- CFA Exams
- CFA Level I Exam
- Topic 3. Corporate Issuers
- Learning Module 6. Capital Structure
- Subject 4. Optimal Capital Structure
CFA Practice Question
Which of the following is likely to lead to an increased use of debt?
B. Little shielded taxable income.
C. A desire for financial flexibility.
D. A relatively conservative management.
A. A higher degree of business risk.
B. Little shielded taxable income.
C. A desire for financial flexibility.
D. A relatively conservative management.
Correct Answer: B
If a firm has little or no used tax shields, then there is incentive to take on debt due to the tax deductibility of the interest payment.
User Contributed Comments 7
| User | Comment |
|---|---|
| quynhnk79 | why not D? someone can explain? |
| achu | 'at any point in time' is the key phrase. At inception maybe D is true but as market changes, D no longer hold. |
| 8thlegend | Different debt instruments, different states interest rates. Too much for a firm to deal with |
| czar | The stated interest rate maybe on a premium bond (higher interest rate than par) or a discount bond (lower interest than par). such interest rates don't indicate the market rate at tht point of time. Secondly, YTM approach requires the mkt rate in the calc. of debt component for WACC |
| dmfz | I disagree, the coupon payment is the coupon payment, the bond maybe trading at 40 and if you and if it was $1000 bond with a 10% coupon, you will pay $5 regadless. |
| assiduous | This question isn't worded the best. I like the intent behind the question but it confuses those who aren't 100% clear on the concept. The way the question is worded both A and D are correct. Using czar's explanation A is correct. Using dmfz explanation D is correct. Perhaps "The before-tax cost of 'new' debt" is more clear cut. Take a company whose debt ratings dip below investment grade. The before-tax cost would still be the stated interest on the debt for any debt capital received when the company had investment grade ratings. However, should the company seek out any additional debt capital, the before-tax cost of the new debt will be subject to the current market borrowing rate. Also, considering debt capital is outstanding for years on in, the phrase "at any point in time" is really misleading. |
| Teeto | WACC is foward looking. So opportunity cost is always a market one, since opportunities are valued by the market. |