Introduction to Finance

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C H A PT E R 1 8 Capital Structure and The Cost of Capital
 29. 
(LO 18.8)
Describe the reasoning behind the static trade-off
hypothesis.
 30. 
(LO 18.8)
How do agency costs aff ect a fi rm’s optimal capital 
structure? How can diff erences in agency costs explain capital struc-
ture diff erences across countries?
 31. 
(LO 18.8)
How do you expect the capital structures of two fi rms 
to diff er if one is involved in steel production and the other designs 
software to solve business problems?
 32. 
(LO 18.8)
What implications might the pecking order and market 
timing hypotheses have for an optimal capital structure? Is the WACC 
an important concept under these hypotheses?
Problems
1. 
AQ&Q has EBIT of $2 million, total assets of $10 million, stock-
holders’ equity of $4 million, and pretax interest expense of 10 percent.
a. 
What is AQ&Q’s indiff erence level of EBIT?
b. 
Given its current situation, might it benefi t from increasing or 
decreasing its use of debt? Explain.
c. 
Suppose AQ&Q’s average tax rate is 40 percent. How does this 
aff ect your answers to (a) and (b)?
2. 
URA Incorporated has an operating income of $5 million, total 
assets of $45 million, outstanding debt of $20 million, and annual 
interest expense of $3 million.
a. 
What is URA’s indiff erence level of EBIT?
b. 
Given its current situation, might URA benefi t from increasing 
or decreasing its use of debt? Explain.
c. 
Suppose forecasted net income is $4 million next year. If it has a 
40 percent average tax rate, what will be its expected level of earn-
ings before interest and taxes (EBIT)? Will this forecast change 
your answer to (b)? Why?