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 lower business risk compared to other firms in their industry Firms that have relatively higher 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, a firm with a very positive outlook might tend to use debt financing ???? the normal target capital structure. Beyond Equal to According to the windows of opportunity theory, managers ???? in efficient markets. Don’t believe Believe O According to pecking-order hypothesis, a profitable firm is likely to use ???? debt than a less profitable firm. Less More 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: The firm’s 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. Identify which of the two theories is described by the statement. Trade-off theory Pecking-order hypothesis
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