Title 4.6 Capital Structure.pdf ✅

1. Which of the following companies will most likely employ the greatest amount of debt relative to its equity?  A. A real estate developer during its initial growth phase B. A cyclical car manufacturer during an economic downturn C. A consulting firm that uses highly paid consultants and few physical assets Explanation A firm will typically increase the proportion of debt in its capital structure as it matures through its life cycle. In early (ie, start-up) stages, businesses have very limited access to debt due to high operating risk and unstable cash flows. In general, as a business gradually matures, more funds can be borrowed since increased revenues and stable cash flows are opening the firm to more potential lenders. However, there are exceptions to this tendency for capital-intensive, capital-light, and cyclical businesses. Capital-intensive firms (eg, companies operating in real estate, utilities, or transportation) require relatively high levels of debt financing to purchase fixed assets during any stage of the life cycle. For example, a real estate developer would most likely have a lot of debt, even in its early stages. Capital-light firms (eg, consulting firms, software companies) have fewer capital expenditures. Such companies often require little debt financing throughout the life cycle (Choice C). Cyclical firms (eg, car manufacturers, mining companies) have more volatile revenues and cash flows that fluctuate with economic cycles. This volatility reduces their debt capacity, especially during an economic downturn (Choice B). Things to remember: Generally, firms will borrow more funds as they mature and thus have proportionately more debt in their capital structure. However, exceptions to this tendency exist for capital-intensive, capital-light, and cyclical businesses. Explain factors affecting capital structure and the weighted-average cost of capital LOS Copyright © UWorld. Copyright CFA Institute. All rights reserved.
2. Analysts most appropriately use the company's weighted average cost of capital to determine a project's:  A. value. B. future cash flows. C. investment opportunity schedule. Explanation A company's weighted average cost of capital is the rate the company pays for new capital to fund new projects, which typically require cash outflows to generate cash inflows. Inflows and outflows may occur throughout the project's life. The project's value is the net present value of its cash inflows and outflows. The discount rate used to find that the present value is the WACC. Therefore, analysts use the WACC to calculate a project's value. (Choice B) A project's future cash flows are estimated by making assumptions about the project's need for cash (ie, outflows) and its ability to generate cash (ie, inflows). The WACC is then used to discount those cash flows to find the project's net present value. (Choice C) The investment opportunity schedule (IOS) is a graph of all the company's projects ranked from highest to lowest return against the cumulative amount of new capital needed for each project. A company's WACC does not determine the IOS. Things to remember: A company's weighted average cost of capital (WACC) is the rate the company pays for new capital to fund new projects, which typically require cash outflows to generate cash inflows. The project's value is the net present value of its cash inflows and outflows. The discount rate used to find that present value is the WACC, so analysts use the WACC to find a project's value. Calculate and interpret the weighted-average cost of capital for a company LOS Copyright © UWorld. Copyright CFA Institute. All rights reserved.
3. An analyst wants to calculate a company's weighted average cost of capital (WACC) and compiles the following data: Weight of debt 20% Market yield on similar BBB debt 8% Corporate tax rate 30% Weight of preferred stock 10% Preferred dividend £2.00 Preferred stock share price £40.00 Weight of common stock 70% Last common dividend £1.90 Expected common dividend £2.00 Common dividend growth rate 5% Common stock share price £50.00 The analyst believes that the company's debt should be rated BBB. If the analyst uses the debt-rating approach to calculate the cost of debt and the dividend discount model (DDM) approach to calculate the cost of equity, the WACC is closest to: A. 7.79%  B. 7.92% C. 8.40% Explanation The weighted average cost of capital (WACC) for a company is the weighted average cost of the different sources of capital. Suppliers of capital require risk-adjusted returns. The most common sources of capital include equity, preferred stock, and debt. Calculate costs of each capital source: Insert variables to calculcate WACC: Calculate and interpret the weighted-average cost of capital for a company LOS
4. All else equal, if a firm maintains a larger proportion of equity in its actual capital structure than in its target structure, the most likely reason is that: A. the stock is currently trading at a historic low price.  B. the stock will be included in an index once it reaches a greater market capitalization. C. management is raising capital for an infrastructure project that produces stable cash flows. Explanation Reasons for deviations from target capital structure Debt ratings can deteriorate with more debt Target capital structure may use book values Type of capital may depend on investment cash flows Market conditions (stock price, interest rates) Aspirations to list stock on an index Information asymmetry/information signaling A firm's stated capital structure (ie, mix of debt and equity) policy is often based on how much debt the firm can assume. Mature companies typically prefer to issue debt since debt is cheaper than equity and its market value is more predictable. Debt such as tax shields (from interest deductions) can enhance a firm's value, but debt may also reduce the value by increasing the risk of financial distress and bankruptcy. In theory, an optimal (ie, target) capital structure results in the lowest WACC and the highest firm valuation. At this optimal ratio of debt to equity, the difference between the expected benefits and costs of debt is maximized. In reality, capital structures often deviate from their optimal targets for the reasons shown in the table above. For example, investors may desire an increase in a company's market cap to satisfy index listing requirements. In response, the company may issue more public equity, which can cause the actual capital structure to deviate from the target. (Choice A) Firms tend to issue equity when the share price is high, not low. When the share price is low, the proceeds from the issuance will also be low. (Choice C) The type of capital raised for a project depends largely on the project's nature. An infrastructure project with stable cash flows is well suited to servicing debt, so the firm in this instance would more likely increase the proportion of debt, not equity, in its capital structure. Things to remember: In theory, an optimal (ie, target) capital structure results in the lowest WACC and the highest firm valuation. In reality, firms often deviate from their target capital structures. A firm may issue more equity to have its stock listed in an index, causing a deviation from the target capital structure. Explain factors affecting capital structure and the weighted-average cost of capital LOS Copyright © UWorld. Copyright CFA Institute. All rights reserved.