Certified Treasury Professional Capital Structure and Funding Questions and Answers

Question 1

According to the pecking order theory of capital structure, which of the following funding sources would a company's management prefer to use first when financing a new investment?

Accepted Answer

Using retained earnings

Answer

The pecking order theory suggests that firms prioritize their sources of financing, preferring internal financing (retained earnings) first. If external financing is required, they will then issue debt before finally resorting to issuing new equity, which is considered the most costly option due to asymmetric information and potential negative signals to the market.

Question 2

In a world with corporate taxes but no personal taxes or bankruptcy costs, what is the key implication of the Modigliani-Miller (M&M) Proposition I with taxes?

Accepted Answer

The value of a levered firm exceeds the value of an unlevered firm by the present value of the interest tax shield.

Answer

M&M Proposition I with taxes states that because interest payments on debt are tax-deductible, leverage creates a 'tax shield' that adds value to the firm. The total value of the levered firm is equal to the value of an identical unlevered firm plus the present value of this tax shield.

Question 3

A manufacturing company is undergoing a review by a major credit rating agency. Which of the following events would most likely lead to a downgrade of the company's credit rating?

Accepted Answer

A significant increase in its debt-to-EBITDA ratio beyond industry norms.

Answer

Credit rating agencies focus on a company's ability to meet its debt obligations. A higher debt-to-EBITDA ratio is a key leverage metric that indicates the company has more debt relative to its earnings, which increases its default risk and makes a downgrade more likely.

Question 4

Which of the following statements best describes the primary effect of increasing a company's financial leverage?

Accepted Answer

It magnifies the impact of changes in EBIT on earnings per share (EPS).

Answer

Financial leverage is the use of fixed-cost financing, like debt. These fixed interest payments must be made regardless of the level of Earnings Before Interest and Taxes (EBIT). This causes any change in EBIT to have a magnified, or amplified, effect on the net income available to shareholders and, consequently, on earnings per share (EPS).

Question 5

A company's CFO is evaluating a new project that has a similar risk profile to the company's existing operations. The company intends to maintain its target capital structure to fund the project. What is the most appropriate discount rate to use when calculating the Net Present Value (NPV) of this project?

Accepted Answer

The company's Weighted Average Cost of Capital (WACC)

Answer

The Weighted Average Cost of Capital (WACC) represents the blended, or average, cost of all the capital sources (debt, equity) a company uses, weighted by their respective proportions. For a project with an average risk profile that does not alter the firm's overall capital structure, the WACC is the correct hurdle rate or discount rate to use for evaluation.

Certified Treasury Professional Exam Practice Test

Certified Treasury Professional Exam Practice Test

Certified Treasury Professional Capital Structure and Funding Questions and Answers