Practice: Capital Structure

Corporate Issuers. 36 question(s) in this unit's pool (2 above the exam). Free up to ten a day; the coach picks which ones based on what you have already answered and when each is next due.

Corporate IssuersCapital Structure
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Today's practice

Pick an answer, say how sure you are, then reveal. Every wrong choice gets its own explanation. Questions you have already answered correctly and confidently stay out of the way until they are due for review again.

Question 1Exam level

According to Modigliani and Miller's Proposition I with no taxes, the value of a firm is most likely described as being determined by:

How sure are you?

Correct: B. The correct answer is The cash flows generated by its assets.
A. You might think leverage ratios matter. They do in the real world. Under M-M's perfect market assumptions (no taxes, no distress costs, no asymmetric information), the D/E ratio is irrelevant to firm value.
C. Cost of equity sounds like a key value driver. Cost of equity changes with leverage under Prop II, but WACC and firm value stay constant. Cost of equity is endogenous, not exogenous.

Unit: capital-structure

Question 2Exam level

A firm has an unlevered cost of equity of 10% and a cost of debt of 6%. The firm's debt-to-equity ratio is 0.5. According to M-M Proposition II (no taxes), the firm's levered cost of equity is CLOSEST to:

How sure are you?

Correct: B. The correct answer is 12.0%.
A. Candidates who confuse Prop I and Prop II think cost of equity doesn't change. Prop I says firm VALUE doesn't change, not that cost of equity doesn't change. Prop II explicitly says cost of equity rises with leverage.
C. Using D/E = 0.5 as if it means debt is 50% of total assets (applying to total capital not equity). The D/E ratio is debt divided by equity, not debt divided by total capital. If D/E = 0.5, then D/(D+E) = 0.333, not 0.5.

Unit: capital-structure

Question 3Exam level

Under Modigliani-Miller with corporate taxes, a firm should most likely theoretically:

How sure are you?

Correct: C. The correct answer is Use as much debt as possible to maximize the value of the tax shield.
A. Students know debt carries risk, so they instinctively avoid extreme debt. In the M-M with taxes (but no distress costs) framework, the only effect of debt is the tax shield. There is no offsetting cost, so more debt is always better.
B. This is actually the correct answer under TRADE-OFF THEORY, not M-M with taxes. Trade-off theory adds financial distress costs to create an interior optimum. Under pure M-M with taxes, there is no distress cost. No balancing force.

Unit: capital-structure

Question 4Exam level

According to the trade-off theory of capital structure, the optimal capital structure is most likely where:

How sure are you?

Correct: B. The correct answer is The marginal tax benefit of additional debt equals the marginal cost of financial distress.
A. D/E = 1 sounds like a balanced midpoint. Neither all-debt nor all-equity. The optimal D/E is firm-specific and depends on the tax rate, probability of distress, and magnitude of distress costs. It is not universally 1.0.
C. Low cost of debt sounds optimal. The cost of debt is determined by credit risk, not chosen by management. The optimal capital structure is about the balance of benefits and costs, not about achieving a particular interest rate.

Unit: capital-structure

Question 5Exam level

A company's CFO argues that issuing equity would signal to the market that the stock is overvalued. This reasoning is MOST consistent with which capital structure theory?

How sure are you?

Correct: C. The correct answer is Pecking order theory.
A. M-M Prop I talks about capital structure being irrelevant, so it seems like a logical frame. M-M assumes perfect information. No asymmetric information. Prop I says how you finance doesn't matter, not that market signals exist.
B. Trade-off theory is mentioned frequently and seems like a catch-all. Trade-off theory is about taxes vs. distress costs. It says nothing about signaling effects or information asymmetry.

Unit: capital-structure

Question 6Exam level

Which of the following is most likely NOT an assumption of the original Modigliani-Miller framework (no taxes)?

How sure are you?

Correct: C. The correct answer is Corporate tax rates are positive.
A. Transaction costs seem like a real-world complication that might not be in a simple model. Absence of transaction costs IS one of the M-M assumptions. The question asks what is NOT an assumption, and 'no transaction costs' IS assumed.
B. Risk-free borrowing sounds unrealistic, so candidates think it might be excluded. M-M assumes individuals and corporations can borrow at the same risk-free rate. This IS one of the assumptions.

Unit: capital-structure

Question 7Exam level

Firm A is unlevered with a value of $50 million. The corporate tax rate is 30%. If the firm issues $20 million of debt and uses proceeds to repurchase equity, the value of the levered firm under M-M with taxes is closest to:

How sure are you?

Correct: C. The correct answer is $56.0 million.
A. Candidates who remember Prop I (no taxes) conclude firm value doesn't change with leverage. Prop I with NO TAXES says value is unchanged. This question specifies taxes, which changes the result. The tax shield adds T*D to firm value.
B. Computing 30% of $50M instead of 30% of $20M: 0.30 x $50M = $15M... no, actually 50+4=54 suggests using 20% of $20M or some other arithmetic error. The formula is T*D where D is the amount of debt issued ($20M), not the total firm value ($50M).

Unit: capital-structure

Question 8Exam level

Under M-M Proposition II without taxes, as a firm most likely increases its financial leverage, its weighted average cost of capital (WACC) will:

How sure are you?

Correct: C. The correct answer is Remain constant, because the increase in cost of equity exactly offsets the lower cost of debt.
A. More financial risk should increase the hurdle rate. This is real-world intuition. Under M-M no-tax perfect markets, the rise in equity cost exactly compensates. The blended rate stays flat. Financial risk affects equity cost but not WACC.
B. Debt is cheaper than equity, so substituting equity for debt should reduce WACC. As you substitute debt for equity, equity becomes riskier and its required return rises. The 'cheap' debt advantage is exactly cancelled by 'more expensive' equity.

Unit: capital-structure

Question 9Exam level

Which of the following costs is most likely classified as an indirect cost of financial distress?

How sure are you?

Correct: B. The correct answer is Loss of key supplier contracts due to concerns about the firm's viability.
A. Accounting fees are certainly associated with financial distress. Accounting/filing fees are DIRECT costs. Explicit, measurable cash outlays to third parties.
C. Liquidation costs feel like they could be indirect since they relate to asset sales. Administrative costs of liquidating assets are direct, explicit costs. They are paid out as cash.

Unit: capital-structure

Question 10Exam level

According to the pecking order theory, which of the following financing sources would a company use LAST when it needs external capital, most likely?

How sure are you?

Correct: C. The correct answer is Issuing new equity.
A. Retained earnings are internal and limited, so candidates think external sources would be used before exhausting internal sources. Retained earnings are the FIRST choice. They carry no issuance costs, no signaling costs, and no information asymmetry problems.
B. Bank debt seems like a major commitment that would be avoided. Debt is preferred over equity because debt issuance is a weaker negative signal than equity issuance. Debt holders have priority claims, so their presence signals management's confidence in cash flow coverage.

Unit: capital-structure

Question 11Harder

A highly profitable, asset-heavy industrial company with stable cash flows would most likely have a HIGHER optimal debt ratio compared to a high-growth technology startup according to the trade-off theory. Which factor BEST explains this?

How sure are you?

Correct: A. The correct answer is Industrial companies have more tangible assets that can serve as collateral and lower distress probability.
B. Tax shield benefit is the same for all profitable firms at the same tax rate. Both types of firms benefit equally from the tax shield at the same tax rate. The difference in optimal leverage comes from the distress cost side, not the benefit side.
C. Access to equity markets sounds like a practical constraint. Trade-off theory is a theoretical framework about the balance of costs and benefits. Market access is a practical friction not part of the theoretical model.

Unit: capital-structure

Question 12Harder

The MM framework assumes that both individuals and corporations can borrow at the same rate. What type of transaction does this assumption enable that underpins Proposition I, most likely?

How sure are you?

Correct: B. The correct answer is Homemade leverage: investors can replicate any capital structure on their own account.
A. Taxes are a major M-M topic so tax arbitrage seems relevant. The original M-M framework assumes NO taxes. There is no tax arbitrage to exploit. The equal borrowing rate assumption is about homemade leverage, not taxes.
C. Arbitrage is the enforcement mechanism in M-M, so short selling sounds related. The specific mechanism is homemade leverage (personal borrowing), not short selling. Short selling is not explicitly part of the M-M arbitrage argument.

Unit: capital-structure

Question 13Exam level

A company's stock trades at $40.00. It just paid a dividend of $2.00 (D0 = $2.00). Dividends are expected to grow at 5% annually. Using the dividend growth model, the company's cost of equity is closest to:

How sure are you?

Correct: B. The correct answer is 10.25%.
A. Choosing 5.25% might tempt you if you mistakenly used the dividend yield alone, forgetting to add the growth rate to find the cost of equity as required by the dividend growth model.
C. Choosing 10.50% might tempt you if you mistakenly used the dividend yield of 5% and added the growth rate of 5% without adjusting for the actual dividend yield based on the stock price, leading to a violation of the proper dividend growth model formula which correctly calculates the cost of equity as 10.25%.

Unit: capital-structure

Question 14Exam level

An analyst is estimating the cost of equity for a private company that does not pay dividends and has no publicly traded debt. Which cost-of-equity estimation method is MOST appropriate?

How sure are you?

Correct: C. The correct answer is Capital Asset Pricing Model.
A. DDM seems like a fundamental equity method. DDM requires dividends. A non-dividend-paying company has no D1 to use in the formula.
B. Bond yield plus risk premium feels conservative and appropriate for cost of equity. This Requires an observable bond yield for the company. Private company with no public debt. No yield is available.

Unit: capital-structure

Question 15Exam level

A company's 10-year bonds yield 7.5%. An analyst estimates the equity risk premium over the firm's bonds is 4.0%. Using the bond yield plus risk premium method, the cost of equity is closest to:

How sure are you?

Correct: C. The correct answer is 11.5%.
A. Choosing 4.0% might tempt you if you mistakenly consider the equity risk premium alone as the cost of equity, but you must remember to add the bond yield to the equity risk premium, not use the premium in isolation.
B. Choosing 7.5% might seem logical if you assume the cost of equity equals the bond yield, but this ignores the equity risk premium which must be added to the bond yield to accurately reflect the higher risk of equity.

Unit: capital-structure

Question 16Exam level

Using CAPM, a stock has a beta of 1.3. The risk-free rate is 3.0% and the expected market return is 9.0%. The cost of equity is closest to:

How sure are you?

Correct: B. The correct answer is 10.8%.
A. You might be tempted to choose 7.8% if you mistakenly subtracted the risk-free rate from the market risk premium instead of adding it, which violates the CAPM formula that requires you to add the product of beta and the market risk premium to the risk-free rate.
C. You might be tempted to choose 11.7% if you incorrectly added the beta times the market risk premium to the risk-free rate twice, but the CAPM formula only requires adding it once, making 11.7% an overestimation.

Unit: capital-structure

Question 17Exam level

A company issues preferred stock with an annual dividend of $5.00 per share. The current market price is $62.50. Flotation costs are $2.50 per share. The cost of preferred stock, adjusted for flotation costs, is closest to:

How sure are you?

Correct: B. The correct answer is 8.33%.
A. Choosing 8.0% might tempt you if you forgot to adjust for flotation costs, leading you to calculate the cost of preferred stock based solely on the annual dividend and the market price, which ignores the impact of the $2.50 flotation cost per share.
C. Choosing 9.0% might tempt you if you forgot to adjust for flotation costs, leading you to divide the annual dividend by the market price without subtracting the $2.50 flotation cost, which violates the requirement to account for all issuance expenses in the cost of preferred stock calculation.

Unit: capital-structure

Question 18Exam level

An analyst uses a historical beta of 1.5 for a stock. Applying the Bloomberg beta adjustment formula, the adjusted (predicted) beta is closest to:

How sure are you?

Correct: C. The correct answer is 1.33.
A. Choosing 1.00 might tempt you if you assume the adjustment formula resets beta to the market average, but the Bloomberg beta adjustment formula aims to reduce the regression to the mean effect, not to a flat 1.00, thus 1.00 violates the concept of adjusting historical beta rather than resetting it.
B. Choosing 1.17 might tempt you if you incorrectly assume a more significant adjustment towards the market average, but the Bloomberg beta adjustment formula actually reduces the historical beta less aggressively, leading to a closer value to the original 1.5 rather than a sharp decline to 1.17.

Unit: capital-structure

Question 19Exam level

When estimating the cost of equity using the CAPM, the equity risk premium is most likely estimated using:

How sure are you?

Correct: A. The correct answer is Historical arithmetic mean returns on the market portfolio minus the risk-free rate.
B. Dividend yield feels like a market-level return. ERP includes both dividend yield AND capital gains component of market return. Dividend yield alone understates total market return.
C. Historical return sounds like the right data source. The ERP is a MARKET premium, not a company-specific return. Using the company's own return gives beta-adjusted return, not the broad market risk premium.

Unit: capital-structure

Question 20Harder

According to CFA Institute, flotation costs for new equity issuance are most likely handled by:

How sure are you?

Correct: B. The correct answer is Treating flotation costs as a cash outflow in the NPV calculation of the project.
A. Adding to cost of equity is how many practitioners and some textbooks handle it. It is also shown as a calculation in the curriculum. CFA Institute specifically identifies Method A as less theoretically sound. The preferred treatment is as a cash flow, not a rate adjustment. The exam tests the CFA-preferred method.
C. Flotation costs are a one-time cost, so ignoring them sounds efficient. Flotation costs are a real economic cost of raising capital and must be accounted for. Ignoring them understates the true cost of equity financing.

Unit: capital-structure

Question 21Exam level

A stable utility company has a stock price of $50, an expected dividend next year of $3.00, and a long-run dividend growth rate of 4%. Its 20-year bonds yield 6.5%. Using the dividend growth model, the cost of equity is closest to:

How sure are you?

Correct: B. The correct answer is 10.0%.
A. Choosing 6.0% might seem plausible if you mistakenly used the bond yield as the cost of equity, but the dividend growth model requires using the dividend yield plus the growth rate, leading to a higher cost of equity of 10.0%.
C. Choosing 11.5% might tempt you if you incorrectly add the dividend yield and the growth rate, but the dividend growth model requires you to add the dividend yield, which is 6%, to the growth rate of 4%, not to overestimate by adding an inflated yield.

Unit: capital-structure

Question 22Exam level

The sustainable growth rate for a company with ROE of 15% and a dividend payout ratio of 40% is closest to:

How sure are you?

Correct: B. The correct answer is 9.0%.
A. You might have calculated the retention ratio incorrectly by subtracting the dividend payout ratio from 100%, leading to 60% instead of the correct 60% used in the formula, but then mistakenly using this as the growth rate itself rather than multiplying it by the ROE to find the sustainable growth rate.
C. Choosing 15.0% might seem logical if you think the sustainable growth rate equals the ROE, but this ignores the impact of the dividend payout ratio, which reduces the growth rate to 9.0% by limiting the amount of earnings reinvested in the company.

Unit: capital-structure

Question 23Exam level

Which of the following is most likely a LIMITATION of using the capital asset pricing model (CAPM) to estimate the cost of equity?

How sure are you?

Correct: B. The correct answer is CAPM assumes a single risk factor (market risk) explains all returns.
A. Candidates who confuse DDM and CAPM limitations select this. CAPM uses beta, risk-free rate, and ERP. No dividends required. Dividend history is irrelevant to CAPM.
C. Sounds like a reasonable limitation. CAPM is actually most applicable to publicly traded companies where market data is available to estimate beta. The limitation is for non-traded firms, not traded ones.

Unit: capital-structure

Question 24Exam level

A firm has a capital structure of $400 million in equity (market value) and $600 million in debt (market value). The firm's after-tax cost of debt is 4.8%, its cost of equity is 11.2%, and its marginal tax rate is 35%. The firm's WACC is closest to:

How sure are you?

Correct: A. The correct answer is 7.36%.
B. You might use simple average: (11.2% + 4.8%) / 2 = 8.0%. This ignores the capital structure weights entirely. WACC is a weighted average. The weights reflect how much of each capital source funds the firm. Equal weighting is only correct when E = D, which is not the case here.
C. You might apply (1-T) a second time to the already-after-tax debt cost: (0.60 × 4.8% × 0.65) + (0.40 × 11.2%) = 1.872% + 4.48% = 6.35%, then rounds or miscalculates. The after-tax cost of debt was explicitly stated as 4.8%. The tax shield is already embedded. Applying (1-T) again double-counts the tax benefit.

Unit: capital-structure

Question 25Exam level

A company has the following capital structure and costs: - Long-term debt: book value $200M, market value $180M, coupon rate 6%, yield to maturity 7%, tax rate 30% - Common equity: book value $300M, market value $420M, required return 13% Which of the following correctly calculates the weight of debt for WACC purposes? The value is closest to:

How sure are you?

Correct: B. The correct answer is 180 / (180 + 420) = 30.0%.
A. Uses book values throughout: 200/(200+300). Appears in most financial statements, which candidates read most recently. Book values reflect historical accounting entries, not current market prices. WACC uses market-value weights because they reflect today's cost to raise capital.
C. Mixes book value of debt with market value of equity, creating an inconsistent denominator. All components must use the same valuation basis. Mixing book and market values produces a meaningless weight.

Unit: capital-structure

Question 26Harder

A firm currently has a WACC of 8.5% with a D/E ratio of 0.4. The firm increases its D/E ratio to 1.0. Under Modigliani-Miller with corporate taxes, and assuming financial distress costs are negligible, which statement about the firm's WACC is most accurate?

How sure are you?

Correct: B. The correct answer is WACC decreases because the tax shield on debt is now larger.
A. This is the real-world answer if financial distress costs are included, and it matches the U-shaped WACC curve candidates have memorized. The question says 'negligible distress costs'. You might miss that qualifier. Under MM with taxes and no distress costs, the tax shield dominates. WACC falls monotonically with leverage in this theoretical framework.
C. Technically the new cost of equity IS needed to compute the exact new WACC. You might feel this is cautious and analytical. The question asks for directional effect, not exact computation. The CFA curriculum unambiguously states the directional answer for MM-with-taxes: WACC falls as debt increases.

Unit: capital-structure

Question 27Exam level

A firm's preferred stock has a par value of $50 and pays a quarterly dividend of $0.75. The stock currently trades at $45. What is the cost of preferred stock for WACC purposes, most likely?

How sure are you?

Correct: B. The correct answer is 6.67% (annual dividend / market price).
A. Uses par value as denominator: $3.00/$50 = 6.00%. Par value is given prominently and candidates confuse it with market price. Cost of capital is based on what investors are paying today (market price), not what the stock was originally issued for (par value). Market price = $45, not $50.
C. You might assume preferred stock should have a growth component like common equity (applying Gordon Growth Model logic). Preferred stock pays fixed dividends with no growth. The Gordon Growth Model with g=0 collapses to D/P. No growth term. No capital gains assumption is needed.

Unit: capital-structure

Question 28Exam level

A firm uses the bond-yield-plus-risk-premium approach to estimate its cost of equity. The firm's 10-year bonds yield 6.5%. The typical risk premium over bond yield for similar firms is 3.5%. Using CAPM separately, with a beta of 1.2, risk-free rate of 3.0%, and market risk premium of 5.5%, what would the analyst most likely conclude about the cost of equity?

How sure are you?

Correct: B. The correct answer is Use 9.8% (average of both methods).
A. CAPM is the most widely known method and feels more 'rigorous.' Candidates prefer the formula-based approach. CAPM requires an estimated beta and market risk premium, both of which carry estimation error. The bond-yield method uses observable market data directly. Neither method is strictly superior.
C. Logical-sounding answer. If two methods are both correct, shouldn't they agree? The CFA curriculum explicitly acknowledges that different methods will produce different estimates. This is expected due to different underlying assumptions. Discrepancy is normal, not an error.

Unit: capital-structure

Question 29Exam level

A company has the following data: - Market value of debt: $500M at a pre-tax YTM of 6% - Market value of common equity: $750M with a required return of 12% - Market value of preferred stock: $250M with a dividend yield of 8% - Corporate tax rate: 40% the firm's WACC is closest to:

How sure are you?

Correct: B. The correct answer is 8.55%.
A. You might apply (1-T) to preferred stock dividends as well as debt interest: preferred cost = 8% × 0.60 = 4.8%. This inflates the tax shield incorrectly. Preferred stock dividends are NOT tax-deductible. Only debt interest generates a tax shield. Applying (1-T) to preferred stock is a fundamental conceptual error.
C. You might omit preferred stock entirely and only uses debt and equity: (0.40 × 3.60%) + (0.60 × 12%) = 1.44% + 7.20% = 8.64%, then then miscalculates weights treating debt+equity = 100%. All sources of capital must be included. Omitting preferred stock changes the weights for debt and equity and produces an incorrect WACC.

Unit: capital-structure

Question 30Exam level

Which of the following statements about the appropriate weights for WACC is most accurate?

How sure are you?

Correct: A. The correct answer is Market value weights should be used because they reflect the current cost of raising capital.
B. Target weights are a 'goal' not an observable fact, which feels like it should be excluded from a calculation. The CFA curriculum explicitly states that if a firm has a target capital structure, those target weights are appropriate for WACC. They represent the firm's long-run financing mix. Target weights are preferred over current weights when they are available.
C. Sounds like it could be a valid exception case. If the market perfectly prices assets, wouldn't book = market? Even if total asset market value equals book value, the market values of individual debt and equity claims can differ from book values due to interest rate changes, credit quality changes, and retained earnings. The equality condition is far more restrictive than stated.

Unit: capital-structure

Question 31Exam level

A project has an IRR of 9.2%. The firm's WACC is 8.5%. The firm's CFO argues that the project should be rejected because the company's target return for this division is 11%. Which of the following is the most appropriate response to the CFO?

How sure are you?

Correct: A. The correct answer is Accept the project because IRR > WACC, so it creates shareholder value.
B. You might have learned that NPV is theoretically superior to IRR. This answer seems to apply that lesson. The question asks about the accept/reject decision given IRR and WACC, both of which are provided. NPV cannot be calculated without the cash flows. When IRR is given and it exceeds WACC, the correct action is accept. Both methods give the same decision when applied correctly.
C. Sounds like sound resource allocation logic. Why take 9.2% when you might get 12% elsewhere? Capital budgeting under the CFA framework treats each project independently against the WACC hurdle rate (assuming unlimited capital). The comparison to alternative projects is a capital rationing scenario, which must be explicitly stated.

Unit: capital-structure

Question 32Exam level

A firm is computing WACC using the dividend discount model to estimate its cost of equity. The stock price is $40, the most recent annual dividend was $2.00, and dividends are expected to grow at 4% per year indefinitely. The cost of equity is closest to:

How sure are you?

Correct: B. The correct answer is 9.20% (D1/P0 + g).
A. D0/P0 + g = 5.00% + 4.00% = 9.00%. You might include the growth rate but uses D0 instead of D1. The DDM formula requires D1 (next period's dividend) in the numerator, not D0 (this period's dividend). D1 = D0 × (1+g). This single error accounts for 0.20% understatement of cost of equity.
C. The growth rate is given directly and some candidates interpret 'cost of equity' loosely as 'what equity grows at.'. The growth rate alone is not the cost of equity. Investors require the current dividend yield PLUS the growth rate. Omitting the dividend yield entirely is a fundamental formula error.

Unit: capital-structure

Question 33Exam level

A firm's WACC is 9%. It is considering two independent projects: Project A costs $500,000 with an expected return of 10%; Project B costs $800,000 with an expected return of 8%. The combination of decisions most consistent with shareholder value maximization is most likely:

How sure are you?

Correct: B. Project A: expected return (10%) exceeds WACC (9%), a positive-NPV project, so it should be accepted. Project B: expected return (8%) is below WACC (9%), a negative-NPV project, so it should be rejected. Accepting Project B would destroy shareholder value because its return does not cover the cost of the capital deployed.
A. Both projects do have positive expected returns, but a positive return alone is not enough. Project B's 8% return sits below the firm's 9% cost of capital, so accepting it destroys value even though 8% sounds like a fine return in isolation.
C. Project B's larger dollar cost does not make it value-creating. In raw dollars Project B generates $64,000 (8% of $800,000) but costs $72,000 in capital (9% of $800,000), an $8,000 annual value destruction; only the spread above WACC, not the absolute dollar size, determines whether a project should be accepted.

Unit: capital-structure

Question 34Exam level

Which of the following most likely explains why it is appropriate to use the marginal cost of capital rather than the historical (embedded) cost of capital when computing WACC for capital budgeting?

How sure are you?

Correct: B. The correct answer is Capital budgeting decisions involve new projects funded by new capital raised at current market rates.
A. In low-interest-rate environments, marginal cost was indeed lower than historical cost (bonds issued at 7% in 2000 vs. new bonds at 3% in 2015). You might overgeneralize from this specific period. Marginal cost can be higher OR lower than historical cost depending on the interest rate environment and the firm's credit quality changes.
C. Sounds like the CAPM formula. You might confuse cost of equity estimation methods with the definition of marginal cost of capital. This describes one method for estimating cost of equity (CAPM). Marginal cost of capital applies to the entire capital structure (debt + equity + preferred), and its definition is the cost of the next incremental unit of capital, not a specific formula.

Unit: capital-structure

Question 35Above the exam

A firm operates with an all-equity capital structure worth $50 million (Modigliani-Miller Proposition I, no taxes, assumed to hold). The firm then issues $20 million of debt and uses the proceeds to repurchase equity, with no change in operating cash flows. Combining MM Proposition I (no taxes) with MM Proposition II (no taxes), the firm's WACC after the recapitalization is most likely to:

How sure are you?

Correct: B. Under MM Proposition I (no taxes), total firm value, and therefore WACC, is unaffected by capital structure. MM Proposition II explains the mechanism: as leverage increases, the cost of equity rises linearly to compensate equity holders for the additional financial risk they now bear, and this rising cost of equity exactly offsets the effect of weighting more of the capital structure toward cheaper debt, leaving WACC unchanged at every leverage level.
A. Debt being cheaper than equity does not, by itself, change WACC under the MM (no taxes) framework, because Proposition II shows the cost of equity rises just enough to offset using more of that cheaper debt; assuming WACC rises ignores this exact offsetting mechanism the two propositions describe together.
C. The intuitive appeal of 'more cheap debt lowers the average cost' is exactly the trap MM Proposition II is built to correct: the RISING cost of equity as leverage increases exactly cancels out the weighting effect, which is why MM (no taxes) concludes WACC is invariant to capital structure, not decreasing with more debt.

Unit: capital-structure

Question 36Above the exam

A firm operates in a world with corporate taxes (MM with taxes) and is currently unlevered with a firm value of $80 million and a 25% corporate tax rate. It is considering issuing $30 million in permanent debt and using the proceeds to repurchase equity. Combining MM Proposition I with taxes with the interest tax shield concept, the levered firm's value is most likely closest to:

How sure are you?

Correct: B. Under MM Proposition I WITH corporate taxes, levering up creates value through the interest tax shield: VL = VU + (tax rate x Debt) for permanent debt. Here VL = $80 million + (0.25 x $30 million) = $80 million + $7.5 million = $87.5 million. This is a combined-concept item: the NO-TAX version of Proposition I says capital structure is irrelevant, but once taxes are introduced, debt creates real value through the deductibility of interest expense.
A. The 'capital structure is irrelevant' result is specifically the NO-TAX version of MM Proposition I; once corporate taxes are introduced, debt financing creates real value through the interest tax shield, so firm value is NOT unchanged by the recapitalization in this scenario.
C. Simply adding the full face value of new debt to firm value overstates the effect; only the TAX SHIELD portion of the debt (tax rate x debt amount), not the full principal amount itself, adds to firm value under MM with taxes; the debt is proceeds used to repurchase equity, not new capital added to the firm's asset base.

Unit: capital-structure