Question 1

Fuji Inc. is registered as a business in the film-making industry and has a required return on its assets of 12%. It can borrow in the debt market at 6%. If there are no taxes and M&M's proposition II holds, what is the cost of equity if there is 100% equity financing?

Accepted Answer

According to M&M's Proposition II, the cost of equity increases with the use of leverage or debt. Since Fuji Inc. has 100% equity financing, there is no use of debt and hence, the cost of equity is equal to the required return on its assets, which is given as 12%. Therefore, the correct choice is A) 12%.

Question 2

The Modigliani-Miller model of capital structure begins with the simple assumption that the investing decision and financing decision of a firm are inseparable.

Accepted Answer

The Modigliani-Miller model actually begins with the assumption that the investing decision and financing decision of a firm are separate, known as the separation principle. This allows the model to analyze the impact of capital structure on a firm's value independently of its investment decisions.

Question 3

The contribution of M&M comes from the fact that there is a constant trade-off ratio. Which of the statements below describe this constant trade-off ratio?

Accepted Answer

M&M theory assumes that there is a constant trade-off ratio between debt and equity. As a firm increases its debt-to-equity ratio, the cost of equity increases due to increased risk perception by investors. This increase in the cost of equity offsets the benefits of the lower cost of debt, resulting in a constant overall cost of capital. Therefore, choice A is the correct statement that describes the constant trade-off ratio.

Question 4

Which of the formulations below expresses the weighted average cost of capital (WACC) formula?

Accepted Answer

The answer of Which of the formulations below expresses the...

Question 5

Consider the Modigliani and Miller world of corporate taxes. An unleveraged (all-equity) firm value is $100 million. By adding debt, the annual interest expense is $10 million, the corporate tax rate is 40%, and the discount rate on the tax shield is 10%. What is the gain to leverage or the value added from issuing debt?

Accepted Answer

According to the Modigliani-Miller theorem, the value of the leveraged firm is equal to the value of the unleveraged firm plus the present value of the tax shield. Therefore, the value of the leveraged firm is:

Value of leveraged firm = Value of unleveraged firm + PV of tax shield

Value of leveraged firm = $100 million + ($10 million × 0.4 ÷ 0.1)

Value of leveraged firm = $100 million + $40 million

Value of leveraged firm = $140 million

The gain to leverage or the value added from issuing debt is therefore $40 million. Therefore, the correct answer is C.

Question 6

Longmont Inc. is in the property management business and has a required return on its assets of 10%. It can borrow in the debt market at 5%. If there are no taxes and M&M's proposition II holds, what is the cost of equity if there is 10% equity financing and 90% debt financing?

Accepted Answer

The answer of Longmont Inc. is in the property management...

Question 7

Proposition II from M&M says that the cost of equity is a function of which of the items below?

Accepted Answer

Proposition II from M&M states that the cost of equity of a firm is a function of the required return on assets, the cost of debt, and the debt-equity ratio of the firm. Therefore, all of the items mentioned in the options above are factors that affect the cost of equity according to M&M.

Question 8

Modigliani and Miller followed up their initial work with a new model that incorporated a world with corporate taxes. Which of the statements below result from this model?

Accepted Answer

Modigliani and Miller's model with corporate taxes concluded that all debt financing is optimal, with a new Proposition I, and that the WACC of the firm falls as more debt is added, with a new Proposition II. Additionally, the model found that the more debt sold, the greater the tax shield, and the smaller the government's share of the firm.

Question 9

Consider the M&M world of corporate taxes. The interest expense is $10 million, the corporate tax rate is 20%, and the discount rate on the tax shield is 10%. What is the gain to leverage or the value added from issuing debt?

Accepted Answer

The answer of Consider the M&M world of corporate taxes....

Question 10

Transitions Inc. is an import-export company specializing in products from Asia and the West Coast. It can borrow in the debt market at 8%. Its cost of equity with 40% D/V ratio is 12%. Its corporate tax rate is 30%. If the M&M world of taxes holds true, what is the WACC for Transitions Inc. with a 40% D/V financing?

Accepted Answer

The answer of Transitions Inc. is an import-export company specializing...

Question 11

Pain-Free Inc. is a business dealing in pain reduction medication. It has a required return on its assets of 18%. It can borrow in the debt market at 10%. If there are no taxes and M&M's proposition II holds, what is the cost of equity if there is 50% equity financing and 50% debt financing?

Accepted Answer

According to M&M proposition II, the cost of equity (Ke) increases as the amount of debt (D) increases because of the increased risk to equity holders. The formula for the cost of equity with 50% debt financing is Ke = Rf + (Rm-Rf)(beta) + (Rm-Rf)(D/E). Given that the required return on assets (Roa) is 18%, the cost of debt (Kd) is 10%, the beta is not given, and the debt-to-equity ratio is 1:1, we can calculate the cost of equity as follows: Ke = 0.5(18%) + 0.5(18% - 10%)(1) = 26%. Therefore, the correct answer is B.

Question 12

M&M's Proposition II suggests that in a world of no taxes and no bankruptcy, ________.

Accepted Answer

M&M's Proposition II suggests that the value of the firm is independent of its capital structure in a world of no taxes and no bankruptcy. However, the cost of equity increases with increasing debt, thereby offsetting the advantage of cheaper debt. Therefore, choice C is correct as it summarizes the key message of M&M's Proposition II. Choices A and B are incorrect as they suggest that the value of the firm and its cost of capital are affected by the debt-equity ratio, which is not the case in the absence of taxes and bankruptcy. Choice D is incorrect as choice C is correct.

Question 13

Consider the Modigliani and Miller world of corporate taxes. An unlevered (all-equity) firm value is $500 million. By adding debt, the annual interest expense is $100 million, the corporate tax rate is 30%, and the discount rate on the tax shield is 8%. What is the gain to leverage or the value added from issuing debt?

Accepted Answer

The answer of Consider the Modigliani and Miller world of...

Question 14

A simple way of stating the original M&M proposition 1 is that it doesn't matter how you slice the pie--the size of the pie is still the same.

Accepted Answer

The original M&M proposition 1 states that the size of a set (or group) does not change even if its elements are rearranged or partitioned into subsets. This can also be stated as "the whole is equal to the sum of its parts." The phrase "how you slice the pie" in the question refers to partitioning the pie into smaller pieces, which does not affect the total amount of pie. Therefore, the statement is true.

Question 15

The original Modigliani and Miller proposition I states that the value of a firm depends on its capital structure.

Accepted Answer

The original Modigliani and Miller proposition I states that in the absence of taxes and other market imperfections, the value of a firm is independent of its capital structure.

Question 16

M&M Proposition I states that, in a world of no taxes and no bankruptcy, ________.

Accepted Answer

M&M Proposition I, under the assumptions of no taxes and no bankruptcy costs, states that the value of a firm is not affected by its choice of financing. This result is known as the irrelevance proposition. Thus, option D is the correct answer. Option A is incorrect because M&M Proposition I assumes no taxes or bankruptcy costs, so the cost of debt is irrelevant. Option B is incorrect because M&M Proposition I states that in the absence of taxes and bankruptcy costs, the choice of financing has no impact on firm value, so it is not relevant in determining the firm's value in the short-run. Option C is also incorrect because M&M Proposition I states that how a company finances its operations does not affect its value.

Question 17

The Modigliani and Miller original proposition II states that the value of the firm depends on three things: the required rate of return on the firm's assets, the firm's cost of debt, and the firm's debt-to-equity ratio.

Accepted Answer

The Modigliani and Miller original proposition II, also known as the capital structure irrelevance principle, states that the value of the firm is independent of its capital structure, and is only determined by the required rate of return on the firm's assets and the risk of these assets. However, if we assume a constant required rate of return, then the value of the firm may depend on the cost of debt and the debt-to-equity ratio, as stated in proposition II.

Question 18

In the Modigliani & Miller model of capital structure, with no corporate taxes, as a firm increases the D/V ratio, the cost of equity also increases.

Accepted Answer

According to the Modigliani & Miller model of capital structure with no corporate taxes, the cost of equity increases as the firm increases its debt-to-equity (D/V) ratio, because the increased financial risk associated with higher leverage makes equity investors demand a higher rate of return.

Question 19

In regards to the formula  which of the statements below is FALSE?

Accepted Answer

The answer of In regards to the formula  which...

Question 20

Fuji Inc. is registered as a business in the film-making industry. It can borrow in the debt market at 9%. Its cost of equity with 50% debt is 12%. Its corporate tax rate is 30%. If the M&M world of taxes holds, what is the WACC for Fuji with 50% debt financing?

Accepted Answer

The answer of Fuji Inc. is registered as a business...

Quiz 16: Capital Structure