Question 1

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 is the extent to which a firm uses debt financing relative to equity financing. By increasing the use of debt financing, a firm's fixed interest payments increase, which can magnify the effect of fluctuations in earnings on the return received by equity holders. This increased sensitivity to changes in earnings results in higher market (or systematic) risk and a higher beta coefficient.

Question 2

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 refers to the degree to which a firm's fixed costs affect its profitability. Financial leverage, on the other hand, refers to the degree to which a firm's debt affects its profitability. Both operating leverage and financial leverage affect a firm's EPS and EBIT.

Question 3

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

Accepted Answer

Modigliani and Miller were awarded the Nobel Memorial Prize in Economic Sciences in 1985 for their contributions to the theory of corporate finance, including capital structure theory.

Question 4

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 5

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 assess the risk of bankruptcy for each borrower and charge higher rates to those deemed to have a higher likelihood of defaulting on their loan, in order to mitigate their own potential losses.

Question 6

Financial risk refers to the extra risk stockholders bear 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 the additional risk that shareholders face due to a company's use of debt financing. When a company uses debt to finance its operations, it has a greater financial risk than if it had used only equity financing. Debt usually comes with fixed interest payments that the company must make regardless of how well it is performing. This means that if a company experiences financial difficulties and cannot make its debt payments, it can face bankruptcy. This creates additional risk for the shareholders who have invested in the company, as their value could be significantly reduced or even erased.

Question 7

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 8

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) only consider the operating cash flows of the firm, which are not affected by the capital structure. The capital structure affects the financing cash flows and the overall value of the firm, but not the FCF.

Question 9

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 10

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 measure a firm's financial structure and cost structure, respectively, which can be identical for two firms. However, business risk, which refers to the uncertainty and variability of a firm's earnings due to external factors such as economic conditions, can differ between firms. Therefore, if Firm A has more business risk than Firm B, its EPS would be more variable, even if financial and operating leverage are the same for both firms.

Question 11

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 12

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 of capital structure argues that companies must balance the advantages of obtaining financing through debt, such as the tax savings from interest payments, against the potential costs of financial distress, such as the risk of bankruptcy.

Question 13

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 a variety of factors, such as competition, technological changes, regulatory environment, and management quality. While debt usage can impact the firm's financial risk, it is not the sole determinant of business risk.

Question 14

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, Modigliani and Miller (MM) argued that the use of debt has no effect on the firm's value. Their proposition, known as the irrelevance proposition, relies on the assumption of perfect capital markets, where all investors have access to the same information and can borrow and lend at the same rate as the firm. In such a world, the cost of capital is unaffected by the capital structure, and the value of the firm is determined solely by its operating income.

Question 15

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

Accepted Answer

Financial leverage refers to a company's use of borrowed funds to increase its return on equity. When a firm borrows money, it is using financial leverage.

Question 16

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 17

Modigliani and Miller's first article led to the conclusion that capital structure is extremely important, and that efirm has an optimal capital structure that maximizes its value and minimizes its cost of capital.

Accepted Answer

Modigliani and Miller's first article concluded that, under certain assumptions, the capital structure is irrelevant to a firm's value and does not affect its cost of capital.

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, published in 1958, argued that under certain conditions, capital structure is irrelevant and has no impact on a firm's value. This conclusion was based on the assumption of perfect capital markets, where there are no taxes or bankruptcy costs, and all investors have the same information and access to capital on the same terms. However, subsequent research has challenged this notion and shown that capital structure decisions can have real-world implications for firm value.

Question 19

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...

Question 20

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

Modigliani and Miller (MM) argued that in a world without taxes, the capital structure of a firm is irrelevant and does not affect its overall value. Therefore, there is no optimal capital structure in a world without taxes. However, if we assume that there are bankruptcy costs associated with debt financing, the optimal capital structure would include some equity financing to reduce the probability of bankruptcy. This means that the optimal capital structure is not 100% debt financing in a world without taxes.

Quiz 14: Capital Structure and Leverage