Corporate Finance Flashcards

According to the Modigliani-Miller theorem with corporate taxes, firm value increases with debt because:

Answer: Interest payments are tax-deductible, creating a valuable tax shield

The interest tax shield reduces the firm's tax liability, and this tax benefit increases firm value as more debt is used.

The optimal capital structure for a firm minimizes:

Answer: Weighted average cost of capital (WACC)

The optimal capital structure is the specific debt-equity mix that minimizes WACC, thereby maximizing the present value of the firm.

Financial leverage amplifies:

Answer: Both positive and negative returns to equity holders

Financial leverage magnifies both gains and losses for equity holders because fixed interest obligations remain regardless of operating performance levels.

Which capital structure theory suggests firms prefer internal financing first, then debt, and equity only as a last resort?

Answer: Pecking order theory

The pecking order theory (Myers and Majluf) argues firms rank financing sources to minimize information asymmetry costs, preferring retained earnings, then debt, then new equity.

The degree of financial leverage (DFL) measures:

Answer: The sensitivity of earnings per share (EPS) to a change in EBIT

DFL measures how a given percentage change in EBIT translates into a percentage change in EPS, reflecting the impact of fixed financial charges on equity earnings.

A firm's debt-to-equity ratio increases from 0.5 to 1.0. All else equal, this change will most likely:

Answer: Increase the firm's financial risk

A higher debt-to-equity ratio increases financial risk because greater fixed interest obligations raise the probability of financial distress.