DCF Capital Structure 2

Question 1

What does the Pecking Order Theory predict about how firms choose their financing sources?

Accepted Answer

Firms prefer internal financing first, then debt, and issue equity only as a last resort

Answer

Firms prefer equity issuance to avoid interest obligations

Answer

All financing sources are treated as equally desirable

Answer

Firms prioritize the lowest-cost financing regardless of information effects

Question 2

Which type of debt holds the highest priority claim in a company's capital structure during liquidation?

Accepted Answer

Senior secured debt

Answer

Senior unsecured debt

Answer

Subordinated debt

Answer

Mezzanine debt

Question 3

In a DCF model, how does adding moderate financial leverage initially affect WACC?

Accepted Answer

WACC decreases because after-tax debt cost is lower than the cost of equity

Answer

WACC increases because debt always raises the overall cost of capital

Answer

WACC is unaffected because capital structure is irrelevant in practice

Answer

WACC increases due to immediately higher required equity returns

Question 4

What does 'unlevering' a beta accomplish in DCF analysis?

Accepted Answer

It removes the effect of financial leverage to isolate the asset (business risk) beta

Answer

It increases a company's beta to match highly leveraged industry peers

Answer

It converts the equity beta into a cost of debt estimate

Answer

It adjusts the terminal value for changes in the company's leverage

Question 5

What is mezzanine financing in the context of a company's capital structure?

Accepted Answer

Hybrid financing between senior debt and equity, typically with equity-like features such as warrants

Answer

Short-term revolving credit facilities used for working capital

Answer

Government-subsidized loan programs for small businesses

Answer

The equity contribution from a private equity sponsor in a buyout

Question 6

How does a leveraged buyout (LBO) alter the target company's capital structure?

Accepted Answer

It substantially increases debt, creating high financial leverage to fund the acquisition price

Answer

It eliminates all existing debt and replaces it entirely with new equity

Answer

It converts existing equity into preferred stock with fixed dividends

Answer

It maintains the current capital structure while adding a layer of equity

Question 7

What does the interest coverage ratio measure, and why is it important in capital structure analysis?

Accepted Answer

EBIT divided by interest expense; it measures a firm's ability to service its debt from operating earnings

Answer

Net income divided by total debt; it measures profitability relative to leverage

Answer

Operating cash flow divided by debt principal; it measures long-term solvency

Answer

Revenue divided by interest payments; it measures sales efficiency versus financing costs