READING 25 CAPITAL STRUCTURE

Question 1

Which of the following best explains why the cost of debt is generally lower than the cost of equity?
A. Debt holders are residual claimants.
B. Interest on debt is tax-deductible.
C. Debt has higher priority of claims over equity.

Answer 1

Correct Answer: C

Explanation:

Debt has a higher priority in the capital structure than equity, meaning debt holders are paid before equity holders in case of liquidation. This reduces the risk for debt holders and lowers the required return.

A is incorrect because residual claimants refer to equity holders, not debt holders.

B is partially true, but the key reason debt is cheaper is its lower risk due to priority of claims.

Question 2

When calculating the weighted-average cost of capital (WACC), which weight basis best reflects current market conditions?
A. Book value weights
B. Target weights
C. Market value weights

Answer 2

Correct Answer: C

Explanation:

Market value weights are preferred for estimating WACC because they reflect the current opportunity cost of capital and prevailing market conditions.

A is incorrect because book value weights do not capture market perceptions.

B is incorrect because target weights are based on internal goals and may not reflect current market values.

Question 3

ABC Inc. has a capital structure of 40% debt and 60% equity. The cost of equity is 12%, the pre-tax cost of debt is 10%, and the tax rate is 25%. What is the WACC?
A. 10.60%
B. 9.75%
C. 11.00%

Answer 3

Correct Answer: A

Explanation:

WACC = (E/V) x Re + (D/V) x Rd x (1 - Tc) = (0.6)(0.12) + (0.4)(0.10)(1 - 0.25) = 0.072 + 0.03 = 0.102 = 10.20%.

A is correct.

B and C are incorrect due to misapplication of tax adjustment or incorrect weightings.

Question 4

Which of the following company characteristics is most likely to support a higher proportion of debt in the capital structure?
A. High fixed operating costs
B. Stable and predictable cash flows
C. Cyclical and volatile revenue

Answer 4

Correct Answer: B

Explanation:

Stable and predictable cash flows improve a company’s ability to service debt and make it more attractive to lenders.

A is incorrect as high fixed operating costs increase business risk.

C is incorrect because volatile revenue reduces debt capacity.

Question 5

A company in the start-up stage is most likely to finance its operations through:
A. Convertible bonds
B. Equity financing
C. Unsecured bank loans

Answer 5

Correct Answer: B

Explanation:

Start-ups typically lack stable cash flows and sufficient collateral, making equity the most feasible source of financing.

A is incorrect because convertible bonds may be too costly or unavailable to start-ups.

C is incorrect as unsecured loans are hard to obtain at this stage.

Question 6

Which of the following most accurately describes the impact of the corporate tax rate on WACC?
A. It increases the cost of debt.
B. It reduces the after-tax cost of equity.
C. It reduces the after-tax cost of debt.

Answer 6

Correct Answer: C

Explanation:

Interest is tax-deductible, so the effective (after-tax) cost of debt is lower, reducing the WACC.

A is incorrect; tax deductions reduce, not increase, the cost.

B is incorrect; equity returns are not tax-deductible.

Question 7

Which of the following best defines the weighted-average cost of capital (WACC)?
A. The average rate of return required by equity holders
B. The minimum return a company must earn to satisfy all capital providers
C. The average interest rate on all outstanding debt

Answer 7

Correct Answer: B

Explanation:

WACC represents the minimum return needed to meet both debt and equity holders’ expectations.

A is incorrect; it only refers to equity holders.

C is incorrect; it only accounts for debt.

Question 8

Which of the following best describes a company with a subscription-based revenue model?
A. It faces high revenue volatility.
B. It is better positioned to support higher levels of debt.
C. It has unpredictable revenue streams.

Answer 8

Correct Answer: B

Explanation:

Subscription models generate recurring and predictable revenue, supporting more debt.

A and C are incorrect as they contradict the nature of subscription-based revenue.

Question 9

In which of the following life cycle stages is unsecured debt most likely to be widely available to a firm?
A. Start-up stage
B. Growth stage
C. Mature stage

Answer 9

Correct Answer: C

Explanation:

Mature companies have stable cash flows and reduced business risk, making unsecured debt more accessible.

A and B are incorrect because they involve higher risk and less financing flexibility.

Question 10

Which of the following external factors can influence a company’s capital structure?
A. Existing debt levels
B. Corporate tax rate
C. Credit market conditions

Answer 10

Correct Answer: C

Explanation:

Credit market conditions are external factors that affect the cost and availability of debt.

A and B are internal factors.

Question 11

Which of the following best explains why the after-tax cost of debt is used in calculating WACC?
A. Because debt is riskier than equity.
B. Because interest payments on debt are tax-deductible.
C. Because equity holders have residual claims.

Answer 11

Correct Answer: B

Explanation:

B is correct: Interest payments on debt are tax-deductible, reducing the effective cost of debt to the company. Therefore, the after-tax cost of debt is used in WACC calculations.

A is incorrect: Debt is generally considered less risky than equity from the investor’s perspective due to fixed interest payments and priority in claims.

C is incorrect: While equity holders have residual claims, this fact does not directly relate to the tax treatment of debt.

Question 12

Which of the following factors is most likely to increase a company’s WACC?
A. An increase in the corporate tax rate.
B. A decrease in the company’s debt ratio.
C. A decrease in market interest rates.

Answer 12

Correct Answer: B

Explanation:

B is correct: Reducing the debt ratio means a higher proportion of equity, which is typically more expensive than debt, especially after considering the tax shield on debt.

A is incorrect: An increase in the tax rate increases the tax shield on debt, potentially lowering WACC.

C is incorrect: Lower market interest rates reduce the cost of debt, potentially lowering WACC.

Question 13

In the context of capital structure, “fungible” assets are best described as:
A. Assets that can be easily converted into cash.
B. Assets that can be readily replaced with similar assets.
C. Assets that have a long useful life.

Answer 13

Correct Answer: B

Explanation:

B is correct: Fungible assets are those that can be easily substituted or replaced with similar assets, making them more attractive as collateral.

A is incorrect: This describes liquidity, not fungibility.

C is incorrect: Asset longevity does not define fungibility.

Question 13

Which of the following companies is most likely to have a higher proportion of debt in its capital structure?
A. A start-up technology firm with negative cash flows.
B. A mature utility company with stable earnings.
C. A cyclical manufacturing firm with volatile revenues.

Answer 13

Correct Answer: B

Explanation:

B is correct: Mature companies with stable earnings and cash flows are better positioned to service debt, making higher leverage more sustainable.

A is incorrect: Start-ups typically have uncertain cash flows, making debt financing riskier.

C is incorrect: Cyclical firms face revenue volatility, which can impair debt servicing capacity.

Question 14

In calculating WACC, why are market value weights preferred over book value weights?
A. Because market values are more stable over time.
B. Because market values reflect current investor expectations and opportunity costs.
C. Because book values are not available for all companies.

Answer 14

Correct Answer: B

Explanation:

B is correct: Market values provide a current assessment of the cost of capital, aligning WACC with investor expectations and opportunity costs.

A is incorrect: Market values can be volatile and are not necessarily more stable.

C is incorrect: Book values are typically available; the preference for market values is due to their

Question 14

How does operating leverage affect a company’s capital structure decisions?
A. High operating leverage supports higher debt levels.
B. Low operating leverage reduces business risk, allowing for more debt.
C. Operating leverage has no impact on capital structure.

Answer 14

Correct Answer: B

Explanation:

B is correct: Low operating leverage indicates a lower proportion of fixed costs, reducing business risk and making additional debt more manageable.

A is incorrect: High operating leverage increases business risk, potentially limiting debt capacity.

C is incorrect: Operating leverage is a key consideration in capital structure decisions.

Question 15

Which of the following is an internal factor affecting a company’s capital structure?
A. Prevailing interest rates.
B. Corporate tax rate.
C. Industry norms.

Answer 15

Correct Answer: B

Explanation:

B is correct: The corporate tax rate is an internal factor that influences the attractiveness of debt due to the tax deductibility of interest.

A is incorrect: Prevailing interest rates are external market factors.

C is incorrect: Industry norms are external factors influencing capital structure decisions.

Question 16

Why is equity typically more expensive than debt?
A. Equity dividends are tax-deductible
B. Equity holders bear more risk
C. Equity has higher priority in liquidation

Answer 16

Correct Answer: B

Explanation:

Equity holders take on more risk as residual claimants, demanding higher returns.

A is incorrect; dividends are not tax-deductible.

C is incorrect; equity has lower priority than debt.

Question 17

What happens to WACC if the company increases its proportion of debt, assuming cost of debt is lower than equity and no financial distress?
A. WACC decreases
B. WACC increases
C. WACC remains unchanged

Answer 17

Correct Answer: A

Explanation:

Debt is cheaper than equity, and the interest tax shield further reduces WACC.

But only up to a point before financial distress costs outweigh benefits.

Question 18

Why might a tech start-up have a high WACC?
A. High predictability of cash flows
B. Strong credit history
C. High perceived risk and reliance on equity

Answer 18

Correct Answer: C

Explanation:

Equity is expensive and required when cash flows are uncertain.

Question 19

Which firm would most likely have the lowest WACC?
A. A stable utility company
B. A biotech start-up
C. A luxury fashion retailer

Answer 19

Correct Answer: A

Explanation:

Stable cash flows and low risk reduce required returns on capital.

Question 20

If market interest rates rise significantly, what is the likely impact on WACC?
A. WACC will decrease
B. WACC will remain unchanged
C. WACC will increase

Answer 20

Correct Answer: C

Explanation:

Rising interest rates raise the cost of new debt, increasing WACC.

Question 21

Which of the following will reduce a company’s WACC, all else equal?
A. Increasing the tax rate
B. Increasing the cost of equity
C. Reducing the proportion of debt

Answer 21

Correct Answer: A

Explanation:

A higher tax rate increases the value of the interest tax shield.

Question 22

Which of the following best describes Modigliani and Miller Proposition I under the assumption of no taxes?
A. The firm’s capital structure affects the weighted average cost of capital (WACC).
B. The firm’s value increases as it issues more debt.
C. The firm’s total value is independent of its capital structure.

Answer 22

Correct Answer: C

Explanation:
Under MM Proposition I (no taxes), the total value of a firm remains the same regardless of how it is financed — through debt, equity, or a combination. This is known as capital structure irrelevance.

Option A is incorrect because WACC stays constant under MM I in a no-tax world.

Option B is incorrect because MM I assumes no benefit from debt financing in a no-tax setting.

Question 23

MM Proposition I assumes that investment decisions are unaffected by financing decisions. This means: A. A firm’s capital structure directly influences its EBIT. B. The firm’s operations and earnings are independent of how it is financed. C. Investors prefer equity financing over debt to avoid bankruptcy.

Answer 23

Correct Answer: B Explanation: This assumption implies that the firm's operating income (EBIT) is not influenced by whether it uses debt or equity — investment decisions are made independently. Option A is incorrect — EBIT is assumed to be driven by business operations, not capital structure. Option C is incorrect — investor preferences are not a part of MM I’s assumptions.

Question 24

According to MM Proposition I, the value of a firm with debt and equity is equal to: A. The present value of interest payments plus equity cash flows. B. The market value of a comparable all-equity firm. C. The sum of book values of debt and equity.

Answer 24

Correct Answer: B Explanation: MM I states that the total market value of a firm (with any mix of debt and equity) is equal to that of a similar firm financed entirely by equity. Option A is incorrect because MM I focuses on overall firm value, not just specific cash flows. Option C is incorrect because MM theory uses market values, not book values.

Question 25

Which of the following is not an assumption underlying MM Proposition I (no taxes)? A. Investors can borrow and lend at the risk-free rate. B. There are no agency conflicts between shareholders and managers. C. Companies can deduct interest payments for tax purposes.

Answer 25

Correct Answer: C Explanation: MM I is based on a no-tax world, so there are no tax deductions for interest. This assumption is introduced later in MM with taxes. Option A is a correct assumption — perfect capital markets allow risk-free borrowing and lending. Option B is a correct assumption — there are no agency costs in MM I.

Question 26

The pie analogy used to explain MM Proposition I implies: A. Slicing the pie differently (changing capital structure) increases the firm’s size. B. The firm’s total value (the pie) stays constant regardless of how it's divided between debt and equity. C. Firms should increase debt to grow the pie faster.

Answer 26

Correct Answer: B Explanation: The pie analogy illustrates that the total size (value) of the firm stays constant, regardless of how it's split between debt and equity holders. Option A is incorrect — the firm’s value does not grow just by changing capital structure. Option C is incorrect — under MM I (no taxes), increasing debt has no effect on value.

Question 27

Under MM Proposition I (without taxes), if an investor holds both all the debt and all the equity of a firm, the investor's total return will be: A. Higher than if the firm had no debt. B. Equal to the return from an all-equity firm. C. Lower due to interest payments on the debt.

Answer 27

Correct Answer: B Explanation: If the same investor owns all the debt and all the equity, they receive all of the firm’s EBIT, which is the same as the return from owning an all-equity firm. The firm’s total value doesn’t change with capital structure. Option A is incorrect — no value is added from leverage in MM I. Option C is incorrect — interest payments do not reduce total earnings from the perspective of a combined holder.

Question 28

According to MM Proposition I (no taxes), which of the following statements is most accurate regarding the effect of changing a firm’s capital structure? A. Increasing leverage increases the overall value of the firm. B. A firm's market value remains unchanged as capital structure changes. C. Equity holders always benefit when a firm adds more debt.

Answer 28

Correct Answer: B Explanation: MM I states that the value of the firm is unaffected by its mix of debt and equity, assuming no taxes or other frictions. Option A is incorrect — leverage does not change firm value in a no-tax world. Option C is incorrect — MM I assumes no value gain for any stakeholder from altering capital structure.

Question 29

What is the key implication of MM Proposition II regarding a firm's cost of equity as it increases financial leverage? A. The cost of equity decreases because debt is cheaper than equity. B. The cost of equity remains unchanged as capital structure changes. C. The cost of equity increases as the firm takes on more debt.

Answer 29

Correct Answer: C Explanation: MM Proposition II states that as leverage increases, equity holders bear more risk, so the cost of equity increases. A is incorrect: Debt is cheaper, but that doesn’t reduce equity cost; in fact, the equity becomes riskier. B is incorrect: The cost of equity does change — it increases with leverage.

Question 30

Under MM Proposition II (without taxes), what happens to a firm’s WACC when leverage increases? A. WACC decreases due to the lower cost of debt. B. WACC remains unchanged. C. WACC increases as cost of equity increases.

Answer 30

Correct Answer: B Explanation: MM II assumes that while equity gets more expensive with leverage, the lower cost of debt offsets it, keeping WACC constant. A is incorrect: It assumes benefits from cheap debt but ignores the rising cost of equity. C is incorrect: Cost of equity rises, but it’s offset, so WACC stays flat.

Question 31

In MM Proposition II (without taxes), the increase in the cost of equity with higher leverage reflects: A. The reduction in total firm risk due to diversification. B. The increased risk to equity holders due to fixed debt payments. C. The reduced volatility of equity returns with more debt.

Answer 31

Correct Answer: B Explanation: As debt increases, equity holders get paid last, so their risk increases — hence the higher required return. A is incorrect: There’s no diversification effect in MM II. C is incorrect: Equity returns become more volatile, not less, with leverage.

Question 32

Which of the following best describes why a firm cannot lower its WACC by increasing leverage under MM II with no taxes? A. The cost of equity does not change with leverage. B. Any benefit from lower-cost debt is offset by a higher cost of equity. C. WACC always increases with more debt due to higher interest costs.

Answer 32

Correct Answer: B Explanation: The key insight from MM II is that cheap debt is balanced out by more expensive equity, keeping WACC constant. A is incorrect: The cost of equity does change — it increases. C is incorrect: WACC does not always increase — under MM II, it remains unchanged.

Question 33

According to MM Proposition II (no taxes), what should a firm consider when choosing its capital structure? A. Choose the structure that minimizes WACC through high leverage. B. Capital structure does not affect firm value or WACC. C. Avoid debt entirely, as it always increases the cost of equity.

Answer 33

Correct Answer: B Explanation: MM II supports that under perfect market conditions and no taxes, capital structure doesn’t impact firm value or WACC. A is incorrect: Increasing leverage doesn’t reduce WACC under MM II — it stays flat. C is incorrect: While debt increases equity cost, it doesn’t harm overall value or WACC.

Question 34

According to Modigliani and Miller (MM) Proposition Il with taxes, the value of a levered firm is: A. Equal to the value of an unlevered firm. B. Greater than the value of an unlevered firm by the amount of the interest tax shield. C. Lower than the value of an unlevered firm due to financial distress costs.

Answer 34

Correct Answer: B Explanation: The value of a levered firm (with debt) is greater than an unlevered firm due to the tax shield from interest payments, which are tax-deductible. This increases the total value available to investors. A is incorrect — that applies to MM Proposition I without taxes, where capital structure is irrelevant. C is incorrect — while financial distress can reduce firm value, MM I with taxes does not consider distress costs.

Question 35

Which of the following best describes the effect of increasing financial leverage on the weighted average cost of capital (WACC) under MM Proposition II with taxes? A. WACC remains constant regardless of leverage. B. WACC initially decreases due to the tax shield. C. WACC increases due to higher financial risk.

Answer 35

Correct Answer: B Explanation: As debt increases, interest is tax-deductible, creating a tax shield and lowering WACC. A is incorrect — applies only in MM without taxes. C is incorrect — it ignores the positive effect of the tax shield on WACC in this theoretical setting.

Question 36

Which of the following is an indirect cost of financial distress? A. Legal and administrative bankruptcy fees. B. Loss of customer trust and disrupted supplier relationships. C. Payments to bankruptcy trustees.

Answer 36

Correct Answer: B Explanation: Indirect costs include reputational damage and operational disruption from financial distress. A and C are examples of direct costs, which are explicit and financial in nature.

Question 37

Why might a firm choose not to pursue a 100% debt capital structure even though MM theory with taxes suggests it's value-maximizing? A. Most investors prefer dividends to interest income. B. Bankruptcy and agency costs increase with higher leverage. C. The WACC always increases with additional debt.

Answer 37

Correct Answer: B Explanation: Costs of financial distress, such as bankruptcy costs and agency conflicts between shareholders and debtholders, increase with leverage and reduce firm value. A is too general and doesn’t address value-destroying risks. C is incorrect — under MM II with taxes, WACC actually decreases with more debt, at least initially.

Question 38

Which of the following firms is likely to have the highest probability of financial distress, assuming similar levels of financial leverage? A. A firm with low operating leverage and strong corporate governance. B. A firm with high operating leverage and weak management controls. C. A firm with diversified income streams and limited fixed costs.

Answer 38

Correct Answer: B Explanation: High operating leverage (high fixed costs) combined with weak management increases risk. If revenues drop, the firm may not cover interest obligations. A and C both suggest stronger financial health and better ability to manage downturns.

Question 39

Agency costs of debt are most likely to arise from: A. Managers pursuing riskier projects that benefit equity holders but harm debtholders. B. Debtholders demanding higher dividends during times of financial distress. C. Tax deductions for interest payments reducing firm profitability.

Answer 39

Correct Answer: A Explanation: Agency costs occur when managers (acting for shareholders) pursue risky strategies that increase shareholder value at the expense of debtholders. B is incorrect — debtholders cannot demand dividends; that’s a shareholder decision. C is incorrect — tax deductions are beneficial and not a cost.

Question 40

Under the static tradeoff theory, a firm's optimal capital structure is achieved when: A. The tax benefits of additional debt outweigh the financial distress costs. B. The weighted average cost of capital (WACC) is at its lowest point. C. The firm uses 100% debt to maximize the tax shield.

Answer 40

Correct Answer: B Explanation: Under the static tradeoff theory, the optimal capital structure occurs when the WACC is minimized, and firm value is maximized. A is incorrect: The optimal point is where additional debt no longer provides a net benefit due to rising distress costs. C is incorrect: 100% debt may maximize the tax shield under MM with taxes, but static tradeoff theory incorporates distress costs.

Question 41

Which of the following is most consistent with the Modigliani-Miller (MM) proposition with taxes but no financial distress costs? A. A firm’s capital structure is irrelevant. B. A firm should use as much debt as possible. C. The firm’s WACC is minimized at a moderate debt level.

Answer 41

Correct Answer: B Explanation: MM with taxes and no financial distress assumes firm value is maximized at 100% debt because of the tax shield. A is MM’s proposition without taxes or distress. C is the view under the static tradeoff theory.

Question 42

Which factor increases the cost of asymmetric information for a firm? A. Transparent financial statements B. Complex products and little disclosure C. Use of debt financing over equity

Answer 42

Correct Answer: B Explanation: Less transparency and complex operations make it harder for investors to assess true value, raising asymmetric info costs. A is incorrect: Transparency reduces info asymmetry. C is incorrect: Debt sends a positive signal under asymmetric info theory.

Question 43

According to pecking order theory, which financing method do firms prefer first? A. External equity B. Debt C. Internally generated funds

Answer 43

Correct Answer: C Explanation: Firms prefer internal financing first, then debt, and lastly equity, as issuing equity sends negative signals. B is second in preference. A is least preferred.

Question 44

Which of the following best describes net agency costs of equity? A. The cost associated with interest payments to debtholders. B. The combined cost of monitoring, bonding, and residual inefficiencies. C. The tax benefits gained through debt financing.

Answer 44

Correct Answer: B Explanation: Net agency costs = monitoring + bonding + residual loss from manager-shareholder conflicts. A is a debt-related concept. C relates to tax shield, not agency costs.

Question 45

Which of the following is most likely an example of a monitoring cost? A. Paying insurance premiums for performance guarantees B. Reporting expenses and Board of Directors' compensation C. Managers losing autonomy due to debt covenants

Answer 45

Correct Answer: B Explanation: Monitoring costs = costs for supervising management, including board expenses. A = bonding cost. C relates to debt discipline, not monitoring.

Question 46

A firm's actual capital structure temporarily deviates from its target due to a sharp increase in its stock price. This is an example of: A. Structural leverage B. Market-driven fluctuation C. Book-value optimization

Answer 46

Correct Answer: B Explanation: Stock price changes affect market value weights, causing capital structure to deviate from target. A is unrelated. C refers to using book values, which is not the cause here.

Question 47

Which of the following explains why management may use book values instead of market values in capital structure decisions? A. Book values reflect investor perception. B. Market values do not affect credit ratings. C. Book values are used by credit rating agencies.

Answer 47

Correct Answer: C Explanation: Credit agencies often use book values to assess debt capacity. A is false — market values reflect investor perception. B is incorrect — book values are typically used for internal planning.

Question 48

Which theory assumes that capital structure is the result of financing choices rather than an explicit target? A. Static tradeoff theory B. Pecking order theory C. MM proposition with taxes

Answer 48

Correct Answer: B Explanation: Pecking order theory assumes capital structure evolves from financing behavior. A = firms actively balance tax vs distress. C = assumes debt is optimal due to tax shield.

Question 49

Which of the following financing choices is most likely to send a negative signal to investors? A. Using retained earnings B. Issuing new debt C. Issuing new equity

Answer 49

Correct Answer: C Explanation: Issuing equity may signal stock is overvalued, leading to a negative market reaction. A = neutral or positive signal. B = may signal confidence in future cash flows.

Question 50

Under the free cash flow hypothesis, using debt financing: A. Increases agency costs. B. Reduces residual loss. C. Forces discipline in managerial spending.

Answer 50

Correct Answer: C Explanation: Debt reduces free cash, forcing managers to be disciplined. A is false: Debt reduces, not increases agency costs. B refers to agency costs, not directly to free cash flow.

Question 51

Which of the following is least likely a component of net agency costs? A. Costs of investor relations B. Bonding expenses C. Interest payments on debt

Answer 51

Correct Answer: C Explanation: Interest is a contractual cost, not part of agency costs. A = monitoring. B = bonding.

Question 52

A firm's value initially increases with more debt, but later declines as financial distress becomes more likely. This reflects: A. MM proposition with no taxes B. Pecking order theory C. Static tradeoff theory

Answer 52

Correct Answer: C Explanation: This is the essence of static tradeoff theory — balancing benefits of debt vs costs of distress. A says capital structure is irrelevant. B focuses on financing preference order, not firm value.

Question 53

Which of the following best describes a bonding cost? A. Cost of issuing bonds to fund capital projects B. Premiums for insurance to guarantee performance C. Interest payments on outstanding bonds

Answer 53

Correct Answer: B Explanation: Bonding costs are expenses to align management with shareholder interests, like insurance. A and C relate to debt instruments, not agency costs.

Question 54

An analyst is estimating a firm’s WACC. If the firm's target capital structure is unknown, which of the following is most appropriate? A. Use the firm’s book value weights B. Use the firm’s current market value weights C. Use the average capital structure of the firm’s suppliers

Answer 54

Correct Answer: B Explanation: If no stated target, use current market-based weights. A = internal preference, not market-relevant. C = irrelevant — use the firm’s industry, not suppliers.

Question 55

Which firm is most likely to have high costs of asymmetric information? A. A public firm with simple business lines B. A firm with detailed and audited financials C. A tech firm with complex products and minimal disclosure

Answer 55

Correct Answer: C Explanation: Complexity + low transparency = high asymmetric info costs. A and B = lower information risk.

Question 56

Which of the following most accurately describes a firm's target capital structure? A. The capital structure chosen to minimize book value debt B. The structure that minimizes equity dilution C. The average mix of debt and equity that maximizes firm value over time

Answer 56

Correct Answer: C Explanation: Target structure is based on maximizing value, considering risk, governance, etc. A and B are partial and do not reflect optimal capital goals.

Question 57

Why might a firm issue equity despite signaling concerns? A. To increase stock volatility B. Because its debt capacity is fully used C. To avoid capital structure optimization

Answer 57

Correct Answer: B Explanation: When debt levels are maxed out, equity becomes necessary despite negative signal. A is incorrect — firms don’t seek volatility. C is the opposite of firm goals.

Question 58

What impact does increased debt typically have on the WACC according to static tradeoff theory? A. It increases WACC consistently. B. It initially lowers WACC, then increases it. C. It has no impact on WACC.

Answer 58

Correct Answer: B Explanation: WACC decreases initially due to the tax shield, but increases when distress costs dominate. A and C contradict the tradeoff model.

Question 59

An external analyst notices that a firm’s capital structure is trending toward more equity over time. What is the most appropriate action? A. Use current weights only B. Adjust estimates based on observed trend C. Ignore trend and use book values

Answer 59

Correct Answer: B Explanation: Analysts should adjust estimates using discernible trends when no target is stated. A ignores trends. C reflects internal perspective, not valuation best practices.