The Modigliani and Miller theories are based on several unrealistic assumptions about 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 thee factors on the capital structure of a firm.

1. 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, or

Firms that have relatively lower business risk compared to other firms in their industry

2. Based on your understanding of the capital structure theories, identify the best option for the missing part of the statement.

(a) According to signalling theory, if managers expect the firms stock price to decrease, they are???? to raise capital through equity financing. Encouraged / Discouraged

(b) A leveraged buyout (LBO) helps the firm ??? both its excess cash flows and managers temptation to incur wasteful expenses. Reduce / Increase

(c) Under the pecking-order hypothesis, a firm will raise capital by using its net income, selling its marketable securities, issuing debt, and then issuing stock as the last resort. This statement is ????. True / False

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 the case:

The firms debt-equity decision finds the optimal balance between the interest tax shield benefits of debt financing and the costs of financial distress associated with issuing debt.

3. Identify which of the two theories is described by the statement:

Trade-off theory, or

Pecking-order hypothesis