Capital Structure – Question Bank
LO.a: Explain the Modigliani–Miller propositions regarding capital structure, including
the effects of leverage, taxes, financial distress, agency costs, and asymmetric information
on a company’s cost of equity, cost of capital, and optimal capital structure.
1. According to Modigliani and Miller’s Proposition I with taxes ignoring costs of financial
distress and bankruptcy, the value of a company with debt is: A. equal to value of a company
without any debt.
B. greater than the all-equity company by an amount equal to the debt tax shield.
C. less than the unlevered company by an amount equal to the debt tax shield.
2. According to MM Proposition II with taxes, ignoring financial distress and bankruptcy costs,
the cost of equity for a levered firm:
A. rises as debt increases but not as fast as it does in the no-tax case.
B. falls as debt increases by an amount equal to the slope coefficient.
C. falls as debt increases reducing the weighted average cost of capital of the levered
company.
The following financial information of DD Company is relevant for questions 3 - 4.
Yield to maturity on debt 8.0%
Debt-to-total capital ratio 25%
Cost of capital if all equity-financed 10.0%
Earnings before interest and taxes $100,000
Marginal tax rate 30%
3. Based on the above information, the current cost of equity capital is closest to: A. 9.5%.
B. 10.5%. C.
10.0%.
4. Given the above information the current weighted average cost of capital and value of the firm
are closest to:
A. 10.5%; $670,000.
B. 10.0%; $700,000.
C. 9.30%; $753,000.
5. The expected financial distress cost is composed of:
A. costs of financial distress and bankruptcy, given that it happens and probability of
financial distress /bankruptcy. B. direct and indirect costs.
C. agency costs and impaired ability to manage business.
6. Companies with fewer marketable tangible assets when faced with financial distress most
likely incur:
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, Capital Structure – Question Bank
A. higher costs from financial distress.
B. lower costs from financial distress.
C. no financial distress costs.
7. The three components of agency costs are:
A. monitoring costs, residual costs, forgone investment opportunities.
B. impaired ability to do business, legal costs, bonding costs.
C. monitoring costs, bonding costs, residual loss.
8. The fpecking forder ftheory fsuggests fthat fwhen fchoosing ffinancing fmethods, fmanagers’ ffirst
fpreference fis: f
A. public fequity fofferings. f
B. internal ffinancing. f
C. debt fissuance. f
f
LO.b: fDescribe ftarget fcapital fstructure fand fexplain fwhy fa fcompany’s factual fcapital
fstructure fmay ffluctuate faround fits ftarget. f
f
9. Which fof fthe ffollowing fstatements fis fleast faccurate? fOptimal fcapital fstructure fis: fA. fthat
fcapital fstructure fwhich fmaximizes fthe ffirm fvalue. f
B. that fpoint fwhere fthe fearnings fper fshare fof fa ffirm fare fmaximized. f
C. a fpoint fbeyond fwhich ffurther fincreases fin ffirm fvalue fdue fto fincreasing fleverage fare
fcounterbalanced fby fits fvalue-reducing feffects. f
f
10. The fstatic ftrade-off ftheory fbalances fthe fpresent fvalue fof fcosts fof ffinancial fdistress fagainst:
fA. fpresent fvalue fof finterest ftax fshield. f
B. value fof fan funlevered ffirm. f
C. value fof fagency fcosts. f
f
11. Consider fthe ffollowing finformation fregarding festimates fof fbefore ftax fcosts fof fdebt fand
fequity ffor fGTS fcompany. f fMarginal ftax frate fis f30%: f
Debt-to-Total fCapital fRatio f Cost fof fDebt f(%) f Cost fof fEquity f(%) f
(%) f
10 f 6.0 f 11.5 f
20 f 6.5 f 12.0 f
30 f 7.0 f 12.6 f
40 f 9.5 f 13.5 f
Based fon fthe fabove festimates, fwhat fdebt-to-total fcapital fratio fwould fminimize fGTS’s f
WACC? f
A. 30% f
B. 40% fC. f20%. f
f
LO.c: fDescribe fthe frole fof fdebt fratings fin fcapital fstructure fpolicy. f
f
Copyright © IFT. All rights reserved. Page 2
LO.a: Explain the Modigliani–Miller propositions regarding capital structure, including
the effects of leverage, taxes, financial distress, agency costs, and asymmetric information
on a company’s cost of equity, cost of capital, and optimal capital structure.
1. According to Modigliani and Miller’s Proposition I with taxes ignoring costs of financial
distress and bankruptcy, the value of a company with debt is: A. equal to value of a company
without any debt.
B. greater than the all-equity company by an amount equal to the debt tax shield.
C. less than the unlevered company by an amount equal to the debt tax shield.
2. According to MM Proposition II with taxes, ignoring financial distress and bankruptcy costs,
the cost of equity for a levered firm:
A. rises as debt increases but not as fast as it does in the no-tax case.
B. falls as debt increases by an amount equal to the slope coefficient.
C. falls as debt increases reducing the weighted average cost of capital of the levered
company.
The following financial information of DD Company is relevant for questions 3 - 4.
Yield to maturity on debt 8.0%
Debt-to-total capital ratio 25%
Cost of capital if all equity-financed 10.0%
Earnings before interest and taxes $100,000
Marginal tax rate 30%
3. Based on the above information, the current cost of equity capital is closest to: A. 9.5%.
B. 10.5%. C.
10.0%.
4. Given the above information the current weighted average cost of capital and value of the firm
are closest to:
A. 10.5%; $670,000.
B. 10.0%; $700,000.
C. 9.30%; $753,000.
5. The expected financial distress cost is composed of:
A. costs of financial distress and bankruptcy, given that it happens and probability of
financial distress /bankruptcy. B. direct and indirect costs.
C. agency costs and impaired ability to manage business.
6. Companies with fewer marketable tangible assets when faced with financial distress most
likely incur:
Copyright © IFT. All rights reserved. Page 1
, Capital Structure – Question Bank
A. higher costs from financial distress.
B. lower costs from financial distress.
C. no financial distress costs.
7. The three components of agency costs are:
A. monitoring costs, residual costs, forgone investment opportunities.
B. impaired ability to do business, legal costs, bonding costs.
C. monitoring costs, bonding costs, residual loss.
8. The fpecking forder ftheory fsuggests fthat fwhen fchoosing ffinancing fmethods, fmanagers’ ffirst
fpreference fis: f
A. public fequity fofferings. f
B. internal ffinancing. f
C. debt fissuance. f
f
LO.b: fDescribe ftarget fcapital fstructure fand fexplain fwhy fa fcompany’s factual fcapital
fstructure fmay ffluctuate faround fits ftarget. f
f
9. Which fof fthe ffollowing fstatements fis fleast faccurate? fOptimal fcapital fstructure fis: fA. fthat
fcapital fstructure fwhich fmaximizes fthe ffirm fvalue. f
B. that fpoint fwhere fthe fearnings fper fshare fof fa ffirm fare fmaximized. f
C. a fpoint fbeyond fwhich ffurther fincreases fin ffirm fvalue fdue fto fincreasing fleverage fare
fcounterbalanced fby fits fvalue-reducing feffects. f
f
10. The fstatic ftrade-off ftheory fbalances fthe fpresent fvalue fof fcosts fof ffinancial fdistress fagainst:
fA. fpresent fvalue fof finterest ftax fshield. f
B. value fof fan funlevered ffirm. f
C. value fof fagency fcosts. f
f
11. Consider fthe ffollowing finformation fregarding festimates fof fbefore ftax fcosts fof fdebt fand
fequity ffor fGTS fcompany. f fMarginal ftax frate fis f30%: f
Debt-to-Total fCapital fRatio f Cost fof fDebt f(%) f Cost fof fEquity f(%) f
(%) f
10 f 6.0 f 11.5 f
20 f 6.5 f 12.0 f
30 f 7.0 f 12.6 f
40 f 9.5 f 13.5 f
Based fon fthe fabove festimates, fwhat fdebt-to-total fcapital fratio fwould fminimize fGTS’s f
WACC? f
A. 30% f
B. 40% fC. f20%. f
f
LO.c: fDescribe fthe frole fof fdebt fratings fin fcapital fstructure fpolicy. f
f
Copyright © IFT. All rights reserved. Page 2
