Question 1

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 2

Investors require a higher return on ordinary share investments if a firm uses less leverage.

Accepted Answer

This statement is false. Investors may actually require a lower return on ordinary share investments if a firm uses less leverage, because a lower level of debt signifies less financial risk and potentially higher stability for the company.

Question 3

The hierarchy of funding sources as applied to capital structure is derived from

Accepted Answer

The answer of The hierarchy of funding sources as applied...

Question 4

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

Accepted Answer

Given the tax rate of 40%, increasing debt will result in higher interest payments, which are tax-deductible expenses. This will result in a lower taxable income and therefore lower taxes to be paid, leaving more cash flow available for investors. Additionally, since bankruptcy costs are negligible until a debt to equity ratio of greater than one, there is no risk of bankruptcy in this scenario. Therefore, increasing debt will increase cash flows to investors.

Question 5

The inclusion of bankruptcy costs and taxes in firm valuation

Accepted Answer

The inclusion of bankruptcy costs and taxes is consistent with a saucer-shaped cost of capital curve, where the cost of capital initially decreases as more debt is added to the capital structure due to the tax shield benefits, but then increases as the probability of bankruptcy and associated costs rise with higher levels of debt.

Question 6

Lowell Corporation and Lawrence Corporation each have EBIT of $4 million.Lowell has no debt and no interest expense;Lawrence has $2 million in debt at a before-tax rate of 8%.The tax rate is 40%.How much cash does each firm return to its investors.

Accepted Answer

The answer of Lowell Corporation and Lawrence Corporation each have...

Question 7

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

Accepted Answer

In the absence of financial distress costs, the tax advantage of debt is maximized and there is no benefit to having equity in the capital structure. As a result, the optimal capital structure would be 100% debt, as it minimizes the weighted average cost of capital (WACC) and maximizes firm value.

Question 8

Other things the same,the use of debt financing reduces the firm's total tax bill,resulting in a higher total market value.

Accepted Answer

This is because interest payments on debt are tax-deductible, lowering the firm's taxable income and reducing its tax liability. This results in higher after-tax cash flows, which in turn increases the firm's total market value.

Question 9

Agency costs occur when managers choose the easiest form of financing over the value maximising capital structure.

Accepted Answer

Agency costs refer to the costs incurred by a firm due to conflicts of interest between the managers and the shareholders. These conflicts arise because managers may prioritize their own interests over the interests of the shareholders. In case of capital structure decisions, managers may choose a financing option that is easier for them to manage or has less constraints, even if it is not the option that maximizes shareholder value. This results in agency costs.

Question 10

The Trade-off Theory of capital structure theory indicates that

Accepted Answer

The Trade-off Theory states that there is a trade-off between the benefits and costs of debt financing. The tax shield on debt is a benefit of debt financing, but too much debt can lead to financial distress and ultimately firm failure. Therefore, there is a range of capital structures that is optimal rather than a single, ideal structure. All of the options listed in the question are correct statements about the Trade-off Theory, making D the correct choice.

Question 11

Which of the following is part of a firm's financial structure but NOT a component of its capital structure?

Accepted Answer

Accounts payable are a part of a firm's financial structure because they represent the money owed by the company to its suppliers for goods or services received on credit. However, they are not a component of the capital structure, which refers to the long-term funding sources of the company such as equity, debt, and retained earnings. Retained earnings, on the other hand, are a component of both the financial and capital structure as they represent the portion of net income that is reinvested back into the business. Mortgage bonds are a component of the capital structure as they represent long-term debt financing that requires the company to make regular interest payments to bondholders.

Question 12

Newbury Inc.has retained $2 million in earnings this year.It can borrow up to $1.5 million at a rate of 8% and sell the same amount of new shares at a cost of 17%.Newbury's cost of ordinary equity without selling any new shares is 16%.If Newbury's capital budget is $2.5 million,the hierarchical funding model says management will use

Accepted Answer

The hierarchical funding model prioritizes using retained earnings first, then debt, and finally new equity. Newbury will use $2 million in retained earnings and the remaining $0.5 million from debt.

Question 13

The Modigliani and Miller Capital Structure Theorem suggests that the cost of equity decreases as financial leverage increases.

Accepted Answer

The Modigliani and Miller Capital Structure Theorem, under the assumption of no taxes, suggests that the cost of equity increases as financial leverage increases, to compensate for the higher risk.

Question 14

Capital structure theory suggests that companies may put the interests of ________ ahead of the interests of ________.

Accepted Answer

Capital structure theory suggests that companies may put the interests of shareholders ahead of the interests of bondholders. This is because shareholders have residual claims on the company's earnings and assets, while bondholders have fixed claims that are typically senior to equity claims. Therefore, companies may prioritize shareholder wealth maximization at the expense of bondholders in certain situations, such as when making dividend or capital investment decisions.

Question 15

The most acceptable view of capital structure,according to the text,is that the weighted average cost of capital

Accepted Answer

The text suggests that the most acceptable view of capital structure is that the weighted average cost of capital first falls with moderate levels of leverage and then increases as a firm's leverage becomes high. This is known as the trade-off theory of capital structure.

Question 16

Given the existence of taxes and bankruptcy costs,the optimal capital structure is 100% debt.

Accepted Answer

While taxes and bankruptcy costs can have an impact on a company's capital structure, the optimal capital structure is not always 100% debt. Other factors such as the company's industry, growth opportunities, and risk profile also play a role in determining the optimal mix of debt and equity financing.

Question 17

Chelsea Corporation's cost of equity is 16% and it is 100% equity financed.If it can borrow enough money at 10% to buy back half of its shares,what would happen to the cost of equity under the original assumptions of the Modigliani and Miller Capital Structure Theorem?

Accepted Answer

According to the Modigliani and Miller Theorem, when a firm increases its leverage, the cost of equity increases because equity holders require a higher return due to increased financial risk. With 50% debt at 10%, the cost of equity rises to 22%.

Question 18

The objective of capital structure management is to maximise the market value of the firm's equity.

Accepted Answer

The ultimate aim of capital structure management is to increase the value of the firm's equity by finding the optimal mix of debt and equity financing.

Question 19

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

Accepted Answer

Increasing debt too much can result in a greater likelihood of firm failure (financial distress). Although interest expense lowers taxes and may result in a lower cost of capital, too much debt can increase the probability of financial distress and bankruptcy, which would ultimately increase the firm's cost of capital.

Question 20

The theory that managers may prefer internal sources of funds to the lowest cost source of funds is known as

Accepted Answer

The hierarchy of funding, also known as the pecking order theory, suggests that managers prefer internal financing first, then debt, and issue equity as a last resort.

Quiz 15: Capital Structure Policy