Deck 21: Capital Structure Dynamics

Question 1

If a firm has an exceptionally good year and grows as a result, then

A)the debt-equity ratio of the firm will increase.
B)the debt ratio of the firm will increase.
C)the equity of the firm will increase.
D)both A and B.

Answer 1

the equity of the firm will increase.

Question 2

Empirical evidence suggests that

A)managers tend to borrow more at long-term rates rather than use short-term debt when the yield curve is steep.
B)managers tend to repurchase shares after the share price has increased and issue more equity when it has decreased in order to maintain the firm's debt-equity ratio.
C)managers try to time the market in deciding when to repurchase their shares.
D)All of the above are true statements.

Answer 2

managers try to time the market in deciding when to repurchase their shares.

Question 3

Which of the following statements is true?

A)A firm's value tends to decrease when it announces its plans to issue senior debt securities since its debt ratio will increase dramatically.
B)Management tends to favor issuing equity over debt.
C)Management tends to favor issuing debt over equity.
D)A firm's value tends to increase when it announces its plans to issue junior securities since these securities have a lower cost of capital.

Answer 3

Management tends to favor issuing debt over equity.

Question 4

Your firm has an excessive amount of cash and no good project opportunities on the
horizon. One of your colleagues suggests it be invested in Treasury bills in order to
earn at least a little more return for your shareholders. How would you respond to
this suggestion?

Question 5

Which of the following actions would necessarily result in a higher firm value, all else equal?

A)Convertible bondholders convert their bonds to shares of common stock.
B)The firm retires some of its debt.
C)The firm issues new debt.
D)The firm repurchases its shares.

Question 6

A firm has $5 million in debt , $1 million of which is convertible to shares of common stock, and $10 million in equity. If all the firm's convertible bondholders convert, what will happen
To the debt-equity ratio of the firm?

A)It will decrease from 50% to 36.4%.
B)It will decrease from 50% to 44.4%.
C)It will decrease from 50% to 40%.
D)It will decrease from 50% to 45.5%.

Question 7

Arrange the following in the correct pecking order, from highest to lowest: I. Short-term debt
II. New equity financing
III. Long-term debt
IV. Retained earnings

A)I, III, IV, II
B)IV, III, I, II
C)II, IV, III, I
D)IV, I, III, II

Question 8

A firm is currently financed with $2 million in debt and $6 million in equity. What will happen to its debt-equity ratio if it simultaneously issues another $2 million in debt and $2 million in
Equity?

A)The debt-equity ratio would increase from 33 1/3% to 100%.
B)The debt-equity ratio would increase from 25% to 33 1/3%.
C)The debt-equity ratio would be unchanged.
D)The debt-equity ratio would increase from 33 1/3% to 50%.

Question 9

Which of the following is the most senior claim in the pecking order?

A)collateralized long-term debt
B)factored receivables
C)short-term debt with strong covenants
D)retained earnings

Question 10

Which of the following statements about the financing pyramid is true?

A)The financing pyramid is just a more general way of referring to the pecking order.
B)The financing pyramid suggests that most of a firm's financing should be through the use of equity.
C)Most publicly-traded firms use the financing pyramid financing arrangement.
D)Both the financing pyramid and the pecking order suggest that firms should use a lot of short-term, collateralized debt in their capital structures.

Question 11

A firm that is worth $2 million and is financed with 40% risk-free debt and 60% equity grows in value to $3 million. What is its new debt-equity ratio?

A)76.5%
B)63.2%
C)36.4%
D)26.7%

Question 12

A firm in a declining industry has not been able to identify any positive NPV projects in which to invest. In such a case, firm's management should

A)look for a firm to buy that is in an entirely different industry.
B)increase its use of debt in order to decrease its cost of capital, which might result in positive NPV projects being available.
C)invest any excess cash in U.S. Treasury securities in order to earn at least a small return for the firm's shareholders.
D)pay out excess cash to its shareholders by increasing dividends and/or share repurchases.

Question 13

Which of the following theories provides a reason that issuing debt may be favored over issuing equity?

A)inside information
B)agency considerations
C)issuing costs
D)all of the above

Question 14

Which of the following would be the most senior security?

A)short-term, unsecured debt
B)a collateralized, long-term bond with no covenants
C)short-term debt with strong covenants
D)an unsecured, long-term bond with strong covenants

Question 15

Assume a perfect M&M world. A firm is currently valued at $500 million, $200 million of which is debt (including non-financial debt). It pays out $10 million in dividends and $20
Million to service its existing debt. It also raises another $60 million in debt and uses some of it
To repurchase $50 million of its common shares. What is the new value of the firm, and what is
Its new debt-equity ratio?

A)Value = $510 million; Debt-equity = 40.0%
B)Value = $480 million; Debt-equity = 50.0%
C)Value = $360 million; Debt-equity = 55.6%
D)Value = $480 million; Debt-equity = 100.0%

Question 16

Which of the following actions would necessarily result in a lower firm value, all else equal?

A)The firm issues debt and uses the money to repurchase some of its stock.
B)Warrant owners exercise their warrants.
C)The firm issues new equity through a primary seasoned equity offering.
D)The firm retires some of its debt.

Question 17

Which of the following statements about leveraged buyout firms (LBOs)is true?

A)Because an LBO owns a portfolio of many different companies, it is very well-diversified and, therefore, has a very low cost of capital.
B)LBOs typically use the assets of all their various companies to collateralize debt needed to finance additional acquisitions.
C)LBOs follow the pecking order religiously when they finance their acquisitions.
D)None of the above is a true statement.

Question 18

A firm that is worth $1 million and is financed with 30% risk-free debt and 70% equity grows in value to $1.5 million. What is its new debt-equity ratio?

A)25.0%
B)33.3%
C)20.0%
D)26.3%

Question 19

Which of the following actions would necessarily result in a lower debt-equity ratio, all else equal?

A)The firm uses its excess cash to repurchase some of its shares of common stock.
B)Warrant owners exercise their warrants.
C)The firm pays a special dividend to its shareholders.
D)All of the above would lower the debt-equity ratio of the firm.

Question 20

Which of the following actions would necessarily result in a higher debt-equity ratio, all else equal?

A)Convertible bondholders convert their bonds to shares of common stock.
B)The value of the firm's equity increases because of a lower cost of equity capital.
C)Warrant owners exercise their warrants.
D)The firm uses its excess cash to repurchase some of its shares.

Question 21

Which of the following would you expect to offer the highest interest rate, all else equal?

A)a convertible bond
B)a callable bond
C)a putable bond
D)a collateralized bond

Question 22

A firm that is worth $800 million initiates a rights offering that will allow each of its 100 million shareholders to buy one additional share at a discount of 15%. If only 25% of the existing
Shareholders participate in the rights offering and the others simply let their rights expire,
What is the percentage gain to the participating shareholders? Assume the firm is all-equity
Financed, and round your answer to the nearest tenth of a percent.

A)14.1%
B)3.7%
C)15.0%
D)4.9%

Question 23

Which of the following statements regarding optimal capital structure is true?

A)A firm that is not operating at its optimal capital structure is likely to be acquired by another firm that can earn arbitrage profits by purchasing the firm at a low market price
And making the necessary adjustments to it capital structure.
B)The optimal capital structure tends to change as a firm's market value changes.
C)The optimal capital structure is elusive and largely irrelevant, and managers can spend their time better on other issues.
D)None of the above is a true statement.

Question 24

A survey of CFOs indicated that

A)financial flexibility is only a concern for managers of smaller firms; larger, publicly-traded firms are easily able to raise funds as necessary.
B)having a low interest coverage ratio is very important to them.
C)they pay close attention to their bond ratings and interest coverage ratios.
D)targeting an optimal long-term capital structure is more important to them than working capital management issues.

Question 25

A type of offering that allows existing shareholders to maintain their proportionate ownership of the firm is called a

A)rights offering.
B)general warrant.
C)preferred warrant.
D)Rule 415 offering.

Question 26

Which of the following statements about an ECAPS (Enhanced Capital Advantaged Security)is true?

A)Interest payments may be delayed at the option of the issuer.
B)ECAPS are exchange-traded funds that invest in secured, short-term debt instruments.
C)Interest payments are taxed at the same rate as dividend income to the individual investor.
D)Interest payments are not tax-deductible since these are perpetual bonds.

Question 27

Most bonds trade

A)in the over-the-counter market.
B)on the American Bond Exchange.
C)on the New York Bond Exchange.
D)on electronic communication networks (ECNs).

Question 28

How is a revolver different from term debt?

Question 29

Which of the following statements regarding working capital management is (are)true?

A)An irrevocable credit line will allow a firm to maintain its financial flexibility, even in times of financial distress, and is relatively low cost.
B)Investing cash in liquid assets, such as Treasury bills, allows a firm to maintain financial flexibility at no cost.
C)Matching income with liability streams works best if your cash flows are fairly predictable.
D)All of the above are true statements.

Question 30

Which of the following statements about coercive bond exchange offers is true?

A)A bond with a coercive exchange offer provides upside potential with limited downside risk to the bondholders.
B)A bond with a coercive exchange offer would have to offer a higher rate of return, all else equal.
C)The owner of a bond that has a coercive exchange offer will be better off if he or she chooses not to participate in the offer.
D)If all the bondholders choose to participate in a coercive exchange offer, they will collectively be better off.

Question 31

Treasury stock refers to

A)bonds issued by the U.S. government.
B)ownership interests in a commercial bank.
C)shares of stock that have been authorized to be sold, but that have not yet been sold to the public.
D)shares of stock that have been repurchased by the company that issued them.

Question 32

A "revolver" is

A)a bond that is both callable and convertible.
B)debt with no effective maturity since it can be rolled over an infinite number of times at the request of the borrowing firm.
C)an open line of credit with a bank that requires the borrowing firm to pay a fee on any unused portion of the credit line.
D)an intermediate-term, zero-coupon bond.

Question 33

True, False, or Uncertain: Managers should try to maintain the highest level of
liquidity that they possibly can in order to insure the firm has maximum financial
flexibility. Explain.

Question 34

The different tranches of term debt

A)have different repayment schedules and different maturity dates.
B)have different repayment schedules but the same maturity date.
C)all offer the same promised interest rate.
D)Both B and C are true statements.

Question 35

What are the three methods described in this chapter that a publicly-held firm can use
to sell additional equity? Briefly explain each method.

Question 36

A firm can choose to remain private and avoid a lot of regulatory issues if its shares are not sold to the general public and if it has fewer than how many investors?

A)1,000
B)150
C)100
D)500

Question 37

Which of the following statements about the preliminary prospectus is (are)true?

A)It indicates the maximum price at which the shares will be sold in the IPO.
B)It typically provides a price range within which the shares are expected to be offered for sale.
C)It provides prospective buyers with the specific assumptions used to set the price at which the shares will be offered.
D)All of the above are true statements.

Question 38

Why would a firm choose to issue new shares through a rights offering, given that
when they do so, they sell the shares to existing shareholders at a price that is below
the current market value of the stock?

Question 39

In what way do leveraged buyout firms deviate from the pecking order in their
financing arrangements? Be specific. What is a major result of this deviation?

Question 40

Based on empirical evidence, how quickly do managers react to counteract market
changes to their capital structures? What implication does this have on the use of
comparables?

Question 41

A $400 million, all-equity-financed firm raises another $50 million in equity, paying $10 million in issuing fees. The value of the existing equity drops to $375 million. The total cost of
The issue is

A)$25 million.
B)$60 million.
C)$50 million.
D)$35 million.

Question 42

An all-equity-financed firm is worth $800 million and raises another $200 million with new equity, paying $80 million in issuing fees. Calculate the percentage dilution, assuming that all
The dilution is due to the dilution of ownership interest of the existing shareholders. Round
Your answer to the nearest tenth of a percent.

A)25.0%
B)21.7%
C)15.0%
D)39.8%

Question 43

The lock-up period is the period of time

A)during which a firm's management is prohibited from discussing any matters relating to an upcoming IPO.
B)during which auditors prepare the financial statements necessary for the filing of the preliminary prospectus.
C)between the filing of the preliminary prospectus and receiving SEC approval.
D)during which insiders are not allowed to sell their shares after the initial public offering.

Question 44

Empirical evidence suggests that

A)an increase in equity ratio is good news.
B)an increase in the debt ratio is viewed as bad news.
C)an increase in firm size is viewed as bad news.
D)all of the above.

Question 45

What is trade credit? How is it a source of financing? Are there any limitations
associated with this type of financing?

Question 46

If shares in successful IPOs are oversubscribed by a factor of 5 and if offerings either appreciate or depreciate by 10% on the first day of trading, what would you expect your rate of return to
Be without IPO underpricing, assuming fair rationing? (Assume half of the offerings are
Successful.)

A)-4%
B)-1%
C)-5%
D)+1%

Question 47

A $600 million, all-equity-financed firm raises another $100 million in equity, paying $30 million in issuing fees. The value of the existing equity drops to $570 million. The total cost of
The issue is

A)$60 million
B)$100 million.
C)$130 million.
D)$30 million.

Question 48

Dilution

A)is the result of the decrease in the percentage ownership of the existing shareholders.
B)can be positive or negative.
C)is equal to the net issuing announcement drop as a percent of the new equity raised.
D)both B and C.

Question 49

A supplier offers your firm a 2% discount if you pay your bill within 10 days of the invoice. Otherwise, the full balance is due in 40 days. What is the effective annual cost of forgoing the
Discount and using this trade credit? Assume a 365-day year, and round your answer to the
Nearest tenth of a percent.

A)27.9%
B)27.3%
C)24.0%
D)24.5%

Question 50

Results of a study on dividend increases found that an announcement of a dividend increase produced, on average,

A)a 1.5% decrease in price.
B)a 200 basis point increase in price.
C)a 4% increase in price.
D)a 25 basis point increase in price.

Question 51

Based on empirical evidence of publicly traded firms in the U.S. from 1980 to 2000, the average dilution associated with an equity issue was

A)15%.
B)2%.
C)10%.
D)5%.

Question 52

A supplier offers your firm a 2% discount if you pay your bill within 10 days of the invoice. Otherwise, the full balance is due in 40 days. You choose to use the trade credit, but you delay
Your payment until 60 days after receiving the invoice. What is the effective annual cost to you
Of this arrangement? Assume a 365-day year, and round your answer to the nearest tenth of a
Percent.

A)27.9%
B)15.9%
C)24.0%
D)none of the above

Question 53

Trade credit is

A)a type of bank loan.
B)an international financing arrangement.
C)venture capital financing.
D)supplier financing.

Question 54

Shares in a successful IPO are oversubscribed by a factor of 4. Offerings are expected
either to appreciate by 20% or depreciate by 20% on the first day of trading. If half of
the offerings are oversubscribed, by what percentage do the shares of an IPO have to
be underpriced to keep you in the market, assuming fair rationing?

Question 55

The underwriting fees charged by the investment bankers when a new security is issued are paid

A)by the new shareholders.
B)by both the old and the new shareholders, based on their percentage ownership interests.
C)by the old shareholders.
D)by all the existing investors in the firm, including the bondholders if it is a debt issue.

Question 56

On average,

A)the announcement of a debt-for-equity exchange results in an increase in stock price.
B)the announcement of a new equity issue results in an increase in stock price.
C)the announcement of a new debt issue results in an increase in stock price.
D)both A and C.

Question 57

Which of the following perspectives of capital structure is not supported by the empirical evidence?

A)corporate tax perspective
B)financial distress costs perspective
C)inside information perspective
D)agency perspective

Question 58

What are the two agency conflicts that might explain why IPOs tend to be
underpriced? Discuss briefly.

Question 59

Which of the following statements regarding initial public offerings (IPOs)is true?

A)Approximately 50% of the firm is sold in the typical IPO.
B)The IPO stock price typically increases about 2% when the lock-up period is about to expire.
C)IPOs tend to be slightly overpriced.
D)On average, IPO firms underperform similar benchmark firms, beginning 6 months after the IPO.

Question 60

An all-equity-financed firm is worth $500 million and raises another $100 million with new equity, paying $20 million in issuing fees. Calculate the percentage dilution, assuming that all
The dilution is due to the dilution of ownership interest of the existing shareholders. Round
Your answer to the nearest tenth of a percent.

A)17.2%
B)19.8%
C)20.0%
D)none of the above

Question 61

According to the empirical evidence, how is an increase in firm size regarded by the
markets? Is there any difference in the market reaction if the increase is due to a debt
issue or a new equity issue?