CTP Capital Structure and Funding 5 — Questions and Answers
Question 1: A company faces a 'debt maturity wall' in 18 months. What is the FIRST action a treasurer should take?
- Immediately declare bankruptcy to restructure obligations
- Begin refinancing discussions early to avoid forced refinancing in distressed conditions (Correct answer)
- Accelerate dividend payments to shareholders before maturity
- Convert all debt to equity through a forced exchange
Correct answer: Begin refinancing discussions early to avoid forced refinancing in distressed conditions
Proactive refinancing well before maturity gives the company negotiating leverage, access to better market conditions, and avoids the distress premium lenders charge near-term maturities.
Question 2: Which type of equity offering results in NO new proceeds for the company?
- Initial public offering (IPO)
- Follow-on primary offering
- Secondary offering by existing shareholders (Correct answer)
- At-the-market (ATM) equity program
Correct answer: Secondary offering by existing shareholders
A secondary offering involves existing shareholders selling their shares, so proceeds go to those sellers rather than the company, which receives no capital from the transaction.
Question 3: What is the purpose of a 'cross-default' clause in a loan agreement?
- To allow the borrower to prepay the loan without penalty
- To trigger a default on one debt instrument if the borrower defaults on any other debt obligation (Correct answer)
- To set interest rates based on the borrower's credit rating
- To restrict dividend payments during the loan term
Correct answer: To trigger a default on one debt instrument if the borrower defaults on any other debt obligation
A cross-default clause protects lenders by making a default on any debt obligation automatically trigger a default under their agreement, giving them equal standing to accelerate repayment.
Question 4: In project finance, what distinguishes it from traditional corporate finance?
- Project finance relies on the sponsor's balance sheet for repayment
- Debt is repaid solely from the project's cash flows and secured by project assets, with limited recourse to sponsors (Correct answer)
- Project finance uses only equity with no debt component
- Project finance is restricted to government-owned entities
Correct answer: Debt is repaid solely from the project's cash flows and secured by project assets, with limited recourse to sponsors
Project finance is non-recourse or limited-recourse, meaning lenders rely on the project's standalone cash flows and assets for repayment rather than the sponsoring company's balance sheet.
Question 5: A company's stock trades at a 40% discount to book value. What does this signal about equity issuance?
- It is an ideal time to issue equity as shares are cheap to sell
- Issuing equity at below book value dilutes existing shareholders and may signal market distrust (Correct answer)
- The company should immediately retire all outstanding shares
- Book value discounts have no impact on financing decisions
Correct answer: Issuing equity at below book value dilutes existing shareholders and may signal market distrust
Issuing equity below book value transfers value from existing shareholders to new investors and may be interpreted by markets as a negative signal about management's outlook.
Question 6: What is the primary function of a 'debt service reserve account' (DSRA) in structured finance?
- To hold excess equity contributions from sponsors
- To provide a liquidity buffer ensuring debt payments can be made even during temporary cash flow shortfalls (Correct answer)
- To escrow principal repayments until bond maturity
- To fund capital expenditures when operating cash flows are insufficient
Correct answer: To provide a liquidity buffer ensuring debt payments can be made even during temporary cash flow shortfalls
A DSRA is typically funded with 3-6 months of debt service and held in trust, giving lenders comfort that near-term payments are secure even if project revenues temporarily decline.
Question 7: Which of the following best describes the 'agency cost of equity' problem in capital structure?
- Shareholders demanding higher dividends than the company can afford
- Managers acting in their own interests rather than maximizing shareholder value, partly mitigated by debt obligations (Correct answer)
- Investment banks charging excessive fees for equity underwriting
- Shareholders filing lawsuits against management for poor performance
Correct answer: Managers acting in their own interests rather than maximizing shareholder value, partly mitigated by debt obligations
Agency costs of equity arise from manager-shareholder conflicts; debt can reduce these costs by constraining managerial discretion over free cash flow and aligning incentives through default risk.
CTP Capital Structure and Funding 5
A company faces a 'debt maturity wall' in 18 months.
What is the FIRST action a treasurer should take?