CHAPTER 5
CAPITAL STRUCTURE
SOLUTIONS
1. B is correct. Proposition I, or the capital structure irrelevance theorem, states that the level of debt versus equity in the capital structure has no effect on company value in perfect markets.
2. C is correct. The cost of equity rises with the use of debt in the capital structure (e.g., with increasing financial leverage).
3. C is correct.
4. C is correct. If the company’s WACC increases as a result of taking on additional debt, the company has moved beyond the optimal capital range. The costs of financial distress may outweigh any tax benefits of the use of debt.
5. A is correct. The use of long-maturity debt is expected to be inversely related to the level of inflation.
6. A is correct. According to the pecking order theory, internally generated funds are preferable to both new equity and new debt. If internal financing is insufficient, managers next prefer new debt, and finally new equity.
7. B is correct. The static trade-off theory indicates that there is a trade-off between the tax shield from interest on debt and the costs of financial distress, leading to an optimal amount of debt in a company’s capital structure.
8. A is correct. The market value of equity is ($30)(10,000,000) = $300,000,000. With the market value of debt equal to $100,000,000, the market value of the company is $100,000,000 + $300,000,000 = $400,000,000. Therefore, ...
