Capital Structure Theories
What does MM Proposition II (no taxes) show about the relationship between leverage and the cost of equity?
As leverage (D/E) increases, the cost of equity increases linearly to offset cheaper debt
What type of financing has no information asymmetry problem?
Retained earnings
What does MCC stand for and what does it represent?
Marginal Cost of Capital = the cost of the last dollar of new capital raised
Under the Trade-Off Theory, why might firms not use 100% debt even if interest is tax-deductible?
Because financial distress and bankruptcy costs increase with too much debt
Why can debt issuance be interpreted as a positive signal to the market?
Managers issue debt when they are confident future cash flows will cover it, signaling strength.
When a firm takes on a lot of risky debt, does Hamada’s formula overestimate or underestimate the equity beta?
It overestimates it, because in reality some risk is borne by debt holders too.
How does introducing financial flexibility (real options) modify the classic Trade-Off Theory?
It adds value to keeping borrowing capacity unused. Firms may prefer lower leverage today to preserve the option to borrow later for strategic opportunities or downturns. This explains why many firms operate below their theoretical optimal debt ratio.
What is the main difference between the Trade-Off Theory and the Pecking Order Theory regarding target leverage?
Trade-Off Theory assumes firms have an optimal leverage ratio balancing tax shields and distress costs, while Pecking Order Theory says there is no target , financing depends on the availability of internal funds.
What causes the Marginal Cost of Capital (MCC) to increase after the retained earnings break point?
Because the firm must issue new equity, which is more expensive due to flotation costs and investor risk perception.