Capital Structure Theory: Understanding the Optimal Mix of Financing

Capital Structure Theory

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Question

Which of the following statements about capital structure theory is most correct?

Answers

A. In general, an increase in the corporate tax rate would cause firms to use less debt in their capital structures.

B. Signaling theory suggests firms should in normal times maintain reserve-borrowing capacity which can be used if an especially good investment opportunity comes along.

C. All of the statements are correct.

D. None of the statements are correct.

E. According to the "trade-off theory," a decrease in the costs of debt would lead firms to increase equity financing in their capital structures. B

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Explanations

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A. B. C. D. E.

Explanation

An increase in the corporate tax rate reduces the after-tax cost of debt making it more attractive relative to equity. Thus, firms might be expected to use more debt.

The trade-off theory of leverage states a firm trades off the benefits of debt financing (favorable corporate tax treatment) against the higher interest rates and bankruptcy costs.

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