Question 1

If the static theory of capital structure is true, then the optimal level of debt for a given ﬁrm
increases as its marginal tax rate increases and decreases as the costs of ﬁnancial distress
increase.

Accepted Answer

According to the static theory of capital structure, the optimal level of debt for a firm increases as its marginal tax rate increases because debt interest payments are tax-deductible. However, the optimal level of debt decreases as the costs of financial distress increase because high levels of debt can increase the likelihood of bankruptcy and financial distress costs. Therefore, both statements are correct.

Question 2

When taxes are factored in, debt ﬁnancing creates positive value in the form of an interest tax
shield.

Accepted Answer

Debt financing allows companies to deduct interest payments from their taxable income, reducing the amount of taxes they owe. This interest tax shield creates a positive value for the company by lowering their overall tax burden.

Question 3

When taxes are factored in, debt ﬁnancing lowers a ﬁrm's cost of equity.

Accepted Answer

Debt financing increases a firm's financial risk, which increases the cost of equity. Additionally, the interest paid on debt is tax-deductible, which can lower a firm's overall tax liability but does not directly lower the cost of equity.

Question 4

The interest tax shield has no value for a ﬁrm when the ﬁrm is unlevered.

Accepted Answer

The interest tax shield only has value for a firm when it is leveraged and has debt to pay off interest on. If a firm is unlevered, it has no debt and therefore no interest payments to deduct from its taxable income.

Question 5

According to the static theory of capital structure, value-maximizing ﬁnancial managers will borrow
to the point where the ﬁrm's business risk is just equal to its ﬁnancial risk.

Accepted Answer

The static theory of capital structure suggests that firms should borrow up to the point where the tax shield from debt equals the costs of financial distress, not where business risk equals financial risk.

Question 6

The interest tax shield has no value for a ﬁrm when a ﬁrm elects 100% equity as its capital structure.

Accepted Answer

The interest tax shield is only applicable to firms that have debt in their capital structure since they are able to deduct interest payments on debt from their taxable income, resulting in lower tax payments. If a firm has 100% equity, they have no debt and therefore no interest tax shield.

Question 7

When taxes are factored in, debt ﬁnancing lowers a ﬁrm's weighted average cost of capital.

Accepted Answer

Debt financing allows a firm to deduct interest payments on their taxes, which reduces the overall cost of borrowing and results in a lower weighted average cost of capital.

Question 8

Interest tax shield applies to levered ﬁrms but not to unlevered ﬁrms.

Accepted Answer

Interest tax shield refers to the tax deduction on interest payments made by a company to its debt holders. This tax deduction reduces the amount of taxes the company has to pay, resulting in a lower cost of debt for the company. Therefore, only levered firms with debt financing benefit from the interest tax shield, while unlevered firms that use only equity financing do not.

Question 9

The interest tax shield has no value for a ﬁrm when the tax rate is equal to zero.

Accepted Answer

The interest tax shield is based on the tax deduction that a firm can take for paying interest on debt. If the tax rate is zero, there is no tax to avoid, so the interest tax shield has no value.

Question 10

According to M&M Proposition II without taxes, a ﬁrm's cost of equity is a function of the required
rate of return on the ﬁrm's assets, the ﬁrm's debt/equity ratio, and the ﬁrm's cost of debt.

Accepted Answer

According to M&M Proposition II without taxes, the cost of equity is solely based on the required rate of return on the firm's assets and the firm's debt/equity ratio. The cost of debt is not directly factored into the cost of equity calculation.

Question 11

The optimal capital structure is the mixture of debt and equity which maximizes the market price of
the ﬁrm's bonds.

Accepted Answer

The optimal capital structure is the mixture of debt and equity which maximizes the overall value of the firm, not just the market price of its bonds.

Question 12

The interest tax shield has no value for a ﬁrm when the debt-equity ratio is exactly equal to 1.

Accepted Answer

The interest tax shield has value as long as there is debt, regardless of the debt-equity ratio, because interest payments are tax-deductible.

Question 13

A sizeable increase in taxable income will tend to diminish the beneﬁt of the interest tax shield.

Accepted Answer

A sizeable increase in taxable income will not diminish the benefit of the interest tax shield; instead, it may enhance it, as the interest tax shield is more valuable when there is more taxable income to shield from taxes.

Question 14

A reduction in tax rates will tend to diminish the beneﬁt of the interest tax shield.

Accepted Answer

If tax rates are reduced, then the amount of taxes saved through deducting interest expenses will also be lower, thus reducing the benefit of the interest tax shield.

Question 15

The maximum value of a ﬁrm is at the point where the additional gain from leverage is just offset by
the additional ﬁnancial distress cost.

Accepted Answer

This is known as the optimal capital structure theory, which suggests that a firm should leverage up to a point where the marginal benefits of debt are equal to the marginal costs of financial distress. Beyond this point, the costs of financial distress would outweigh any further benefits of leverage, resulting in a decrease in firm value.

Question 16

As ﬁnancial risk increases so too does the cost of equity.

Accepted Answer

The cost of equity is proportional to the level of financial risk faced by the company, so as financial risk increases, the cost of equity also increases.

Question 17

A large depreciation tax deduction will tend to diminish the beneﬁt of the interest tax shield.

Accepted Answer

A large depreciation tax deduction will reduce the taxable income, which in turn will reduce the amount of interest expense that can be deducted from taxes. This will diminish the benefit of the interest tax shield.

Question 18

When taxes are factored in, debt ﬁnancing increases the value of a ﬁrm.

Accepted Answer

Debt financing allows for interest payments to be tax-deductible, which reduces the firm's taxable income and therefore lowers the amount of taxes paid. This tax shield increases the value of the firm, making debt financing beneficial.

Question 19

Financial risk applies to levered ﬁrms but not to unlevered ﬁrms.

Accepted Answer

Financial risk is the risk that a firm will not be able to meet its financial obligations, such as paying its debts or making interest payments. Levered firms are firms that have debt, while unlevered firms do not. Debt can increase a firm's financial risk because it increases the firm's fixed costs and makes it more difficult to meet its financial obligations in the event of a downturn in the economy.

Question 20

A large tax loss carry forward will tend to diminish the beneﬁt of the interest tax shield.

Accepted Answer

A tax loss carry forward allows a company to offset future taxable income with prior years' losses, reducing its tax liability. However, this also means there may be less taxable income to shield with interest payments, thereby diminishing the benefit of the interest tax shield.

Quiz 16: Financial Leverage and Capital Structure Policy

If the static theory of capital structure is true, then the optimal level of debt for a given ﬁrm increases as its marginal tax rate increases and decreases as the costs of ﬁnancial distress increase.

When taxes are factored in, debt ﬁnancing creates positive value in the form of an interest tax shield.