DCF Capital Structure 1 — Questions and Answers
Question 1: What does 'capital structure' refer to in corporate finance?
- The mix of debt and equity financing a company uses to fund its assets (Correct answer)
- The total market capitalization of a company
- The company's allocation of capital among different business units
- The amount of working capital available for operations
Correct answer: The mix of debt and equity financing a company uses to fund its assets
Capital structure refers to the proportion of debt and equity a company uses to finance its operations and assets, determining how the firm is funded on the liability and equity side of the balance sheet.
Question 2: According to the Modigliani-Miller theorem in a world with no taxes and perfect markets, what is true about capital structure?
- It is irrelevant to firm value in a perfect market (Correct answer)
- Firms should maximize debt to lower WACC
- Equity always costs less than debt on an after-tax basis
- Capital structure is the primary driver of firm value
Correct answer: It is irrelevant to firm value in a perfect market
MM Proposition I states that in a world without taxes, transaction costs, or information asymmetry, a firm's value is unaffected by how it is financed.
Question 3: What creates the 'debt tax shield' in capital structure analysis?
- Interest payments on debt are tax-deductible, reducing taxable income (Correct answer)
- Debt holders receive preferential capital gains tax treatment
- Equity dividends are tax-exempt for the issuing company
- Debt reduces a firm's effective tax rate on revenues
Correct answer: Interest payments on debt are tax-deductible, reducing taxable income
Since interest expense is deductible for corporate tax purposes, debt financing generates a tax shield equal to the interest payment multiplied by the corporate tax rate.
Question 4: Which theory of capital structure states that firms balance the tax shield benefits of debt against the costs of financial distress?
- The trade-off theory (Correct answer)
- The pecking order theory
- The market timing theory
- The signaling theory
Correct answer: The trade-off theory
The trade-off theory posits that firms choose debt levels where the marginal benefit of the debt tax shield equals the marginal cost of financial distress, yielding an optimal capital structure.
Question 5: How is the debt-to-capital ratio calculated?
- Total debt divided by (total debt plus total equity) (Correct answer)
- Total debt divided by total assets
- Total equity divided by total debt
- Net debt divided by EBITDA
Correct answer: Total debt divided by (total debt plus total equity)
The debt-to-capital ratio equals total debt divided by the sum of total debt and total equity, expressing debt as a share of the total capitalization of the firm.
Question 6: What happens to the cost of equity as a company takes on progressively more debt?
- It increases because equity holders bear greater financial risk (Correct answer)
- It decreases as shareholders benefit directly from leverage
- It remains constant regardless of the level of financial leverage
- It converges toward the cost of debt at high leverage levels
Correct answer: It increases because equity holders bear greater financial risk
As leverage increases, equity holders are exposed to greater financial risk because their subordinated claim absorbs losses first, causing them to demand a higher return.
Question 7: In a DCF valuation, why is WACC used as the discount rate for free cash flows to the firm (FCFF)?
- It reflects the blended required return of all capital providers weighted by their market-value proportions (Correct answer)
- It is always lower than the cost of equity, producing a higher valuation
- It eliminates the need to model interest payments in the cash flows
- It is mandated by GAAP for enterprise valuations
Correct answer: It reflects the blended required return of all capital providers weighted by their market-value proportions
WACC represents the minimum return required by all capital providers—debt and equity—blended by their market-value weights, making it the appropriate rate for discounting cash flows available to all stakeholders.
DCF Capital Structure 1
What does 'capital structure' refer to in corporate finance?