question archive The tradeoff model of capital structure provides several insights to financial managers concerning optimal capital structure
The tradeoff model of capital structure provides several insights to financial managers concerning optimal capital structure
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The tradeoff model of capital structure provides several insights to financial managers concerning optimal capital structure. Which of the following insights is false?
1. Other things equal, firms with high corporate tax rates should use less debt financing than firms with low tax rates.
2. Other things equal, firms with high business risk should use less debt financing than firms with low business risk.
3. Other things equal, firms with large amounts of marketable fixed assets should use more debt financing than firms whose value stems mostly from intangible assets.
4. Other things equal, firms whose value stems from intangible assets should use less debt financing than firms with few intangible assets.
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Answer is Option 1.
Statement 1 is false. Firms with high corporate tax rates should use more debt financing relative to those with low tax rates. This is because interest expense is tax deductible. Hence, the higher tax rate would help company attain higher interest expense tax shield and hence higher profitability.
Statement 2 is correct. High business risk should lead to use of lower debt financing. Higher debt financing may add financial risk aggravating overall risk of the firm.
Statement 3 and 4 are correct. Those with higher intangible assets on their balance sheet should use lower amount of debt, given in case of default, they won't be able to sell their assets (intangibles) to payback the loans.
