6. Capital structure theory Aa Aa E 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? Firms with volatile earnings Firms with stable earnings Based on your understanding of the capital structure theories, identify the best option for the missing part of each statement. Option 1 Option 2 According to signalling theory, if managers expect the firm's stock price to decrease, they are ???? to raise capital through equity financing. Encouraged Discouraged High levels of debt reduce excess cash flows and ???? managers' decisions, thereby reducing the possibility that managers will engage in wasteful spending. Help Constrain Under the pecking-order hypothesis, a firm will raise capital by using its net income, selling its marketable securities, issuing debt, and then issuing stock as the last resort. This statement is ????. True False Several dominant theories try to explain why financial managers make the capital structure decisions that they do. The following statement describes one such theory. Consider this case: The firm's debt-equity decision finds the optimal balance between the interest tax shield benefits of debt financing and the costs of financial distress associated with issuing debt. Identify which of the two theories below is described by the statement. O O Trade-off theory Pecking-order hypothesis