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Solutions Manual

CHAPTER 24

ASSESSING LONG-TERM DEBT,
EQUITY AND CAPITAL STRUCTURE

SUGGESTED ANSWERS TO THE REVIEW QUESTIONS AND PROBLEMS

I. Questions

1. Capital structure is the composition of a firm’s financing, which consists
of its permanent sources of capital.

2. The financial manager’s objective in making capital structure decisions
is to find the financing mix that maximizes the market value of the firm.
This structure is called the optimal capital structure.

3. Under idealized conditions with no income taxes, the traditional
approach to capital structure suggests that there is an optimal capital
structure which simultaneously maximizes the firm’s market value and
minimizes its weighted average cost of capital.

Under idealized conditions with no income taxes, the Modigliani and
Miller model implies that the total market value and cost of capital are
independent of a firm’s capital structure.

Under idealized conditions with corporate income taxes, the Modigliani
and Miller model concludes that leverage affects value, and that firms
should be financed with virtually all debt.

Under relaxed assumptions, the contemporary approach suggests that
there is an optimal range for the capital structure of the firm. If the firm
finances outside this range, the value of the firm will decline.

4. Choosing an optimal or target capital structure involves tradeoff among
opposing benefits and costs and requires the use of both analytical
techniques and informed judgment.

5. A firm can analyze its capital structure by performing an EBIT – EPS
analysis; assessing risk associated with various capital structures;
computing debt management ratios and comparing them with industry
standards; and seeking the opinion of lenders, investment analysts, and
investment bankers. EBIT – EPS analysis is useful for evaluating the
sensitivity of EPS to changes in EBIT under various financing plans.

24-1

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