1. According to Modigliani-Miller (MM) Hypothesis "Proposition I" (without taxes), the value of a firm is:
Maximized at 100% Equity.
Independent of its Capital Structure.
Maximized at 100% Debt.
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:
Return on Investment (ROI) is higher than the Cost of Debt.
Return on Investment (ROI) is lower than the Cost of Debt.
Tax rate is zero.
Debt is zero.
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?
Retained Earnings -> Debt -> Equity
Debt -> Equity -> Retained Earnings
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:
Maximizes the Weighted Average Cost of Capital (WACC).
Minimizes the value of the firm.
Eliminates all debt.
Minimizes WACC and Maximizes the value of the firm.
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:
Overall Cost of Capital (Ko) remains constant regardless of leverage.
Cost of Equity remains constant.
Cost of Debt increases with leverage.
Value of firm changes with debt.
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:
Tax benefits of debt vs. Financial distress costs of debt.
Equity issuance costs vs. Debt issuance costs.
Short term vs Long term debt.
Profit and Loss.
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:
Financial Distress Costs.
Floatation Costs.
Sunk Costs.
Agency 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 Corporate Tax Rate increases.
The Debt-Equity Ratio decreases.
The Dividend Payout Ratio increases.
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:
Lenders perceive higher default risk and demand a higher risk premium.
The government imposes penalties.
Equity holders demand less return.
The tax rate increases.
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):
Remains constant.
Increases linearly to offset the benefit of cheaper debt.
Decreases.
Becomes zero.
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:
Cost of capital is constant regardless of debt.
The value of the firm depends solely on its assets, not financing.
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.
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:
Customers and Suppliers.
Government and Company.
Shareholders (Principals) and Managers (Agents), or Shareholders and Debt-holders.
Short-term and Long-term investors.
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 + (Debt * Tax Rate).
Vu / Cost of Capital.
Vu - Bankruptcy Costs.
Value of Unlevered Firm (Vu).
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:
Its actual earnings are insufficient to pay a fair return on its capital investment.
It has excess cash surplus.
It is highly profitable.
It has too much debt.
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.