Question 1

A firm's capital structure does not affect its free cash flows as discussed in the text,because FCF reflects only operating cash flows,which are available to service debt,to pay dividends to stockholders,and for other purposes.

Accepted Answer

True

Question 2

Other things held constant,an increase in financial leverage will increase a firm's market (or systematic)risk as measured by its beta coefficient.

Accepted Answer

Financial leverage refers to the use of debt financing to fund a company's operations and investments. By taking on more debt, a company may increase its financial risk, which in turn can contribute to an increase in market or systematic risk. This is reflected in the company's beta coefficient, which measures the extent to which its stock price moves in response to changes in the overall market or economy. Therefore, an increase in financial leverage will typically lead to an increase in beta, indicating greater market risk.

Question 3

In a world with no taxes,Modigliani and Miller (MM)show that a firm's capital structure does not affect its value.However,when taxes are considered,MM show a positive relationship between debt and value,i.e. ,the firm's value rises as it uses more and more debt,other things held constant.

Accepted Answer

True

Question 4

According to Modigliani and Miller (MM),in a world with corporate income taxes the optimal capital structure calls for approximately 100% debt financing.

Accepted Answer

The answer of According to Modigliani and Miller (MM),in a...

Question 5

According to Modigliani and Miller (MM),in a world without taxes the optimal capital structure for a firm is approximately 100% debt financing.

Accepted Answer

The answer of According to Modigliani and Miller (MM),in a...

Question 6

It is possible for Firms A and B to have identical financial and operating leverage,yet for Firm A to have more risk as measured by the variability of EPS.This would occur if Firm A has more business risk than Firm B.

Accepted Answer

Financial leverage and operating leverage relate to a firm's capital structure and cost structure, respectively. The combination of the two determines a firm's overall degree of leverage. However, business risk is a different type of risk that is independent of a firm's leverage. Business risk refers to the uncertainty or variability of a firm's sales and earnings due to factors such as competition, technological change, and market conditions. Therefore, it is possible for two firms to have identical financial and operating leverage but different levels of business risk, which can result in different levels of risk as measured by EPS variability.

Question 7

Provided a firm does not use an extreme amount of debt,operating leverage typically affects only EPS,while financial leverage affects both EPS and EBIT.

Accepted Answer

Operating leverage affects both EPS and EBIT, as it involves fixed costs that can increase or decrease profits depending on changes in sales volume. Financial leverage, on the other hand, primarily affects EPS as it involves the use of debt to finance operations, which can increase or decrease profits due to the interest expense.

Question 8

Financial risk refers to the extra risk borne by stockholders as a result of a firm's use of debt as compared with their risk if the firm had used no debt.

Accepted Answer

Financial risk is a term used to describe the risk that stockholders face due to a firm's use of debt to finance its operations. This type of risk arises because the use of debt increases a company's financial leverage, which in turn magnifies the potential gains or losses that stockholders may experience. If a company uses no debt, its stockholders would face less financial risk. Therefore, the statement is true.

Question 9

Modigliani and Miller's first article led to the conclusion that capital structure is extremely important,and that every firm has an optimal capital structure that maximizes its value and minimizes its cost of capital.

Accepted Answer

The answer of Modigliani and Miller's first article led to...

Question 10

The trade-off theory states that capital structure decisions involve a tradeoff between the costs and benefits of debt financing.

Accepted Answer

The trade-off theory indeed suggests that firms must balance the advantages of taking on debt, such as the tax shield on interest payments and potential increase in shareholder value, with the potential drawbacks, such as the risk of financial distress and the cost of servicing debt.

Question 11

Modigliani and Miller's first article led to the conclusion that capital structure is "irrelevant" because it has no effect on a firm's value.However,that article was criticized because it assumed that no taxes existed.MM then revised their original article to include corporate taxes,and this model led to the conclusion that a firm's value would be maximized if it used (almost)100% debt.

Accepted Answer

The answer of Modigliani and Miller's first article led to...

Question 12

A firm's business risk is largely determined by the financial characteristics of its industry,especially by the amount of debt the average firm in the industry uses.

Accepted Answer

A firm's business risk is impacted by several factors, including the competition in the industry, the regulatory environment, the company's diversification, and the level of technological change. The amount of debt used by the average firm in the industry may impact a firm's financial risk, but it is not the only determinant of the overall business risk.

Question 13

If a firm borrows money,it is using financial leverage.

Accepted Answer

Financial leverage refers to the use of borrowed funds to finance the purchase of assets. This can increase the potential return on investment, but also increases the risk of losses.

Question 14

Modigliani and Miller's first article led to the conclusion that capital structure is "irrelevant" because it has no effect on a firm's value.

Accepted Answer

Modigliani and Miller's first article, published in 1958, concluded that in a perfect and frictionless market, capital structure is irrelevant to a firm's value. This is also known as the "MM Proposition I" or the "no-arbitrage argument." However, this proposition assumes a variety of unrealistic assumptions, such as no taxes, no transaction costs, and perfect information, among others. Therefore, in the real world, capital structure can have an impact on a firm's value.

Question 15

As the text indicates,a firm's financial risk can and should be divided into separate market and diversifiable risk components.

Accepted Answer

The answer of As the text indicates,a firm's financial risk...

Question 16

If two firms have the same expected earnings per share (EPS)and the same standard deviation of expected EPS,then they must have the same amount of business risk.

Accepted Answer

The answer of If two firms have the same expected...

Question 17

Different borrowers have different risks of bankruptcy,and if a borrower goes bankrupt,its lenders will probably not get back the full amount of funds that they loaned.Therefore,lenders charge higher rates to borrowers judged to be more likely to go bankrupt.

Accepted Answer

This statement is true. Lenders need to compensate for the higher risk of default by charging higher interest rates to borrowers who are deemed more likely to go bankrupt.

Question 18

According to Modigliani and Miller (MM),in a world without corporate income taxes the use of debt has no effect on the firm's value.

Accepted Answer

According to Modigliani and Miller (MM), in a world without corporate income taxes, the use of debt has no effect on the firm's value. This is known as the Proposition I of MM.

Question 19

Modigliani and Miller (MM)won Nobel Prizes for their work on capital structure theory.

Accepted Answer

Modigliani and Miller (MM) won the Nobel Prize in Economics in 1985 for their work on capital structure theory.

Question 20

The graphical probability distribution of ROE for a firm that uses financial leverage would tend to be more peaked than the distribution if the firm used no leverage,other things held constant.

Accepted Answer

Financial leverage increases the variability of ROE because it amplifies the effects of changes in operating income on the returns to equity holders, leading to a wider, not more peaked, distribution.

Quiz 13: Capital Structure and Leverage