8. More on capital structure theory Aa Aa The Modigliani and Miller theories are

Question

8. More on capital structure theory Aa Aa The Modigliani and Miller theories are based on several unrealistic assumptions about debt financing. In reality, there are costs, taxes, and other factors associated with debt financing. These costs or effects have led to several theories that explain the impact of these factors on the capital structure of a firm Based on your understanding of the trade-off theory, what kind of firms are likely to use more leverage? O Firms with a higher proportion of variable-versus-fixed costs Firms with a higher proportion of fixed-versus-variable costs

Explanation / Answer

Higher proportion of variable versus fixed

Reason: The above type of firms have low degree of operating leverage & also less chance of nancial distress. Hence, such rms are able to use more debt nancing. However, for firms where high proportion of fixed versus varibale: volatile earnings & high degree of operating leverage, extent to which xed assets are used in rm's operations, would lead to cash ows which are uncertain, & ability to service debt varies. These rms have high business risk & higher probability of bankruptcy & are therefore less likely to use debt.

Encouraged..so that they can issue equity at current higher prices

Don't believe. They believe that many times stock prices & interest rates are either too low or too high versus their fundamental values thus they issue equity when stock is overpriced & repurchase shares with debt if stock is under priced.

Less. Because a firm first uses internal capital by reinvesting its income & selling short-term marketable securities. And then it issues debt. Profitable firms will be able to use internal capital

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