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1. Which capital structure theory recognizes the fact that investors and managers do not have the same information regarding a firm’s prospects?

2. The capital structure that maximizes the stock price is also the one that the___________ WACC.

3. In Modigliani & Miller’s Proposition I with taxes the value of a levered firm is equal to the value of an unlevered firm plus____________ .

4. In Modigliani & Miller without taxes, what is the optimal debt to equity ratio?

5. The trade-off theory of capital structure states that debt initially adds value. Explain why

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Jarrod Robel
Jarrod RobelLv2
28 Sep 2019

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When the assumptions of Modigliani and Miller’s Irrelevance Hypothesis regarding corporate capital structure are relaxed so that they are more consistent with real-world conditions, i.e. there are corporate taxes (and interest payments are tax deductible) and there are costs of financial distress, then which of the following is true?

Firm value and WACC are independent of the firm's capital structure.

Firm value increases and WACC decreases initially as more debt is added to the firm's capital structure, however, there comes a point where adding additional debt generates potential costs of financial distress that outweigh the benefits of further reducing taxes. After this point, firm value starts to decrease and WACC starts toincrease as more debt is added.

Each firm has an optimal capital structure where WACC is maximized.

Each firm has an optimal capital structure where firm value is minimized.

Firm value increases and WACC increases initially as more debt is added to the firm's capital structure, however, there comes a point where adding additional debt generates potential costs of financial distress that outweigh the benefits of further reducing taxes. After this point, firm value and WACC start to decrease as more debt is added.

When the assumptions of Modigliani and Miller’s Irrelevance Hypothesis regarding corporate capital structure are relaxed so that they are more consistent with real-world conditions, i.e. there are corporate taxes (and interest payments are tax deductible) and there are costs of financial distress, then which of the following is true? Firm value increases and WACC decreases initially as more debt is added to the firm's capital structure, however, there comes a point where adding additional debt generates potential costs of financial distress that outweigh the benefits of further reducing taxes. After this point, firm value starts to decrease and WACC starts to increase as more debt is added. Each firm has an optimal capital structure where firm value is minimized. Firm value increases and WACC increases initially as more debt is added to the firm's capital structure, however, there comes a point where adding additional debt generates potential costs of financial distress that outweigh the benefits of further reducing taxes. After this point, firm value and WACC start to decrease as more debt is added. Each firm has an optimal capital structure where WACC is maximized. Firm value and WACC are independent of the firm's capital structure.

Which of the following statements regarding Modigliani and Miller (MM)’s propositions is most accurate?

A.

Firm value is maximized with a capital structure consisting of 100% equity

B.

The required rate of return of equity increases as the firm increases its financial leverage

C.

The use of debt financing increases the firm’s earnings volatility

D.

It does not matter which capital structure firm choose because capital structure is irrelevant in terms of firm value, with or without taxes.

E.

All of above are wrong

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