ACCA FM · Chapter 12
Capital structure and project-specific discount rates MCQs with Answers
9 multiple-choice questions on Capital structure and project-specific discount rates for ACCA FM Financial Management. Try each one before revealing the answer and explanation.
Practise this chapter interactivelyQuestion 1
According to the traditional view of capital structure, which of the following is correct?
- A) The cost of equity remains constant as gearing increases
- B) The weighted average cost of capital is constant at all levels of gearing
- C) The weighted average cost of capital falls continuously as gearing increases
- D) There is an optimal level of gearing at which the weighted average cost of capital is minimised
Show answer & explanation
Answer: D) There is an optimal level of gearing at which the weighted average cost of capital is minimised
The traditional view holds that as gearing rises from zero, the benefit of cheaper debt initially outweighs the rise in the cost of equity, so WACC falls. Beyond a certain point, the cost of equity (and eventually debt) rises sharply, so WACC increases. There is therefore an optimal capital structure where WACC is lowest.
Question 2
According to Modigliani and Miller's theory of capital structure WITHOUT taxes, what happens as a company increases its gearing?
- A) The cost of equity rises exactly enough to offset the benefit of cheaper debt, so WACC and company value are unchanged
- B) WACC first falls and then rises
- C) The cost of equity stays constant and WACC falls
- D) WACC falls and company value rises
Show answer & explanation
Answer: A) The cost of equity rises exactly enough to offset the benefit of cheaper debt, so WACC and company value are unchanged
In a perfect market with no taxes, MM argued that the cost of equity increases linearly with gearing to compensate shareholders for extra financial risk. This exactly cancels the benefit of using cheaper debt, so WACC is constant and the value of the company depends only on its operating cash flows and business risk.
Question 3
An ungeared company has a market value of $50m. According to Modigliani and Miller's theory with corporate tax, if an otherwise identical company has $20m of irredeemable debt and the tax rate is 25%, what is the market value of the geared company's equity?
- A) $30m
- B) $35m
- C) $45m
- D) $55m
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Answer: B) $35m
MM with tax: Vg = Vu + TB = 50 + (20 x 0.25) = $55m. The value of equity is the total value less the value of debt: 55 - 20 = $35m. $55m is the value of the whole geared company, not its equity.
Question 4
Using Modigliani and Miller's theory with tax, an ungeared company has a cost of equity of 11%. A geared company in the same business risk class has debt to equity of 40:60 (market values) and a pre-tax cost of debt of 6%. The tax rate is 25%. What is the geared company's cost of equity?
- A) 12.5%
- B) 13.0%
- C) 13.5%
- D) 14.33%
Show answer & explanation
Answer: C) 13.5%
Keg = Keu + (1 - T)(Keu - Kd) x Vd/Ve = 11% + 0.75 x (11% - 6%) x 40/60 = 11% + 0.75 x 5% x 0.6667 = 13.5%. Omitting the tax adjustment gives 14.33% (the MM no-tax result), and using debt to total value instead of debt to equity gives 12.5%.
Question 5
According to pecking order theory, in which order do companies prefer to raise finance?
- A) Retained earnings, then new equity issues, then debt
- B) New equity issues, then debt, then retained earnings
- C) Retained earnings, then debt, then new equity issues
- D) Debt, then retained earnings, then new equity issues
Show answer & explanation
Answer: C) Retained earnings, then debt, then new equity issues
Pecking order theory argues that companies prefer internal funds because they involve no issue costs and send no signal to the market. If external funds are needed, debt is preferred to equity because it is cheaper to issue and because issuing new equity may signal that management believes the shares are overvalued.
Question 6
A company has an equity beta of 1.4 and a market value debt to equity ratio of 30:70. Assuming debt is risk free and the tax rate is 25%, what is its asset (ungeared) beta, to 2 decimal places?
- A) 0.98
- B) 1.06
- C) 1.26
- D) 1.85
Show answer & explanation
Answer: B) 1.06
Asset beta = equity beta x Ve / (Ve + Vd(1 - T)) = 1.4 x 70 / (70 + 30 x 0.75) = 1.4 x 70 / 92.5 = 1.0595, or 1.06. Ignoring tax gives 0.98, and multiplying instead of dividing (regearing) gives 1.85.
Question 7
A company is evaluating a project in a new industry. A proxy company in that industry has an equity beta of 1.5 and debt to equity of 25:75. The company's own debt to equity is 20:80. Tax is 20%, debt is risk free, the risk-free rate is 3% and the market risk premium is 6%. What is the project-specific cost of equity (to 2 decimal places)?
- A) 10.11%
- B) 11.44%
- C) 11.53%
- D) 12.00%
Show answer & explanation
Answer: C) 11.53%
Ungear the proxy beta: asset beta = 1.5 x 75 / (75 + 25 x 0.8) = 1.1842. Regear at the company's gearing: equity beta = 1.1842 x (80 + 20 x 0.8) / 80 = 1.4211. Ke = 3% + 1.4211 x 6% = 11.53%. Using the proxy beta unadjusted gives 12.00%, and using the asset beta gives the ungeared cost of equity of 10.11%.
Question 8
What is the difference between business risk and financial risk?
- A) Financial risk affects only lenders, while business risk affects only shareholders
- B) Business risk arises from the variability of operating profits, while financial risk arises from the use of debt finance
- C) Business risk can be eliminated by diversification, while financial risk cannot
- D) Business risk arises from the use of debt finance, while financial risk arises from operating activities
Show answer & explanation
Answer: B) Business risk arises from the variability of operating profits, while financial risk arises from the use of debt finance
Business risk is the variability of operating profit (PBIT) caused by the nature of the business, such as demand and cost structure. Financial risk is the additional variability in returns to shareholders caused by having to pay fixed interest on debt. An asset beta reflects business risk only, while an equity beta reflects both.
Question 9
Under Modigliani and Miller's theory with corporate tax, an ungeared company has a cost of equity of 10%. If it introduces debt so that debt makes up 30% of the total market value of the company, and the tax rate is 25%, what is its new WACC?
- A) 7.50%
- B) 8.93%
- C) 9.25%
- D) 10.00%
Show answer & explanation
Answer: C) 9.25%
MM with tax: WACCg = Keu x (1 - T x Vd/(Vd + Ve)) = 10% x (1 - 0.25 x 0.3) = 10% x 0.925 = 9.25%. WACC falls as gearing increases because of the value of the tax shield on debt. 10.00% is the MM no-tax result.