital Structure and Funding 2
Which metric best measures a company's ability to service its debt obligations from operating cash flow?