Capital Structure quiz

If MM's other assumptions are maintained, removing the no tax assumption means that the value of the firm is maximized when the value of the tax shield is maximized, which occurs with a capital structure of 100% debt .

According to Modigliani and Miller's Proposition I, under certain assumptions, including the absence of taxes and bankruptcy costs, the value of a firm is unaffected by its capital structure .

According to the pecking order theory, managers prefer internal financing. If internal financing is insufficient, managers next prefer debt, then equity—in order of increasing visibility to outsiders .

During the start-up stage a firm is unlikely to have positive earnings and cash flows or significant assets that can be pledged as debt collateral, so firms in this stage are typically financed by equity only .

Pecking order theory is based on information asymmetry and the resulting signals that different financing choices send to investors. It suggests that retained earnings are the first choice for financing an investment and issuing new equity is the least preferred choice.

The pecking order theory of capital structure assumes that firms have a preference ordering for capital sources. They prefer to use internally-generated equity first. When the internally-generated equity is exhausted, they issue new debt capital. As a last resort they will rely on externally-sourced equity. The reason that new equity is the last resort is that the issuance of new stock is assumed to send a negative signal to investors regarding firm value.

When interest rates have fallen to low levels that are expected to persist, firms often increase their target proportion of debt to reflect its lower cost. Firms may issue equity when they perceive the market price of their stock to be temporarily high or repurchase their stock when they judge the price to be low.

If the company’s WACC increases as a result of taking on additional debt, the company has moved beyond the optimal capital range. The costs of financial distress may outweigh any tax benefits from the use of debt .

Stock dividends, like stock splits, have no impact on the value of a company’s equity. Issuing shares to acquire a competitor would increase equity relative to debt in the capital structure. Share price appreciation would also increase the market value of equity, thus increasing equity relative to debt .

The cost of equity rises with the use of debt in the capital structure (e.g., with increasing financial leverage) .

Share price changes will cause the market value of the company’s equity to change; book value is unaffected.

Statements A and B are accurate.

MM’s Proposition I (with no taxes) states that capital structure is irrelevant because the decrease in a firm’s WACC from additional debt financing is just offset by the increase in WACC from a decrease in equity financing. The cost of debt is held constant and the cost of equity financing increases as the proportion of debt in the capital structure is increased .

Given the asymmetric returns on stock options, we would expect managers with significant stock options in their compensation to favor greater financial leverage and issuance of debt to increase potential stock price gains. Issuing common stock could decrease the market price of shares, which would decrease the value of stock options.

The tax shield provided by debt causes the WACC to decrease as leverage increases. The value of the firm is maximized at the point where the WACC is minimized, which is 100% debt under the MM assumptions .

Companies generally raise capital when it is needed, such as for investment spending or when market pricing and terms are favorable for debt or equity issuance.

As cash flows become more predictable, the company is able to support more debt in its capital structure; the optimal capital structure includes a higher proportion of debt. While mature companies do borrow to support growth, this action would typically not occur because the company is optimizing its capital structure. Likewise, while a mature company might issue equity to finance growth, this action would not be the typical approach for a company optimizing its capital structure .

Management is generally focused on maximizing the value of equity .

Credit ratings can be factored into management's capital structure policy if a firm has a minimum rating objective, and this is likely to be adversely affected by issuing additional debt .