Factors affecting capital structure and the WACC — MCQs

A company needs USD 10 million. It can issue debt at 6% or issue shares at USD 20. With EBIT of USD 4 million, 5 million existing shares, and a 25% tax rate, the EPS-maximizing choice is:

Ardent Systems operates two divisions with substantially different business models. Its Software division sells subscription-based workflow products with recurring revenue, low marginal distribution costs, and high expected growth. Its Logistics division owns physical distribution facilities, earns contract-based revenue, and requires significant maintenance capital expenditures. Investors have argued that consolidated reporting obscures the divisions' different growth, capital intensity, and risk characteristics. The board is considering a corporate restructuring. A strategic buyer has offered to acquire Logistics, while advisers have also proposed either a pro rata spin-off or liquidation of the division's assets. Selected valuation data appear in Exhibit 1, and the board's objectives and restructuring alternatives appear in Exhibit 2. The estimated stand-alone DCF value reflects Logistics' expected cash flows under Ardent's ownership and excludes any buyer-specific synergies. The strategic buyer expects annual pre-tax operating synergies from combining distribution networks. These synergies support the offered price, but Ardent would incur transaction fees and tax on the sale. Net sale proceeds would be available for debt repayment, investment in Software, or distributions to shareholders. A spin-off would not provide Ardent with cash but would give each Ardent shareholder a proportionate ownership interest in the newly independent Logistics company. The spin-off is assumed to satisfy all requirements for tax-free treatment. Ardent also reviews its company-wide cost of capital. The values in Exhibit 1 are current market values. The cost of equity was estimated with a beta reflecting Ardent's present operating and financial risk, and the pre-tax cost of debt reflects the current required return on its debt. Interest is fully tax deductible, and the stated tax rate is the relevant marginal rate. During the review, one director proposes acquiring a small software competitor and argues that any acquisition increasing Ardent's earnings per share must create shareholder value. The finance team responds that EPS accretion can be affected by purchase consideration, financing, and the relative earnings yields of the acquirer and target. It recommends evaluating incremental after-tax cash flows, synergies, integration costs, and the acquisition premium instead of relying solely on reported EPS.

Valen Chemicals is reviewing its cost of capital and evaluating an expansion into specialty coatings. The company's debt and equity are publicly traded, and the financing information in Exhibit 1 reflects current market values. Valen's debt beta is assumed to be zero, interest is tax deductible, and the company expects to maintain its current company-wide capital structure for existing operations. The specialty-coatings project has less operating risk than Valen's existing chemical businesses. The finance director therefore selects a publicly traded pure-play comparable company. Exhibit 1 provides the comparable company's observed equity beta and debt-to-equity ratio. The comparable and Valen face the same 25% corporate tax rate. The project will be financed at its own target debt-to-equity ratio, also shown in the exhibit. The finance director will use the standard beta unlevering and relevering equations and CAPM to estimate the project's cost of equity. Valen is also considering a USD 100 million open-market share repurchase funded entirely with surplus cash. For analysis of the repurchase, management assumes perfect capital markets, no taxes or transaction costs, no information asymmetry, and repurchases at fair value. One director argues that the repurchase must create value because fewer outstanding shares will increase earnings per share. Another director notes that the company will distribute cash of equal value to the shares acquired. An environmental review identifies emissions from the proposed coatings facility that could become subject to tighter regulation. Although current law does not require immediate remediation, the analyst concludes that the issue could affect expected operating costs, customer demand, and future regulatory penalties. The analyst can estimate probability-weighted cash-flow effects from these exposures. She is considering whether to incorporate those effects in projected cash flows and also add a separate ESG risk premium to the discount rate. Unless project-specific information indicates otherwise, Valen uses market-value capital weights and after-tax borrowing costs. Management has instructed the analyst to avoid counting the same economic risk in both expected cash flows and the discount rate.

An analyst assessing an ordinary publicly traded corporation should most likely characterize the corporation itself as having:

An analyst assesses the rights of an ordinary shareholder in a solvent public corporation. The shareholder's position is best described as:

A company applying a residual dividend policy has net income of USD 50 million, a USD 60 million capital budget, and a target debt weight of 40%. The calculated dividend payout ratio is closest to:

Northstar Commerce operates a digital marketplace connecting independent merchants with retail customers. Equity analyst David Okoro is reviewing the company before recommending whether his firm should participate in a new Class A share issuance. Northstar was founded by Elena Maric, who remains chief executive officer and owns all outstanding Class B shares. Public investors own the Class A shares. Both classes have equal economic rights to dividends and liquidation proceeds, but their voting rights differ as shown in Exhibit 1. Neither class has cumulative voting rights. Okoro notes that Northstar has expanded rapidly by subsidizing customer deliveries and charging merchants below-market introductory fees. Management states that these expenditures are justified because the platform becomes more valuable to each participant as the numbers of merchants and customers increase. Northstar does not manufacture products, and its customer agreements can be cancelled monthly without penalty. The board is considering a logistics contract intended to support further expansion. The proposed provider is owned by Maric's brother, and the contract price is approximately 12% above the lowest competing bid. Management argues that the related company has greater knowledge of Northstar's systems and can begin work sooner. Northstar's governance policy requires disclosure of director and executive conflicts but does not specify who must approve a related-party transaction. Maric has disclosed the family relationship and intends to vote as a director on the contract. Okoro also reviews board composition and executive compensation. Three nominally non-executive directors have received substantial consulting fees from Northstar during each of the last three years. The two directors described as independent have no business or family relationships with management. Revenue growth has increased Maric's annual bonus, although operating margins, return on invested capital, and free cash flow have all declined. The board has not established minimum profitability or return-on-capital conditions for the bonus. Okoro concludes that public shareholders bear significant agency risk because voting control, executive authority, and influence over board nominations are concentrated in Maric. He nevertheless recognizes that concentrated ownership may align the founder with long-term value when effective independent oversight and appropriate incentives are present.

Meridian Link operates a digital business-to-business marketplace connecting small manufacturers with commercial purchasers. The company does not own warehouses or delivery fleets. It earns transaction fees when orders are completed and charges suppliers optional subscription fees for analytics and priority placement. Management reports that adding suppliers attracts more purchasers by improving product selection, while adding purchasers attracts additional suppliers by increasing potential order volume. The marginal cost of serving an additional participant is low once the platform infrastructure is established. Meridian completed an initial public offering two years ago. Its charter established the dual-class share structure summarized in Exhibit 1. The founder argues that this structure permits management to pursue long-term investment without pressure from short-term shareholders. Several institutional investors acknowledge that potential benefit but are concerned that voting rights disproportionate to economic ownership can entrench management and weaken the influence of minority shareholders. The founder recently proposed that Meridian outsource customer-support services to a private company wholly owned by the founder's sibling. The proposed contract is material relative to Meridian's annual operating expenses. Pricing has not been compared with bids from unrelated providers, and the founder participated in preliminary negotiations. Meridian's code of governance requires directors to disclose personal interests but does not specify the approval process for related-party transactions. The founder believes disclosure followed by a vote of the full board is sufficient. Equity analyst Dev Patel is also reviewing Meridian's environmental exposure. Data centers operated by third-party cloud providers account for a significant portion of the platform's operating costs. Meridian has publicly disclosed that a proposed carbon-pricing regime could increase future cloud-service charges. Patel considers the proposal sufficiently probable to affect expected operating costs, although the final tax rate remains uncertain. He incorporates probability-weighted carbon-related expenses into his cash-flow forecasts. Patel's colleague argues that the exposure should also be captured by adding a broad ESG premium to Meridian's discount rate. Patel responds that valuation inputs must remain internally consistent: expected costs should be reflected in cash flows, and the discount rate should be adjusted only for material systematic risk that is not already captured elsewhere. Both analysts agree that an ESG label alone does not establish financial materiality; the transmission channel to revenue, costs, assets, liabilities, or financing conditions must be identified.