CPAnet Forum: optimum capital structure and net worth

Active Topics

Memberlist

Help

BEC STUDY GROUP
CPAnet Forum : BEC STUDY GROUP

Topic: optimum capital structure and net worth (

Topic Closed)

Author

Message

<< Prev Topic | Next Topic >>

kj_nyc
Major Contributor

Joined: 05 Jun 2009
Location: United States
Online Status: Offline
Posts: 1145

Posted: 30 Aug 2009 at 19:21 \| IP Logged

Becker Question CPA-03937

Osgood Products has announced that it plans to finance future investments so that the firm will achieve an optimum capital structure. Which one of the following corporate objectives is consistent with the announcement?

a. Maximize earnings per share.
b. Minimize the cost of debt.
c. Maximize the net worth of the firm.
d. Minimize the cost of equity.

Explanation
Choice "c" is correct. The optimal capital structure is the financial structure that would theoretically maximize shareholder wealth by maximizing the net worth of the company.
Choices "a", "b", and "d" are incorrect. Strategies (not objectives) for creating an optimal capital structure to
maximize net worth include:
1. Maximizing earnings per share (answer "a").
2. Minimizing the cost of debt (answer "b").
3. Minimizing the cost of equity (answer "d").
4. Maximizing cash flow (answer not given).

Why would maximizing net worth of the company maximize shareholder wealth? I assume we use the formula net worth = equity = total assets - total liabilities (or do they mean a different type of "net worth" here)? Having high net worth would mean having minimal debt; I would think that EPS would be a better measure of shareholder wealth than net worth?

Crammer
Major Contributor

Joined: 19 Aug 2009
Location: United States
Online Status: Offline
Posts: 283

Posted: 31 Aug 2009 at 00:28 \| IP Logged

I think what they're talking about is synonymous with the weighted average cost of debt (WACC). The mixture of debt and equity securities that produce the lowest WACC maximizes the value (net worth) of the firm. As WACC decreases Net Worth increases.

CPA N2009
Major Contributor

Joined: 10 Jul 2009
Location: United States
Online Status: Offline
Posts: 299

Posted: 31 Aug 2009 at 09:51 \| IP Logged

kj, This question stumped me when i was studing for REG as well. The questions ask for an objective (goal) not a strategy to get there. I always thought it was a play on words and they are getting too techincal - but I saw questions on the exam like this one. It's just a reminder to always RTFQ - even while studing - before I start the m/c I put that at the top of my scrape sheet of paper to make sure I understand what is being asked before I start working the problem.

__________________
REG - July 09 - 95
BEC - Aug 09 - 81
FAR - Oct 09 - 84
AUD - Nov 09

Gotta Keep Movin' On

kj_nyc
Major Contributor

Joined: 05 Jun 2009
Location: United States
Online Status: Offline
Posts: 1145

Posted: 31 Aug 2009 at 15:42 \| IP Logged

Thanks, Crammer and CPA N2009. It looks like the "net worth" in this answer explanation is different from the technical GAAP term that only means total assets minus total liabilities, and I was getting hung up on that. And I always need that RTFQ reminder. It's easy for me to misread a question, come up with an answer that doesn't match any of the choices, then finally see that it's because I had misunderstood what the question was asking.

Sorry, you can NOT post a reply.
This topic is closed.

Printable version

You cannot post new topics in this forum
You cannot reply to topics in this forum
You cannot delete your posts in this forum
You cannot edit your posts in this forum
You cannot create polls in this forum
You cannot vote in polls in this forum