Question

CFO: Before our next meeting with the bankers, let’s take a second and make sure that we have a common understanding about the company’s capital structure. We get to choose the form of money used to finance TNG’s activities. We can use borrowed (debt) money or retained earnings, we can sell new shares of common stock, or we can sell new preferred shares. So, my question to you, Natalia, is how do we know what sources of financing have been used in the past, and how much of each should we use in the future?

Natalia: The (right-hand or bottom / left-hand or top) section of the company’s balance sheet reports the forms of financing that have been used in the past. These forms of financing represent ongoing financial commitments of the firm. Since TNG’s current capital structure consists of 54.5% debt and 45.5% common equity, then we know that our current (debt capacity / equity capacity), or the proportion of debt in the capital structure, is 54.5%.

CFO And?

Natalia: We know that TNG can exhibit three possible capital structures: its current, actual capital structure, a target capital structure, and an optimal capital structure. The (target / optimal) capital structure is the long-run structure at which TNG ultimately wants to operate, while an (actual / optimal) capital structure will maximize the value of TNG’s common stock and make our shareholders very happy.

CFO Good, Natalia! Now, is there a relationship between a firm’s optimal capital structure and its weighted average cost of capital?

Natalia Yes, there is a relationship; not only will an optimal capital structure maximize the value of a corporation, it will also (maximize / minimize) the company’s weighted average cost of capital. However, the exact value of the (equity-to-debt ratio / debt-to-equity ratio) that corresponds to an organization’s optimal capital structure depends on its industry and the characteristics of the firm.

CFO Excellent overview, Natalia! You’ve passed my first test with flying colors! With this understanding of the theory and some real-world experience, you’ll be earning your bonus in no time.

Answer 1

The correct answers are as below:

Natalia: The (right-hand or bottom ) section of the company’s balance sheet reports the forms of financing that have been used in the past. These forms of financing represent ongoing financial commitments of the firm. Since TNG’s current capital structure consists of 54.5% debt and 45.5% common equity, then we know that our current (debt capacity ), or the proportion of debt in the capital structure, is 54.5%.

CFO And?

Natalia: We know that TNG can exhibit three possible capital structures: its current, actual capital structure, a target capital structure, and an optimal capital structure. The (target ) capital structure is the long-run structure at which TNG ultimately wants to operate, while an (optimal) capital structure will maximize the value of TNG’s common stock and make our shareholders very happy.

CFO Good, Natalia! Now, is there a relationship between a firm’s optimal capital structure and its weighted average cost of capital?

Natalia Yes, there is a relationship; not only will an optimal capital structure maximize the value of a corporation, it will also ( minimize) the company’s weighted average cost of capital. However, the exact value of the (debt-to-equity ratio) that corresponds to an organization’s optimal capital structure depends on its industry and the characteristics of the firm.

CFO Excellent overview, Natalia! You’ve passed my first test with flying colors! With this understanding of the theory and some real-world experience, you’ll be earning your bonus in no time.