The Modigliani and Miller theories are based on several unrealistic assumptions
ID: 2793608 • 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? O Firms that have relatively higher business risk compared to other firms in their industry O Firms that have relatively lower 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. Option 1 Option2 According to signalling theory, if managers expect the firm's stock price to decrease, they are 2777 to raise capital through equity financing. Encouraged Discouraged A leveraged buyout (LBO) helps the firm 2227 both its excess cash flows and managers' temptation to incur wasteful expenses. Reduce Increase Firms that maintain an adequate reserve borrowing capacity will be able to ???? money at a reasonable cost when good investment opportunities arise. Borrow Lend Several dominant theories try to explain why financial managers make the capital structure decisions that they do. The following statement describes one such theory. Consider this case: The firm's debt-equity decision finds the optimal balance between the interest tax shield benefits of debt financing and the costs of financial distress associated with issuing debt. Identify which of the two theories is described by the statement. O Pecking-order hypothesis O Trade-off theoryExplanation / Answer
Firms that have relatively lower business risk compared to other firms in the industry tedn to use more leverage. This is because, lower risk implies lower bankruptcy cost therby lowering the cost of capital. Thus we see businesses that have matured use more of debt financing compared to a startup firm which is more riskier and will be prone to cash flow problems that in turn will increase the distress quotient if debt is in the capital structure.
If the managers expect the stock price to decrease they are discouraged to raise capital from equity markets due to lower value of capital raised through the authorized route and instead will be encouraged to buy back the shares to provide a signalling effect to the market that they have confidence in the firms prospects.
A leveraged buy out involves substantial debt in acquiring another company. The reason for raising debt is to reduce excess cash flows which the manager may use to incur wasteful expenditures on projects.
Firms that maintain an adequate borrowing capacity will be able to borrow money at reasonable cost when opportunities arise as lenders look for capacity to repay.
Trade Of theory talks about the optimal capital structure decisions and that a firms debt equity decision finds the optimal balance between interest tax shield benefits of debt financing an costs of financial distress associated with issuing debt.