CFA Level I · CFA Level I Exam · Capital Structure
Other factors held constant, a company with highly volatile and unpredictable operating cash flows is most likely to choose a target capital structure with:
A company with volatile, unpredictable operating cash flows would most likely choose less debt. Fixed debt obligations are harder to meet when cash flows swing, so the chance of financial distress and its costs rises, outweighing the tax shield benefit of interest deductibility.
- Aa lower proportion of debtCorrect
- Ba higher proportion of debt
- Ca higher proportion of debt because interest is tax deductible
Explanation
Volatile cash flows raise the probability that fixed interest and principal payments cannot be met, increasing expected financial distress costs. Such companies therefore tend to use less debt. The tax deductibility of interest does not remove this distress risk, so the third option is wrong.
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