8. More on capital structure theory Aa Aa E The Modigliani and Miller theories are based on several unrealistic assumptions about debt financing. In reality, there are costs, taxes, and other factors associated with debt financing. These costs or effects have led to several theories that explain the impact of these factors on the capital structure of a firm. Based on your understanding of the trade-off theory, what kind of firms are likely to use more leverage? Firms that have relatively higher business risk compared to other firms in their industry Firms that have relatively lower business risk compared to other firms in their industry Based on your understanding of the capital structure theories, identify the best option for the missing part of the statement Option 1 Option 2 According to signalling theory, if managers expect the firm's stock price to decrease, they are ???? to raise capital through equity financing. Encouraged Discouraged A leveraged buyout (LBO) helps the firm ???? both its excess cash flows and managers' temptation to incur wasteful expenses. Reduce Increase O Firms that maintain an adequate reserve borrowing capacity will be able to ???? money at a reasonable cost when good investment opportunities arise. Borrow Lend Several dominant theories try to explain why financial managers make the capital structure decisions that they do. The following statement describes one such theory. Consider this case: Firms prefer internal funds, but if forced to raise external capital, they prefer debt rather than equity issuance. Identify which of the two theories is described by the statement. O Pecking-order hypothesis O Trade-off theory