Question 1

An optimal capital structure is achieved

Accepted Answer

An optimal capital structure is achieved when a firm's expected stock price is maximized. This is because the stock price reflects the present value of future cash flows, adjusted for risk, and maximizing the stock price is generally seen as maximizing shareholder value.

Question 2

Which of the following is consistent with the original formulation of the Modigliani and Miller Capital Structure Theorem?

Accepted Answer

The Modigliani and Miller Capital Structure Theorem states that a firm's weighted average cost of capital and common stock price are independent of its capital structure or the amount of financial leverage used by the firm. Thus, option C is consistent with the original formulation of this theory. Options A and D are incorrect, as the theorem specifically focuses on financial leverage and not operating leverage. Option B is also incorrect, as according to the theorem, the common stock price should not be affected by changes in the firm's capital structure.

Question 3

Which of the following will happen if the original Modigliani and Miller Theorem is relaxed to include taxes, but not bankruptcy costs?

Accepted Answer

The inclusion of taxes in the Modigliani and Miller Theorem suggests that there are tax advantages to using debt financing. As a result, at a certain point, increased usage of financial leverage will lower a firm's weighted average cost of capital since the tax benefits outweigh the increased risk of financial distress. Therefore, option B is the correct answer.

Question 4

The original form of the Modigliani and Miller Capital Structure Theorem

Accepted Answer

The Modigliani and Miller Capital Structure Theorem ignores the effect of taxes (A) and transaction costs (C), making choice D the correct one.

Question 5

Which of the following is a reasonable conclusion from the trade-off theory of capital structure?

Accepted Answer

The trade-off theory of capital structure suggests that there is an optimal level of debt for a firm, beyond which the costs of financial distress outweigh the benefits of the tax shield provided by debt. Modest levels of debt can provide a tax benefit without significantly increasing the risk of financial distress, leading to a more favorable impact on a firm's average cost of capital and stock price compared to no debt. Therefore, option D is the most reasonable conclusion from the trade-off theory.

Question 6

An optimal capital structure is achieved

Accepted Answer

An optimal capital structure is achieved when a firm's weighted average cost of capital is minimized. This means that the cost of financing the firm's assets is minimized, which in turn maximizes the value of the firm to its shareholders. Companies strive to achieve an optimal capital structure by balancing the use of various sources of funds, such as debt and equity, in a way that minimizes the cost of capital while taking into consideration the risks associated with each source of financing.

Question 7

When the impact of taxes is considered, as the firm takes on more debt

Accepted Answer

When a firm takes on more debt, the interest payments on that debt are tax-deductible, which reduces the firm's taxable income and thus its taxes. This effect increases the total cash flows available to stockholders and bondholders because less cash is paid out in taxes.

Question 8

Using the original Modigliani and Miller assumptions if a firm's cost of capital is 12% when it is all equity financed and its cost of debt is 8%, the cost of equity will be [blank] % when the firm is financed with equal amount of debt and equity.

Accepted Answer

According to Modigliani and Miller, the cost of equity in a leveraged firm is given by the formula: 
Cost of Equity = Cost of Unlevered Equity + (Cost of Debt − Tax Rate) x (Debt/Equity) 
Assuming that the tax rate is 0 and the firm's cost of un-levered equity is 12%, we can calculate the cost of equity as follows:

Cost of Equity = 12% + (8% - 0) x (1/1) 
Cost of Equity = 12% + 8% 
Cost of Equity = 16%

Question 9

Which of the following is consistent with the trade-off theory of capital structure?

Accepted Answer

The trade-off theory states that there is an optimal level of debt financing that balances the benefits of the tax shield with the costs of financial distress and agency costs. This suggests that at some point, increasing debt will cause the costs of financial distress to outweigh the tax benefits, resulting in a higher cost of capital. Therefore, option D is the most consistent with the trade-off theory of capital structure. Options A and B are incorrect because they suggest that the cost of capital continuously decreases or remains constant, which is not consistent with the trade-off theory. Option C is incorrect because there are significant costs associated with bankruptcy, including legal fees and lost reputation.

Question 10

Assume that the tax rate is 34% and bankruptcy costs are negligible until a firm's debt to equity ratio is greater than one.If Millers Inc.increases debt from 10% of its capital structure to 40%, cash flows to investors will -.

Accepted Answer

By increasing debt from 10% to 40%, Millers Inc. will benefit from the tax shield of debt, which will increase its cash flows to investors. The tax shield is calculated as the tax rate multiplied by the interest expense. Since the tax rate is 34%, and the interest expense will increase with more debt, the tax shield will increase as well, thereby increasing the cash flows to investors. Additionally, since the debt to equity ratio is still below one, there are no bankruptcy costs to consider, so the increase in cash flows is even greater.

Question 11

Optimal capital structure is

Accepted Answer

Optimal capital structure is defined as the funding mix that maximizes a company's stock price by balancing the cost of capital with the risk. This involves finding the right proportion of debt, equity, and other securities that minimizes the company's overall cost of capital and thereby maximizes the value of the company to its shareholders.

Question 12

The trade-off theory of capital structure management assumes

Accepted Answer

The trade-off theory of capital structure management assumes that firms might fail as a result of too much debt. The theory acknowledges that there are costs and benefits to both debt and equity financing, and that firms must strike a balance between the two in order to maximize value. This theory also assumes that there are corporate income taxes and that the cost of equity increases with financial leverage, making choice A and B incorrect.

Question 13

The inclusion of bankruptcy costs and taxes in firm valuation

Accepted Answer

The inclusion of bankruptcy costs and taxes in firm valuation is consistent with a saucer-shaped cost of capital curve. This is because adding debt initially lowers the cost of capital due to the tax shield, but as more debt is added, the risk of bankruptcy increases, leading to higher bankruptcy costs, which in turn increases the cost of capital. Eventually, the cost of capital begins to rise again, resulting in a saucer-shaped curve.

Question 14

What is being traded off in trade-off theory?

Accepted Answer

The trade-off theory describes the decision-making process of a firm when determining the optimal capital structure. The theory suggests that there is a trade-off between the tax savings from interest payments and the financial distress costs associated with high levels of debt. Therefore, the best choice is A.

Question 15

From the information below, select the optimal capital structure for Mountain High Corp.

Accepted Answer

The optimal capital structure for a firm is the one that maximizes its value. While there is no one-size-fits-all solution, in general, firms should aim for a balance between debt and equity that minimizes their weighted average cost of capital (WACC) while maximizing their EPS and stock price.

Option C, with a debt-to-equity ratio of 60:40, has the highest EPS and stock price of all options, suggesting that the company is maximizing its value under this structure. Additionally, a higher proportion of debt means a lower cost of capital due to tax savings, which also improves the company's value. Overall, option C offers the best capital structure for Mountain High Corp.

Question 16

The Trade-off Theory view of capital structure management says that the cost of capital curve is

Accepted Answer

The answer of The Trade-off Theory view of capital structure...

Question 17

The Trade-off Theory of capital structure theory indicates that

Accepted Answer

The Trade-off Theory suggests that there is a trade-off between the tax benefits of debt and the costs of financial distress. So, the tax shield on debt can increase firm value, but at the same time, high financial leverage can also increase the probability of financial distress which could lead to firm failure. Therefore, there is a range of capital structures, rather than a single optimal capital structure for each firm. So, all the given options in the question are correct according to the Trade-off Theory.

Question 18

Which of the following is a conclusion of agency theory?

Accepted Answer

The answer of Which of the following is a conclusion...

Question 19

With taxes, but in the absence of financial distress costs, the optimal capital structure would be -

Accepted Answer

In the presence of taxes but absence of financial distress costs, the optimal capital structure would be 100% debt. This is because interest payments on debt are tax-deductible, reducing the company's taxable income and thus its tax liability. Without the counterbalancing cost of financial distress, this makes debt financing more attractive than equity.

Question 20

If interest expense lowers taxes, why does the WACC not decrease indefinitely with the addition of more debt?

Accepted Answer

While interest expense does lower taxes, adding more and more debt can increase the risk of financial distress or bankruptcy, which will increase the cost of equity and offset the tax benefits. Therefore, the WACC does not decrease indefinitely with the addition of more debt.

Quiz 16: Capital Structure Policy

An optimal capital structure is achieved

Which of the following is consistent with the original formulation of the Modigliani and Miller Capital Structure Theorem?

Which of the following will happen if the original Modigliani and Miller Theorem is relaxed to include taxes, but not bankruptcy costs?

The original form of the Modigliani and Miller Capital Structure Theorem

Which of the following is a reasonable conclusion from the trade-off theory of capital structure?

An optimal capital structure is achieved

When the impact of taxes is considered, as the firm takes on more debt

Using the original Modigliani and Miller assumptions if a firm's cost of capital is 12% when it is all equity financed and its cost of debt is 8%, the cost of equity will be [blank] % when the firm is financed with equal amount of debt and equity.

Which of the following is consistent with the trade-off theory of capital structure?

Assume that the tax rate is 34% and bankruptcy costs are negligible until a firm's debt to equity ratio is greater than one.If Millers Inc.increases debt from 10% of its capital structure to 40%, cash flows to investors will -.

Optimal capital structure is

The trade-off theory of capital structure management assumes

The inclusion of bankruptcy costs and taxes in firm valuation

What is being traded off in trade-off theory?

From the information below, select the optimal capital structure for Mountain High Corp.

The Trade-off Theory view of capital structure management says that the cost of capital curve is

The Trade-off Theory of capital structure theory indicates that

Which of the following is a conclusion of agency theory?

With taxes, but in the absence of financial distress costs, the optimal capital structure would be -

If interest expense lowers taxes, why does the WACC not decrease indefinitely with the addition of more debt?