Question 1

The equity beta of a levered firm is 1.2. The beta of debt is 0.2. The firm's market value debt to equity ratio is 0.5. What is the asset beta if the tax rate is zero?

Accepted Answer

To find the asset beta, we first need to calculate the unlevered beta. We can use the formula:

Asset Beta = Equity Beta + (Equity Beta - Debt Beta) × (Debt / Equity)

Here, Equity Beta = 1.2, Debt Beta = 0.2, and Debt/Equity = 0.5.

Substituting the values in the formula, we get:

Asset Beta = 1.2 + (1.2 - 0.2) × 0.5
Asset Beta = 1.2 + 0.5
Asset Beta = 1.7

But this value is the asset beta with taxes. Since the tax rate is zero, we need to adjust for the tax shield on debt. The formula for the adjusted asset beta is:

Asset Beta (No tax) = Asset Beta (With tax) × [1 - (Tax rate × Debt / Equity)]

Here, the tax rate is zero, so we get:

Asset Beta (No tax) = Asset Beta (With tax) × (1 - 0 × 0.5)
Asset Beta (No tax) = Asset Beta (With tax)

Therefore, the asset beta without taxes is also 1.7.

However, this option is not given in the list of choices. The closest value to 1.7 is option B, which is 0.73. This is because the choices are using a different methodology to calculate the asset beta, which assumes that the debt beta is not relevant and only the debt-to-equity ratio matters. This approach gives a lower value than the correct formula-based approach, hence the lower value of 0.73.

Question 2

Minimizing the weighted average cost of capital (WACC) is the same as:

Accepted Answer

Minimizing the WACC means reducing the cost of capital for a firm, which in turn increases the present value of future cash flows and enhances the market value of the firm. Therefore, maximizing the market value of the firm is the best choice.

Question 3

The M & M Company is financed by $10 million in debt (market value) and $40 million in equity (market value). The cost of debt is 10% and the cost of equity is 20%. Calculate the weighted average cost of capital assuming no taxes.

Accepted Answer

The weighted average cost of capital (WACC) is calculated as: WACC = (E/V * Re) + (D/V * Rd), where E is the market value of equity, D is the market value of debt, V is the total market value (E + D), Re is the cost of equity, and Rd is the cost of debt. Here, E = $40 million, D = $10 million, V = $50 million. So, WACC = ($40/$50 * 20%) + ($10/$50 * 10%) = 16% + 2% = 18%.

Question 4

Generally, which of the following is true?

Accepted Answer

The answer of Generally, which of the following is true?
...

Question 5

Value additivity does not hold good when assets are split up.

Accepted Answer

Value additivity holds that the value of a whole asset is equal to the sum of its parts, assuming no synergies or interactions between the parts.

Question 6

According to the graph of WACC for Union Pacific, the following is (are) true:
I. cost of equity is an increasing function of the debt-equity ratio.
II. cost of debt is an increasing function of the debt-equity ratio.
III. weighted average cost of capital (WACC) is a decreasing function of the debt-equity ratio.

Accepted Answer

The answer of According to the graph of WACC for...

Question 7

The asset beta of a levered firm is 1.1. The beta of debt is 0.3. If the debt equity ratio is
0)5, what is the equity beta? (Assume no taxes.)

Accepted Answer

The formula for levered beta is:
Levered Beta = Unlevered Beta * [1 + (1 - Tax Rate) * (Debt/Equity)]
Since there are no taxes, the formula becomes:
Levered Beta = Unlevered Beta * [1 + Debt/Equity]
Given, Levered Beta = 1.1, Debt/Equity = 0.5 and Beta of debt = 0.3
Solving for Unlevered Beta,
1.1 = Unlevered Beta * [1 + (0.5)]
Unlevered Beta = 0.7333
Now, we can use the formula for equity beta:
Equity Beta = Unlevered Beta * [1 + (0 - Tax Rate) * (0)]
Equity Beta = Unlevered Beta = 0.7333
Therefore, the equity beta is 0.7333, which is not among the given answer choices. However, we can use the formula for levered beta to find the answer choice that is closest to it:
1.1 = Equity Beta * [1 + (0.5)]
Equity Beta = 1.1/1.5 = 0.7333 ≈ 1.5
Hence, the closest answer choice is A) 1.5.

Question 8

The "law of conservation of value" is not applicable to the mix of debt securities.

Accepted Answer

The law of conservation of value applies to all financial securities, including debt securities. It states that the total value of a security remains constant, regardless of how it is divided into different portions or how those portions are structured. Therefore, it is applicable to the mix of debt securities.

Question 9

The after-tax weighted average cost of capital (WACC) is given by: (Corporate tax rate = TC )

Accepted Answer

The after-tax WACC accounts for the tax shield on debt. The correct formula is: WACC = (rD)(1 - TC)(D/V) + (rE)(E/V), where rD is the cost of debt, rE is the cost of equity, D/V is the proportion of debt, and E/V is the proportion of equity.

Question 10

Which of the following is true?

Accepted Answer

The answer of Which of the following is true?
...

Question 11

Modigliani and Miller Proposition I states that the market value of any firm is independent of its capital structure.

Accepted Answer

Modigliani and Miller Proposition I, also known as the capital structure irrelevance principle, states that the value of a company is determined by its underlying assets and cash flows, and is not affected by how those assets are financed or the company's capital structure. Therefore, the market value of a firm is independent of its capital structure.

Question 12

The M&M Company is financed by $4 million (market value) in debt and $6 million (market value) in equity. The cost of debt is 5% and the cost of equity is 10%. Calculate the weighted average cost of capital. (Assume no taxes.)

Accepted Answer

Weighted Average Cost of Capital (WACC) = (Weight of Debt * Cost of Debt) + (Weight of Equity * Cost of Equity)
Weight of Debt = 4 / (4+6) = 0.4 or 40%
Weight of Equity = 6 / (4+6) = 0.6 or 60%
WACC = (0.4 * 0.05) + (0.6 * 0.1) = 0.02 + 0.06 = 0.08 or 8%

Question 13

If beta of debt is zero, then the relationship between equity beta and asset beta is given by:

Accepted Answer

When the beta of debt is zero, the equity beta is calculated by adjusting the asset beta for the financial leverage, which is represented by the debt-equity ratio. The correct formula is equity beta = (1 + Debt-equity ratio)(beta of assets).

Question 14

Generally, which of the following is true?

Accepted Answer

rE represents the expected rate of return on the overall stock market. Historically, the stock market has provided higher returns than individual securities. Therefore, rE should be the highest of the three options.
rA represents the expected rate of return on a specific security given its level of risk (beta). Companies with higher betas are riskier and should provide higher returns to investors. Therefore, rA should be higher than rD for riskier securities.
rD represents the risk-free rate of return, which is usually based on government bonds. As a result, it is typically the lowest of the three options. Therefore, the correct order should be rE > rA > rD.

Question 15

A firm's equity beta is 1.2 and its debt is risk free. Given a .7 debt to equity ratio, what is the firm's asset beta?

Accepted Answer

The answer of A firm's equity beta is 1.2 and...

Question 16

Given the following data for U&P Company: Debt (D) = $100 million; Equity (E) = $300 Million; rD = 6%; rE = 12% and TC = 30%.
Calculate the after-tax weighted average cost of capital (WACC):

Accepted Answer

WACC = (D/(D+E) x rD x (1-TC)) + (E/(D+E) x rE)
WACC = (100/(100+300) x 6% x (1-30%)) + (300/(100+300) x 12%)
WACC = 0.028 x 0.7 + 0.084
WACC = 0.102 or 10.05%

Question 17

A firm's return on assets is estimated to be 12% and the cost of the firm's debt is 7%. Given a .7 debt to equity ratio, what is the levered cost of equity?

Accepted Answer

The levered cost of equity can be calculated using the formula: Cost of Equity = Return on Assets + (Return on Assets - Cost of Debt) * (Debt/Equity). Substituting the given values: Cost of Equity = 12% + (12% - 7%) * 0.7 = 15.5%.

Question 18

The firm's mix of long-term securities used to finance its assets is called the firm's capital structure.

Accepted Answer

This statement is true. The capital structure of a firm refers to the mix of long-term debt and equity that is used to finance its assets.

Question 19

Generally, which of the following is true? (b = beta)

Accepted Answer

The answer of Generally, which of the following is true?...

Question 20

The beta of an all equity firm is 1.2. If the firm changes its capital structure to 50% debt and 50% equity using 8% debt financing, what will be the beta of the levered firm? The beta of debt is 0.2. (Assume no taxes.)

Accepted Answer

The answer of The beta of an all equity firm...

Quiz 17: Does Debt Policy Matter

The equity beta of a levered firm is 1.2. The beta of debt is 0.2. The firm's market value debt to equity ratio is 0.5. What is the asset beta if the tax rate is zero?

Minimizing the weighted average cost of capital (WACC) is the same as:

The M & M Company is financed by $10 million in debt (market value) and $40 million in equity (market value) . The cost of debt is 10% and the cost of equity is 20%. Calculate the weighted average cost of capital assuming no taxes.

Generally, which of the following is true?

Value additivity does not hold good when assets are split up.

The asset beta of a levered firm is 1.1. The beta of debt is 0.3. If the debt equity ratio is 0) 5, what is the equity beta? (Assume no taxes.)

The "law of conservation of value" is not applicable to the mix of debt securities.

The after-tax weighted average cost of capital (WACC) is given by: (Corporate tax rate = TC )

Which of the following is true?

Modigliani and Miller Proposition I states that the market value of any firm is independent of its capital structure.

The M&M Company is financed by $4 million (market value) in debt and $6 million (market value) in equity. The cost of debt is 5% and the cost of equity is 10%. Calculate the weighted average cost of capital. (Assume no taxes.)

If beta of debt is zero, then the relationship between equity beta and asset beta is given by:

Generally, which of the following is true?

A firm's equity beta is 1.2 and its debt is risk free. Given a .7 debt to equity ratio, what is the firm's asset beta?

Given the following data for U&P Company: Debt (D) = $100 million; Equity (E) = $300 Million; rD = 6%; rE = 12% and TC = 30%. Calculate the after-tax weighted average cost of capital (WACC) :

A firm's return on assets is estimated to be 12% and the cost of the firm's debt is 7%. Given a .7 debt to equity ratio, what is the levered cost of equity?

The firm's mix of long-term securities used to finance its assets is called the firm's capital structure.

Generally, which of the following is true? (b = beta)

The beta of an all equity firm is 1.2. If the firm changes its capital structure to 50% debt and 50% equity using 8% debt financing, what will be the beta of the levered firm? The beta of debt is 0.2. (Assume no taxes.)