Alternative capital structure theories The Modigliani and Miller theories are based on several unrealistic assumptions related to the use of debt financing. In reality, there are costs, taxes, and other factors associated with the use of borrowed funds. These costs or effects have led to several theories that explain the impact of these factors on the capital structure decisions made by a firm's managers.
1. Based on your understanding of the trade-off theory, what kind of firms are likely to use more leverage?
A. Firms with a higher proportion of variable-versus-fixed costs.
B. Firms with a higher proportion of fixed-versus-variable costs.
2. Based on your understanding of the capital structure theories, identify the best option for the missing part of the statement.
A. According to signaling theory, if managers expect the firm's stock price to decrease-even if the firm has a profitable investment opportunity-they should be financing likely to raise capital through equity.
B. According to pecking-order hypothesis, a profitable firm is likely to use profitable firm.
3. According to the reserved borrowing capacity theory, a firm should use less equity and more debt financing than is generally recommended so that the firm can sell additional shares if it encounters a new investment opportunity This statement is:.
A. False
B. True
4. Several dominant theories try to explain why financial managers make the capital structure decisions that they do. The following statement describes one such theory;
Firms prefer internal funds, but if forced to raise external rather than equity issuance. Which of the two theories listed below is best described by the statement.
A. Pecking-order hypothesis
B. Trade-off theory