Capital Structure quiz

The static trade-off theory indicates that there is a trade-off between the tax shield for interest on debt and the costs of financial distress, leading to an optimal amount of debt in a company’s capital structure .

Long-term debt is more exposed than short-term debt to the risk of a management decision that is not debtholder-friendly. Secured debt is less exposed than unsecured debt to such a risk, and with low leverage, the risk of a debt-equity conflict is reduced, not increased, relative to high leverage .

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 .

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 .

Proposition I, or the capital structure irrelevance theorem, states that in perfect markets the level of debt versus equity in the capital structure has no effect on company value .

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.

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.

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 .

Cash flow typically turns positive during the growth stage, but it may be negative, particularly at the beginning of this stage.

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 .

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.

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 .

The optimal capital structure minimizes the firm’s WACC and maximizes the firm’s value (stock price)

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 .

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 .

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 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.

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 .

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 .

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.