Question 1

The market value of Firm L's debt is $200,000 and its yield is 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 2

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, bankruptcy costs, or other market imperfections. The Miller model extends the MM framework by incorporating personal and corporate taxes to examine their effects on capital structure decisions.

Question 3

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

Accepted Answer

True

Question 4

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

Accepted Answer

According to the Modigliani-Miller (MM) theorem, in a world without taxes, a firm's value is not affected by its capital structure. This means that the value of a firm remains the same regardless of whether it uses debt or equity to finance its activities. This result holds under certain assumptions, such as perfect capital markets and no bankruptcy costs, and is based on the idea that investors can replicate any capital structure they prefer through personal leverage. However, in the presence of taxes or other market imperfections, the MM theorem does not hold and the optimal capital structure of a firm may depend on factors such as the tax rate, the cost of bankruptcy, and the agency costs associated with debt financing.

Question 5

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

Accepted Answer

Modigliani and Miller (MM) proposed that in a world with taxes, debt financing provides a tax shield (since interest payments are tax-deductible) which can make almost 100% debt financing the optimal capital structure for a firm, as it minimizes the cost of capital by maximizing the tax shield benefit.

Question 6

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

Accepted Answer

In the MM extension with growth, the appropriate discount rate for the tax shield is the cost of debt, not the after-tax cost of debt, because the tax shield itself is a function of the interest expense, which is before tax.

Question 7

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 increases a firm's exposure to interest rate risk and can amplify the effect of market fluctuations on a firm's earnings, leading to an increase in systematic risk as reflected by its beta coefficient.

Question 8

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

The statement accurately reflects the findings of MM's theory with and without taxes. Without taxes, the capital structure does not affect the firm's value, but with taxes, the value of the firm generally increases as debt is added due to the tax shield on interest payments.

Question 9

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 that incorporates personal taxes.

Question 10

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

Accepted Answer

The WACC under the MM extension with growth is actually greater than the WACC under MM's original assumptions because the growth rate affects the cost of equity and the tax shield.

Question 11

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

Accepted Answer

The MM extension with growth suggests that the value of the firm is affected by the amount of debt due to the tax shield benefits, contradicting the statement that the firm's value is independent of its debt level.

Question 12

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

Accepted Answer

The answer of The major contribution of the Miller model...

Question 13

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

Accepted Answer

The Miller model extends the Modigliani-Miller theorem by incorporating both corporate and personal taxes, not by starting without corporate taxes and then adding personal taxes. The original MM model assumes no taxes, and then the Miller model considers the effects of both types of taxes on capital structure.

Question 14

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 (MM) theorem, in a world without taxes, transaction costs, or bankruptcy costs, the capital structure of a firm (debt vs. equity financing) does not affect its overall value. This implies there is no optimal capital structure in terms of debt-to-equity ratio.

Question 15

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

Accepted Answer

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

Question 16

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

Accepted Answer

In 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 related to the interest payments on debt, which are tax deductible. Therefore, the tax shield benefits the equity holders who do not have to pay taxes on that portion of the firm's earnings. The unlevered cost of equity represents the return required by equity holders in a company with no debt, and it is used to discount the tax shield as it is a cash flow accruing to equity holders.

Question 17

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 18

Which of the following statements concerning capital structure theory is NOT CORRECT? A) Under MM with zero taxes, financial leverage has no effect on a firm's value. B) 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. C) Under MM with corporate taxes, r_s increases with leverage, and this increase exactly offsets the tax benefits of debt financing. D) Under MM with corporate taxes, the effect of business risk is automatically incorporated because r_sL is a function of r_sU. E) The major contribution of Miller's theory is that it demonstrates that personal taxes decrease the value of using corporate debt.

Accepted Answer

The statement in option C is not correct. Under MM with corporate taxes, r_s decreases with leverage, while the tax benefits of debt financing increase. This means that there is an optimal level of leverage that maximizes the value of the firm.

Question 19

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

Accepted Answer

In the MM extension with growth, the appropriate discount rate for the tax shield is the cost of debt, not the WACC.

Question 20

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 is known as the option analogy of risky debt, where the equity can be seen as a call option on the firm's assets with the strike price being equivalent to the face value of the debt.

Quiz 21: Dynamic Capital Structures

The MM model is the same as the Miller model,but with zero corporate 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 without taxes,a firm's value is not affected by its capital structure.

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

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

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.

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

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

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

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

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

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?

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

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.

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

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

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.