Question 1

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

Accepted Answer

MM Proposition I with tax 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 involves some level of debt, and the firm can increase its value by maximizing its debt level while still being able to meet its debt obligations.

Question 2

The interest tax shield has no value for a firm when the:
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 an all-equity capital structure.

Accepted Answer

The interest tax shield has no value when the tax rate is zero (I), the firm is unlevered (III), or when a firm chooses an all-equity capital structure (IV), as there is no interest expense to shield from taxes.

Question 3

Which one of these best supports the argument that leverage increases shareholder risk?

Accepted Answer

EPS variability increases when leverage is used. When a firm uses debt to finance its operations, it creates fixed interest obligations that must be met regardless of the company's financial performance. As a result, the variability of earnings per share (EPS) increases. This increased volatility in EPS translates into increased risk for shareholders, making C the best option to support the argument that leverage increases shareholder risk.

Question 4

The MM propositions would suggest that firms should prefer which one of these debt-to-equity ratios?

Accepted Answer

The answer of The MM propositions would suggest that firms...

Question 5

The fact that interest payments on debt are tax deductible is a key factor in which of these propositions?

Accepted Answer

The answer of The fact that interest payments on debt...

Question 6

What does the present value of the tax shield from debt formula assume?

Accepted Answer

The present value of the tax shield from debt formula assumes that the debt is perpetual, meaning it has no maturity date and will not be paid off or replaced. This allows for a constant tax shield from interest payments. The formula also assumes a constant interest rate on the debt and tax rate.

Question 7

Why does MM Proposition I not hold in the presence of corporate taxation?

Accepted Answer

Corporate taxes provide a tax shield on interest payments, making debt financing more attractive and reducing the overall tax burden for a levered firm compared to an unlevered firm.

Question 8

The interest tax shield is a key reason why:

Accepted Answer

The interest tax shield reduces the net cost of debt to a firm by allowing the firm to deduct interest payments from its taxable income, resulting in a lower tax bill. As a result, firms can usually borrow funds at a lower cost than the cost of equity, which does not offer a similar tax shield. This makes B the correct choice. Choices A and D are incorrect because the interest tax shield is a benefit of leveraged financing and would increase the value of the firm relative to an unlevered firm. Choice C is incorrect because firms may choose to borrow more when the tax shield is particularly valuable. Choice E is incorrect because firms prefer debt financing over equity financing when the interest tax shield and the lower cost of capital are greater than the costs of servicing the debt.

Question 9

MM Proposition I with no tax supports the argument that:

Accepted Answer

MM Proposition I with no tax argues that the value of a firm is determined by its real assets and the cash flows they generate, and not by how the firm finances those assets. Therefore, the way a firm arranges its finances is completely irrelevant.

Question 10

Financial leverage impacts the performance of a firm by:

Accepted Answer

Financial leverage increases the fixed financing costs of a firm (interest payments). This means that when the firm's EBIT increases, the amount of interest paid remains constant, causing net income to increase by a greater percentage. However, when EBIT decreases, the amount of interest paid still remains constant, causing net income to decrease by a greater percentage. This leads to increased volatility in the firm's net income.

Question 11

Which of these statements apply MM Proposition II without taxes?
I.The expected return on equity is positively related to leverage.
II.The value of a firm cannot be changed by changing its capital structure.
III.Risk to equity holders increases with leverage.
IV.The expected return on equity is affected by the firm's debt-to-equity ratio.

Accepted Answer

MM Proposition II without taxes states that the expected return on equity is positively related to leverage (I), risk to equity holders increases with leverage (III), and the expected return on equity is affected by the firm's debt-to-equity ratio (IV). Proposition II does not state that the firm's value is unaffected by capital structure, which is part of Proposition I.

Question 12

Which one of these events might cause the biggest challenge to the MM propositions?

Accepted Answer

The answer of Which one of these events might cause...

Question 13

Which of these proposes that the value of a levered firm exceeds the value of an unlevered firm by the present value of the tax shield?

Accepted Answer

MM Proposition I with tax states that the value of a levered firm exceeds the value of an unlevered firm by the present value of the tax shield, which is equivalent to choice B. Proposition II focuses on the effect of debt on a firm's cost of equity and does not directly address the value of a levered versus unlevered firm. Proposition I without tax and Proposition II without tax also do not address the tax shield.

Question 14

Bryan invested in Bryco stock 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:

Accepted Answer

To unlever his position, Bryan should sell some shares of Bryco stock and loan out the proceeds. This action offsets the firm's increased leverage by reducing his exposure to the firm's equity risk.

Question 15

MM Proposition II is the proposition that:

Accepted Answer

MM Proposition II states that a firm's cost of equity increases linearly with its debt-equity ratio, reflecting the increased risk to equity holders as leverage increases.

Question 16

MM Proposition I with tax supports the theory that:

Accepted Answer

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

Question 17

MM Proposition II with tax:

Accepted Answer

The answer of MM Proposition II with tax:
...

Question 18

Which of these will appear on a market value balance sheet?
I.Original cost of fixed assets less any depreciation to date
II.Issue value of bonds
III.Current sales value of a firm's plant and equipment
IV.Current market value of the outstanding shares of stock

Accepted Answer

Only III and IV will appear on a market value balance sheet since it focuses on the current market value of an asset or liability rather than their original cost or issue value. Therefore, options I and II are incorrect as they focus on the original cost or issue value rather than current market value.

Question 19

A firm should select the capital structure which:

Accepted Answer

The primary goal of a firm should be to maximize the value of the firm, and the capital structure plays a critical role in this process. A firm should choose the capital structure that maximizes the value of the firm, taking into account various factors such as cost of capital, risk, and tax considerations. This may involve using debt financing to take advantage of tax shields or finding a balance between debt and equity to minimize the cost of capital. Ultimately, the choice of capital structure depends on the unique characteristics and goals of the firm.

Question 20

Consider the pie models of corporate structure.What is the difference between the all-equity pie and the levered pie for a firm in the presence of taxes?

Accepted Answer

The answer of Consider the pie models of corporate structure.What...

Quiz 14: Capital Structure: Basic Concepts