Question 1

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 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 a company's use of borrowed funds to finance its operations. By taking on more debt, a company increases its financial leverage and its interest expense. This can increase the volatility of the company's earnings and cash flows, which in turn increases the risk to equity investors. As a result, the company's beta coefficient will increase, indicating a higher level of systematic risk.

Question 3

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

In a world without corporate income taxes, MM theory states that the value of a firm is solely determined by its ability to generate and distribute earnings to shareholders, regardless of whether the firm uses debt or equity financing. Therefore, the use of debt has no effect on the firm's value.

Question 4

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...

Question 5

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 related to the use of debt in a company's capital structure. The more debt a company has, the higher the financial risk it faces. This is because debt obligations must be met regardless of the company's performance. When a company uses debt, it increases the financial risk for its stockholders as they bear the extra risk due to the firm's use of debt. Therefore, the statement is true.

Question 6

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 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 refers to the relationship between fixed and variable costs, which can impact the break-even point and ultimately the profitability of a company. Financial leverage, on the other hand, refers to the use of debt financing and its impact on the cost of capital and interest expenses, which can affect both EPS and EBIT.

Question 8

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 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

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

Accepted Answer

Financial leverage refers to the concept of a firm using borrowed funds to increase the potential return on equity. By borrowing money, the firm can invest in projects or assets that generate a higher rate of return than the cost of borrowing, thereby amplifying the gains for shareholders. However, financial leverage also increases the risks and potential losses for shareholders if the investments do not generate enough profits to cover the cost of borrowing.

Question 11

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 MM, in a world without taxes, the optimal capital structure for a firm is 100% equity financing, not 100% debt financing.

Question 12

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 consider the risk of bankruptcy when setting interest rates for borrowers. Borrowers with a higher risk of bankruptcy are charged higher rates to compensate for the potential loss of funds if they default on the loan.

Question 13

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.

Question 14

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 are only part of the overall risk of a firm. Business risk, which is the risk that the firm's operations and sales will be affected by external factors such as competition, market demand, and regulatory changes, also plays a role in determining the overall risk of the firm. Therefore, even if two firms have the same financial and operating leverage, the one with greater business risk will have higher variability of EPS and therefore more risk.

Question 15

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

Accepted Answer

Modigliani and Miller won the Nobel Prize in Economics in 1985 for their work on corporate finance, including their theories on capital structure.

Question 16

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 flows (FCF) are the cash flows available after operating expenses, capital expenditures, and taxes have been paid. The firm's capital structure does not affect these cash flows because they are generated from the operations of the company and are available for various purposes, including servicing debt, paying dividends, or investing in the business.

Question 17

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...

Question 18

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 is known for the proposition that, under certain assumptions, the value of a firm is not affected by its capital structure. Therefore, the capital structure is considered "irrelevant." However, their second article introduced the concept of taxes and bankruptcy costs, which showed that in the real world, capital structure can affect a firm's value.

Question 19

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 posits that there is an optimal capital structure consisting of a balance between the benefits and costs of debt financing. The costs of debt financing include interest payments, bankruptcy costs, and agency costs, while the benefits of debt financing include tax benefits and increased financial flexibility. The theory suggests that firms should choose a debt-to-equity ratio that maximizes the benefits of debt financing while minimizing its costs.

Question 20

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 such as competition, government regulations, market demand, and technological changes. While the amount of debt an industry uses can have an impact on the financial risk of individual firms, it is not the sole determinant of business risk.

Quiz 13: Capital Structure and Leverage