ACCA Advanced Financial Management (AFM) Practice Exam

Under what conditions does capital structure not affect cash flows?

1. If there are considerable taxes and bankruptcy costs

2. If there are no taxes, no bankruptcy costs, and no effect on management incentives

3. If management has substantial incentives

4. If the market is highly volatile

The correct answer is: If there are no taxes, no bankruptcy costs, and no effect on management incentives

The assertion that capital structure does not affect cash flows holds true under specific ideal conditions, which are indeed encapsulated by the scenario with no taxes, no bankruptcy costs, and no effect on management incentives. This scenario aligns with the fundamental principle outlined in the Modigliani-Miller theorem, which posits that in a perfect market scenario—with no taxes, no transaction costs, and symmetric information—the value of a firm is unaffected by its capital structure. In this context, when there are no taxes, cash flows generated from assets remain intact regardless of how those assets are financed. Additionally, without bankruptcy costs, the firm does not incur any financial distress costs which could otherwise impact cash flows. The absence of management incentives related to capital structure means that decisions made by management regarding financing do not impact operational performance or cash flow generation. By excluding these variables, we create a simplified environment in which cash flows remain constant regardless of whether the firm is financed through debt, equity, or a combination of both. This leads to the conclusion that under these idealized conditions, capital structure is indeed irrelevant to cash flows. This understanding is critical, especially in analyzing corporate finance decisions in a real-world context where market imperfections often exist.