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?

    <p>U-shaped</p> 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?

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

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

    <p>Raising debt funds</p> Signup and view all the answers

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

    <p>Financial risk</p> Signup and view all the answers

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

    <p>When EBIT is high</p> Signup and view all the answers

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

    <p>ROE decreases</p> Signup and view all the answers

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

    <p>Because they affect the firm's EPS and ROE</p> Signup and view all the answers

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