Level 6: Financial Management

Multiple Choice Question Practice – Capital Structure Theories

Chapter 16: Cost of Capital – Capital Structure theories, impact of

cost of capital on investments
1. One of the following diagrams is consistent with the so-called “traditional view” of
gearing often held in contrast with the views of Modigliani and Miller.
Diagram A Diagram B

Cost Cost
ke ke

k k

gearing gearing
iging
Diagram C Diagram D

Cost ke Cost ke

k
k

gearing gearing
Which diagram is correct?
A Diagram A
B Diagram B
C Diagram C
D Diagram D

2. A firm’s optimal capital structure:

A is the debt-equity ratio that results in the lowest possible weighted average cost of capital
B is generally a mix of 40 percent debt and 60 percent equity
C is found by locating the mix of debt and equity which causes the earnings per share to
equal exactly £1
D is the debt-equity ratio that exists at the point where the firm’s weighted after tax cost of
debt is minimised.

3. __________ costs are those associated with engaging in various business transactions
that may cause the firm to not have the exact optimal capital structure.
A Agency
B Bankruptcy
C Managerial
D Transaction

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Level 6: Financial Management
Multiple Choice Question Practice – Capital Structure Theories

4. Which of the following are arguments for using the weighted average cost of capital
(WACC) in project appraisal?

A The company has a significant proportion of floating rate capital, the cost of which
constantly fluctuates.
B New investments might have different business risk characteristics from the existing
operations.
C The new project might alter the financial risk of the whole company.

D It should be used because the marginal cost of capital should be roughly equal to the
weighted average cost of current capital.

5. Use of weighted average cost of capital (WACC), to determine the discount rate at which
to deduce the NPV of a particular project, requires that certain assumptions be made.

Which of the following is not one of those required assumptions?

A Use of the capital asset pricing model to deduce costs of capital is inappropriate

B The costs of the elements of finance will not alter in the future from the costs being
used in the WACC calculation

C There is a known target gearing ratio

D The project is of similar risk to others undertaken by the business

6. Which of the following statements is most correct?

A The optimal capital structure minimises the WACC.
B If the after-tax cost of equity financing exceeds the after-tax cost of debt financing, firms
are always able to reduce their WACC by increasing the debt in their capital structure.
C Increasing the amount of debt in a firm's capital structure is likely to increase the cost of
both debt and equity financing.
D Answers a and c are both correct.

7. A company is considering whether to invest in a new project that has the same risk as its
core business, but will be financed by raising a bank loan. The company will raise future
finance using equity and debt finance to maintain the company's target capital structure.
Which of the following do you consider to be the most appropriate discount rate to
use in the project's appraisal?
A A CAPM risk-adjusted discount rate
B The company's cost of debt finance
C The company's historic WACC (weighted by market values)
D The company's historic WACC (weighted by book values)

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Level 6: Financial Management
Multiple Choice Question Practice – Capital Structure Theories

8. According to Modigliani and Miller the cost of equity will always rise with increased
gearing because
A the firm is more likely to go bankrupt
B debt is allowable against tax
C the return to shareholders becomes more variable
D the tax shield on debt increases the value of the shareholders’ equity

9. Which of the following statements concerning the capital structure is false?

A The traditional view is that there is an optimal capital mix at which the average cost of
capital is minimised.
B Under the traditional theory of cost of capital, the cost rises initially and then falls as
gearing increases.
C Modigliani and Miller believed that the firm’s WACC is not influenced by changes in its
capital structure.
D Tax relief on interest payments lowers the WACC

10. The existence of __________ on the balance sheet generates tax advantages that
directly influence the capital structure of the firm.
A A large proportion of fixed assets
B long-term debt
C retained earnings
D All of the above answers are true

11. In general, what would happen to the debt ratio of a firm if it always kept an optimal
capital structure and if: 1) the government changed tax laws that allowed the
deduction of dividend financing and 2) excluded the deduction of interest expense?
A The debt ratio would fall
B The debt ratio would rise
C The debt ratio would not change
D It is impossible to say

12. The presence of which one of the following costs is not used as a major argument
against the M&M arbitrage process?

A Bankruptcy costs
B Agency costs
C Transactions costs
D Insurance costs
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Level 6: Financial Management
Multiple Choice Question Practice – Capital Structure Theories

13. One of the following diagrams is consistent with Modigliani and Miller’s theory of
gearing in a world with NO taxation (1958).
NB: ke denotes the cost of equity and k represents the WACC.
Diagram A Diagram B

Cost Cost
ke ke

k k

gearing gearing
iging
Diagram C Diagram D

Cost ke Cost ke

k
k
gearing gearing

Ignoring taxation, which diagram is correct?

A Diagram A

B Diagram B

C Diagram C

D Diagram D

14. In a world with taxes, Modigliani & Miller concluded that debt finance is cheaper
than equity because:
A Loans are less risky than equity
B Equity shareholders will require a lower return if more debt is taken on
C Favourable tax treatment of dividends lowers the WACC
D Favourable tax treatment of interest paid (tax shield) lowers the WACC

15. Which of the following statements about capital structure is incorrect?

A Miller and Modigliani's first paper said that WACC is constant
B In the traditional approach, the cost of capital curve is initially horizontal but starts to slope
upward at high levels of gearing to reflect financial and bankruptcy risk
C Miller and Modigliani's first paper said that the cost of equity increases due to financial risk
D Miller and Modigliani's second paper considered the tax efficiency of corporate debt

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Level 6: Financial Management
Multiple Choice Question Practice – Capital Structure Theories

16. The cost of capital for a firm -when we allow for taxes, bankruptcy, and agency costs
A remains constant with increasing levels of financial leverage
B first declines and then ultimately rises with increasing levels of financial leverage
C increases with increasing levels of financial leverage
D decreases with increasing levels of financial leverage

17. Which of these statements on the cost of different sources of finance is not correct?
A Convertible debt will have a lower cost of capital compared to ordinary debt
B Retained earnings are a cheaper way of raising equity finance than a new issue of shares
C Preference shares will have a lower cost compared to ordinary shares
D The tax deductibility of interest payments reduces the cost of debt
18. According to Pecking Order Theory, the order of preference for sources of finance is
A Retained earnings; equity shares; preference shares; debt
B Debt; preference shares; equity shares; retained earnings
C Retained earnings; debt; preference shares; equity shares
D Equity shares; preference shares; convertible debt; straight debt

19. Two companies are identical in every respect except for their capital structure. XY has a
debt: equity ratio of 1:4, and its equity has a ß value of 1.26.
PQ has a debt: equity ratio of 3:5. Corporation tax is at 30%.
Estimate a ß value for PQ’s equity.
A 1.07
B 1.26
C 1.52
D 1.64
20. Below are stages in the investment appraisal process using the CAPM.
1. Take an average of the ungeared proxy betas.
2. Insert the regeared proxy beta into the capital asset pricing model.
3. Regear the averaged ungeared proxy beta.
4. Ungear the individual proxy equity betas.
What is the correct order of the stages?
A 2, 4, 3, 1
B 4, 1, 3, 2
C 4, 3, 1, 2
D 1, 3, 4, 2

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Level 6: Financial Management
Multiple Choice Question Practice – Capital Structure Theories

MULTIPLE CHOICE ANSWERS:

1. Answer: (C)
As gearing increases, k first falls due to the lower cost of debt, but as k e begins to
increase rapidly, this dominates and k rises.

2. Answer: (A) Optimal capital structure exists when WACC is lowest.

3. Answer: (D) Transaction costs exist in the real world.

4. Answer: (D)
The use of a company’s existing WACC in project appraisal is appropriate if the project
and its financing are the same as those of the company at the moment.
If they are different, then the cost of capital used may require adjustment.

5. Answer: (A)
Use of the capital asset pricing model to deduce costs of capital is inappropriate.

6. Answer: (D) Both statements A & C are correct.

7. Answer: (C) WACC weighted by market values is appropriate as long as business risk
and financial risk remain the same.

8. Answer: (C) At very high levels of gearing, the firm is more likely to go bankrupt, but
this risk is basically transferred to debt-holders.
Debt, as a tax-allowable expense, results in the tax shield which increases the value of
the firm, but does not affect the risk of equity.
The cost of equity rises with increased gearing because shareholders expect a greater
return for the increased risk (increased variability of returns)
9. Answer: (B) Under the traditional theory of cost of capital, the cost declines initially and
then rises as gearing increases.
10. Answer: (B) Long term debt

11. Answer: (A) The debt ratio would fall – equity would become more attractive as debt
no longer had the tax advantage.
12. Answer: (D) Insurance costs. Only A – C are real-world relevant costs that MM ignore.

13. Answer: (A)

According to MM ignoring taxation, the WACC is unaffected by gearing changes.
Therefore, as gearing increases, the cost of debt remains unchanged, but the cost of
equity rises to keep the WACC constant.

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Level 6: Financial Management
Multiple Choice Question Practice – Capital Structure Theories

14. Answer: (D) MM’s major contribution was to identify the fact that loan finance is only
logically cheaper due to the favourable tax treatment of interest paid by businesses.
Though it may appear cheaper because loans are less risky than equity, this is illusory.
There is a less obvious cost that accompanies capital gearing – an increase in equity
holders required returns. These two cancel one another out.

15. Answer: (B) The traditional view sees WACC as saucer-shaped.

16. Answer: (B) K declines due to tax shield, then rises due to costs of financial distress.

17. Answer: (A) All the statements are true apart from 'Convertible debt will have a lower
cost of capital compared to ordinary debt'. Convertible debt will have a lower interest
rate than ordinary debt, but its cost of debt will be higher than ordinary debt as it has
some equity characteristics.

18. Answer: (C)

Strictly speaking, the order of preference should be:
Retained earnings; straight debt; convertible debt; preference shares; equity shares

19. Answer: (C) 1.52

Estimate an ungeared beta from XY data:

βa = 1.26 4 = 1.07
4 + (1(1-0.3))
Estimate a geared beta for PQ using this ungeared beta:
βe = 1.07 5 + (3(1 – 0.3)) = 1.52
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20. Answer: (B)