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

Free cash flow (FCF) reflects the cash generated from a company's operations and is available to pay for debt, dividends, or investments. The firm's capital structure, such as debt-to-equity ratio, does not directly affect the FCF calculation as it only considers the operating cash flows.

Question 2

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

According to Modigliani and Miller's proposition with taxes, the value of a leveraged firm is higher than the value of an unleveraged firm due to the tax shield provided by debt financing. This implies that, theoretically, in a world with corporate income taxes, the optimal capital structure would maximize debt financing to take full advantage of the tax benefits, leading to the conclusion of approximately 100% debt financing being optimal.

Question 3

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 is true because lenders want to compensate for the higher risk by charging a higher interest rate to such borrowers.

Question 4

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

Modigliani and Miller (MM) theory states that in a world without taxes, the use of debt would not affect a firm's value. This is because any tax benefits of debt would be offset by the increased cost of equity financing. Therefore, the value of the firm would remain the same regardless of its capital structure.

Question 5

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 borrowed funds to finance a firm's assets. An increase in financial leverage results in an increase in fixed financial costs such as interest payments, which leads to higher variability in earnings and ultimately increases the firm's market (or systematic) risk. This risk is reflected in the firm's beta coefficient, which measures the sensitivity of its stock price to changes in the overall market. Therefore, an increase in financial leverage leads to a higher beta coefficient, indicating increased market risk.

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 determine a firm's financial risk, while business risk arises from the nature of the firm's operations, such as competition, regulation, and technological changes. Therefore, if Firm A has more business risk than Firm B, its EPS would be more volatile, even if both firms have identical financial and operating leverage.

Question 7

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, presented the proposition that under certain assumptions, a firm's capital structure does not affect its market value. This conclusion became known as the "irrelevance principle."

Question 8

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

Modigliani and Miller's proposition with taxes suggests that due to the tax deductibility of interest payments, increasing debt in a firm's capital structure can reduce taxable income and thus increase the firm's value by reducing its tax liability.

Question 9

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

Accepted Answer

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

Question 10

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

Modigliani and Miller's first article, published in 1958, concluded that under certain assumptions, including no taxes and perfect capital markets, the capital structure of a firm is irrelevant to its value. This means that the mix of debt and equity financing a firm uses does not affect its overall value.

Question 11

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

Two firms can have the same expected EPS and the same standard deviation of expected EPS but still have different amounts of business risk due to differences in their operational leverage, industry characteristics, competitive position, or other factors that affect the stability of their cash flows and operational risks.

Question 12

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 companies must balance the advantages and disadvantages of debt financing while making capital structure decisions.

Question 13

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

According to Modigliani and Miller (MM) in a world without taxes, the capital structure of a firm is irrelevant to its value. This means there is no optimal capital structure and the mix of debt and equity financing does not affect the overall cost of capital or the value of the firm.

Question 14

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

Accepted Answer

Financial leverage refers to the use of borrowed funds to increase the potential return on investment. When a firm borrows money, it is using financial leverage.

Question 15

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 relates to the fixed costs of a firm's operations. Financial leverage, on the other hand, primarily affects EPS as it involves the use of debt to finance the business. Both types of leverage can impact a company's overall profitability and risk.

Question 16

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 the risk that arises from the use of debt financing. If a firm uses debt financing, it is obligated to make fixed payments to its creditors, regardless of whether it generates enough cash flow to cover those payments. The use of debt increases the financial risk of a firm, since the stockholders have to bear the extra risk associated with these fixed payments. If a firm had used no debt, the stockholders would not have had to bear this additional risk.

Question 17

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 determined by various factors, including competition, market demand, technological changes, and the company's own financial management. The amount of debt used by the average firm in the industry may affect the cost of borrowing for a particular firm, but it is not a sole determinant of business risk.

Question 18

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 19

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. This would tend to make the distribution of ROE wider or more spread out, not more peaked.

Question 20

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

Modigliani and Miller's revised model, which included corporate taxes, concluded that due to the tax deductibility of interest payments, a firm could increase its value by increasing its debt level, theoretically suggesting an optimal capital structure of nearly 100% debt.

Quiz 14: Capital Structure and Leverage