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Capital Structure Theory

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Questions and Answers

What is the relationship between the cost of debt and the cost of equity according to the traditional approach?

The cost of debt and cost of equity are inversely related

The cost of debt and cost of equity are independent of each other

The cost of debt is always lower than the cost of equity (correct)

The cost of debt is always higher than the cost of equity

What is the primary goal of a firm's capital structure according to the traditional approach?

To maximize the market value of the firm

To minimize the cost of equity

To achieve an optimal balance between debt and equity (correct)

To increase the cost of debt

What is the effect of financial leverage on a firm's weighted average cost of capital according to the traditional approach?

It has no effect on the weighted average cost of capital

It decreases the weighted average cost of capital (correct)

It depends on the firm's total value

It increases the weighted average cost of capital

What is the shape of the curve of the average cost of capital in Figure 18-1?

U-shaped Signup and view all the answers

What is the relationship between a firm's capital structure and its market value according to the traditional approach?

The market value of the firm is maximized at the optimal capital structure Signup and view all the answers

What is a major determinant of capital structure decisions if equity shareholders want to maintain control?

Raising debt funds Signup and view all the answers

What is the risk referred to when debt is used in capital structure decisions?

Financial risk Signup and view all the answers

When is debt financing preferable to equity financing from an EPS point of view?

When EBIT is high Signup and view all the answers

What happens to ROE when the ROA is less than the cost of debt?

ROE decreases Signup and view all the answers

Why do cost of different components of capital influence capital structure decisions?

Because they affect the firm's EPS and ROE Signup and view all the answers