Question

Which of the following statements is  false if capital markets have both taxes and financial distress as the market imperfections?

	A.	If two firms are identical but differ only in their capital structure, then the value of the levered firm is higher than the value of the unlevered firm by the present value of the interest tax shield
	B.	There is an optimal capital structure that can maximize firm value
	C.	The capital structure choice considers a trade-off between the tax benefit of leverage and the cost of financial distress
	D.	The optimal capital structure is the leverage level that the firm’s weighted average cost of capital is minimized

Answer 1

If the capital markets have both financial distress and taxes as the market imperfections, we cannot say that a leverage firm is valued higher than an unlevered firm by the PV of interest tax shield. There is an optimal capital structure that can maximise firm value. The trade off theory is applicable in this case. The optimal capital structure is the leverage level that the firm’s weighted average cost of capital is minimized and the firm value maximised. Therefore, the following is false-

A.

If two firms are identical but differ only in their capital structure, then the value of the levered firm is higher than the value of the unlevered firm by the present value of the interest tax shield.