Question 1

M&M Proposition I with taxes is based on the concept that:
A)the optimal capital structure is the one that is totally financed with equity.
B)the capital structure of a firm does not matter because investors can use homemade leverage.
C)a firm's WACC is unaffected by a change in the firm's capital structure.
D)the value of a firm increases as the firm's debt increases because of the interest tax shield.
E)the cost of equity increases as the debt-equity ratio of a firm increases.

Accepted Answer

M&M Proposition I with taxes states that the value of a firm increases as the firm's debt increases because of the interest tax shield. This proposition is based on the assumption that the tax benefit from debt outweighs the cost of financial distress. Therefore, increasing debt in the capital structure is favorable to increase the value of the firm.

Question 2

The capital structure that maximizes the value of a firm also:
A)minimizes financial distress costs.
B)minimizes the cost of capital.
C)maximizes the present value of the tax shield on debt.
D)maximizes the value of the debt.
E)maximizes the value of the unlevered firm.

Accepted Answer

The capital structure that maximizes the value of a firm is the one that minimizes the weighted average cost of capital (WACC). As a result, the cost of capital is minimized.

Question 3

M&M Proposition II is the proposition that: A)the capital structure of a firm has no effect on the firm's value. B)the cost of equity depends on the return on debt, the debt-equity ratio, and the tax rate. C)a firm's cost of equity is a linear function with a slope equal to (R_A - R_D). D)the cost of equity is equivalent to the required rate of return on a firm's assets. E)the size of the pie does not depend on how the pie is sliced.

Accepted Answer

The answer of M&M Proposition II is the proposition that:
A)the...

Question 4

M&M Proposition I with tax supports the theory that:
A)a firm's weighted average cost of capital decreases as the firm's debt-equity ratio increases.
B)the value of a firm is inversely related to the amount of leverage used by the firm.
C)the value of an unlevered firm is equal to the value of a levered firm plus the value of the interest tax shield.
D)a firm's cost of capital is the same regardless of the mix of debt and equity used by the firm.
E)a firm's cost of equity increases as the debt-equity ratio of the firm decreases.

Accepted Answer

The answer of M&M Proposition I with tax supports the...

Question 5

The interest tax shield is a key reason why:
A)the required rate of return on assets rises when debt is added to the capital structure.
B)the value of an unlevered firm is equal to the value of a levered firm.
C)the net cost of debt to a firm is generally less than the cost of equity.
D)the cost of debt is equal to the cost of equity for a levered firm.
E)firms prefer equity financing over debt financing.

Accepted Answer

The interest tax shield allows a firm to deduct the interest expense from its taxable income, which reduces the net cost of debt to the firm. This means that the cost of debt is generally less than the cost of equity, making it a more attractive form of financing. Choices A, B, D, and E are all incorrect statements.

Question 6

Based on M&M Proposition II with taxes, the weighted average cost of capital: A)is equal to the aftertax cost of debt. B)has a linear relationship with the cost of equity capital. C)is unaffected by the tax rate. D)decreases as the debt-equity ratio increases. E)is equal to R_U * (1 - T_C).

Accepted Answer

With taxes, the weighted average cost of capital (WACC) decreases as the debt-equity ratio increases due to the tax shield on debt.

Question 7

Which one of the following is a direct bankruptcy cost?
A)company CEO's time spent in bankruptcy court
B)maintaining cash reserves
C)maintaining a debt-equity ratio that is lower than the optimal ratio
D)losing a key company employee
E)paying an outside accountant fees to prepare bankruptcy reports

Accepted Answer

Paying an outside accountant fees to prepare bankruptcy reports is a direct bankruptcy cost as it is an expense incurred specifically due to the bankruptcy process. The other options are indirect bankruptcy costs as they may be incurred regardless of whether or not the company goes bankrupt, and their relationship to bankruptcy is indirect.

Question 8

M&M Proposition I with no tax supports the argument that:
A)business risk determines the return on assets.
B)the cost of equity rises as leverage rises.
C)the debt-equity ratio of a firm is completely irrelevant.
D)a firm should borrow money to the point where the tax benefit from debt is equal to the cost of the increased probability of financial distress.
E)homemade leverage is irrelevant.

Accepted Answer

M&M Proposition I with no tax states that the value of a firm is not affected by its capital structure, implying that the debt-equity ratio is irrelevant. This proposition assumes perfect markets, no taxes, and equal access to information and borrowing costs for all firms and investors. It also states that the cost of capital is determined by the business risk of the assets, not by how they are financed. Therefore, the answer is C - the debt-equity ratio of a firm is completely irrelevant.

Question 9

The interest tax shield has no value when a firm has a:
I. tax rate of zero.
II. debt-equity ratio of 1.
III. zero debt.
IV. zero leverage.
A)I and III only
B)II and IV only
C)I, III, and IV only
D)II, III, and IV only
E)I, II, and IV only

Accepted Answer

The interest tax shield is derived from the tax deduction on interest payments made on debt. Therefore, if a firm has no debt (III) or no leverage (IV), there would be no interest tax shield. Additionally, if the tax rate is zero (I), there would be no tax benefit from the interest deduction. However, a debt-equity ratio of 1 (II) would imply that the firm has an equal amount of debt and equity, which means that there would be interest payments and therefore an interest tax shield.

Question 10

The concept of homemade leverage is most associated with:
A)M&M Proposition I with no tax.
B)M&M Proposition II with no tax.
C)M&M Proposition I with tax.
D)M&M Proposition II with tax.
E)static theory proposition.

Accepted Answer

The answer of The concept of homemade leverage is most...

Question 11

Which one of the following statements is correct concerning the relationship between a levered and an unlevered capital structure? Assume there are no taxes.
A)At the break-even point, there is no advantage to debt.
B)The earnings per share will equal zero when EBIT is zero for a levered firm.
C)The advantages of leverage are inversely related to the level of EBIT.
D)The use of leverage at any level of EBIT increases the EPS.
E)EPS are more sensitive to changes in EBIT when a firm is unlevered.

Accepted Answer

At the break-even point, the firm is generating just enough EBIT to cover its operating costs and debt obligations. In this scenario, there is no advantage to debt since the use of debt does not increase the firm's profitability or return on equity. Additionally, at the break-even point, the cost of debt is the same as the cost of equity, making the two financing options equally desirable. Therefore, the correct statement is that at the break-even point, there is no advantage to debt.

Question 12

Bankruptcy:
A)creates value for a firm.
B)transfers value from shareholders to bondholders.
C)technically occurs when total equity equals total debt.
D)costs are limited to legal and administrative fees.
E)is an inexpensive means of reorganizing a firm.

Accepted Answer

Bankruptcy transfers value from shareholders to bondholders because bondholders have a higher claim on the assets of the firm in the event of bankruptcy. Shareholders may lose their entire investment while bondholders receive a portion of the remaining assets after debt obligations are paid off.

Question 13

Which one of the following has the greatest tendency to increase the percentage of debt included in the optimal capital structure of a firm?
A)exceptionally high depreciation expenses
B)very low marginal tax rate
C)substantial tax shields from other sources
D)low probabilities of financial distress
E)minimal taxable income

Accepted Answer

Low probabilities of financial distress make it more attractive for a firm to include a higher percentage of debt in its capital structure, as the risks associated with default are perceived to be lower. This encourages firms to leverage the benefits of debt financing, such as tax shields on interest payments, without facing significant risks of financial distress.

Question 14

Which one of the following makes the capital structure of a firm irrelevant?
A)taxes
B)interest tax shield
C)100 percent dividend payout ratio
D)debt-equity ratio that is greater than 0 but less than 1
E)homemade leverage

Accepted Answer

The Modigliani-Miller theorem posits that under certain conditions, the capital structure of a firm (how it finances its operations through debt vs. equity) is irrelevant to its value. One of these conditions is the absence of taxes, costs of financial distress, and asymmetric information, allowing for "homemade leverage." Homemade leverage refers to the ability of investors to create their own desired level of leverage by borrowing or lending on their own, thus making the firm's choice of capital structure irrelevant to the overall cost of capital and the value of the firm.

Question 15

Which of the following statements are correct in relation to M&M Proposition II with no taxes?
I. The required return on assets is equal to the weighted average cost of capital.
II. Financial risk is determined by the debt-equity ratio.
III. Financial risk determines the return on assets.
IV. The cost of equity declines when the amount of leverage used by a firm rises.
A)I and III only
B)II and IV only
C)I and II only
D)III and IV only
E)I and IV only

Accepted Answer

I. Correct. According to M&M Proposition II with no taxes, the required return on assets is equal to the weighted average cost of capital. 
II. Correct. Financial risk is determined by the debt-equity ratio as per M&M Proposition II with no taxes. 
III. Incorrect. Financial risk does not determine the return on assets, rather it is determined by the required return on assets itself. 
IV. Incorrect. As per M&M Proposition II with no taxes, the cost of equity does not decline when the amount of leverage used by a firm rises.

Question 16

If a firm has the optimal amount of debt, then the: A)direct financial distress costs must equal the present value of the interest tax shield. B)value of the levered firm will exceed the value of the firm if it were unlevered. C)value of the firm is minimized. D)value of the firm is equal to V_L + T_C * D. E)debt-equity ratio is equal to 1.0.

Accepted Answer

If a firm has the optimal amount of debt, it means that it has balanced the benefits of the interest tax shield and the costs of financial distress. At this point, the value of the levered firm will exceed the value of the firm if it were unlevered, indicating that the firm has reached its optimal capital structure.

Question 17

The business risk of a firm:
A)depends on the firm's level of unsystematic risk.
B)is inversely related to the required return on the firm's assets.
C)is dependent upon the relative weights of the debt and equity used to finance the firm.
D)has a positive relationship with the firm's cost of equity.
E)has no relationship with the required return on a firm's assets according to M&M Proposition II.

Accepted Answer

The answer of The business risk of a firm:
A)depends on...

Question 18

M&M Proposition II with taxes:
A)has the same general implications as M&M Proposition II without taxes.
B)states that a firm's capital structure is irrelevant.
C)supports the argument that business risk is determined by the capital structure decision.
D)supports the argument that the cost of equity decreases as the debt-equity ratio increases.
E)concludes that the capital structure decision is irrelevant to the value of a firm.

Accepted Answer

M & M Proposition II with taxes generally implies that the cost of capital decreases as leverage increases, due to the tax shield provided by debt. This is a modification of the original M & M Proposition II without taxes, which suggests that the cost of capital is unaffected by the capital structure. However, both propositions imply that leveraging affects the cost of capital, albeit in opposite directions due to the consideration of taxes.

Question 19

Jessica invested in Quantro stock when the firm was unlevered. Since then, Quantro has changed its capital structure and now has a debt-equity ratio of 0.30. To unlever her position, Jessica needs to:
A)borrow some money and purchase additional shares of Quantro stock.
B)maintain her current equity position as the debt of the firm did not affect her personally.
C)sell some shares of Quantro stock and hold the proceeds in cash.
D)sell some shares of Quantro stock and loan out the sale proceeds.
E)create a personal debt-equity ratio of 0.30.

Accepted Answer

To unlever her position in a levered firm, Jessica needs to mimic the effect of the firm having no debt from her perspective. This involves reducing her exposure to the equity of the firm and creating a personal cash inflow that mimics the interest payments a debt holder would receive, effectively offsetting the firm's leverage. Selling some shares and loaning out the proceeds allows her to adjust her personal financial position to counterbalance the firm's debt, simulating an unlevered investment in the firm.

Question 20

Which of the following statements related to financial risk are correct?
I. Financial risk is the risk associated with the use of debt financing.
II. As financial risk increases so too does the cost of equity.
III. Financial risk is wholly dependent upon the financial policy of a firm.
IV. Financial risk is the risk that is inherent in a firm's operations.
A)I and III only
B)II and IV only
C)II and III only
D)I, II, and III only
E)I, II, III, and IV

Accepted Answer

I. Financial risk indeed pertains to the risk associated with using debt financing, as it reflects the additional risk placed on a company's shareholders due to the use of debt. II. As financial risk increases, the cost of equity can also increase because equity holders require a higher return to compensate for the increased risk. III. Financial risk is influenced by a firm's financial policy, particularly its decisions regarding capital structure (debt vs. equity financing). IV is incorrect because financial risk is distinct from operational risk, which is the risk inherent in a firm's operations.

Quiz 16: Financial Leverage and Capital Structure Policy

M&M Proposition I with taxes is based on the concept that:

The capital structure that maximizes the value of a firm also:

M&M Proposition II is the proposition that:

M&M Proposition I with tax supports the theory that:

The interest tax shield is a key reason why:

Based on M&M Proposition II with taxes, the weighted average cost of capital:

Which one of the following is a direct bankruptcy cost?

M&M Proposition I with no tax supports the argument that:

The interest tax shield has no value when a firm has a: I. tax rate of zero. II. debt-equity ratio of 1. III. zero debt. IV. zero leverage.

The concept of homemade leverage is most associated with:

Which one of the following statements is correct concerning the relationship between a levered and an unlevered capital structure? Assume there are no taxes.

Bankruptcy:

Which one of the following has the greatest tendency to increase the percentage of debt included in the optimal capital structure of a firm?

Which one of the following makes the capital structure of a firm irrelevant?

If a firm has the optimal amount of debt, then the:

The business risk of a firm:

M&M Proposition II with taxes:

Jessica invested in Quantro stock when the firm was unlevered. Since then, Quantro has changed its capital structure and now has a debt-equity ratio of 0.30. To unlever her position, Jessica needs to: