DCF Capital Structure 3

Question 1

In DCF analysis, what is the relationship between enterprise value (EV) and equity value?

Accepted Answer

Equity Value = Enterprise Value − Net Debt (total debt minus cash)

Answer

Equity Value = Enterprise Value + Total Debt

Answer

Equity Value = Enterprise Value × Cost of Equity

Answer

Equity Value = Enterprise Value − Total Assets

Question 2

In the WACC formula, what weights should be used for the debt and equity components?

Accepted Answer

Market values of debt and equity, not book values

Answer

Book values from the balance sheet for consistency with accounting standards

Answer

Equal weights of 50% each to avoid judgment calls

Answer

The target weights set by management at the time of the IPO

Question 3

According to the trade-off theory, which types of firms would be expected to carry less debt in their capital structure?

Accepted Answer

High-growth firms with predominantly intangible assets

Answer

Mature, capital-intensive firms with stable cash flows and tangible assets

Answer

Regulated utilities with predictable revenue streams

Answer

Large conglomerates with diversified revenue sources

Question 4

What is the Adjusted Present Value (APV) method, and when is it preferred over the WACC approach?

Accepted Answer

APV values the unlevered firm and adds financing side effects separately; preferred when capital structure changes over time

Answer

APV uses book-value weights instead of market-value weights for WACC components

Answer

APV adjusts the terminal value for expected changes in the debt level

Answer

APV is always preferred over WACC because it avoids circular reference problems

Question 5

What is the Hamada equation used for in DCF and capital structure analysis?

Accepted Answer

Re-levering an unlevered (asset) beta to reflect a specific capital structure: β_L = β_U × [1 + (1 − T) × (D/E)]

Answer

Calculating the after-tax cost of debt from the pre-tax borrowing rate

Answer

Estimating the equity risk premium from historical market returns

Answer

Converting enterprise value to equity value by adjusting for taxes on debt

Question 6

Why do analysts typically use a target capital structure rather than the current capital structure when calculating WACC in a DCF model?

Accepted Answer

It reflects long-run financing intentions and avoids WACC distortions from temporary leverage changes

Answer

Current capital structures are not disclosed in public SEC filings

Answer

Target structures always produce a lower WACC and higher valuation

Answer

Regulatory guidance requires the use of target structures for fairness opinions

Question 7

What does 'financial flexibility' mean in capital structure management, and why do many firms deliberately maintain unused debt capacity?

Accepted Answer

The ability to access capital on favorable terms when opportunities arise, preserved by keeping leverage below maximum capacity

Answer

The ability to renegotiate interest rates on existing debt at any time

Answer

Maintaining unlimited revolving credit lines to fund day-to-day operations

Answer

The option embedded in convertible bonds allowing debt-to-equity conversion