Question 1

The interest tax shield has no value for a firm when the debt-equity ratio is exactly equal to 1.

Accepted Answer

The value of the interest tax shield is derived from the tax deductibility of interest payments, not directly from the debt-equity ratio. A firm with a debt-equity ratio of 1 can still benefit from the interest tax shield if it has taxable income against which the interest can be deducted.

Question 2

A sizeable increase in taxable income will tend to diminish the benefit of the interest tax shield.

Accepted Answer

The interest tax shield refers to the tax savings achieved by deducting interest payments, reducing taxable income. A sizeable increase in taxable income actually increases the absolute dollar benefit of the interest tax shield, as there is more income against which the interest can be deducted, potentially reducing the overall tax rate applied to higher income levels.

Question 3

Interest tax shield applies to levered firms but not to unlevered firms.

Accepted Answer

Interest tax shield refers to the tax savings achieved by a firm through the deductibility of interest expenses on its debt, which only applies to firms that have debt (levered firms) and not to those without debt (unlevered firms).

Question 4

The maximum value of a firm is at the point where the additional gain from leverage is just offset by the additional financial distress cost.

Accepted Answer

This statement reflects the trade-off theory of capital structure, which posits that firms balance the benefits of debt (such as tax shields) against the costs of potential financial distress, aiming to maximize firm value at an optimal level of leverage.

Question 5

When taxes are factored in, debt financing creates positive value in the form of an interest tax shield.

Accepted Answer

Debt financing allows companies to deduct interest payments on their debt from their taxable income, which reduces the amount of tax they have to pay. This reduction in taxes is known as the interest tax shield, creating positive value for the company.

Question 6

When taxes are factored in, debt financing lowers a firm's weighted average cost of capital.

Accepted Answer

Debt financing can lower a firm's weighted average cost of capital (WACC) because interest payments on debt are tax-deductible, effectively reducing the cost of debt after taxes and thus lowering the overall WACC.

Question 7

If the static theory of capital structure is true, then the optimal level of debt for a given firm increases as its marginal tax rate increases and decreases as the costs of financial distress increase.

Accepted Answer

The static theory of capital structure suggests that firms balance the tax benefits of debt financing against the costs of financial distress. As the marginal tax rate increases, the tax shield from debt becomes more valuable, making higher levels of debt more attractive. Conversely, as the costs of financial distress increase, the drawbacks of debt become more significant, making lower levels of debt optimal.

Question 8

According to the static theory of capital structure, value-maximizing financial managers will borrow to the point where the firm's business risk is just equal to its financial risk.

Accepted Answer

According to the static theory of capital structure, value-maximizing financial managers will borrow up to the point where the tax shield benefits from additional debt are exactly offset by the costs of financial distress. This optimal point does not necessarily equate the firm's business risk with its financial risk.

Question 9

The interest tax shield has no value for a firm when the firm is unlevered.

Accepted Answer

The interest tax shield refers to the tax savings a company achieves due to the tax-deductibility of interest expenses. If a firm is unlevered, meaning it has no debt, there are no interest expenses to deduct, and therefore, no interest tax shield value.

Question 10

A large tax loss carry forward will tend to diminish the benefit of the interest tax shield.

Accepted Answer

A large tax loss carry forward can reduce taxable income, which in turn reduces the benefit of the interest tax shield since the shield is only valuable when there is taxable income to offset.

Question 11

When taxes are factored in, debt financing increases the value of a firm.

Accepted Answer

Due to the tax deductibility of interest payments, debt financing can lower a firm's tax liability, effectively increasing the firm's value by reducing its overall cost of capital.

Question 12

When taxes are factored in, debt financing lowers a firm's cost of equity.

Accepted Answer

Debt financing can increase a firm's cost of equity because it introduces financial risk, which equity holders require to be compensated for with a higher return.

Question 13

The interest tax shield has no value for a firm when a firm elects 100% equity as its capital structure.

Accepted Answer

The interest tax shield refers to the tax savings a company achieves due to the tax-deductibility of interest expenses. If a firm uses 100% equity financing, it has no debt and therefore no interest expenses to deduct, rendering the interest tax shield valueless.

Question 14

A reduction in tax rates will tend to diminish the benefit of the interest tax shield.

Accepted Answer

A reduction in tax rates decreases the value of the interest tax shield because the shield is directly proportional to the tax rate; lower tax rates mean less tax savings from deducting interest expenses.

Question 15

As financial risk increases so too does the cost of equity.

Accepted Answer

As financial risk increases, investors demand a higher return for the increased risk they are taking on, which leads to an increase in the cost of equity.

Question 16

The interest tax shield has no value for a firm when the tax rate is equal to zero.

Accepted Answer

When the tax rate is equal to zero, there are no taxes to save through the deduction of interest expenses, rendering the interest tax shield valueless.

Question 17

The optimal capital structure is the mixture of debt and equity which maximizes the market price of the firm's bonds.

Accepted Answer

The optimal capital structure is the mixture of debt and equity that maximizes the firm's overall value, not specifically the market price of its bonds.

Question 18

A large depreciation tax deduction will tend to diminish the benefit of the interest tax shield.

Accepted Answer

A large depreciation tax deduction will reduce the taxable income, which in turn will reduce the amount of interest expense that can be deducted from taxes. This will diminish the benefit of the interest tax shield.

Question 19

Financial risk applies to levered firms but not to unlevered firms.

Accepted Answer

Financial risk arises from the use of debt financing, which is only relevant for levered firms.

Question 20

According to M&M Proposition II without taxes, a firm's cost of equity is a function of the required rate of return on the firm's assets, the firm's debt/equity ratio, and the firm's cost of debt.

Accepted Answer

M&M Proposition II without taxes states that a firm's cost of equity capital is a linear function of the firm's debt/equity ratio, reflecting the increased risk taken on by equity holders as more debt is used in the firm's capital structure. This cost of equity is also dependent on the firm's overall cost of capital and its cost of debt.

Quiz 16: Financial Leverage and Capital Structure Policy