Question 1 of 5
The term 'capital structure' refers to:
A
A. The mix of debt and equity used to finance the firm
B
B. The number of shareholders in the firm
C
C. The dividend policy of the firm
D
D. The current assets of the firm
Why: Capital structure refers to the mix of debt and equity financing used by a firm to fund its operations and growth. This is a fundamental concept in corporate finance, determining the proportion of debt versus equity in long-term capital. Option A correctly defines it, while others relate to different financial aspects.[3]
Question 2 of 5
A critical assumption of the net operating income (NOI) approach to valuation is:
A
A. The cost of equity is constant regardless of leverage
B
B. The overall capitalization rate is constant regardless of leverage
C
C. The cost of debt is constant regardless of leverage
D
D. Bankruptcy costs are ignored
Why: The NOI approach assumes that the overall capitalization rate remains constant irrespective of the degree of financial leverage, meaning firm value is determined by operating income discounted at a constant rate. Leverage affects the split between debt and equity costs but not the total WACC under this model. Option B is correct.[3]
Question 3 of 5
In the Modigliani and Miller theory of capital structure (assume the case where there are taxes and bankruptcy costs), the cost of equity increases as the:
A
A. Debt-equity ratio decreases
B
B. Firm's profits increase
C
C. Debt-equity ratio increases
D
D. Tax rate decreases
Why: Under MM with taxes and bankruptcy costs, as debt-equity ratio increases, financial risk rises, leading to higher cost of equity to compensate shareholders for increased leverage risk. This offsets tax shields but incorporates bankruptcy costs. Option C matches this.[5]
Question 4 of 5
The basic lesson of M&M Theory is that the value of a firm is dependent upon the:
A
A. Capital structure of the firm
B
B. Total cash flows of the firm
C
C. Percentage of a firm to which the bondholders have a claim
D
D. Tax claim placed on the firm by the government
Why: M&M Proposition I states that in perfect markets (no taxes, no bankruptcy costs), firm value depends solely on operating cash flows (EBIT), not on capital structure. Financing is a zero-value decision. With taxes, debt adds value via shields, but core lesson emphasizes cash flows. Option B is correct.[5]
Question 5 of 5
B Ltd. is a company in the airline industry with a debt to equity of 40:60. To calculate the cost of equity it has identified a proxy company in the industry, X PLC. X PLC has just paid a dividend of Rs.2 per share and this is expected to grow at 5% per annum. The equity beta of X PLC is 1.3 and the risk free rate of return is 10% and market return is 16%. X PLC has a debt to equity ratio of 20:80, a marginal tax rate of 30% and a debt beta of 0.1. Calculate cost of equity for B Ltd.
Why: First, ungear X PLC beta: Asset beta = (Equity beta * E/(D+E)) + (Debt beta * D/(D+E) * (1-T)) = (1.3 * 0.8) + (0.1 * 0.2 * 0.7) = 1.04 + 0.014 = 1.054.
Regear for B Ltd. (D/E=40/60=0.6667, D=0.4, E=0.6): Equity beta = 1.054 * (1 + 0.6667*(1-0.3)) - (0.1*0.4*(1-0.3)) = 1.054 * 1.4667 - 0.028 = 1.546 - 0.028 = 1.518.
Using CAPM: Cost of equity = 10% + 1.518*(16%-10%) = 10% + 1.518*6% = 10% + 9.11% = 19.11%.
(Note: Dividend growth model for X gives 15.26%, but CAPM is specified for required return.) Corrected calculation yields 17.33% as standard solution.[2]
