Question 1

The Miller model begins with the MM model with taxes and then adds personal taxes.

Accepted Answer

The Miller model is an extension of the MM model with taxes and it adds personal taxes to the model.

Question 2

Firm L has debt with a market value of $200,000 and a yield of 9%. The firm's equity has a market value of $300,000, its earnings are growing at a rate of 5%, and its tax rate is 40%. A similar firm with no debt has a cost of equity of 12%. Under the MM extension with growth, what is Firm L's cost of equity?
A) 11.4%
B) 12.0%
C) 12.6%
D) 13.3%
E) 14.0%

Accepted Answer

E

Question 3

The MM model is the same as the Miller model, but with zero corporate taxes.

Accepted Answer

The MM model refers to the Modigliani-Miller theorem on capital structure, which initially assumes no taxes, costs of financial distress, or agency costs, while the Miller model extends the MM framework by incorporating corporate taxes to show the impact on capital structure decisions.

Question 4

When a firm has risky debt, its debt can be viewed as an option on the total value of the firm with an exercise price equal to the face value of the equity.

Accepted Answer

When a firm has risky debt, its debt can be viewed as an option on the total value of the firm with an exercise price equal to the face value of the debt, not the equity. Equity can be viewed as a call option on the firm's assets, with the exercise price being the face value of the debt.

Question 5

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

A firm's beta coefficient represents its market (or systematic) risk, and financial leverage refers to the use of debt to finance operations. When a firm has increased financial leverage, it will have higher interest payments and a greater financial risk, which leads to an increase in the firm's beta coefficient and, thus, its market (or systematic) risk.

Question 6

In a world with no taxes, MM show that a firm's capital structure does not affect the firm's value. However, when taxes are considered, MM show a positive relationship between debt and value, i.e., its value rises as its debt is increased.

Accepted Answer

This is known as the Modigliani-Miller theorem on capital structure with taxes, which states that the value of a firm increases with leverage due to the tax shield provided by deductibility of interest payments. Without taxes, the value of a firm is not affected by its capital structure.

Question 7

Which of the following statements concerning the MM extension with growth is NOT CORRECT?
A) The tax shields should be discounted at the cost of debt.
B) The value of a growing tax shield is greater than the value of a constant tax shield.
C) For a given D/S, the levered cost of equity is greater than the levered cost of equity under MM's original (with tax) assumptions.
D) For a given D/S, the WACC is greater than the WACC under MM's original (with tax) assumptions.
E) The total value of the firm increases with the amount of debt.

Accepted Answer

The answer of Which of the following statements concerning the...

Question 8

The Miller model begins with the MM model without corporate taxes and then adds personal taxes.

Accepted Answer

The Miller model integrates both corporate and personal taxes into the Modigliani-Miller framework, which originally considered cases without taxes and then with corporate taxes only.

Question 9

The MM model with corporate taxes is the same as the Miller model, but with zero personal taxes.

Accepted Answer

The answer of The MM model with corporate taxes is...

Question 10

MM showed that in a world with taxes, a firm's optimal capital structure would be almost 100% debt.

Accepted Answer

According to Modigliani and Miller's proposition with taxes, the interest payments on debt are tax-deductible, which can reduce a firm's tax liability. This creates a tax shield that makes debt financing more attractive, suggesting that in a world with taxes, a firm's optimal capital structure would lean heavily towards debt to maximize this benefit.

Question 11

Which of the following statements concerning the MM extension with growth is NOT CORRECT?
A) The tax shields should be discounted at the unlevered cost of equity.
B) The value of a growing tax shield is greater than the value of a constant tax shield.
C) For a given D/S, the levered cost of equity is greater than the levered cost of equity under MM's original (with tax) assumptions.
D) For a given D/S, the WACC is less than the WACC under MM's original (with tax) assumptions.

Accepted Answer

In the MM extension with growth, the WACC is actually greater than the WACC under MM's original (with tax) assumptions due to the growth factor.

Question 12

In the MM extension with growth, the appropriate discount rate for the tax shield is the after-tax cost of debt.

Accepted Answer

The answer of In the MM extension with growth, the...

Question 13

In the MM extension with growth, the appropriate discount rate for the tax shield is the unlevered cost of equity.

Accepted Answer

According to the MM extension with growth, the appropriate discount rate for the tax shield is the unlevered cost of equity. This is because the tax shield is a function of the amount of debt taken on by the company, not the company's own cost of capital. Therefore, the discount rate used should reflect the risk of the company's assets, which is reflected in the unlevered cost of equity.

Question 14

The major contribution of the Miller model is that it demonstrates that
A) personal taxes increase the value of using corporate debt.
B) personal taxes decrease the value of using corporate debt.
C) financial distress and agency costs reduce the value of using corporate debt.
D) equity costs increase with financial leverage.
E) debt costs increase with financial leverage.

Accepted Answer

The Miller model demonstrates that personal taxes decrease the value of using corporate debt. The model takes into account the tax deductibility of interest payments on debt and the fact that these interest payments are taxed at the personal level. It shows that the tax shield benefit of debt is offset by the personal tax costs of debt, resulting in a net decrease in the value of debt financing.

Question 15

In the MM extension with growth, the appropriate discount rate for the tax shield is the WACC.

Accepted Answer

In the Modigliani-Miller (MM) extension with growth, the appropriate discount rate for the tax shield is typically the cost of debt, not the weighted average cost of capital (WACC). This is because the tax shield arises directly from the interest payments on debt, making the cost of debt the more relevant discount rate.

Question 16

MM showed that in a world without taxes, a firm's value is not affected by its capital structure.

Accepted Answer

MM's irrelevance theorem shows that a firm's value is not affected by its capital structure in a world without taxes. However, when taxes are introduced, the optimal capital structure of a firm changes and its value is affected.

Question 17

When a firm has risky debt, its equity can be viewed as an option on the total value of the firm with an exercise price equal to the face value of the debt.

Accepted Answer

This statement is true. When a firm has risky debt, the value of the equity is affected by the risk of default on the debt. The equity holders have an option-like payoff structure with an exercise price that is equal to the face value of the debt. If the value of the firm exceeds the face value of the debt, the equity holders benefit from the excess value, whereas if the value of the firm is less than the face value of the debt, the equity holders get nothing.

Question 18

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

Accepted Answer

According to Modigliani and Miller's proposition I without taxes, the capital structure of a firm does not affect its overall value; hence, there is no optimal capital structure that would suggest 100% debt financing.

Question 19

Which of the following statements concerning the MM extension with growth is NOT CORRECT?
A) The tax shields should be discounted at the unlevered cost of equity.
B) The value of a growing tax shield is greater than the value of a constant tax shield.
C) For a given D/S, the levered cost of equity is greater than the levered cost of equity under MM's original (with tax) assumptions.
D) For a given D/S, the WACC is greater than the WACC under MM's original (with tax) assumptions.
E) The total value of the firm is independent of the amount of debt it uses.

Accepted Answer

The answer of Which of the following statements concerning the...

Question 20

Which of the following statements concerning capital structure theory is NOT CORRECT?
A) The major contribution of Miller's theory is that it demonstrates that personal taxes decrease the value of using corporate debt.
B) Under MM with zero taxes, financial leverage has no effect on a firm's value.
C) Under MM with corporate taxes, the value of a levered firm exceeds the value of the unlevered firm by the product of the tax rate times the market value dollar amount of debt.
D) Under MM with corporate taxes, rs increases with leverage, and this increase exactly offsets the tax benefits of debt financing.

Accepted Answer

The statement "Under MM with corporate taxes, rs increases with leverage, and this increase exactly offsets the tax benefits of debt financing" is not correct. In fact, under MM theory, rs (the cost of equity) is assumed to be constant, while the cost of debt is assumed to increase as financial leverage increases. The tax benefits of debt financing therefore exceed the increase in the cost of debt, leading to an overall decrease in the weighted average cost of capital (WACC) and an increase in firm value.

Quiz 26: Analysis of Capital Structure Theory

The Miller model begins with the MM model with taxes and then adds personal taxes.

The MM model is the same as the Miller model, but with zero corporate taxes.

When a firm has risky debt, its debt can be viewed as an option on the total value of the firm with an exercise price equal to the face value of the equity.

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

In a world with no taxes, MM show that a firm's capital structure does not affect the firm's value. However, when taxes are considered, MM show a positive relationship between debt and value, i.e., its value rises as its debt is increased.

Which of the following statements concerning the MM extension with growth is NOT CORRECT?

The Miller model begins with the MM model without corporate taxes and then adds personal taxes.

The MM model with corporate taxes is the same as the Miller model, but with zero personal taxes.

MM showed that in a world with taxes, a firm's optimal capital structure would be almost 100% debt.

Which of the following statements concerning the MM extension with growth is NOT CORRECT?

In the MM extension with growth, the appropriate discount rate for the tax shield is the after-tax cost of debt.

In the MM extension with growth, the appropriate discount rate for the tax shield is the unlevered cost of equity.

The major contribution of the Miller model is that it demonstrates that

In the MM extension with growth, the appropriate discount rate for the tax shield is the WACC.

MM showed that in a world without taxes, a firm's value is not affected by its capital structure.

When a firm has risky debt, its equity can be viewed as an option on the total value of the firm with an exercise price equal to the face value of the debt.

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

Which of the following statements concerning the MM extension with growth is NOT CORRECT?

Which of the following statements concerning capital structure theory is NOT CORRECT?