The Modigliani and Miller theories are based on several unrealistic assumptions
ID: 2749341 • Letter: T
Question
The Modigliani and Miller theories are based on several unrealistic assumptions about debt financing. In reality, there are costs, taxes, and other factors associated with debt financing. These costs or effects have led to several theories that explain the impact of these factors on the capital structure of a firm. Based on your understanding of the trade-off theory, what kind of firms are likely to use more leverage? Firms that have relatively lower business risk compared to other firms in their industry Firms that have relatively higher business risk compared to other firms in their industry Based on your understanding of the capital structure theories, identify the best option for the missing part of the statement.Explanation / Answer
Accoridng to trade off theory, firms that have lower business risk compared to other firms in their industry use more leverage.
This is because if business is having higher amount of business risk, which implies higher fluctuations in sales which in turn leads to fluctuation in cash flows and thereby firm's inability to pay fixed charges and interest payments.
According to signalling theory, if managers expect the firm's stock price to decrease, they are encouraged to raise capital through equity finance
According to the windows of opportunity theory managers don't believe in efficient markets
according to the windows of opportunity theiry, Managers don't believe in market efficiency and when managers see stock prices and interest rates are sometimes either too low or too high relative to their true fundamental values, they issue equity when stock is overpriced and buybacks with debt if under priced.
Firms which maintain an adequate reserve borrowing capacity will be able to borrow money at reasonable cost when good investment opportunities arise
The above implication comes from signalling theory.it says keep adequare reserve borrowing capacity and in future when a good opportunity comes, use debt financing and carry out the project
The firms debt equity decision finds the optimal balance between the interest tax shields benefits of debt financing and the costs of financial distress associated with issuing debt. : correct answer : Trade off theory
This is the main implication of trade off theory. Theory says that debt can be borrowed as long as interest tax shield benefits balances the cost of financial distress.
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