Question 1

MM Proposition I with corporate taxes states that:

Accepted Answer

MM Proposition I with corporate taxes states that by raising the debt-to-equity ratio, the firm can lower its taxes and thereby increase its total value.

Question 2

MM Proposition II is the proposition that:

Accepted Answer

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

Question 3

Bryan invested in Bryco,Inc. 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

The answer of Bryan invested in Bryco,Inc. stock when the...

Question 4

The capital structure chosen by a firm doesn't really matter because of:

Accepted Answer

Homemade leverage implies that investors can create their own leverage by borrowing or lending on their own, making the firm's capital structure irrelevant under certain conditions, as per the Modigliani-Miller theorem.

Question 5

MM Proposition I with no tax supports the argument that:

Accepted Answer

MM Proposition I states that, under certain assumptions (such as no taxes and perfect markets), the value of a firm is independent of its capital structure. In other words, it does not matter how a firm finances its operations - whether through equity or debt - the total value of the firm remains the same. Therefore, choice C is the correct answer as it states that it is completely irrelevant how a firm arranges its finances. Options A, B, D, and E are all related to factors that affect a firm's financing decisions, but MM Proposition I argues that financing decisions do not impact the value of the firm in a perfect market with no taxes.

Question 6

Uptown Interior Designs is an all equity firm that has 40,000 shares of stock outstanding. The company has decided to borrow $1 million to buy out the shares of a deceased stockholder who holds 2,500 shares. What is the total value of this firm if you ignore taxes?

Accepted Answer

The total value of the firm can be calculated as follows:

Total Value = Total Equity + Total Debt

Total Equity = Number of Shares Outstanding * Price per Share

Since all shares are equity, we can find the price per share by dividing the total equity by the number of shares outstanding:

Price per Share = Total Equity / Number of Shares Outstanding

Total Equity = Price per Share * Number of Shares Outstanding
Total Equity = $15.6 million ($390 per share)

Total Debt is given as $1 million.

Therefore, Total Value = $15.6 million + $1 million = $16.6 million

Note that we must subtract the value of the 2,500 shares being repurchased by the company. The repurchase price is not given, so we cannot remove this value from the total value calculation. However, we know that this value must be less than or equal to the $1 million borrowed, so the total value must be greater than or equal to $15.6 million. Therefore, the correct answer choice is C.

Question 7

In a world of no corporate taxes if the use of leverage does not change the value of the levered firm relative to the unlevered firm is known as:

Accepted Answer

This scenario describes MM Proposition I, which states that the value of the firm is determined by its cash flows and the risk of its assets, and is independent of its capital structure. In a world with no corporate taxes, the cost of capital is also independent of the capital structure. Therefore, the market value of the firm is invariant to the use of leverage.

Question 8

You own 25% of Unique Vacations,Inc. You have decided to retire and want to sell your shares in this closely held,all equity firm. The other shareholders have agreed to have the firm borrow $1.5 million to purchase your 1,000 shares of stock. What is the total value of this firm today if you ignore taxes?

Accepted Answer

The firm is borrowing $1.5 million to buy 25% of the shares, implying the total value of the firm is $1.5 million / 0.25 = $6.0 million.

Question 9

Which of the following statements are correct in relation to MM Proposition II with no taxes?
I. The required return on assets is equal to the weighted average cost of capital.
II. Financial risk is determined by the debt-equity ratio.
III. Financial risk determines the return on assets.
IV. The cost of equity declines when the amount of leverage used by a firm rises.

Accepted Answer

Statement I is correct as per MM Proposition II with no taxes. 
Statement II is also correct as per the same proposition, as financial risk is determined by the debt-equity ratio. 
Statements III and IV are incorrect, as financial risk does not determine the return on assets and the cost of equity does not decline when the amount of leverage used by a firm rises in MM Proposition II with no taxes.

Question 10

Thompson & Thomson is an all equity firm that has 500,000 shares of stock outstanding. The company is in the process of borrowing $8 million at 9% interest to repurchase 200,000 shares of the outstanding stock. What is the value of this firm if you ignore taxes?

Accepted Answer

The value of the firm is the sum of the value of the debt and the value of the equity. The value of the debt is $8 million. The value of the equity is the number of shares outstanding multiplied by the price per share. The price per share is the value of the firm divided by the number of shares outstanding. So, the value of the firm is:Value of the firm = Value of the debt + Value of the equityValue of the firm = $8 million + (500,000 shares * Price per share)Value of the firm = $8 million + (500,000 shares * Value of the firm / 500,000 shares)Value of the firm = $8 million + Value of the firmValue of the firm = $16 millionThe value of the firm is $16 million.

Question 11

The change in firm value in the presence of corporate taxes only is:

Accepted Answer

Corporate taxes provide a tax shield on the debt interest, which benefits equityholders by increasing the firm's value.

Question 12

Which of the following will tend to diminish the benefit of the interest tax shield given a progressive tax rate structure?
I. A reduction in tax rates
II. A large tax loss carryforward
III. A large depreciation tax deduction
IV. A sizeable increase in taxable income

Accepted Answer

I. A reduction in tax rates: If tax rates are reduced, the benefit of the interest tax shield will also reduce.
II. A large tax loss carryforward: A large tax loss carryforward reduces the company's taxable income, which reduces the benefit of the interest tax shield.
III. A large depreciation tax deduction: A large depreciation tax deduction reduces the taxable income and, therefore, reduces the benefit of the interest tax shield.
IV. A sizeable increase in taxable income: A sizeable increase in taxable income increases the company's tax liability, making the interest tax shield more valuable. However, this option does not diminish the benefit of the interest tax shield, but instead enhances it. Therefore, option IV is incorrect. 
Therefore, options I, II, and III are the correct answers, as they diminish the benefit of the interest tax shield.

Question 13

The interest tax shield is a key reason why:

Accepted Answer

The interest tax shield allows a company to deduct the interest expenses on their debt payments from their taxable income, reducing their overall tax liability. This reduces the net cost of debt to a firm, making it generally less expensive than equity financing. Therefore, C is the correct choice. A, B, D, and E are not correct because they do not accurately reflect the relationship between the interest tax shield and the cost of debt/equity financing.

Question 14

MM Proposition II with taxes:

Accepted Answer

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

Question 15

The proposition that the value of a levered firm is equal to the value of an unlevered firm is known as:

Accepted Answer

MM Proposition I with no tax states that the value of a levered firm is equal to the value of an unlevered firm, assuming no taxes and no bankruptcy costs.

Question 16

The concept of homemade leverage is most associated with:

Accepted Answer

The answer of The concept of homemade leverage is most...

Question 17

A firm should select the capital structure which:

Accepted Answer

The primary objective of a firm is to maximize the value of the firm for its shareholders. Therefore, the capital structure should be chosen in a way that maximizes the value of the firm. This can be achieved by balancing the use of debt and equity in such a way that the cost of capital is minimized while maintaining an optimal level of risk for the firm. Choosing a capital structure that produces the highest cost of capital (A) or has no debt (E) may result in a too conservative approach, while choosing a fully unlevered structure (D) may not be optimal for maximizing value. Additionally, minimizing taxes (C) should be considered, but it should not be the primary driver of the capital structure decision.

Question 18

The interest tax shield has no value for a firm when:
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 100% equity as its capital structure.

Accepted Answer

I is correct as the interest tax shield is based on tax deductions on interest paid, so if the tax rate is zero, there is no value to the tax shield. 
III is correct as an unlevered firm has no debt and thus no tax shield. 
IV is correct as an all-equity firm has no debt and thus no interest expense and no tax shield. 
II is incorrect, as a debt-equity ratio of 1 would indicate equal amounts of debt and equity, which would still result in interest expenses and tax shields.

Question 19

MM Proposition I with taxes supports the theory that:

Accepted Answer

MM Proposition I with taxes states that the value of a levered firm increases with the amount of debt due to the tax shield on interest payments, creating a positive linear relationship between debt and firm value.

Question 20

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

Accepted Answer

MM Proposition I with taxes suggests that the value of the firm increases as the total debt increases due to the interest tax shield. This is because interest on debt is tax-deductible, reducing the tax burden and increasing the firm's cash flow. Therefore, a higher debt level is beneficial for the firm's value.

Quiz 16: Capital Structure: Basic Concepts