Question

What is a firm’s optimal capital structure according to the tradeoff theory?

a. 100% equity

b. 100% debt

c.50%equity and 50% debt

d.mix of debt and equity where the marginal cost of debt equals to the marginal cost of equity

e. mix of debt and equity where marginal benefit of debt equals to marginal benefit of equity

what is the firm’s optimal capital structure according to MM theory with corporate tax?

a. 100% equity

b. 100% debt

c.50%equity and 50% debt

d.mix of debt and equity where the marginal cost of debt equals to the marginal cost of equity

e. mix of debt and equity where marginal benefit of debt equals to marginal benefit of equity

Answer 1

Que. 1 ) What is a firm’s optimal capital structure according to the tradeoff theory?

Ans (d) mix of debt and equity where the marginal cost of debt equals to the marginal cost of equity.

The Traditional Theory of Capital Structure says that for any company or investment there is an optimal mix of debt and equity financing that minimizes the WACC and maximizes value. Under this theory, the optimal capital structure occurs where the marginal cost of debt is equal to the marginal cost of equity.

Que 2 what is the firm’s optimal capital structure according to MM theory with corporate tax?

Ans ) A 100 % equity

Theories on Capital Structure

Modigliani-Miller (M&M) Theory

The Modigliani-Miller (M&M) theorem is a capital structure approach named after Franco Modigliani and Merton Miller in the 1950s. Modigliani and Miller were two economics professors who studied capital structure theory and collaborated to develop the capital structure irrelevance proposition.

This proposition states that in perfect markets the capital structure a company uses doesn't matter because the market value of a firm is determined by its earning power and the risk of its underlying assets. According to Modigliani and Miller, value is independent of the method of financing used and a company's investments. The M&M theorem made the two following propositions:

Proposition I

This proposition says that the capital structure is irrelevant to the value of a firm. The value of two identical firms would remain the same and value would not be affected by the choice of financing adopted to finance the assets. The value of a firm is dependent on the expected future earnings. It is when there are no taxes.

Proposition II

This proposition says that the financial leverage boosts the value of a firm and reduces WACC. It is when tax information is available.