FIN 300 W07 EXAM PART 4 | QUESTIONS
AND ANSWERS |2026/2027 UPDATE |
JUST RELEASED
1. According to Modigliani and Miller Proposition I without taxes, what is the primary
determinant of a firm’s value?
A. The total risk of its assets
B. Its capital structure
C. The dividend payout ratio
D. The composition of debt and equity
Answer: A
Conceptual Explanation: In a world without taxes or transaction costs, MM Proposition I
states that the value of the firm is determined by the earning power of its physical assets
and is independent of its capital structure.
2. Under MM Proposition II without taxes, as the debt-to-equity ratio increases, what
happens to the cost of equity?
A. It decreases linearly
B. It increases linearly
C. It remains constant
,D. It decreases at a decreasing rate
Answer: B
Conceptual Explanation: MM Proposition II states that the cost of equity increases
linearly with the debt-to-equity ratio because shareholders require a higher return to
compensate for increased financial risk.
3. Which of the following best describes the ‘Interest Tax Shield’?
A. The reduction in taxes due to dividend payments
B. The tax savings resulting from the deductibility of interest payments
C. The total value of a firm’s debt multiplied by the tax rate
D. The increase in EBIT due to debt financing
Answer: B
Conceptual Explanation: The interest tax shield is the amount by which a firm’s tax bill is
reduced because interest on debt is a tax-deductible expense.
4. In the presence of corporate taxes but no financial distress costs, what is the optimal
capital structure according to MM?
A. 100% debt
B. No debt at all
C. 50% debt and 50% equity
D. Debt equal to the value of fixed assets
, Answer: A
Conceptual Explanation: With corporate taxes and no bankruptcy costs, the value of the
firm is maximized by using 100% debt because of the continuous increase in the present
value of the tax shield.
5. The Static Trade-off Theory of capital structure suggests that the optimal debt level is
reached when:
A. The marginal tax shield benefit equals the marginal distress cost
B. The cost of debt equals the cost of equity
C. The firm has exhausted all internal funds
D. The debt-to-equity ratio is exactly 1.0
Answer: A
Conceptual Explanation: The trade-off theory posits that firms balance the tax benefits of
debt against the costs of potential financial distress to find an optimal capital structure.
6. Which theory suggests that firms prefer internal financing first, followed by debt, and
finally new equity?
A. MM Proposition I
B. Pecking Order Theory
C. Static Trade-off Theory
D. Dividend Irrelevance Theory
AND ANSWERS |2026/2027 UPDATE |
JUST RELEASED
1. According to Modigliani and Miller Proposition I without taxes, what is the primary
determinant of a firm’s value?
A. The total risk of its assets
B. Its capital structure
C. The dividend payout ratio
D. The composition of debt and equity
Answer: A
Conceptual Explanation: In a world without taxes or transaction costs, MM Proposition I
states that the value of the firm is determined by the earning power of its physical assets
and is independent of its capital structure.
2. Under MM Proposition II without taxes, as the debt-to-equity ratio increases, what
happens to the cost of equity?
A. It decreases linearly
B. It increases linearly
C. It remains constant
,D. It decreases at a decreasing rate
Answer: B
Conceptual Explanation: MM Proposition II states that the cost of equity increases
linearly with the debt-to-equity ratio because shareholders require a higher return to
compensate for increased financial risk.
3. Which of the following best describes the ‘Interest Tax Shield’?
A. The reduction in taxes due to dividend payments
B. The tax savings resulting from the deductibility of interest payments
C. The total value of a firm’s debt multiplied by the tax rate
D. The increase in EBIT due to debt financing
Answer: B
Conceptual Explanation: The interest tax shield is the amount by which a firm’s tax bill is
reduced because interest on debt is a tax-deductible expense.
4. In the presence of corporate taxes but no financial distress costs, what is the optimal
capital structure according to MM?
A. 100% debt
B. No debt at all
C. 50% debt and 50% equity
D. Debt equal to the value of fixed assets
, Answer: A
Conceptual Explanation: With corporate taxes and no bankruptcy costs, the value of the
firm is maximized by using 100% debt because of the continuous increase in the present
value of the tax shield.
5. The Static Trade-off Theory of capital structure suggests that the optimal debt level is
reached when:
A. The marginal tax shield benefit equals the marginal distress cost
B. The cost of debt equals the cost of equity
C. The firm has exhausted all internal funds
D. The debt-to-equity ratio is exactly 1.0
Answer: A
Conceptual Explanation: The trade-off theory posits that firms balance the tax benefits of
debt against the costs of potential financial distress to find an optimal capital structure.
6. Which theory suggests that firms prefer internal financing first, followed by debt, and
finally new equity?
A. MM Proposition I
B. Pecking Order Theory
C. Static Trade-off Theory
D. Dividend Irrelevance Theory
