Capital Structure and Corporate Financing Decisions: Theory, Evidence, and Practice

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ANSWERS TO CHAPTER DISCUSSION QUESTIONS 449

distress is unlikely to have any effect on well-diversified portfolios and financial

leverage risk will not be priced.

CHAPTER 5 CAPITAL STRUCTURE AND RETURNS

1. Proposition II states that return on equity is an increasing function of leverage.

Debt increases the riskiness of the stock and hence equity shareholders demand

a higher return on their stocks. Modigliani and Miller (1958) define returns as the

sum of interest, preferred dividends, and stockholders’ income net of corporate

income taxes. They find a positive and linear relationship between leverage and

returns in their cross-sectional estimations in the electric utilities and oil and

gas sectors. Their work led to the development of different theories on capital

structure including the trade-off theory, pecking order theory, agency theory,

market timing theory, corporate control theory, and product cost theory.

2. The trade-off theory states that debt in a firm’s capital structure is beneficial to

equity investors as long as they are rewarded up to the point where the benefit

of the tax deductibility of interest offsets potential bankruptcy costs. The trade-

off theory consists of two parts: static trade-off theory and dynamic trade-off

theory. According to the static trade-off theory, firms select an optimal capital

structure that balances the advantages and disadvantages of using debt and

equity. Dynamic trade-off ...