Capital Structure�and Financing Strategy
FIN143
Turn the operating plan into a funding request the business can sustain.
Bootstrapping, debt, equity, and the terms that connect them
Devon Coombs CPA, MBA
Santa Clara University | Fall 2026
Bring the course together
Earlier learning | Use it in the financing decision |
Founder capital, expertise,�and goals | Set personal risk limits, resource needs, and control�priorities. |
Accounting and unit�economics | Separate growth and profit from cash available. |
Driver-based forecasting | Estimate the cash gap, milestone, timing, and�downside. |
NPV, valuation, and�risk/return | Test value creation and use a risk-matched�discount rate. |
Cap tables and deal terms | Compare dilution, payoff priority, and governance. |
VC fund economics | Assess investor fit and follow-on capacity. |
End product: a justified funding amount, instrument mix, proposed terms,�and contingency plan.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
02
Start with the business and the founder
Choose an operating plan that can create value, then a feasible way to�fund it. External capital can add capabilities as well as cash.
An attractive financing offer can still be a poor fit if its repayment or�growth expectations conflict with the business.
U.S. SBA, Fund your business: funding needs, self-funding, and external capital; Wasserman (2012), author interview on The Founder’s Dilemmas and Rich vs. King.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
03
Sources of cash create different obligations
Source | What the company gives or commits |
Founder funds�and retained cash | Personal capital at risk and its opportunity cost |
Customer funding | Delivery, service, and possible refund obligations |
Grants | Eligibility, restricted uses, and reporting requirements |
Debt | Interest, repayment, and negotiated lender protections |
Equity | Ownership, economic rights, and possible governance�rights |
Convertibles | Contractual conversion rights; a note also has debt�obligations |
Bootstrapping is a funding approach, not a security. Internal funding is limited�by available cash; accounting retained earnings are not a bank balance.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
04
Bootstrapping is a deliberate tradeoff
Bootstrapping can fit a business with modest upfront needs, early�customer receipts, and a founder who values independence.
It may require slower hiring, narrower scope, or staged experiments.�Those choices have opportunity costs; spending personal savings is�not economically free.
Customer prepayments help only after allowing for fulfillment costs�and obligations. Grants help only when eligibility, timing, and�permitted uses fit the plan.
Compare a smaller, credible milestone with a larger externally funded�plan. Do not assume that maximizing the amount raised maximizes�founder value.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
05
Knowledge check: fit the funding to the founder
A founder can afford a $40,000 pilot, wants an independently owned�business, and expects early customer receipts. Moving faster offers no�demonstrated advantage. Which starting strategy best fits these facts?
A. Raise a large VC round to maximize the cash available for�expansion.
B. Borrow against personal assets to preserve all operating flexibility.
C. Fund a limited pilot and reinvest receipts while testing demand.
D. Sell a large equity stake before estimating the pilot’s cash needs.
E. Choose the lowest quoted interest rate before setting the pilot’s�scope.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
06
W8-S006
143
Medium (4/8)
Knowledge check: fit the funding to the founder — Answer
Correct answer: C — Fund a limited pilot and reinvest receipts while�testing demand.
Why: The pilot fits the stated personal loss capacity, cash timing, and�independence goal. Results can inform whether a larger raise is�worthwhile.
Other choices: A and D introduce ownership and growth�commitments without a demonstrated need. B adds personal�downside and lender constraints. E chooses financing before defining�the operating requirement.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
07
W8-S006
143
Medium (4/8)
Translate growth into a monthly cash schedule
Start with customers, price, retention, gross margin, hiring, and collection timing.
Then connect the statements:
Restricted cash can fund only its permitted uses. Forecast the lowest unrestricted�cash balance before the next financeable milestone, including a downside case.�Profitability and positive NPV do not guarantee that payroll can be funded.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
08
Size the raise from the cash gap
Hypothetical; dollars in millions. The lowest forecast cash point occurs just�before a milestone. No new financing or financing costs are included in the�operating forecast.
Cash bridge | Amount |
Cumulative net operating and investment cash outflow | $1.80 |
Required minimum cash reserve | +$0.40 |
Financing fees paid at closing | +$0.10 |
Existing unrestricted cash | −$0.70 |
Required gross funding | $1.60 |
Recalculate after choosing terms: interest, amortization, restricted cash,�and draw conditions may increase the need. Test every month, not just the�milestone date.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
09
Knowledge check: distinguish�usable cash from reported cash
Assumptions: No other financing flows. Grant cash cannot fund this plan or its�reserve.
A company reports $1.20 million cash, including $0.30 million restricted to an�unrelated grant project. Its operating plan has $2.25 million of net cash outflow�to the lowest cash point. It needs a $0.40 million reserve and pays $0.10 million�of closing fees. What gross raise funds this plan?
A. $1.35 million.
B. $1.55 million.
C. $2.75 million.
D. $1.85 million.
E. $1.75 million.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
10
W8-S010
143
Medium (4/8)
Knowledge check: distinguish�usable cash from reported cash — Answer
Correct answer: D — $1.85 million.
Why: Only $1.20m − $0.30m = $0.90m is available. Required funding is�$2.25m + $0.40m + $0.10m − $0.90m = $1.85m.
Other choices: A omits fees and the reserve. B uses restricted cash�for an ineligible purpose. C ignores available cash. E omits closing fees.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
11
W8-S010
143
Medium (4/8)
First ask whether the operating plan creates value
NPV = present value of expected incremental cash flows − initial�investment. Use the return required for the investment’s risk.
Hypothetical: invest $1.00 million today and receive expected cash of�$1.30 million in one year, with no other cash flows. At a risk-matched�15% required return:
NPV = $1.30m ÷ 1.15 − $1.00m = +$0.130m.
The project still needs cash today. A low loan coupon does not make�that coupon the project’s discount rate. Evaluate genuine financing�benefits and costs separately and consistently.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
12
Cash flows and their discount rates
WACC is the weighted average required return on debt and equity, adjusted�for usable interest tax benefits.
Cash flow being valued | Consistent rate |
Free cash flow to the firm (FCFF): after�operating taxes and reinvestment, before debt�financing flows | WACC for the operating risk�and financing policy |
Free cash flow to equity (FCFE): net income +�noncash charges − capital spending − increase�in operating working capital + net borrowing | Cost of equity at the�corresponding leverage |
Net borrowing = new debt issued − principal repaid. Net income already�reflects interest.
Match currency, inflation, and periods. Reflect uncertainty consistently in�expected cash flows and required returns without double-counting risk.
Damodaran (2009), Valuing Young, Start-up and Growth Companies; OpenStax, Principles of Finance 2e, §17.3: WACC.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
13
Knowledge check: avoid a financing-driven NPV error
An expansion has expected cash flows before interest and debt principal. A�defensible WACC for this project’s risk and financing policy is 14%; a lender�quotes 9%. Which valuation treatment is consistent?
A. Discount those cash flows at 14%, keeping debt payments outside�FCFF.
B. Discount those cash flows at 9%, because that is the quoted�borrowing rate.
C. Subtract interest from those cash flows, then discount the result at�14%.
D. Average 9% and 14% equally without checking capital structure�weights.
E. Use the company’s historical loan coupon instead of the project’s risk.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
14
W8-S014
143
Medium (4/8)
Knowledge check: avoid a�financing-driven NPV error — Answer
Correct answer: A — Discount those cash flows at 14%, keeping�debt payments outside FCFF.
Why: FCFF belongs to all capital providers. Its rate must match the�operating risk and financing policy; the loan quote prices only the debt�claim.
Other choices: B substitutes a debt rate for WACC. C mixes�equity-related cash deductions with an FCFF rate. D invents weights. E�substitutes historical financing terms for the relevant opportunity�cost.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
15
W8-S014
143
Medium (4/8)
Modigliani–Miller: establish the benchmark
MM Proposition I, no taxes: with perfect capital markets and the same�operating assets and investment policy, changing the debt/equity mix�does not change total firm value.
The claims divide the business’s cash flows; they do not create�additional operating cash flows by themselves.
The assumptions remove taxes, transaction and distress costs, and�information problems. They are a benchmark for identifying why�financing matters in real companies.
Ask: Which real benefit or cost changes when we change the�financing?
Devon Coombs CPA, MBA · Santa Clara University · FIN143
16
Leverage shifts risk to equity
MM Proposition II, no taxes:
R_e = R_a + (R_a − R_d) × D/E
Debt is senior to equity. With the same operating risk, a smaller equity�cushion absorbs more variability; its required return rises as leverage�increases in the usual case R_a > R_d.
In the frictionless benchmark, cheaper debt is offset by riskier equity.�Debt costs can also rise as debt becomes riskier.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
17
Knowledge check: why cheap debt is not free value
In the MM no-tax benchmark, a firm replaces some equity with cheaper�debt while its operating assets and investment policy stay unchanged.�Why does this not automatically reduce its overall required return?
A. The firm’s operating projects become less profitable whenever it�borrows.
B. Debt and equity investors must receive the same required return.
C. The loan proceeds count as new operating income for the�shareholders.
D. The remaining equity becomes riskier and requires a higher return.
E. The accounting interest expense exactly equals the equity dilution�avoided.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
18
W8-S018
143
Easy (1/8)
Knowledge check: why cheap�debt is not free value — Answer
Correct answer: D — The remaining equity becomes riskier and�requires a higher return.
Why: The financing change reallocates operating risk. The higher�equity return offsets the use of lower-return debt under MM’s�assumptions.
Other choices: A changes the fixed operating assumptions. B�confuses a common underlying business with different claims. C�mistakes financing cash for income. E compares an expense with an�ownership percentage.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
19
W8-S018
143
Easy (1/8)
A tax shield has value only when it can be used
Interest can reduce corporate taxes when the deduction is usable.
In the simplified MM corporate-tax model, V_L = V_U + T_c × D:�permanent fixed debt, a constant tax rate, fully usable deductions, and�no offsetting distress or other financing costs.
V_L and V_U are values with and without debt; T_c is the corporate tax�rate and D is debt.
A loss-making company may receive no current cash-tax saving. A�potential later deduction has a different present value and may be�limited.
Do not automatically give a startup today’s full statutory-rate tax�shield. Model the timing and usability of the expected savings.
OpenStax, Principles of Finance 2e, §17.4: MM and corporate taxes; IRS, business-interest deduction FAQs, FS-2026-14, August 2026.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
20
Debt capacity is a tradeoff, not a preset percentage
Debt can add value through usable tax savings, but it can also increase�expected distress costs: disrupted operations, lost customers,�constrained investment, and restructuring costs.
In a simple model with an interior optimum, add debt until its marginal�tax benefit equals its marginal distress cost.
An interior optimum is not guaranteed. Zero or very low debt may be�best when tax benefits are weak and repayment risk is high.
Evaluate feasible amounts, repayment schedules, and downside�headroom. A spreadsheet minimum is not a loan commitment.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
21
Knowledge check: a startup’s tax-shield decision
A loss-making startup has uncertain future taxable income and large costs if debt�forces it to cut essential development. Which conclusion best applies the tradeoff�framework?
A. Use the statutory tax rate to value an immediate tax shield on every dollar�borrowed.
B. Weigh realizable tax savings against distress costs; little or no debt may be�best.
C. Ignore future deductions because a current tax loss makes them�permanently worthless.
D. Borrow to the point where the debt return and equity return become equal.
E. Target the debt percentage used by profitable peers before testing�repayment capacity.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
22
W8-S022
143
Medium (4/8)
Knowledge check: a startup’s tax-shield decision — Answer
Correct answer: B — Weigh realizable tax savings against distress�costs; little or no debt may be best.
Why: The benefit depends on whether and when tax savings are�usable; the costs depend on the consequences of financial distress.�The optimum can be at zero debt.
Other choices: A assumes immediate usability. C confuses no current�benefit with no possible future benefit. D uses the wrong optimality�condition. E imports a peer ratio without testing this company’s�constraints.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
23
W8-S022
143
Medium (4/8)
Pecking order explains a preference, not a requirement
Myers and Majluf (1984): when managers know more than outside�investors, financing choices can create adverse-selection costs.
The classic order is internal funds → relatively safe debt → equity. An�equity issue may be interpreted as unfavorable information; it is not�proof of overvaluation. Risky debt is information-sensitive too.
A pre-revenue company may have neither retained cash nor�conventional debt capacity. Founder funds, customer financing,�eligible grants, or equity-like capital may therefore come earlier.
The practical choice must respect what is available and sustainable.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
24
Knowledge check: when the pecking order is constrained
A pre-revenue company has a promising but uncertain project, no retained�cash, and no credible way to service a conventional loan. What follows from�the pecking-order discussion?
A. Delay any equity issue until conventional debt has been fully exhausted.
B. Select the lowest loan coupon and treat the repayment plan as a later�decision.
C. Treat the founder’s projected future sales as available internal funding�today.
D. Infer that an equity offer means the founder believes the company is�overvalued.
E. Consider equity-like funding or a smaller staged plan within available�resources.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
25
W8-S025
143
Medium (4/8)
Knowledge check: when the�pecking order is constrained — Answer
Correct answer: E — Consider equity-like funding or a smaller�staged plan within available resources.
Why: The theoretical preference does not create internal cash or debt�capacity. Risk-bearing funding or a smaller milestone can fit the actual�constraints.
Other choices: A turns a preference into a compulsory sequence. B�ignores repayment. C treats a forecast as current cash. D turns a�possible information signal into proof.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
26
W8-S025
143
Medium (4/8)
Financing changes incentives as well as cash claims
Covenants, reporting, governance, and equity incentives can reduce�conflicts. They also cost money and may restrict useful flexibility.
Evaluate whether each protection addresses a real risk without blocking�the operating plan.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
27
Discipline and signals depend on the setting
Jensen (1986): distributing excess cash can limit waste in mature firms�with more cash than worthwhile investments. Debt can impose discipline,�but mandatory payments can also crowd out valuable investment.
Ross (1977): financing can signal private information when incentives�make the signal credible. Borrowing by itself does not prove that a�company is strong.
A startup funding product discovery is not the same as a mature�company generating surplus cash.
Judge the investment need, incentives, repayment capacity, and�contractual consequences together.
Jensen (1986), Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers; Ross (1977), The Determination of Financial Structure: The Incentive-Signalling�Approach.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
28
Knowledge check: identify the financing conflict
After borrowing, shareholders prefer a new project with lower expected total�company value but more upside if it succeeds. Lenders bear more loss if it fails.�Which concern most directly explains a covenant restricting that change?
A. Debt overhang: shareholders reject a valuable new investment.
B. Free-cash-flow waste: managers retain surplus cash after all worthwhile�investment.
C. Risk shifting: shareholders benefit from a risk increase at lenders’�expense.
D. Adverse selection: outside investors cannot infer value before funds are�raised.
E. A tax-shield limit: interest deductions are deferred until future taxable�years.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
29
W8-S029
143
Easy (1/8)
Knowledge check: identify the financing conflict — Answer
Correct answer: C — Risk shifting: shareholders benefit from a risk�increase at lenders’ expense.
Why: This is an incentive problem after financing: shareholders may�prefer a payoff shift that hurts creditors and lowers total value. The�covenant limits that risk transfer.
Other choices: A is underinvestment, not the described risky switch. B�concerns excess cash. D concerns hidden information before�financing. E concerns tax deductions, not project-selection incentives.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
30
W8-S029
143
Easy (1/8)
Cost of equity and dilution answer different questions
Cost of equity: the expected rate of return investors require for�bearing equity risk. It is an opportunity cost, not a promised payment.
Dilution: the reduction in an existing holder’s ownership percentage�when additional shares or convertible claims are issued.
Selling 20% of the company is not a 20% annual financing rate. The�investor’s eventual return depends on timing, future value, and�contractual rights.
Equity absorbs losses without ordinary loan-style scheduled�repayments. Its upside participation can be costly in a successful�outcome, but that does not make it universally the worst financing�choice.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
31
W8-S029
143
Easy (1/8)
CAPM prices systematic equity risk
R_e = R_f + beta_E × equity risk premium
Hypothetical: R_f = 4%, beta_E = 1.4, and the premium = 5% gives�R_e = 11%.
CAPM assumes diversified investors. Company-specific failure risk still�affects expected cash flows even when it adds no CAPM risk premium.�Beta measures market exposure, not failure probability. Founder�concentration and VC target returns require separate judgment.
OpenStax, Principles of Finance 2e, §15.3: CAPM; Damodaran, Valuing Private Companies and Divisions: comparable-company betas.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
32
Knowledge check: what beta does and does not measure
Assumptions: Use the same currency, risk-free rate, and market risk premium.
Two firms have the same estimated equity beta. One also faces a large,�company-specific technical risk that is unrelated to the market. Under the basic�CAPM for diversified investors, which statement is correct?
A. The technical risk necessarily gives that firm a higher CAPM required return.
B. The shared beta implies the two firms have the same probability of failure.
C. The technical risk can be omitted from expected cash flows because it is�diversifiable.
D. A founder’s personal concentration changes the beta used by all market�investors.
E. Their CAPM returns can match even though expected cash flows and failure�risks differ.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
33
W8-S033
143
Medium (4/8)
Knowledge check: what beta�does and does not measure — Answer
Correct answer: E — Their CAPM returns can match even though�expected cash flows and failure risks differ.
Why: With the same risk-free rate and market premium, the same beta�gives the same CAPM return. Company-specific technical risk still�affects expected cash flows and outcomes.
Other choices: A equates total risk with systematic risk. B equates�beta with failure probability. C removes a real operating risk from the�forecast. D conflates personal exposure with market beta.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
34
W8-S033
143
Medium (4/8)
Failure scenarios and required returns
For diversified investors,�company-specific failure changes�expected cash flows. CAPM prices�systematic equity risk. Use an�appropriate discount rate for the�probability-weighted cash flows�without counting the same failure risk�twice.
Illustrative all-equity project: invest�$2m today. At the end of Year 2,�receive $5m with 60% probability or�$0.5m with 40% probability. These are�mutually exclusive, exhaustive�outcomes, after all remaining costs and�taxes. No interim cash flows occur.
Expected Year 2 cash = 60% × $5m +�40% × $0.5m = $3.2m.
Assume CAPM inputs of 4% risk-free,�beta 1.6, and a 5% equity risk premium�appropriately price these cash flows:
Required return = 4% + 1.6 × 5% = 12%.
NPV = −$2m + $3.2m / 1.12² =�+$0.551m.
Include recovery proceeds in the�failure scenario. Do not apply another�success-probability haircut after�computing expected cash flow.
Devon Coombs CPA, MBA | Santa Clara University | FIN143
35
Question: Startup risk and project NPV
KNOWLEDGE CHECK
An all-equity startup project requires $3 million today. It produces no intermediate�cash flows and is liquidated at the end of Year 2.
Outcome | Probability | Cash paid to equity at the end of Year 2 |
Commercial success | 70% | $6.0 million |
Commercial failure | 30% | $0.4 million |
The risk-free rate is 4%, the project's equity beta is 1.6, and the market equity risk�premium is 5%. Assume the resulting CAPM required return is appropriate for�these probability-weighted equity cash flows. Investors are diversified; no�additional risk adjustment is required. The Year 2 cash amounts are after all�remaining costs and taxes and include any recovery proceeds.
What is the project's NPV today, rounded to the nearest $1,000?
A. NPV: +$1,783,000.
B. NPV: +$348,000.
C. NPV: +$444,000.
D. NPV: +$1,320,000.
E. NPV: −$589,000.
Devon Coombs CPA, MBA | Santa Clara University | FIN143
36
W8-S036
143
Hard (6/8)
Answer: Startup risk and project NPV
KNOWLEDGE CHECK
C. NPV: +$444,000.
Work the calculation
CAPM cost of equity = 4% + 1.6 × 5% = 12%.
Expected end-of-Year-2 cash flow = 70% ×�$6 million + 30% × $0.4 million = $4.32�million.
NPV = −$3 million + $4.32 million / 1.12² =�$443,877.55, rounded to +$444,000.
The probabilities capture success and failure�outcomes. The required return prices the�systematic risk of the expected cash flows�under the explicit assumption. Applying�another success-probability haircut would�double-count that adjustment.
Why the other choices are�wrong
A. Values the success payoff as�though success were certain.
B. Omits recovery cash received�in the failure outcome.
D. Probability-weights the�outcomes but does not discount�the future cash.
E. Applies the success�probability again after it has�already been included in�expected cash flow.
Devon Coombs CPA, MBA | Santa Clara University | FIN143
37
W8-S036
143
Hard (6/8)
Estimate startup risk without inventing precision
A private company has no traded share-return history from which to estimate a�conventional regression beta.
Under the simplifying zero-debt-beta model,�beta_E = beta_U × [1 + (1 − T_c) × D/E].
beta_U is unlevered business beta; T_c is the assumed corporate tax rate.
Tax assumptions and financing policy must fit the model. A private startup’s failure�scenarios and illiquidity require additional explicit judgment; copying a public�peer’s WACC is insufficient.
Damodaran, Valuing Private Companies and Divisions: comparable-company betas; Damodaran (2009), Valuing Young, Start-up and Growth Companies.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
38
Knowledge check: use comparables consistently
A private startup will borrow modestly. Its closest public operating peers use�much more leverage. Under the stated beta model, which approach best�estimates the startup’s equity risk?
A. Use peer equity betas unchanged because the firms have similar operating�exposure.
B. Remove each peer’s leverage, then apply the startup’s proposed market-value�D/E.
C. Remove peer leverage and use the resulting business beta directly for the�startup’s equity.
D. Remove leverage using the startup’s D/E, then reapply that same D/E to the�result.
E. Use book-value D/E for both adjustments because the startup’s shares do�not trade.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
39
W8-S039
143
Medium (4/8)
Knowledge check: use comparables consistently — Answer
Correct answer: B — Remove each peer’s leverage, then apply the�startup’s proposed market-value D/E.
Why: Peer equity betas include peer financing risk. Unlever using each�peer’s structure, then relever business risk for the startup. Keep tax�assumptions consistent with the model.
Other choices: A retains excess peer leverage. C omits the startup’s�positive leverage. D removes and reapplies the same wrong structure.�E substitutes accounting balances for the market-value capital�weights the model requires.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
40
W8-S039
143
Medium (4/8)
Comparable betas and the target capital structure
Illustration: debt beta is zero, all firms have a usable 25% tax rate, and the peers�have comparable operating risk. Use each peer's own market-value D/E before�averaging.
Unlevered beta = equity beta / [1 + (1 − tax rate) × D/E].
Peer | Equity beta | D/E | Unlevered beta |
A | 1.56 | 0.40 | 1.56 / 1.30 = 1.20 |
B | 1.38 | 0.20 | 1.38 / 1.15 = 1.20 |
The equal-weight business beta is 1.20. At a target D/E of 0.50:
Target equity beta = 1.20 × [1 + 75% × 0.50] = 1.65.
With a 4% risk-free rate and 5% equity risk premium, cost of equity is 12.25%.
D/E and D/(D + E) have different denominators. If target debt is 30% of total�capital, D/E is 30% / 70%, not 30%.
Devon Coombs CPA, MBA | Santa Clara University | FIN143
41
Question: Startup beta and CAPM
KNOWLEDGE CHECK
A profitable young private company lacks a traded share-price�history. An analyst uses two public peers to estimate its cost of�equity for diversified investors.
Peer | Levered equity beta | Market-value debt-to-equity ratio |
A | 1.68 | 0.50 |
B | 1.32 | 0.125 |
Assume debt has zero beta and use the tax-adjusted relationship�between unlevered beta and equity beta. Both peers and the target�face a 20% marginal corporate tax rate and can use interest�deductions in the year interest is paid. Give the two unlevered peer�betas equal weight. The target's long-run market-value�debt-to-equity ratio is 0.25.
The risk-free rate is 4% and the market equity risk premium is 5%. No�separate size, illiquidity, or company-specific premium is required for�this exercise.
What target equity beta and CAPM cost of equity result?
A. Target equity�beta: 1.500; cost�of equity: 11.50%.
B. Target equity�beta: 1.200; cost�of equity: 10.00%.
C. Target equity�beta: 1.800; cost�of equity: 13.00%.
D. Target equity�beta: 1.392; cost of�equity: 10.96%.
E. Target equity�beta: 1.440; cost�of equity: 11.20%.
Devon Coombs CPA, MBA | Santa Clara University | FIN143
42
W8-S042
143
Hard (7/8)
Answer: Startup beta and CAPM
KNOWLEDGE CHECK
E. Target equity beta: 1.440; cost of�equity: 11.20%.
Work the calculation
Peer A unlevered beta = 1.68 / [1 + (1 −�20%) × 0.50] = 1.200.
Peer B unlevered beta = 1.32 / [1 + (1 −�20%) × 0.125] = 1.200. Their�equal-weight average is 1.200.
Target levered beta = 1.20 × [1 + (1 −�20%) × 0.25] = 1.440.
Cost of equity = 4% + 1.44 × 5% =�11.20%. Beta measures exposure to�systematic market risk under this�model; it is not the probability that the�startup fails. The supplied�zero-debt-beta and tax assumptions�are deliberate simplifications.
Why the other choices are wrong
A. Averages the observed levered peer�betas without removing peer leverage�or applying target leverage.
B. Uses the unlevered beta as the�target equity beta and omits relevering.
C. Relevers the average of already�levered peer betas, double-counting�leverage.
D. Substitutes the target debt-to-value�ratio of 0.20 for the required�debt-to-equity ratio of 0.25.
Devon Coombs CPA, MBA | Santa Clara University | FIN143
43
W8-S042
143
Hard (7/8)
WACC combines the required returns on the claims
For a simplified debt-and-equity capital structure:
WACC = (E/V) × R_e + (D/V) × R_d × (1 − T_c)
V = D + E: debt value plus equity value. Use market-value weights, or�defensible target weights consistent with the valuation. Use current�required returns, not historical coupons or book-equity percentages.
The tax adjustment assumes the interest benefit is usable as modeled.�Material delays or changing leverage may require explicit tax-shield�modeling.
For complex preferred shares and convertibles, model their contractual�payoffs explicitly. A simple WACC does not allocate enterprise value�among every security.
OpenStax, Principles of Finance 2e, §17.3: WACC; OpenStax, Principles of Finance 2e, §17.1: opportunity cost and market-value weights.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
44
Question: The weighted cost of capital
KNOWLEDGE CHECK
A young profitable firm estimates the following financing inputs:
The marginal corporate income tax rate is 25%, and the firm can�use interest deductions in the year interest is paid. Its current�market-value financing proportions are its long-run target, and the�supplied equity beta is appropriate for that target. A planned�financing raises equal dollar amounts of new debt and equity, but�the firm plans to rebalance back to its stated target proportions.
What WACC should discount FCFF under these assumptions,�rounded to two decimal places?
A. 9.88%
B. 10.50%
C. 10.88%
D. 11.44%
E. 12.00%
Devon Coombs CPA, MBA | Santa Clara University | FIN143
45
W8-S045
143
Hard (7/8)
Answer: The weighted cost of capital
KNOWLEDGE CHECK
D. 11.44%
Work the calculation
Cost of equity = 4% + 1.5 × 6% = 13%.�Equity weight = $24/($24 + $8) = 75%;�debt weight = 25%.
After-tax debt cost = 9% × (1 − 25%) =�6.75%.
WACC = 75% × 13% + 25% × 6.75% =�11.4375%, or 11.44%. Book equity, an�old coupon, and a single financing�round's mix do not replace the�specified market-value target and�current costs.
Why the other choices are wrong
A. Uses the proposed new-money mix�as though it were the firm’s target�market-value capital structure.
B. Weights debt and equity using book�equity rather than market equity.
C. Uses the historical coupon rather�than the current marginal cost of debt.
E. Omits the usable interest tax benefit.
Devon Coombs CPA, MBA | Santa Clara University | FIN143
46
W8-S045
143
Hard (7/8)
Do not manufacture an optimum by freezing the inputs
When leverage changes, re-estimate the cost of equity, the borrowing�cost, tax-shield usability, and financing constraints.
WACC can fall over a feasible range if financing benefits outweigh�costs. It need not keep falling as debt rises.
For changing debt schedules, adjusted present value (APV) can�separate unlevered operating value from financing effects. Avoid�counting a tax shield both in after-tax WACC and as an added value.
Use valuation to assess value; use the cash schedule to assess�survival. A positive valuation does not pay a loan installment.
OpenStax, Principles of Finance 2e, §17.5: financial distress and capital structure; Damodaran, The Adjusted Present Value Approach.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
47
Knowledge check: challenge a misleading WACC result
A spreadsheet replaces equity with debt while keeping both required�returns fixed. WACC falls at every step, so the analyst recommends the�maximum debt available. What is the strongest correction?
A. Reprice the claims at each leverage level and test taxes, cash�headroom, and distress.
B. Keep the rates fixed, but substitute book values for market-value�weights.
C. Use the loan coupon for all cash flows once debt exceeds half the�funding.
D. Add the full tax shield to a value already using the same shield through�WACC.
E. Choose the mix that produces the least immediate ownership dilution.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
48
W8-S048
143
Hard (6/8)
Knowledge check: challenge a�misleading WACC result — Answer
Correct answer: A — Reprice the claims at each leverage level and�test taxes, cash headroom, and distress.
Why: The analysis holds financing risk constant while increasing it. A�credible comparison updates the rates and constraints and checks�whether the company can survive its obligations.
Other choices: B does not repair the risk assumption. C discounts the�wrong claim. D counts the tax benefit twice. E optimizes dilution while�ignoring value and cash risk.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
49
W8-S048
143
Hard (6/8)
The financing mix should evolve with the evidence
Business condition | Financing emphasis to evaluate |
Product discovery;�uncertain collections | Founder resources, customer tests, eligible�grants, or risk-bearing equity |
Repeatable demand;�continuing growth burn | Equity for uncertain expansion; limited debt only�with a credible repayment or refinancing plan |
Predictable collections�and positive cash after�reinvestment | Retained cash and appropriately structured debt�may fund more of growth |
Match repayment timing to the assets and cash flows it funds.�Short-term debt can fit a collectible receivables cycle; it can be�dangerous for long, uncertain development.
There is no universal stage-based debt percentage.
U.S. SBA, Loans: repayment ability and program-specific eligibility; Myers (1977), Determinants of Corporate Borrowing.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
50
Debt capacity comes from cash and contractual headroom
For this course: cash available for debt service means cash after�operating costs, cash taxes, required capital spending, and�working-capital needs, before debt service.
DSCR = cash available for debt service ÷ scheduled cash interest�and principal. Lenders may use different contractual definitions.
Test base and downside cases, every payment date, minimum cash,�covenants, collateral, and maturity/refinancing risk. EBITDA and annual�recurring revenue are not substitutes for this cash schedule.
Hypothetical policy: downside cash of $0.70m and required DSCR of�1.25× support at most $0.56m of annual debt service, subject to�monthly tests. This is not a loan-principal amount.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
51
Knowledge check: annual coverage and repayment timing
Downside cash available for debt service is $0.90 million, all received in�month 9. Policy requires annual DSCR of at least 1.50×. Loan A requires�$0.54 million in month 6. Loan B requires $0.60 million across months 10–12.�No cash above the protected reserve or committed refinancing is available�earlier. Which conclusion is supported?
A. Prefer A because its annual coverage exceeds B’s.
B. Approve either loan because both annual ratios meet policy.
C. Prefer A because its earlier maturity reduces refinancing exposure.
D. B passes these tests; verify remaining covenants and payment details.
E. Limit loan principal to $0.60 million regardless of repayment schedule.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
52
W8-S052
143
Hard (6/8)
Knowledge check: annual coverage�and repayment timing — Answer
Correct answer: D — B passes these tests; verify remaining�covenants and payment details.
Why: Annual DSCR is 1.67× for A and 1.50× for B. A matures before�the available cash arrives. B’s stated payments follow collections and�meet the coverage threshold.
Other choices: A ignores the payment date. B treats an annual ratio as�sufficient. C overlooks A’s actual need for refinancing. E mistakes an�annual debt-service limit for a loan-principal limit.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
53
W8-S052
143
Hard (6/8)
Worked growth-stage mix:�debt follows demonstrated capacity
Hypothetical: a $2.00m investment is due now. After that investment,�annual downside cash available for debt service is $0.45m for three�years. Required DSCR is 1.50×.
An eligible loan charges 10% annual interest, with equal annual�principal repayments over three years; ignore fees. A $0.60m loan�needs $0.26m in year one: $0.20m principal + $0.06m interest.�Coverage is 1.73×; later annual payments decline.
If monthly cash, collateral, and covenants also pass, one feasible�request is $0.60m debt + $1.40m equity.
This is 30% debt in the new funding. It is not necessarily 30% debt in�the company’s market-value capital structure.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
54
Knowledge check: distinguish�new funding from capital weights
Assumptions: Use the stated post-transaction structure, with no other capital�claims.
A firm raises $0.60 million of debt and $1.40 million of equity. Immediately�afterward, all debt has a market value of $0.60 million and all equity, including�existing owners’ shares, is worth $15.40 million. Which debt weight belongs in a�WACC using this capital structure?
A. 30.00%, using debt as a share of the new funds raised.
B. 4.29%, dividing debt by the $14.00 million pre-money equity value.
C. 3.90%, dividing debt by the $15.40 million post-money equity value.
D. 3.75%, dividing debt by total debt and equity value of $16.00 million.
E. 70.00%, using new equity as a share of the funds raised.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
55
W8-S055
143
Medium (3/8)
Knowledge check: distinguish�new funding from capital weights — Answer
Correct answer: D — 3.75%, dividing debt by total debt and equity�value of $16.00 million.
Why: $0.60m ÷ ($0.60m + $15.40m) = 3.75%. The equity weight is�96.25%. The funding-flow split does not measure the value of all�existing claims.
Other choices: A uses only this round’s cash. B uses pre-money equity�alone. C calculates D/E instead of D/(D + E). E uses the wrong source�and denominator.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
56
W8-S055
143
Medium (3/8)
Debt capacity across the repayment schedule
Let L be the original loan. With 10% interest on beginning principal and equal principal�repayments over three years, each year's payment is a different fraction of L.
For minimum DSCR of 1.50×:
Loan limit in each year = available cash / (1.50 × that year's payment fraction).
Year | Payment as a fraction�of L | Downside cash | Loan limit |
1 | 1/3 + 10% = 13/30 | $0.78m | $1.20m |
2 | 1/3 + 10% × 2/3 = 2/5 | $0.66m | $1.10m |
3 | 1/3 + 10% × 1/3 = 11/30 | $0.66m | $1.20m |
The maximum loan under these annual tests is the smallest limit: $1.10m. Here Year 2�binds. Assume all other lending conditions pass.
Then fund the remaining cash requirement with available internal cash and new equity. A�debt-service limit is a payment amount; the repayment schedule converts it into a�loan-principal limit.
Devon Coombs CPA, MBA | Santa Clara University | FIN143
57
Question: Debt capacity and funding
KNOWLEDGE CHECK
A company needs $3 million today to fund expansion and its�required cash reserve. It has $400,000 of internal cash available�after protecting existing operating needs. The remaining amount�must come from a new loan and new equity.
Each year, interest is 10% of the principal outstanding at the start�of that year. Interest and one-third of the original principal are�paid at each year-end for three years. The lender requires a�debt-service coverage ratio of at least 1.50 in each year.
Year | Downside cash available for debt service,�after taxes and required reinvestment |
1 | $780,000 |
2 | $650,000 |
3 | $550,000 |
Debt service includes interest and principal. There is no existing�debt, fee, balloon payment, or refinancing. All other lending�conditions are satisfied at or below the maximum loan permitted�by these annual tests, and equity is available for the balance.
What is the maximum loan and minimum new equity required,�rounded to $0.01 million?
A. Maximum loan: $1.00 million;�minimum new equity: $1.60 million.
B. Maximum loan: $1.20 million;�minimum new equity: $1.40 million.
C. Maximum loan: $1.08 million;�minimum new equity: $1.52 million.
D. Maximum loan: $1.10 million;�minimum new equity: $1.50 million.
E. Maximum loan: $1.00 million;�minimum new equity: $2.00 million.
Devon Coombs CPA, MBA | Santa Clara University | FIN143
58
W8-S058
143
Hard (7/8)
Answer: Debt capacity and funding
KNOWLEDGE CHECK
A. Maximum loan: $1.00 million; minimum new equity: $1.60 million.
Work the calculation
Let L be the original loan. Year 1 debt�service is L/3 + 10% × L; Year 2 is L/3 +�10% × 2L/3; Year 3 is L/3 + 10% × L/3.
Year | Debt service�as a share of�original loan | Maximum�loan at 1.50�coverage |
1 | 43.3333% | $1,200,000 |
2 | 40.0000% | $1,083,333.33 |
3 | 36.6667% | $1,000,000 |
The third year binds. With a $1 million�loan, coverage is 1.80×, 1.625×, and�1.50×, respectively.
Minimum new equity = $3 million − $0.4�million internal cash − $1 million debt = $1.6�million. A loan that passes the first year can�still be too large for a later year's cash flow.
Why the other choices are wrong
B. Uses only the first-year coverage test and�ignores the tighter later-year test.
C. Uses only the second-year limit instead of�enforcing coverage in every year.
D. Uses aggregate three-year coverage,�allowing a shortfall in an individual year.
E. Finds debt capacity correctly but omits the�$400,000 of available internal cash from the�funding bridge.
Devon Coombs CPA, MBA | Santa Clara University | FIN143
59
W8-S058
143
Hard (7/8)
Compare debt offers using their actual cash obligations
Bank loans and credit lines: examine repayment capacity, collateral,�guarantees, borrowing-base eligibility, covenants, and maturity. A low�coupon alone does not establish the lowest total economic cost.
Revenue-based financing: payments may vary with sales, but�contracts can include minimum payments, a repayment cap, or a final�due date. Revenue is not gross profit or spare cash.
Compare net cash received with every scheduled or contingent�payment. A 1.3× repayment cap means 30% above the advance in�total; it is not automatically a 30% annual rate.
A personal guarantee moves some business downside onto the�founder.
U.S. SBA, Loans: repayment ability and program-specific eligibility; Stripe Capital, sales-based repayment and contractual minimum payments; provider example.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
60
Venture debt can extend runway and create a new deadline
Venture debt often supplements equity and depends partly on the�lender’s confidence in future financing or repayment. It is not�committed follow-on equity.
Evaluate interest, fees, warrants, collateral, draw conditions,�amortization, maturity, and covenants. Warrants can create dilution.
Undrawn commitments may become unavailable when conditions fail.�A covenant breach can lead to remedies, including acceleration,�depending on the agreement, notice, cure, and waiver provisions.
Model net runway after debt costs and repayments. Do not fund�essential operations on the assumption that the next equity round�must close.
SVB, What is venture debt? Pricing components and contractual constraints; SVB, How does venture debt work? Collateral, covenants, and lender remedies.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
61
Knowledge check: evaluate the debt bridge
A startup is offered venture debt with a low coupon, warrants, a minimum-cash�covenant, and repayment before its next uncommitted equity round. Management�says the loan guarantees extra runway. What is the best response?
A. Compare the coupon with equity dilution and choose the smaller�percentage.
B. Model all payments and draw conditions under a delayed next round.
C. Count the full facility as cash even if later draws require performance�milestones.
D. Assume the lender will waive covenants because acceleration would hurt the�company.
E. Use the expected next-round valuation as proof the debt can be repaid on�time.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
62
W8-S062
143
Medium (4/8)
Knowledge check: evaluate the debt bridge — Answer
Correct answer: B — Model all payments and draw conditions under�a delayed next round.
Why: Useful runway depends on accessible proceeds less fees,�service, and restricted cash, including when the next round is delayed�or absent. The contract determines remedies and availability.
Other choices: A compares different measures. C treats conditional�access as cash. D assumes lender discretion will favor the borrower. E�treats estimated value as timely cash repayment.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
63
W8-S062
143
Medium (4/8)
A bullet loan requires a maturity plan
A bullet loan pays most or all principal at maturity. Interest-only coverage can look�strong while the final principal payment remains unaffordable.
Test cash at every payment date, including principal at maturity and the minimum�operating cash floor.
A forecast refinancing is a scenario, not committed cash. Check lender conditions,�collateral, and the downside if replacement financing is unavailable.
Match long, uncertain development spending with capital that can bear that timing�risk. A lower monthly payment does not make refinancing risk disappear.
Devon Coombs CPA, MBA | Santa Clara University | FIN143
64
Question: Interest coverage and the maturity gap
A company has a $1.2m bullet loan at 10% annual interest, due in full at Year 2. At�that date, cash before the final interest and principal payments is forecast at�$1.4m. The company must retain a $0.3m operating floor. Earlier interest is already�paid, and no refinancing is committed.
What additional cash is needed at maturity to pay the loan and retain the floor?
A. $0.10 million.
B. $0.12 million.
C. $0.22 million.
D. $0.30 million.
E. $1.32 million.
Devon Coombs CPA, MBA | Santa Clara University | FIN143
65
W8-S065
143
Medium (4/8)
Answer: Interest coverage and the maturity gap
C. $0.22 million.
Final interest is $1.2m × 10% = $0.12m; total maturity payment is $1.32m.�Remaining cash is $1.4m − $1.32m = $0.08m.
The floor shortfall is $0.30m − $0.08m = $0.22m.
A omits final interest; B reports interest alone; D reports the entire reserve; E�reports the payment rather than the incremental cash gap. Paying scheduled�interest earlier does not establish capacity to repay principal.
Devon Coombs CPA, MBA | Santa Clara University | FIN143
66
W8-S065
143
Medium (4/8)
A SAFE and a convertible note are not the same obligation
Standard YC SAFE: a contractual right to future equity or specified�event proceeds; no interest or maturity date. It is not ordinary debt�and is not free capital.
Convertible note: debt, typically with interest and a maturity date,�plus conversion provisions. Failure to complete a qualifying round does�not erase the debt terms.
For either, model caps, discounts, conversion mechanics, and the fully�diluted cap table. Include option-pool changes and other outstanding�claims.
A valuation cap affects conversion economics; it is not a complete�priced-round valuation or a guarantee of the next round’s price.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
67
Knowledge check: understand the convertible obligation
A founder compares a standard YC SAFE with an interest-bearing�convertible note that matures in 18 months. Both contain valuation caps.�Which analysis is most important before choosing?
A. Treat both as conventional loans because both have a valuation cap.
B. Exclude both from fully diluted cap-table analysis until they convert.
C. Model both conversion outcomes and the note’s maturity�obligations.
D. Compare the caps alone because they fully determine ownership�and control.
E. Assume the cap fixes the valuation of the next priced equity round.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
68
W8-S068
143
Medium (4/8)
Knowledge check: understand�the convertible obligation — Answer
Correct answer: C — Model both conversion outcomes and the�note’s maturity obligations.
Why: Both instruments create economic claims that can dilute�ownership. The note also creates debt obligations whose interest and�maturity matter if the next financing is delayed.
Other choices: A confuses a pricing term with debt status. B ignores�the claims already promised. D ignores conversion details and other�rights. E treats a conversion cap as a guaranteed future valuation.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
69
W8-S068
143
Medium (4/8)
Wasserman’s Rich vs. King dilemma
Founders often face a tension between attracting resources that may�increase the venture’s value and retaining control.
Wasserman’s research and framework describe this tradeoff; they do�not establish that every VC-backed company becomes more valuable�or that every founder must lose the CEO role.
Ownership percentage, board control, voting rights, and personal�wealth are distinct. A smaller stake can be worth more in a more�valuable company; contractual preferences can change the payoff.
State which rights and outcomes matter to the founder before�negotiating them.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
70
Turn each financing risk into a term to negotiate
Concern | Terms to examine |
Cash available�and timing | Funding amount, closing conditions, and tranche milestones |
Ownership and�future dilution | Pre-money price, conversion claims, option-pool basis, and�anti-dilution |
Exit economics | Preference multiple, participation, seniority, and conversion |
Decision-making | Board seats, voting rights, and consent rights for specified�actions |
Debt survival | Interest, fees, amortization, covenants, security, guarantees,�and remedies |
1× non-participating preferred generally chooses its investment back or�conversion into common, subject to available proceeds. It does not take both. A�2× preference increases the priority amount.
Headline valuation alone cannot identify the better offer.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
71
Knowledge check: compare the rights, not just the price
Assumptions: All proceeds are available to equity; one preferred class; no�debt, fees, dividends, or other claims.
Two investors each offer $2 million for 20% ownership on conversion. Offer A�has a 1× non-participating preference; B has 2× non-participating. At a $6�million equity exit, which statement is correct?
A. A pays the investor $2 million; B pays $4 million, leaving less for common.
B. Both pay the investor $1.2 million because the ownership percentage is�the same.
C. A pays $3.2 million and B pays $5.2 million by adding conversion to�preference.
D. B pays $2 million because the second preference multiple applies only in�bankruptcy.
E. Both pay the investor $2 million because the amount invested is identical.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
72
W8-S072
143
Medium (4/8)
Knowledge check: compare the rights,�not just the price — Answer
Correct answer: A — A pays the investor $2 million;�B pays $4 million, leaving less for common.
Why: Conversion yields 20% × $6m = $1.2m. Each investor instead�takes its larger preference: $2m under A or $4m under B. Common�receives $4m or $2m.
Other choices: B ignores preference. C adds two mutually exclusive�choices. D invents a bankruptcy-only condition. E ignores the different�multiples.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
73
W8-S072
143
Medium (4/8)
Worked proposal: what the next raise must fund
Hypothetical, 18-month�plan; $ millions. Existing cash�is $0.80. Monthly modeling�shows the cash low point at�month 18. No debt service;�no committed external�funding.
Use or reserve | Amount |
Operations before working-capital�changes: product $1.60 +�customer development $0.80 | $2.40 |
Equipment | $0.40 |
Additional working capital | $0.30 |
Financing fees | $0.10 |
Extra burn in the defined downside | $0.50 |
Minimum cash reserve | $0.60 |
Total requirement, less existing�$0.80 cash | $3.50�raise |
Categories do not overlap.�The base case requires $3.00;�$3.50 also covers the defined�downside. It does not cover�every possible outcome.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
74
Worked proposal: equity now, debt when capacity improves
Hypothetical: the 18-month cash plan requires a $3.50 million raise.�Debt-service cash remains negative; there is no eligible borrowing�facility. The founders will not give personal guarantees.
Proposed request: raise $3.50 million of equity at closing to fund the�product and customer milestones, working capital, equipment, fees,�and downside reserve.
Assume a separately justified, negotiated $14.00 million pre-money�price: post-money is $17.50 million; new investors own 20%.
Before the raise, founders own 90% and the option pool is 10% fully�diluted. With no pool top-up or convertibles, they become�72% founders / 8% pool / 20% investors.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
75
Worked proposal: terms that support the operating plan
Hypothetical negotiation objectives for a $3.50 million equity round:
These are proposed terms, not universal�market rules. Three board seats do not�guarantee founder control.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
76
Knowledge check: test whether�the commitment funds the plan
An equity offer commits�$3.50 million: $2.50 million�now and $1.00 million only�after a product milestone.�Existing cash is $0.80�million. Before that�milestone, downside net�cash outflow is $2.80 million�and the required cash floor�is $0.60 million. What is the�strongest response?
A. Accept because the total commitment�exceeds the cash needed before the�milestone.
B. Count the conditional $1.00 million as�current cash once the term sheet is signed.
C. Accept if the valuation is high enough to�offset the temporary cash shortfall.
D. Borrow the shortfall without checking�whether a lender will fund it in that scenario.
E. Renegotiate timing or spending:�accessible cash would fall $0.10 million�below the floor.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
77
W8-S077
143
Medium (4/8)
Knowledge check: test whether�the commitment funds the plan — Answer
Correct answer: E — Renegotiate timing or spending: accessible�cash would fall $0.10 million below the floor.
Why: $0.80m + $2.50m − $2.80m = $0.50m, below the $0.60m floor.�The later $1.00m depends on achieving a milestone the company must�first finance.
Other choices: A ignores timing. B converts a condition into cash. C�substitutes price for liquidity. D assumes debt availability rather than�demonstrating it.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
78
W8-S077
143
Medium (4/8)
Define the next decision before cash forces it
Funding request: name the amount, uses, milestone, timetable,�instrument, proposed rights, and downside response.
Trigger: start fundraising or reduce discretionary spend before the�forecast cash floor is threatened, allowing time for diligence and�closing.
Investor fit: assess mandate, check size, ownership target, remaining�fund life, and follow-on capacity. Reserves or supportive statements�are not a binding commitment to finance the next round.
As the business scales: reconsider retained cash and debt as�collections and repayment capacity improve. Revisit the mix when�operating risk, valuation, taxes, or founder priorities change.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
79
Knowledge check: act before the cash floor is threatened
Assumptions: A raise closes four months after launch and funds the�milestone. Today is month 0.
Cash reaches its minimum reserve in month 3. Pausing nonessential hiring�extends that date to month 5 without delaying the product milestone in�month 7. A bridge becomes drawable only in month 4. An existing investor�is supportive but uncommitted. Which plan best protects the milestone?
A. Start the equity raise now and keep the hiring schedule.
B. Pause nonessential hiring and start the equity raise now.
C. Wait until the product milestone to launch the equity raise.
D. Keep hiring and use the bridge when it becomes drawable.
E. Pause hiring and launch the equity raise in month 2.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
80
W8-S080
143
Hard (6/8)
Knowledge check: act before�the cash floor is threatened — Answer
Correct answer: B — Pause nonessential hiring�and start the equity raise now.
Why: The hiring pause moves the cash-floor deadline to month 5.�Starting now closes the raise in month 4 under the stated assumption,�leaving one month of headroom without delaying the product�milestone.
Other choices: A closes after the month-3 deadline. C closes in month�11. D becomes available after the month-3 deadline. E closes in month�6, after even the extended deadline. Support is not a funding�commitment.
Devon Coombs CPA, MBA · Santa Clara University · FIN143
81
W8-S080
143
Hard (6/8)
Growth alternatives: investment value before financing
Hypothetical, $ millions. A company has $1.00 of retained cash above its�protected operating reserve. It can stage growth or invest fully now.
CAPM inputs: unlevered beta 1.4, risk-free rate 4%, market premium 5%. The�unlevered required return is 11%.
Operating�plan | Invest now | Expected�annual FCFF,�years 1–3 | PV at 11% | NPV |
Staged | $1.00 | $0.55 | $1.344 | $0.344 |
Full | $2.00 | $1.10 | $2.688 | $0.688 |
FCFF is incremental, after operating taxes and reinvestment, paid at�year-end. No terminal proceeds. PV = sum of the three discounted receipts.�Financing effects are excluded here.
Damodaran, Valuing Private Companies and Divisions: comparable-company betas; Damodaran, The Adjusted Present Value Approach.
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The debt schedule changes the financing analysis
Full growth plan ($m): $1.00 retained cash, $0.60 debt, $0.40 equity. Debt�costs 10%, with $0.20 principal repaid annually for three years.
APV adds financing benefits and�subtracts financing costs from�unlevered operating value.
Adjusted NPV = $0.6881 + $0.0257�− $0.010 = $0.7037.
Declining debt changes leverage. APV�separates financing effects instead of�applying one unchanged WACC.
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Funding, dilution, and rights in the growth decision
Hypothetical: each package uses $1.00m retained cash above the reserve. Equity�offers: $9.00m pre-money, no pool increase or convertibles.
Package | External request | New investor�ownership | Adjusted NPV |
Staged growth | None | 0% | $0.344m |
Full, all equity | $1.00m equity | 10.00% | $0.688m |
Full, mixed | $0.60m debt +�$0.40m equity | 4.26% | $0.704m |
Both equity offers: 1× non-participating preferred, one investor seat on a�three-person board. Mixed funding adds repayments and covenants.
All pass cash tests. Mixed funding adds $0.016m of modeled NPV.
Sensitivity: increase expected covenant/distress-cost PV from $0.010m to�$0.030m. Other inputs unchanged, mixed NPV falls to $0.684m,�below all equity’s $0.688m.
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Question: A feasible financing package
KNOWLEDGE CHECK
Founders currently own all of a company. Their financing must meet three requirements:
Any loan charges 10% annual interest on the principal outstanding at the start of each year, paid at year-end. Principal�is repaid in two equal installments at the ends of Years 1 and 2. First-year downside cash available for principal and�interest payments is $420,000; required debt-service coverage is at least 1.40×. For any package that passes this�first-year test, assume Year 2 coverage and all other lending conditions are satisfied. Packages without debt have no�debt-service requirement.
Each package is fixed and cannot be combined with another. Equity is new primary common stock, with no pools,�preferences, convertibles, fees, or other dilution.
Package | Debt at closing | Equity at closing | Pre-money value | Board and other terms |
A | $1.2 million | $1.2 million | $6 million | Founder majority |
B | $0.4 million | $2.0 million | $6 million | Founder majority |
C | $0 | $2.4 million | $4 million | Founder majority |
D | $0 | $2.4 million | $7.2 million | Investor majority |
E | $0 | $1.6 million | $6 million | Founder majority; $0.8 million of�uncommitted funding may arrive later |
Which package satisfies all funding, debt-service, ownership, and control requirements?
A. Package A.
B. Package B.
C. Package C.
D. Package D.
E. Package E.
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W8-S085
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Hard (8/8)
Answer: A feasible financing package
KNOWLEDGE CHECK
B. Package B.
Package | Closing cash�sufficient? | First-year debt�coverage | Founder�ownership | Founder board�majority? | Meets all�requirements? |
A | Yes | 0.5833×; fails | 83.33% | Yes | No |
B | Yes | 1.75×; passes | 75.00% | Yes | Yes |
C | Yes | No debt | 62.50%; fails | Yes | No |
D | Yes | No debt | 75.00% | No | No |
E | No | No debt | 78.95% at closing | Yes | No |
Work the calculation
Package B supplies $0.4 million debt + $2 million�equity = $2.4 million at closing. Founder ownership�is $6/($6 + $2) = 75%, and the founders retain a�board majority.
First-year debt service = $400,000/2 + 10% ×�$400,000 = $240,000. Coverage =�$420,000/$240,000 = 1.75×, exceeding 1.40×.
The task is feasibility under explicit constraints. It�does not ask students to infer that the highest�headline valuation or smallest dilution is�automatically the best financing.
Why the other choices are wrong
A. Raises enough cash and preserves ownership and board�control, but first-year debt service is $720,000 and coverage�is only 0.5833×.
C. Raises enough cash without debt, but founder ownership�falls to $4/($4 + $2.4) = 62.5%, below the required 65%.
D. Raises enough cash and leaves founders with 75%�ownership, but fails the founder board-majority requirement.
E. Preserves ownership and board control, but provides only�$1.6 million at closing; uncommitted future cash does not�fund the required $2.4 million today.
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W8-S085
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Hard (8/8)
A defensible financing recommendation�answers six questions
CAPM/WACC inform valuation. Cash capacity and founder priorities shape�feasible terms. Revisit the mix as these inputs change.
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W8-S085
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Hard (8/8)
Optional practice and deeper reference
The original question stems and answer choices are retained word for�word.
Their answer explanations have been reviewed and, where needed,�qualified. Separate assumptions identify simplified models without�changing the original questions.
Use these questions for reinforcement or independent practice. The�main sequence adds application questions to test the financing�decisions behind the definitions.
Additional reference covers the new-firm debt evidence, U.S. tax�limitations, and adjusted present value.
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Knowledge check: MM and the equity return
Assumptions: D/E uses market values; all rates refer to the stated MM�no-tax setting.
A firm's unlevered return is 12%, its cost of debt is 6%, and its D/E is�1.0. Under MM Proposition II (no taxes), the cost of equity is:
A. 12%
B. 6%
C. 9%
D. 18%
E. 24%
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W8-S089
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Easy (2/8)
Knowledge check: MM and the equity return — Answer
Correct answer: D — 18%
Why: R_e = 12% + (12% − 6%) × 1.0 = 18%. Debt/equity of 1.0 implies�equal debt and equity weights; 0.5 × 18% + 0.5 × 6% = 12%.
Other choices: A omits the leverage premium. B substitutes the debt�return. C averages the unlevered and debt rates. E doubles the�unlevered return without subtracting the debt rate.
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W8-S089
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Easy (2/8)
Knowledge check: compute WACC
Assumptions: Market-value weights; current required returns; fully�usable 25% interest tax benefit; a stable financing policy.
A firm is 60% equity and 40% debt. Cost of equity is 15%, pre-tax cost�of debt is 8%, and the tax rate is 25%. Its WACC is:
A. 11.0%
B. 11.4%
C. 12.2%
D. 9.0%
E. 13.5%
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W8-S091
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Medium (4/8)
Knowledge check: compute WACC — Answer
Correct answer: B — 11.4%
Why: 0.60 × 15% + 0.40 × 8% × (1 − 0.25) = 9.0% + 2.4% = 11.4%.�Without a usable interest tax benefit, the same stated rates and�weights give 12.2%.
Other choices: C omits the tax benefit. D omits the debt contribution.�A and E do not follow the stated weighted calculation. The result is�conditional on these inputs, not a universal startup hurdle rate.
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W8-S091
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Medium (4/8)
Knowledge check: choose the financing package
Assumptions: Hypothetical�model outputs. All borrowing�uses three-year amortization.
A founder seeks the highest�modeled NPV while�preserving the cash floor,�requiring downside DSCR�≥1.50× when borrowing, and�rejecting an investor board�majority. All packages pass�cash-floor tests. NPVs�include financing effects.�Which package fits?
A. Staged growth: NPV $0.344m, no debt�service, no outside ownership or investor�board seats.
B. All equity: NPV $0.688m, no debt service,�investor holds one of three board seats.
C. Mixed debt/equity: NPV $0.704m, DSCR�1.73×, investor holds one of three board seats.
D. Higher debt: NPV $0.720m, DSCR 1.10×, no�new equity or investor board seats.
E. Alternative equity: NPV $0.730m, no debt�service, investor holds two of three board�seats.
Damodaran, The Adjusted Present Value Approach; NVCA, Model Legal Documents: alternative negotiated financing provisions.
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W8-S093
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Hard (6/8)
Knowledge check: choose the financing package — Answer
Correct answer: C — Mixed debt/equity: NPV $0.704m,�DSCR 1.73×, investor holds one of three board seats.
Why: C has the highest modeled NPV among packages satisfying�every stated constraint. Its three-year debt schedule fits repayment�capacity. The decision combines value, liquidity, and governance.
Other choices: A and B are feasible but have lower modeled NPV. D�fails the debt-coverage policy. E violates the board constraint. C’s�$0.016m advantage over B is small: higher financing frictions could�reverse the choice.
Damodaran, The Adjusted Present Value Approach; NVCA, Model Legal Documents: alternative negotiated financing provisions.
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W8-S093
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Hard (6/8)
Original knowledge check: equity’s economic cost
Why can equity become economically expensive even though it has�no scheduled cash repayment?
A. Because equity carries a high fixed interest rate
B. Because equity must be repaid on a set maturity date
C. Because it permanently shares future upside and may dilute�control
D. Because regulators tax equity far more heavily than debt
E. Because issuing equity always triggers a clawback
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W8-S095
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Easy (0/8)
Original knowledge check:�equity’s economic cost — Answer
Correct answer: C — Because it permanently shares future upside�and may dilute control
Why: Equity gives investors a continuing share of the company’s�economic outcomes. In a successful business that share can become�valuable; governance rights may also change. Equity also bears losses�and has no ordinary debt-service schedule.
Other choices: A and B describe debt-like payment terms, not�ordinary equity. D does not explain the ownership tradeoff. E is not a�general rule. Equity is not universally the costliest or least suitable�choice.
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W8-S095
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Easy (0/8)
Original knowledge check: MM Proposition I
Modigliani and Miller (1958) showed that in a world without taxes or�frictions, firm value is:
A. Independent of how the firm is financed
B. Maximized by using as much debt as possible
C. Maximized by using only equity
D. Equal to the sum of interest payments
E. Always higher for private than public firms
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W8-S097
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Easy (0/8)
Original knowledge check: MM Proposition I — Answer
Correct answer: A — Independent of how the firm is financed
Why: With the operating assets and investment policy held fixed,�financing divides the same business cash flows among claims. Under�MM’s frictionless assumptions, that division does not create value.
Other choices: B and C incorrectly prescribe an optimal mix in this�benchmark. D mistakes a financing payment for firm value. E makes�listing status a universal source of value.
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W8-S097
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Easy (0/8)
Original knowledge check: the permanent-debt tax shield
Assumptions: Simplified MM corporate-tax setting: fixed permanent debt, a�constant tax rate, fully usable deductions, and no offsetting financing costs.
A profitable firm is worth $80M unlevered. It adds $30M of permanent debt�at a 21% corporate tax rate. Under MM 1963, its levered value is about:
A. $80.0M
B. $86.3M
C. $110.0M
D. $50.0M
E. $93.0M
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W8-S099
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Easy (2/8)
Original knowledge check:�the permanent-debt tax shield — Answer
Correct answer: B — $86.3M
Why: V_L = $80m + 0.21 × $30m = $86.3m. The added $6.3m is the�present value of the assumed interest tax shield, not the full loan�proceeds.
Other choices: A ignores the shield. C adds the debt proceeds as�value. D subtracts debt as though calculating equity value. E does not�follow the stated tax-shield formula.
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W8-S099
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Easy (2/8)
Original knowledge check: tradeoff theory
Assumptions: Use the simple tax-benefit/distress-cost model and�assume a differentiable interior optimum exists.
The tradeoff theory says the optimal amount of debt is the point�where:
A. Debt reaches a full 100% of the total capital structure
B. The firm carries no debt whatsoever on its books
C. The cost of debt exactly equals the cost of equity
D. The interest tax shield is pushed as large as it can possibly go
E. The marginal tax shield meets the marginal distress cost
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W8-S101
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Easy (0/8)
Original knowledge check: tradeoff theory — Answer
Correct answer: E — The marginal tax shield meets the marginal�distress cost
Why: At an interior optimum in this simplified model, the next�increment of debt adds as much tax-shield value as expected distress�cost.
Other choices: A and D maximize debt or tax benefits without the�associated costs. C equates two required returns rather than marginal�value effects. B can be optimal in other cases, but is not the interior�condition specified here.
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W8-S101
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Easy (0/8)
Original knowledge check: the pecking order
Under the pecking order theory, a firm with a choice prefers to finance�in which order?
A. Internal funds, then debt, then equity
B. Equity, then debt, then internal funds
C. Debt, then equity, then internal funds
D. Equity first, always, to preserve cash
E. Whichever source looks cheapest that quarter
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W8-S103
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Easy (0/8)
Original knowledge check: the pecking order — Answer
Correct answer: A — Internal funds, then debt, then equity
Why: The classic information-asymmetry model prefers internal�funding, then relatively safe debt, then equity when external funds are�needed.
Other choices: B and C reverse elements of the order. D turns equity�into a universal first choice. E ignores the information costs motivating�the theory. This preference does not override financing availability or�repayment capacity.
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W8-S103
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Easy (0/8)
Original knowledge check: pre-revenue constraints
Why can the traditional pecking order break down for a pre-revenue�startup?
A. Startups have effectively unlimited internal funds
B. Banks compete aggressively to lend to pre-revenue startups�today
C. Limited retained earnings and debt capacity can push the�company toward equity-like financing sooner
D. Equity happens to be the cheapest capital for startups
E. Startups are legally barred from ever issuing debt
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W8-S105
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Easy (1/8)
Original knowledge check:�pre-revenue constraints — Answer
Correct answer: C — Limited retained earnings and debt capacity�can push the company toward equity-like financing sooner
Why: A preference for internal cash or debt is not enough when�neither is available at a sustainable scale. Founder resources,�customers, grants, or equity-like financing may fit earlier.
Other choices: A assumes funds that may not exist. B overstates�lender appetite. D incorrectly declares equity universally cheapest. E�invents a legal prohibition.
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W8-S105
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Easy (1/8)
Original knowledge check: asset substitution
Jensen and Meckling (1976) identified an agency cost of debt in which�levered shareholders may:
A. Always choose to repay their outside lenders ahead of schedule
B. Refuse to pay any dividend at all for a full decade
C. Drive the firm's cost of equity all the way to zero
D. Eliminate every monitoring and bonding cost entirely
E. Shift to riskier projects that benefit them, not lenders
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W8-S107
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Easy (0/8)
Original knowledge check: asset substitution — Answer
Correct answer: E — Shift to riskier projects�that benefit them, not lenders
Why: Risk shifting can improve shareholders’ upside while exposing�existing lenders to more loss. It can reduce total company value and�motivates monitoring and contractual protections.
Other choices: A and B are not the identified incentive problem. C is�not an effect of leverage. D incorrectly eliminates agency costs.�Shareholders still bear losses; the conflict concerns how the change in�risk reallocates payoffs.
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W8-S107
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Easy (0/8)
Robb and Robinson: “startup” does not mean “VC-backed”
Robb and Robinson’s 2014 study uses the Kauffman Firm Survey of U.S.�businesses that began operating in 2004.
The sample relied substantially on formal external debt. The authors�report average bank financing roughly seven times average insider debt.
Owner borrowing and personal backing connect business finance to�household exposure. Limited liability at the company level does not erase�a personal guarantee.
This is historical evidence about a broad new-firm sample, not a�recommended debt ratio for a pre-revenue venture or evidence that�every startup qualifies for bank credit.
Robb & Robinson (2014), The Capital Structure Decisions of New Firms; NBER working-paper record; Robb & Robinson, author working paper: sample and financing�categories.
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Original knowledge check: new-firm financing evidence
Robb and Robinson (2014) found that new firms, contrary to the�common view, rely substantially on:
A. Only friends-and-family money at the start
B. Government grants far above all other sources
C. Formal bank debt, often personally backed
D. No outside capital of any kind whatsoever
E. Public equity markets right from the first day
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W8-S110
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Easy (0/8)
Original knowledge check:�new-firm financing evidence — Answer
Correct answer: C — Formal bank debt, often personally backed
Why: Formal bank finance was important in the study’s broad�new-firm sample, including financing connected to owners personally.�The empirical finding challenges an “only friends and family” account.
Other choices: A, B, D, and E do not describe the study’s main finding.�The result does not establish that debt is available, advisable, or�dominant for every VC-oriented startup.
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Easy (0/8)
Original knowledge check: the venture-debt downside
Assumptions: Compare the listed situations. Where acceleration�occurs, assume the agreement validly requires early repayment.
Venture debt is most dangerous to a startup when:
A. The company is comfortably growing well ahead of its plan
B. Market interest rates fall part way through the term
C. The company has just closed a large financing round
D. Growth stalls and a breached covenant forces acceleration
E. The lender's warrants expire without being exercised
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Easy (1/8)
Original knowledge check:�the venture-debt downside — Answer
Correct answer: D — Growth stalls�and a breached covenant forces acceleration
Why: D combines an operating shortfall with a contractual demand for�earlier repayment. That can force an urgent financing or restructuring�when bargaining power is weak.
Other choices: A and C generally improve the described financing�position. B may reduce floating-rate interest expense; E removes�potential warrant dilution. None describes the same immediate cash�crisis. Acceleration depends on the actual agreement and remedies; a�breach does not always trigger it automatically.
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Easy (1/8)
Original knowledge check: wealth and control
Assumptions: Interpret the question within Wasserman’s�wealth/control framework; outcomes vary across companies and�founders.
Wasserman (2012) found that founders who raise venture capital tend�to:
A. Retain their CEO control far more often than others
B. Build more valuable firms but lose CEO control more often
C. Earn strictly less money on average than bootstrappers do
D. Avoid dilution of their stake across the rounds
E. Never keep a board seat after a CEO succession
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W8-S114
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Easy (0/8)
Original knowledge check: wealth and control — Answer
Correct answer: B — Build more valuable firms�but lose CEO control more often
Why: B best captures the intended Rich vs. King tradeoff: external�resources can support a more valuable venture while reducing founder�control. Treat it as a broad descriptive teaching statement, not a�causal promise from raising VC.
Other choices: A runs against the stated tradeoff. C assumes dilution�necessarily reduces dollar wealth. D ignores ownership dilution. E�overstates the loss of a board role after CEO succession.
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Easy (0/8)
U.S. tax reference: separate three different limitations
For a U.S. corporate-tax�example:
This is not simply “a 50% ownership change.”�Forecast actual tax savings and their timing rather�than assuming every accounting deduction�produces immediate cash.
IRS, business-interest deduction FAQs, FS-2026-14, August 2026; IRS, Publication 542: corporations and net operating losses; IRS, Internal Revenue Bulletin�2013-46: §382 ownership-change framework.
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APV separates the business from financing effects
Adjusted present value (APV):
Unlevered operating value
+ present value of financing benefits, such as usable tax shields
− present value of financing costs, such as issuance costs and�incremental distress effects
This can clarify a planned debt schedule that changes substantially�over time. Discount each effect consistently with its risk and timing.
Start from value without financing benefits already embedded. Do not�add tax shields again to an operating value that already reflects them�through after-tax WACC.
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Knowledge check: keep APV internally consistent
A project has an unlevered operating value of $8.0 million. Separately�estimated present values are $0.4 million of usable tax shields, $0.3�million of incremental distress costs, and $0.1 million of issuance�costs. None is included in the $8.0 million. What is APV?
A. $8.4 million.
B. $8.8 million.
C. $8.0 million.
D. $7.6 million.
E. $8.1 million.
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W8-S118
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Easy (2/8)
Knowledge check: keep�APV internally consistent — Answer
Correct answer: C — $8.0 million.
Why: $8.0m + $0.4m − $0.3m − $0.1m = $8.0m. In this hypothetical,�financing benefits exactly offset financing costs.
Other choices: A ignores both costs. B adds the shield twice and�ignores costs. D subtracts costs but omits the shield. E omits issuance�costs.
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W8-S118
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Easy (2/8)