1. According to Modigliani-Miller (MM) Hypothesis "Proposition I" (without taxes), the value of a firm is:
Maximized at 100% Debt.
Independent of its Capital Structure.
Maximized at 100% Equity.
Dependent on its Debt-Equity ratio.
Explanation:
MM Proposition I (No Tax) states that in a perfect market, how a firm finances its operations (Debt vs Equity) is irrelevant to its total value. Value is determined by its earning power and risk of assets, not funding mix.
2. Financial Leverage becomes "Favorable" (Positive) only when:
Debt is zero.
Return on Investment (ROI) is higher than the Cost of Debt.
Tax rate is zero.
Return on Investment (ROI) is lower than the Cost of Debt.
Explanation:
If ROI > Cost of Debt, using debt magnifies the Earnings Per Share (EPS) for shareholders (Trading on Equity). If ROI < Cost of Debt, leverage destroys value.
3. The "Indifference Point" (EBIT-EPS Analysis) refers to the level of EBIT where:
Financial Leverage is zero.
The company makes no profit and no loss.
EPS is zero.
Earnings Per Share (EPS) is the same for two different financing plans.
Explanation:
At the indifference point, the firm is indifferent between choosing Debt plan or Equity plan because the EPS remains identical. Below this EBIT level, equity is better; above it, debt is better.
4. The "Pecking Order Theory" suggests that firms prioritize financing sources in which order?
Debt -> Equity -> Retained Earnings
Retained Earnings -> Debt -> Equity
Equity -> Debt -> Retained Earnings
Retained Earnings -> Equity -> Debt
Explanation:
Firms prefer internal funds (Retained Earnings) first because they are cheapest and safest. Next is Debt. External Equity is the last resort due to high costs and dilution.
5. The "Optimal Capital Structure" is the mix of debt and equity that:
Eliminates all debt.
Minimizes WACC and Maximizes the value of the firm.
Minimizes the value of the firm.
Maximizes the Weighted Average Cost of Capital (WACC).
Explanation:
The goal is to find the cheapest mix of funds. Lower WACC means higher Net Present Value of future cash flows, thus maximizing firm value.
6. The Net Operating Income (NOI) Theory of Capital Structure assumes that:
Cost of Equity remains constant.
Value of firm changes with debt.
Cost of Debt increases with leverage.
Overall Cost of Capital (Ko) remains constant regardless of leverage.
Explanation:
NOI theory suggests that the benefits of cheaper debt are exactly offset by the increasing cost of equity (higher risk), leaving the overall WACC (Ko) and Firm Value unchanged.
7. The "Trade-off Theory" of capital structure argues that a firm balances:
Profit and Loss.
Short term vs Long term debt.
Tax benefits of debt vs. Financial distress costs of debt.
Equity issuance costs vs. Debt issuance costs.
Explanation:
Firms take on debt to get tax shields (benefit), but only up to a point where the risk of bankruptcy (financial distress cost) starts outweighing the tax benefit.
8. Costs associated with bankruptcy or financial distress (like legal fees, loss of customers) are known as:
Agency Costs.
Floatation Costs.
Sunk Costs.
Financial Distress Costs.
Explanation:
These costs offset the tax benefits of debt in the Trade-off Theory, suggesting an optimal level of debt exists.
9. Modigliani-Miller Proposition II (with taxes) states that the Cost of Equity (Ke) increases as:
The Debt-Equity Ratio increases.
The Dividend Payout Ratio increases.
The Corporate Tax Rate increases.
The Debt-Equity Ratio decreases.
Explanation:
As a firm takes on more debt (higher D/E ratio), the financial risk to shareholders increases. Shareholders demand a higher return (Ke) to compensate for this added risk.
10. As the Debt-Equity ratio increases beyond an optimal point, the "Cost of Debt" starts rising because:
The government imposes penalties.
The tax rate increases.
Lenders perceive higher default risk and demand a higher risk premium.
Equity holders demand less return.
Explanation:
Excessive debt increases the probability of bankruptcy. Lenders compensate for this increased credit risk by charging higher interest rates.
11. MM Proposition II (Without Taxes) states that as leverage increases, the Cost of Equity (Ke):
Increases linearly to offset the benefit of cheaper debt.
Becomes zero.
Remains constant.
Decreases.
Explanation:
Cheaper debt reduces WACC, but increased financial risk raises Ke. MM II argues these exactly cancel out, keeping overall WACC constant.
12. The "Traditional View" of Capital Structure suggests that:
Debt is always cheaper than equity, so 100% debt is best.
An optimal capital structure exists where the Overall Cost of Capital (Ko) is minimum and the value of the firm is maximum.
Cost of capital is constant regardless of debt.
The value of the firm depends solely on its assets, not financing.
Explanation:
Unlike MM theory, the Traditional View argues that judicious use of debt initially lowers the WACC (Ko) up to a point. Beyond this point, rising financial risk causes Ke and Kd to rise, increasing WACC. The lowest point of the U-shaped WACC curve is the optimal structure.
13. "Agency Costs" in capital structure arise due to the conflict of interest between:
Short-term and Long-term investors.
Customers and Suppliers.
Shareholders (Principals) and Managers (Agents), or Shareholders and Debt-holders.
Government and Company.
Explanation:
Managers might pursue personal goals (like expensive jets) over shareholder wealth (Agency cost of equity). Shareholders might take high risks to shift loss to debt-holders (Agency cost of debt).
14. According to MM Theory WITH Corporate Taxes, the value of a levered firm (Vl) is equal to:
Vu / Cost of Capital.
Vu + (Debt * Tax Rate).
Value of Unlevered Firm (Vu).
Vu - Bankruptcy Costs.
Explanation:
With taxes, debt provides a tax shield. The value of the firm increases by the Present Value of the Tax Shield, which is Debt * Tax Rate (Dt). So Vl = Vu + Dt.
15. A company is said to be "Over-capitalized" when:
It has too much debt.
It is highly profitable.
It has excess cash surplus.
Its actual earnings are insufficient to pay a fair return on its capital investment.
Explanation:
Over-capitalization doesn't mean too much money. It means the capital base is too large relative to the earnings, leading to low dividend rates and falling share prices.