DCF Capital Structure 2 — Questions and Answers
Question 1: What does the Pecking Order Theory predict about how firms choose their financing sources?
- Firms prefer internal financing first, then debt, and issue equity only as a last resort (Correct answer)
- Firms prefer equity issuance to avoid interest obligations
- All financing sources are treated as equally desirable
- Firms prioritize the lowest-cost financing regardless of information effects
Correct answer: Firms prefer internal financing first, then debt, and issue equity only as a last resort
The Pecking Order Theory (Myers & Majluf) holds that firms prefer retained earnings, then debt, and finally equity to avoid signaling undervaluation to outside investors.
Question 2: Which type of debt holds the highest priority claim in a company's capital structure during liquidation?
- Senior secured debt (Correct answer)
- Senior unsecured debt
- Subordinated debt
- Mezzanine debt
Correct answer: Senior secured debt
Senior secured debt is backed by specific collateral and is repaid before any unsecured or subordinated creditors, giving it the highest priority claim in a liquidation scenario.
Question 3: In a DCF model, how does adding moderate financial leverage initially affect WACC?
- WACC decreases because after-tax debt cost is lower than the cost of equity (Correct answer)
- WACC increases because debt always raises the overall cost of capital
- WACC is unaffected because capital structure is irrelevant in practice
- WACC increases due to immediately higher required equity returns
Correct answer: WACC decreases because after-tax debt cost is lower than the cost of equity
Moderate debt lowers WACC because the after-tax cost of debt is less than the cost of equity; however, excessive leverage eventually raises WACC as distress risk drives up equity and debt costs.
Question 4: What does 'unlevering' a beta accomplish in DCF analysis?
- It removes the effect of financial leverage to isolate the asset (business risk) beta (Correct answer)
- It increases a company's beta to match highly leveraged industry peers
- It converts the equity beta into a cost of debt estimate
- It adjusts the terminal value for changes in the company's leverage
Correct answer: It removes the effect of financial leverage to isolate the asset (business risk) beta
Unlevering strips the financial risk component from an observed equity beta, leaving only the asset beta that reflects the underlying business risk of the firm.
Question 5: What is mezzanine financing in the context of a company's capital structure?
- Hybrid financing between senior debt and equity, typically with equity-like features such as warrants (Correct answer)
- Short-term revolving credit facilities used for working capital
- Government-subsidized loan programs for small businesses
- The equity contribution from a private equity sponsor in a buyout
Correct answer: Hybrid financing between senior debt and equity, typically with equity-like features such as warrants
Mezzanine financing sits between senior debt and equity in seniority, typically carrying higher interest rates and equity conversion features like warrants or PIK interest to compensate for its subordinated position.
Question 6: How does a leveraged buyout (LBO) alter the target company's capital structure?
- It substantially increases debt, creating high financial leverage to fund the acquisition price (Correct answer)
- It eliminates all existing debt and replaces it entirely with new equity
- It converts existing equity into preferred stock with fixed dividends
- It maintains the current capital structure while adding a layer of equity
Correct answer: It substantially increases debt, creating high financial leverage to fund the acquisition price
In an LBO, the acquirer finances the purchase primarily with debt—often 60–80% of the deal price—resulting in a highly leveraged post-acquisition capital structure for the target.
Question 7: What does the interest coverage ratio measure, and why is it important in capital structure analysis?
- EBIT divided by interest expense; it measures a firm's ability to service its debt from operating earnings (Correct answer)
- Net income divided by total debt; it measures profitability relative to leverage
- Operating cash flow divided by debt principal; it measures long-term solvency
- Revenue divided by interest payments; it measures sales efficiency versus financing costs
Correct answer: EBIT divided by interest expense; it measures a firm's ability to service its debt from operating earnings
The interest coverage ratio (EBIT ÷ Interest Expense) shows how many times a company can cover its interest obligations from operating income, serving as a key measure of financial health and debt capacity.
DCF Capital Structure 2
What does the Pecking Order Theory predict about how firms choose their financing sources?