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Flashcards in TUDY UNIT SEVEN CORPORATE CAPITAL STRUCTURE Deck (19):
1

Call provisions give bondholders the right to redeem bonds.
True.
False.

False.
Your answer is correct.
Call provisions give the issuer the right to redeem bonds. If interest rates decline, the issuer can call high-interest bonds and replace them with low-interest bonds.

2

Preferred shareholders have priority over common shareholders in the distribution of assets during liquidation.
True
False

True
Your answer is correct.
If the firm goes bankrupt, the preferred shareholders have priority over common shareholders.

3

Dividends must be paid to holders of common stock before preferred shareholders can receive current or past dividends.
True
False

False
Your answer is correct.
If preferred dividends are cumulative, dividends in arrears must be paid before any common dividends can be paid.

4

The model provided by standard financial theory focuses management effort on minimizing the marginal cost of capital rather than maximizing earnings per share.
True
False

False
Your answer is correct.
Standard financial theory provides a model for the optimal capital structure of every firm. This model holds that shareholder wealth-maximization results from minimizing the weighted-average cost of capital. Thus, the focus of management should not be on maximizing earnings per share (EPS can be increased by taking on more debt, but debt increases risk).

5


Each share of nonparticipating, 8%, cumulative preferred stock in a company that meets its dividend obligations has all of the following characteristics except
A Dividend payments that are not tax deductible by the company.
B A superior claim to common stock equity in the case of liquidation.
C Voting rights in corporate elections.
D No principal repayments.

C Voting rights in corporate elections.
This answer is correct.
Dividends on cumulative preferred stock accrue until declared; that is, the book value of the preferred stock increases by the amount of any undeclared dividends. Participating preferred stock participates with common shareholders in excess earnings of the company. In other words, 8% participating preferred stock might pay a dividend each year greater than 8% when the corporation is extremely profitable. Therefore, nonparticipating preferred stock will receive no more than is stated on the face of the stock. Preferred shareholders rarely have voting rights. Voting rights are exchanged for preferences regarding dividends and liquidation of assets.

6

The target capital structure of Traggle Co. is 50% debt, 10% preferred equity, and 40% common equity. The interest rate on debt is 6%, the yield on the preferred equity is 7%, the cost of common equity is 11.5%, and the tax rate is 40%. Traggle does not anticipate issuing any new stock. What is Traggle’s weighted-average cost of capital?
A 8.30%
B 6.50%
C 6.77%
D 7.10%

D 7.10%

This answer is correct.
A firm’s weighted-average cost of capital is a single, composite rate of return on its combined components of capital. The component cost of debt is the after-tax interest rate on the debt because the interest payments are tax deductible. The after-tax cost of debt is 3.6% [6% × (1.0 – .40)]. The weighted-average cost of capital is calculated as follows:

Target Weight


Component Cost


Weighted Cost





Debt

50%

×

3.6%

=

1.8%
Preferred equity

10%

×

7.0%

=

0.7%
Common equity

40%

×

11.5%

=

4.6%





Totals

100%




7.1%

7

Which one of the following statements is true when comparing bond financing alternatives?
A A bond with a call provision typically has a lower yield to maturity than a similar bond without a call provision.
B A convertible bond must be converted to common stock prior to its maturity.
C A call provision is generally considered detrimental to the investor.
D A call premium requires the investor to pay an amount greater than par at the time of purchase.

C A call provision is generally considered detrimental to the investor.
This answer is correct.
A callable bond can be recalled by the issuer prior to maturity. A call provision is detrimental to the investor because the issuer can recall the bond when market interest rates decline. It is usually exercised only when a company wishes to refinance high-interest debt.

8


Maloney, Inc.’s $1,000 par-value preferred stock paid its $100 per share annual dividend on April 4 of the current year. The preferred stock’s current market price is $960 a share on the date of the dividend distribution. Maloney’s marginal tax rate (combined federal and state) is 40%, and the firm plans to maintain its current capital structure relationship. The component cost of preferred stock to Maloney would be closest to
A 6%
B 10.4%
C 10%
D 6.25%

B 10.4%
This answer is correct.
The component cost of preferred stock is equal to the dividend yield, i.e., the cash dividend divided by the market price of the stock. (Dividends on preferred stock are not deductible for tax purposes; therefore, there is no adjustment for tax savings.) The annual dividend on preferred stock is $100 when the price of the stock is $960. This results in a cost of capital of about 10.4% ($100 ÷ $960).

9

The stock of Fargo Co. is selling for $85. The next annual dividend is expected to be $4.25 and is expected to grow at a rate of 7%. The corporate tax rate is 30%. What percentage represents the firm’s cost of common equity?
A 12.0%
B 5.0%
C 7.0%
D 8.4%

A 12.0%
This answer is correct.
The cost of common stock may be calculated using a form of the dividend growth model. It is based on the assumption that common shareholders demand dividends that increase at a constant rate.
Percentage cost

=

(Net dividend ÷ Net issue proceeds) + Dividend growth rate

=

($4.25 ÷ $85) + 7%

=

5% + 7%

=

12%

10

ABC Co. had debt with a market value of $1 million and an after-tax cost of financing of 8%. ABC also had equity with a market value of $2 million and a cost of equity capital of 9%. ABC’s weighted-average cost of capital would be
A 8.7%
B 9.0%
C 8.0%
D 8.5%

A 8.7%
This answer is correct.
ABC’s weighted-average cost of capital can be calculated as follows:

Market



Component


Weighted

Value

Weight


Cost


Cost






Debt

$1,000,000

33.33%

×

8%

=

2.67%
Equity

2,000,000

66.67%

×

9%

=

6.00%






Totals

$3,000,000

100.00%




8.67%

11

Joint Products, Inc., a corporation with a 40% marginal tax rate, plans to issue $1,000,000 of 8% preferred stock in exchange for $1,000,000 of its 8% bonds currently outstanding. The firm’s total liabilities and equity are equal to $10,000,000. The effect of this exchange on the firm’s weighted-average cost of capital is likely to be
A A decrease, since preferred stock payments do not need to be made each year, whereas debt payments must be made.
B No change, since it involves equal amounts of capital in the exchange and both instruments have the same rate.
C A decrease, since a portion of the debt payments are tax deductible.
D An increase, since a portion of the debt payments are tax deductible.

D An increase, since a portion of the debt payments are tax deductible.
This answer is correct.
The payment of interest on bonds is tax-deductible, whereas dividends on preferred stock must be paid out of after-tax earnings. Thus, when bonds are replaced in the capital structure with preferred stock, an increase in the cost of capital is likely, because there is no longer a tax shield.

12

The cost of debt most frequently is measured as
A Actual interest rate minus tax savings.
B Actual interest rate adjusted for inflation.
C Actual interest rate.
D Actual interest rate plus a risk premium.

A Actual interest rate minus tax savings.
This answer is correct.
The cost of debt most frequently is measured as the after-tax interest rate on the debt. Therefore, the component cost is equal to the effective rate multiplied by 1 minus the marginal tax rate.
View Subunit 7.4 Outline

13

The capital structure of a firm includes bonds with a coupon rate of 12% and an effective interest rate is 14%. The corporate tax rate is 30%. What is the firm’s net cost of debt?
A 9.8%
B 4%
C 8.4%
D 12%

A 9.8%
This answer is correct.
Because of the tax deductibility of interest payments, the cost of debt equals the effective interest rate times one minus the marginal tax rate. The effective rate is used rather than the coupon rate (stated rate) because the effective rate is the actual cost of the amount borrowed. Thus, the net cost of debt is 9.8% [14% × (1.0 – .30)].
View Subunit 7.4 Outline

14

Which of the following types of bonds is most likely to maintain a constant market value?

A. Floating-rate.
B. Callable.
C. Zero-coupon.
D. Convertible.

A. Floating-rate.
Answer (A) is correct.
Floating-rate bonds are most likely to maintain their constant market value because their return varies with market conditions.
(7.1.11)

15

All of the following may allow a firm to set a lower coupon rate on a bond issued at par except a

A. Sinking fund.
B. Conversion option.
C. Call provision.
D. Higher rating from a bond rating agency.

C. Call provision.
Answer (C) is correct.
A bond issued at par may carry a lower coupon rate than other similar bonds in the market if it has some feature that makes it more attractive to investors. For example, a sinking fund reduces default risk. Hence, investors may require a lower risk premium and be willing to accept a lower coupon rate. Other features attractive to investors include covenants in the bond indenture that restrict risky undertakings by the issuer and an option to convert the debt instruments to equity securities. The opportunity to profit from appreciation of the firm’s stock justifies a lower coupon rate. An improvement in a bond’s rating from Aa to Aaa (the highest possible) also justifies reduction in the risk premium and a lower coupon rate. However, a call provision is usually undesirable to investors. The issuer may take advantage of a decline in interest rates to recall the bond and stop paying interest before maturity.
(7.1.19)

16

Scrunchy-Tech, Inc., has determined that it can minimize its weighted-average cost of capital (WACC) by using a debt-equity ratio of 2/3. If the firm’s cost of debt is 9% before taxes, the cost of equity is estimated to be 12% before taxes, and the tax rate is 40%, what is the firm’s WACC?

A. 10.80%
B. 7.92%
C. 6.48%
D. 9.36%

D. 9.36%
Answer (D) is correct.
A firm’s weighted-average cost of capital (WACC) is derived by weighting the (after-tax) cost of debt of 5.4% [9% × (1 – 40%)] and cost of equity of 12%. The tax rate does not affect the cost of equity. Scrunchy-Tech’s WACC can be calculated as follows:



Component


Component

Weight


Cost


Totals





Debt

40%

×

5.4%

=

2.16%
Equity

60%

×

12.0%

=

7.20%






100%




9.36%
(7.5.61)

17

This year, Nelson Industries increased earnings before interest and taxes (EBIT) by 17%. During the same period, earnings per share increased by 42%. The degree of financial leverage that existed during the year is

A. 2.47
B. 5.90
C. 4.20
D. 1.70

A. 2.47
Answer (A) is correct.
If earnings before interest and taxes increased by 17%, and earnings per share income was up 42%, the firm is using leverage effectively. The degree of financial leverage is the percentage change in earnings per share divided by the percentage change in EBIT. Accordingly, Nelson’s degree of financial leverage is 2.47 (.42 ÷ .17).
(7.1.9)

18

A company recently issued 9% preferred stock. The preferred stock sold for $40 a share with a par of $20. The cost of issuing the stock was $5 a share. What is the company’s cost of preferred stock?
A. 10.3%
B. 5.1%
C. 4.5%
D. 9.0%

B. 5.1%
Answer (B) is correct.
The rate of return demanded by holders of preferred stock equals its component cost. The component cost of preferred stock equals the cash dividend divided by the net proceeds received. The cash dividend equals $1.80 ($20 par × 9%), and the net proceeds equal $35 ($40 selling price – $5 issue cost). Thus, the cost of preferred stock is 5.1% ($1.80 ÷ $35).
(7.4.47)

19

What would be the primary reason for a company to agree to a debt covenant limiting the percentage of its long-term debt?
A To lower the company’s bond rating.
B To reduce the interest rate on the bonds being sold.
C To reduce the risk for existing bondholders.
D To cause the price of the company’s stock to rise.

B To reduce the interest rate on the bonds being sold.

This answer is correct.
The bond indenture is the contractual arrangement between the issuer and the bondholders. It contains restrictive covenants intended to prevent the issuer from taking actions contrary to the interests of the bondholders. A trustee, often a bank, is appointed to ensure compliance. For example, the issuer may be required to (1) maintain its financial ratios, e.g., the ratio of total long-term debt to equity or times-interest-earned, at specified levels; (2) limit dividends if earnings do not meet specified requirements; or (3) restrict the amount of new bonds issued to a percentage of bondable property (fixed assets). The undertakings in the debt covenant reduce the risk for holders of the new debt and the default risk premium included in the interest rate.
View Subunit 7.1 Outline