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

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?

Accepted Answer

Senior secured debt

Answer

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?

Accepted Answer

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

Answer

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?

Accepted Answer

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

Answer

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?

Accepted Answer

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

Answer

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.

DCF - Discounted Cash Flow Practice Test

DCF - Discounted Cash Flow Practice Test

DCF Capital Structure 2