Question 1

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, market demand, technological advancements, and regulatory changes. While the amount of debt used by firms in the industry may affect their financial risk, it is not the sole determiner of business risk.

Question 2

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 and operating leverage determine a firm's financial risk, but business risk is independent of these factors. Business risk is the variability in a firm's earnings due to factors such as demand, competition, and technological change. Therefore, even if two firms have the same financial and operating leverage, if one has greater business risk, its EPS will be more variable, making it riskier.

Question 3

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 holds that a firm's capital structure decisions involve a tradeoff between the costs and benefits of debt financing. Specifically, the benefits of debt financing include the tax advantages of interest payments and the ability to leverage earnings, while the costs include bankruptcy costs and agency costs associated with conflicts of interest between shareholders and debt holders. A firm seeking to optimize its capital structure will seek to balance these costs and benefits to achieve the optimal mix of debt and equity financing.

Question 4

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 is true because lenders need to protect themselves from the risk of losing their investment if the borrower goes bankrupt. As such, they charge higher interest rates to borrowers with higher perceived risk of bankruptcy to compensate for that risk.

Question 5

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 capital structure theory, specifically for their proposition that a firm's value is independent of its capital structure.

Question 6

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 risk...

Question 7

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 8

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

The answer of In a world with no taxes,Modigliani and...

Question 9

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

The answer of According to Modigliani and Miller (MM),in a...

Question 10

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 a...

Question 11

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

This is stated in the text. Free cash flows only reflect operating cash flows, which are separate from a firm's capital structure.

Question 12

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, while financial leverage primarily affects EPS but also can have an impact on EBIT.

Question 13

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 the use of debt financing to increase a firm's return on equity. However, it also increases the firm's interest payments and therefore its financial risk. This higher financial risk, in turn, increases the firm's market (or systematic) risk, as measured by its beta coefficient. Therefore, an increase in financial leverage will lead to an increase in a firm's market risk.

Question 14

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 15

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

Accepted Answer

Financial leverage refers to the use of borrowed funds (debt) to finance a firm's investments with the aim of increasing the potential return on investment.

Question 16

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

According to Modigliani and Miller's Proposition I, in a world without corporate income taxes, the use of debt does not affect the overall value of the firm because the cost of equity increases proportionately with the amount of debt used, resulting in a constant weighted average cost of capital (WACC) and no change in the firm's value.

Question 17

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 18

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 19

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 in 1958, "The Cost of Capital, Corporation Finance and the Theory of Investment", argued that under certain assumptions, including perfect capital markets and no taxes, a firm's value is determined solely by its ability to generate earnings and investments, and therefore capital structure (the mix of debt and equity financing) is irrelevant in determining a firm's value. Nevertheless, their subsequent articles recognized the potential impacts of taxes, bankruptcy costs, and agency costs on capital structure decisions in the real world.

Question 20

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

This is a correct statement as the use of debt increases the financial leverage of a firm, which can lead to higher returns for stockholders during good times, but can also result in higher losses during bad times. Therefore, stockholders bear extra risk when a firm uses debt.

Quiz 14: Capital Structure and Leverage

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.

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.

The trade-off theory states that capital structure decisions involve a tradeoff between the costs and benefits of debt financing.

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.

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

As the text indicates,a firm's financial risk can and should be divided into separate market and diversifiable risk components.

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.

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.

According to Modigliani and Miller (MM),in a world without taxes the optimal capital structure for a firm is approximately 100% debt financing.

According to Modigliani and Miller (MM),in a world with corporate income taxes the optimal capital structure calls for approximately 100% debt financing.

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.

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.

Other things held constant,an increase in financial leverage will increase a firm's market (or systematic)risk as measured by its beta coefficient.

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.

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

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.

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.

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.

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.