Question 1

The capital structure chosen by a firm doesn't really matter because of:
A)taxes.
B)the interest tax shield.
C)the relationship between dividends and earnings per share.
D)the effects of leverage on the cost of equity.
E)homemade leverage.

Accepted Answer

Homemade leverage refers to the ability of investors to adjust their own level of debt and achieve the same financial leverage as a company. Thus, the capital structure chosen by a firm does not matter because investors can adjust their own leverage to meet their desired level of risk and return.

Question 2

In a world of no corporate taxes if the use of leverage does not change the value of the levered firm relative to the unlevered firm this is known as:
A)MM Proposition III that the cost of equity is less than the cost of debt.
B)MM Proposition I that leverage is invariant to market value.
C)MM Proposition II that the cost of equity is always constant.
D)MM Proposition I that the market value of the firm is invariant to the capital structure.
E)MM Proposition III that there is no risk associated with leverage in a no tax world.

Accepted Answer

This scenario is described by MM Proposition I, which states that in the absence of taxes and other market imperfections, the market value of a firm is independent of its capital structure. Therefore, the answer is D. MMM Proposition III and E are not relevant in this scenario, and proposition II is only true under certain assumptions.

Question 3

The reason that MM Proposition I does not hold in the presence of corporate taxation is because:
A)levered firms pay less taxes compared with identical unlevered firms.
B)bondholders require higher rates of return compared with stockholders.
C)earnings per share are no longer relevant with taxes.
D)dividends are no longer relevant with taxes.
E)All of the above.

Accepted Answer

MM Proposition I states that the value of a firm is independent of its capital structure. However, this assumes no taxes. With corporate taxation, interest payments on debt are deductible expenses, meaning that levered firms have lower taxable income and thus pay lower taxes compared to identical unlevered firms. This results in a tax shield that increases the value of levered firms, contradicting MM Proposition I.

Question 4

MM Proposition I with corporate taxes states that:
A)capital structure can affect firm value.
B)by raising the debt-to-equity ratio,the firm can lower its taxes and thereby increase its total value.
C)firm value is maximized at an all debt capital structure.
D)All of the above.
E)None of the above.

Accepted Answer

The answer of MM Proposition I with corporate taxes states...

Question 5

A firm should select the capital structure which:
A)produces the highest cost of capital.
B)maximizes the value of the firm.
C)minimizes taxes.
D)is fully unlevered.
E)has no debt.

Accepted Answer

The best capital structure for a firm is the one that maximizes the value of the firm. This means finding the balance between debt and equity financing that results in the lowest cost of capital while still providing sufficient funds for growth and operations. A high cost of capital can hinder a firm's ability to invest in profitable projects and negatively impact shareholder value, while too much debt can increase financial risk and potentially lead to bankruptcy. Therefore, choosing the optimal capital structure is crucial for long-term success.

Question 6

The interest tax shield has no value for a firm when: 
I.the tax rate is equal to zero.
II.the debt-equity ratio is exactly equal to 1.
III.the firm is unlevered.
IV.a firm elects 100% equity as its capital structure.
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

I is correct as the interest tax shield is based on tax deductions on interest paid, so if the tax rate is zero, there is no value to the tax shield. 
III is correct as an unlevered firm has no debt and thus no tax shield. 
IV is correct as an all-equity firm has no debt and thus no interest expense and no tax shield. 
II is incorrect, as a debt-equity ratio of 1 would indicate equal amounts of debt and equity, which would still result in interest expenses and tax shields.

Question 7

Which of the following statements are correct in relation to MM Proposition II with no taxes?
I.The 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

MM Proposition II with no taxes states that the cost of equity increases as the firm's debt-equity ratio increases, but the overall weighted average cost of capital remains constant. Therefore, statement I is correct. However, financial risk is determined by the firm's overall business risk, not just the debt-equity ratio, so statement II is incorrect. Statement III is also incorrect because financial risk does not determine the return on assets - the firm's operating performance and industry conditions impact the return on assets. Finally, statement IV is incorrect because the cost of equity actually increases as the amount of leverage used by a firm rises, due to the increased financial risk.

Question 8

Bryan invested in Bryco NV shares when the firm was financed solely with equity.The firm is now utilizing debt in its capital structure.To unlever his position,Bryan needs to:
A)borrow some money and purchase additional shares of Bryco.
B)maintain his current position as the debt of the firm did not affect his personal leverage position.
C)sell some shares of Bryco and hold the proceeds in cash.
D)sell some shares of Bryco and loan it out such that he creates a personal debt-equity ratio equal to that of the firm.
E)create a personal debt-equity ratio that is equal to exactly 50% of the debt-equity ratio of the firm.

Accepted Answer

The answer of Bryan invested in Bryco NV shares when...

Question 9

Uptown Interior Designs is an all equity firm that has 40,000 shares outstanding.The company has decided to borrow €1 million to buy out the shares of a deceased equityholder who holds 2,500 shares.What is the total value of this firm if you ignore taxes?
A)€15.5 million
B)€15.6 million
C)€16.0 million
D)€16.8 million
E)€17.2 million

Accepted Answer

Total equity of the firm = 40,000 shares
Value of 1 equity share = Total Equity/Number of shares = 40,000 shares
Value of 40,000 shares = Total Equity = 40,000 * Value of 1 equity share
Let the value of 1 equity share be x
Thus, Total Equity = 40,000 * x
Now, the firm borrows €1 million to buy out 2,500 shares from a deceased shareholder. So the firm's equity share capital will decrease by €1 million while its assets will remain unchanged.
Thus, New Total Equity = Total Equity - Borrowed Amount
                      = 40,000 * x - €1 million
                      = €1.6 million - €1 million (x = €0.015)
Now, to calculate the value of the firm:
Value of the firm = Total Equity + Borrowed Amount
                         = New Total Equity + Borrowed Amount
                         = €1.6 million + €1 million
                         = €2.6 million
Therefore, the total value of this firm is €16 million (€2.6 million/0.015). 
Hence, the best choice is C.

Question 10

MM Proposition II is the proposition that:
A)supports the argument that the capital structure of a firm is irrelevant to the value of the firm.
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 capital is a positive linear function of the firm's capital structure.
D)the cost of equity is equivalent to the required return on the total assets of a firm.
E)supports the argument that the size of the pie does not depend on how the pie is sliced.

Accepted Answer

The answer of MM Proposition II is the proposition that:
A)supports...

Question 11

Thompson & Thomson is an all equity firm that has 500,000 shares outstanding.The company is in the process of borrowing €8 million at 9% interest to repurchase 200,000 shares of the outstanding equity.What is the value of this firm if you ignore taxes?
A)€20.0 million
B)€20.8 million
C)€21.0 million
D)€21.2 million
E)€21.3 million

Accepted Answer

In a no-tax scenario, the value of the firm remains unchanged by the capital structure. Therefore, the value of the firm is the same as the initial market value of equity, which is €20 million (500,000 shares x €40 per share).

Question 12

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 payments on their debt from their taxable income, reducing the net cost of debt to the firm. This means that the cost of debt is generally lower than the cost of equity, making it an attractive option for firms to finance their operations.

Question 13

MM Proposition I with taxes supports the theory that:
A)there is a positive linear relationship between the amount of debt in a levered firm and its value.
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 weighted average cost of capital increases as the debt-equity ratio of the firm rises.

Accepted Answer

The answer of MM Proposition I with taxes supports the...

Question 14

The change in firm value in the presence of corporate taxes only is:
A)positive as equityholders face a lower effective tax rate.
B)positive as equityholders gain the tax shield on the debt interest.
C)negative because of the increased risk of default and fewer shares outstanding.
D)negative because of a reduction of equity outstanding.
E)None of the above.

Accepted Answer

The change in firm value in the presence of corporate taxes is positive because equityholders gain the tax shield on the debt interest. This means that the interest payments on debt are tax-deductible, reducing the overall tax burden of the firm and increasing its value.

Question 15

MM Proposition II with taxes:
A)has the same general implications as MM Proposition II without taxes.
B)reveals how the interest tax shield relates to the value of a firm.
C)supports the argument that business risk is determined by the capital structure employed by a firm.
D)supports the argument that the cost of equity decreases as the debt-equity ratio increases.
E)reaches the final conclusion that the capital structure decision is irrelevant to the value of a firm.

Accepted Answer

MM Proposition II with taxes states that the cost of equity is equal to the cost of debt plus a premium for business risk (which is determined by the nature of the firm's operations) and a premium for financial risk (which is determined by the amount of debt used by the firm). This has the same general implications as MM Proposition II without taxes, which states that the cost of equity increases with the amount of financial risk (i.e. debt) assumed by a firm, and that the overall value of a firm is independent of its capital structure. Therefore, choice A is the best answer.

Question 16

MM 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 the firm does not matter because investors can use homemade leverage.
C)the firm is better off with debt based on the weighted average cost of capital.
D)the value of the firm increases as total 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

MM Proposition I with taxes states that the value of the firm increases as total debt increases because of the interest tax shield. This means that the optimal capital structure is one that includes some level of debt financing.

Question 17

The proposition that the value of a levered firm is equal to the value of an unlevered firm is known as:
A)MM Proposition I with no tax.
B)MM Proposition II with no tax.
C)MM Proposition I with tax.
D)MM Proposition II with tax.
E)static theory proposition.

Accepted Answer

The answer of The proposition that the value of a...

Question 18

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

Accepted Answer

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

Question 19

MM 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)it is completely irrelevant how a firm arranges its finances.
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)financial risk is determined by the debt-equity ratio.

Accepted Answer

MM Proposition I, also known as the capital structure irrelevance principle, states that a firm's value is determined by its earnings potential and the risk of its underlying assets, and is independent of the way it finances investments or distributes dividends. Therefore, it argues that a firm's capital structure has no impact on its overall value, assuming no taxes or other imperfections in the market. Thus, choice C is the correct answer as it reflects the key idea of this proposition.

Question 20

Which of the following will tend to diminish the benefit of the interest tax shield given a progressive tax rate structure?
I.a reduction in tax rates
II.a large tax loss carryforward
III.a large depreciation tax deduction
IV.a sizeable increase in taxable income
A)I and II only.
B)I and III only.
C)II and III only.
D)I,II,and III only.
E)I,II,III,and IV.

Accepted Answer

I. A reduction in tax rates will reduce the benefit of the interest tax shield by decreasing the tax savings generated by deducting interest expenses. 
II. A large tax loss carryforward will not affect the benefit of the interest tax shield since it is a carryforward of past losses and does not impact the current year's taxable income. 
III. A large depreciation tax deduction will increase the benefit of the interest tax shield by reducing taxable income and therefore increasing the tax savings generated by deducting interest expenses. 
IV. A sizeable increase in taxable income will diminish the benefit of the interest tax shield by increasing the amount of taxes owed, reducing the tax savings generated by deducting interest expenses. Therefore, choices I, II, and III do not diminish the benefit of the interest tax shield, while choice IV does. Thus, the best choice is D, I, II, and III only.

Quiz 15: Capital Structure: Basic Concepts

The capital structure chosen by a firm doesn't really matter because of:

In a world of no corporate taxes if the use of leverage does not change the value of the levered firm relative to the unlevered firm this is known as:

The reason that MM Proposition I does not hold in the presence of corporate taxation is because:

MM Proposition I with corporate taxes states that:

A firm should select the capital structure which:

The interest tax shield has no value for a firm when: I.the tax rate is equal to zero. II.the debt-equity ratio is exactly equal to 1. III.the firm is unlevered. IV.a firm elects 100% equity as its capital structure.

Bryan invested in Bryco NV shares when the firm was financed solely with equity.The firm is now utilizing debt in its capital structure.To unlever his position,Bryan needs to:

Uptown Interior Designs is an all equity firm that has 40,000 shares outstanding.The company has decided to borrow €1 million to buy out the shares of a deceased equityholder who holds 2,500 shares.What is the total value of this firm if you ignore taxes?

MM Proposition II is the proposition that:

Thompson & Thomson is an all equity firm that has 500,000 shares outstanding.The company is in the process of borrowing €8 million at 9% interest to repurchase 200,000 shares of the outstanding equity.What is the value of this firm if you ignore taxes?

The interest tax shield is a key reason why:

MM Proposition I with taxes supports the theory that:

The change in firm value in the presence of corporate taxes only is:

MM Proposition II with taxes:

MM Proposition I with taxes is based on the concept that:

The proposition that the value of a levered firm is equal to the value of an unlevered firm is known as:

The concept of homemade leverage is most associated with:

MM Proposition I with no tax supports the argument that:

Which of the following will tend to diminish the benefit of the interest tax shield given a progressive tax rate structure? I.a reduction in tax rates II.a large tax loss carryforward III.a large depreciation tax deduction IV.a sizeable increase in taxable income