Capital Structure quiz

According to the pecking order theory, internally generated funds are preferable to both new equity and new debt. If internal financing is insufficient, managers next prefer new debt, then new equity. Managers prefer forms of financing with the least amount of visibility to outsiders .

Mature companies are able to support more debt than start-up companies or growth stage companies because they typically have predictable positive cash flows, lower business risk, and significant liquid assets .

Because MM with taxes does not consider costs of financial distress, it concludes that tax savings of debt financing are maximized at 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 .

For a start-up company of this nature, debt financing is likely to be unattractive to lenders—and therefore very expensive or difficult to obtain. Debt financing is also unappealing to the company, because it commits the company to interest and principal payments that might be difficult to manage given the company’s uncertain cash flow outlook.

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 .

The after-tax cost of debt decreases as the marginal tax rate increases

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 .

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 .

The market value of equity is (USD30)(10,000,000) = USD 300,000,000

With the market value of debt equal to USD 100,000,000

the market value of the company is USD 100,000,000 + USD 300,000,000 = USD 400,000,000.

Therefore, the company is USD 100,000,000/USD 400,000,000 = 0.25, or 25% debt-financed.

For an analyst, target capital structure should always be based on market values of debt and equity. The other two choices are appropriate methods for estimating a firm’s capital structure for analysis .

Financing choices under pecking order theory follow a hierarchy based on visibility to investors with internally generated capital being the most preferred, debt being the next best choice, and external equity being the least preferred financing option .

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.

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 .

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.

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 .

For companies entering the growth stage, revenue and cash flow are typically increasing. Both debt financing costs and business risk tend to be somewhat reduced compared to the start-up stage.

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

An electric utility has the capacity to support substantial debt, with very stable and predictable revenues and cash flows. The software company also has these attributes, but it would have been much less likely to have raised debt during its development and may have raised equity. The mining company has fixed assets, which it would have needed to finance, but the cyclical nature of its business would limit its debt capacity .

The static trade-off theory seeks to balance the costs of financial distress with the tax shield benefits from using debt. Under the static trade-off theory, there is an optimal capital structure that has an optimal proportion of debt that will maximize the value of the firm.