Question 1

The proposition that the value of a levered firm is equal to the value of an unlevered firm is known as:
A)MM Proposition I with no tax.
B)MM Proposition II with no tax.
C)MM Proposition I with tax.
D)MM Proposition II with tax.
E)both MM I with and without tax.

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 there are no taxes, bankruptcy costs, or asymmetric information.

Question 2

MM Proposition I with no tax supports the argument that:
A)business risk determines the return on assets.
B)the cost of equity rises as leverage rises.
C)it is completely irrelevant how a firm arranges its finances.
D)a firm should borrow money to the point where the tax benefit from debt is equal to the cost of the increased probability of financial distress.
E)financial risk is determined by the debt-equity ratio.

Accepted Answer

MM Proposition I with no tax states that the value of a firm is independent of its capital structure. Therefore, it suggests that a firm's financial arrangements are completely irrelevant.

Question 3

A firm should always select the capital structure which:
A)produces the highest cost of capital.
B)maximizes the value of the firm.
C)minimizes taxes.
D)maximizes current dividends.
E)has no debt.

Accepted Answer

The ultimate goal of a firm's capital structure decision should be to maximize the value of the firm for its shareholders. This means selecting a mix of debt and equity that minimizes the cost of capital (and thus, the firm's overall financing costs) while also optimizing the firm's ability to generate profits and cash flows. While minimizing taxes and maximizing current dividends may be important considerations in the short term, they should not take priority over the long-term goal of maximizing shareholder value. Furthermore, having no debt may not be the optimal strategy, as debt can provide tax shields and other benefits to the firm.

Question 4

The unlevered cost of capital is:
A)the cost of capital for a firm with no equity in its capital structure.
B)the cost of capital for a firm with no debt in its capital structure.
C)the interest tax shield times pretax net income.
D)the cost of preferred stock for an all-equity firm.
E)equal to the profit margin for a firm with some debt in its capital structure.

Accepted Answer

The unlevered cost of capital is the cost of capital for a firm with no debt in its capital structure. It is the required return for a project or investment assuming that the project is financed entirely with equity.

Question 5

The concept of homemade leverage is most associated with:
A)MM Proposition I with no tax.
B)MM Proposition II with no tax.
C)MM Proposition I with tax.
D)MM Proposition II with tax.
E)no MM Proposition.

Accepted Answer

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

Question 6

According to MM Proposition II with no taxes,the:
A)return on assets is determined by financial risk.
B)required return on equity is a linear function of the firm's debt-equity ratio.
C)cost of equity in inversely related to the firm's debt-equity ratio.
D)cost of debt must equal the cost of equity.
E)required return on assets exceeds the weighted average cost of capital.

Accepted Answer

MM Proposition II states that the required return on equity is a linear function of the firm's debt-equity ratio. This means that as the firm takes on more debt, the required return on equity will increase in a linear fashion. However, this proposition assumes that there are no taxes, which is not a realistic assumption in the real world.

Question 7

When comparing levered versus unlevered capital structures,leverage works to increase EPS for high levels of EBIT because interest payments on the debt:
A)vary with EBIT levels.
B)stay fixed,leaving less income to be distributed over fewer shares.
C)stay fixed,leaving more income to be distributed over fewer shares.
D)stay fixed,leaving less income to be distributed over more shares.
E)stay fixed,leaving more income to be distributed over more shares.

Accepted Answer

Interest payments on debt remain fixed regardless of EBIT levels, so as EBIT increases, more income is available to be distributed over the fewer shares outstanding, which leads to an increase in EPS.

Question 8

MM Proposition I without taxes proposes that:
A)the value of an unlevered firm exceeds that of a levered firm.
B)there is one ideal capital structure for each firm.
C)leverage does not affect the value of the firm.
D)shareholder wealth is directly affected by the capital structure selected.
E)the value of a levered firm exceeds that of an unlevered firm.

Accepted Answer

MM Proposition I without taxes states that the capital structure of a firm does not affect its overall value. Therefore, leverage does not have an impact on the value of the firm.

Question 9

A key underlying assumption of MM Proposition I without taxes is that:
A)financial leverage increases risk.
B)individuals can borrow at lower rates than corporations.
C)individuals and corporations borrow at the same rate.
D)managers always act to maximize the value of the firm.
E)corporations are all-equity financed.

Accepted Answer

MM Proposition I without taxes assumes that individuals and corporations can borrow at the same rate, making the cost of capital independent of the capital structure. This assumption forms the basis for the proposition that the value of the firm is determined by its cash flows and the risk of its assets, and is not affected by how those assets are financed. Financial leverage, or the use of debt financing, does not increase risk according to this proposition.

Question 10

The effects of financial leverage depend on the operating earnings of the company.Based on this relationship,assume you graph the EPS and EBI for a firm,while ignoring taxes.Which one of these statements correctly states a relationship illustrated by the graph?
A)Financial leverage decreases the slope of the EPS line.
B)Below the break-even point unlevered structures have a lower EPS for every dollar of EBI than levered structures do.
C)Above the break-even point the increase in EPS for unlevered structures is greater than that of levered structures for every dollar increase in EBI.
D)Leverage only provides value above the break-even point.
E)Above the break-even point,the unlevered structure is preferred.

Accepted Answer

Leverage increases EPS above the break-even point, providing value as it amplifies earnings.

Question 11

The firm's capital structure refers to the:
A)mix of current and fixed assets a firm holds.
B)amount of capital invested in the firm.
C)amount of dividends a firm pays.
D)mix of debt and equity used to finance the firm's assets.
E)amount of cash versus receivables the firm holds.

Accepted Answer

The term "capital structure" refers to the mix of debt and equity used to finance a firm's assets. It involves determining what proportion of the firm's assets will be financed by debt (borrowed funds) and what proportion will be financed by equity (owner's funds). The specific mix of debt and equity that a firm chooses will affect its cost of capital, risk level, and overall financial structure. Choices A, B, C, and E do not accurately reflect the concept of capital structure.

Question 12

A manager should attempt to maximize the value of the firm by changing the capital structure if and only if the value of the firm increases:
A)as a result of the change.
B)to the sole benefit of the managers.
C)to the sole benefit of the debtholders.
D)while also decreasing shareholder value.
E)while holding stockholder value constant.

Accepted Answer

The primary objective of a manager is to maximize shareholder value. Changing the capital structure by issuing more debt or equity can affect the value of the firm. Therefore, a manager should only attempt to change the capital structure if it increases the value of the firm. This is in the interest of the shareholders who will benefit from the increase in value. Choices (B) and (C) are incorrect because the manager should not attempt to change the capital structure for the sole benefit of any one group but should aim to maximize the overall value of the firm. Choice (D) is incorrect because the manager should not attempt to decrease shareholder value. Choice (E) is also incorrect because a manager should attempt to increase shareholder value, not hold it constant.

Question 13

A levered firm is a company that has:
A)accounts payable as its only liability.
B)some debt in its capital structure.
C)an all-equity capital structure.
D)a tax loss carry forward.
E)taxable income.

Accepted Answer

A levered firm has debt in its capital structure, which means it has borrowed money and has an obligation to pay it back. This is different from an all-equity firm which has no debt and therefore no interest payments or principal repayments to make. The presence of debt means the firm has leverage, which amplifies both the potential gains and losses for shareholders.

Question 14

In an EPS-EBI graphical relationship,the slope of the debt ray is steeper than the equity ray.The debt ray has a lower intercept because:
A)more shares are outstanding for the same level of EBI.
B)the break-even point is higher with debt.
C)a fixed interest charge must be paid even at low earnings.
D)the amount of interest per share has only a positive effect on the intercept.
E)the break-even point is lower with debt.

Accepted Answer

The lower intercept of the debt ray is due to the fact that a fixed interest charge must be paid even at low earnings. This means that the company must generate sufficient earnings to cover the interest payments before any earnings are available for equity holders. In contrast, equity holders only receive earnings after all other expenses, including interest payments, have been paid. Therefore, the debt ray has a higher break-even point, which results in a lower intercept compared to the equity ray.

Question 15

In the absence of taxes,the capital structure chosen by a firm doesn't really matter because of:
A)taxes.
B)the interest tax shield.
C)the relationship between dividends and earnings per share.
D)the effects of leverage on the cost of equity.
E)homemade leverage.

Accepted Answer

In the absence of taxes, the capital structure chosen by a firm doesn't really matter because investors can create their own leverage by borrowing on their own, a concept known as homemade leverage. This means that the firm's decision on leverage does not affect the overall cost of capital or the value of the firm, aligning with the Modigliani-Miller theorem under no-tax conditions.

Question 16

The use of personal borrowing to change the overall amount of financial leverage to which an individual is exposed is called:
A)homemade leverage.
B)dividend recapture.
C)the weighted average cost of capital.
D)private debt placement.
E)personal offset.

Accepted Answer

The use of personal borrowing to change the overall amount of financial leverage to which an individual is exposed is called homemade leverage. It involves using personal debt to increase or decrease the amount of leverage an individual has, beyond what is provided by their investments or assets.

Question 17

The proposition that the value of the firm is independent of its capital structure is called:
A)the capital asset pricing model.
B)MM Proposition I (no taxes).
C)MM Proposition II (no taxes).
D)the law of one price.
E)the efficient markets hypothesis.

Accepted Answer

MM Proposition I (no taxes) states that the value of the firm is independent of its capital structure, assuming perfect markets and no taxes.

Question 18

Bryan invested in Bryco stock when the firm was financed solely with equity.The firm now has a debt-equity ratio of .3.To maintain the same level of leverage he originally had,Bryan needs to:
A)borrow some money and purchase additional shares of Bryco stock.
B)maintain his current position in Bryco stock.
C)sell some shares of Bryco stock and hold the proceeds in cash.
D)sell some shares of Bryco stock and loan out the proceeds.
E)sell half of his Bryco stock and invest the proceeds in risk-free securities.

Accepted Answer

Bryan originally invested when the firm was all equity, meaning he had no leverage. To maintain the same leverage level after the firm takes on debt, he should sell some shares and loan out the proceeds, effectively reducing his equity exposure and mimicking the firm's new debt-equity ratio.

Question 19

A general rule for managers to follow is to set the firm's capital structure such that the firm's:
A)size is maximized.
B)value is maximized.
C)bondholders are secured.
D)suppliers of raw materials are satisfied.
E)dividend payout is maximized.

Accepted Answer

The main goal of capital structure decisions is to maximize the value of the firm, which is achieved by balancing the cost of debt and equity financing while minimizing the overall risk. Maximizing firm size, securing bondholders, satisfying suppliers, or maximizing dividend payout may be important secondary objectives, but they are not the primary goal of capital structure decisions.

Question 20

The increase in risk to shareholders when financial leverage is introduced is best evidenced by:
A)higher EPS as EBIT increases.
B)a higher variability of EPS with debt than with all-equity financing.
C)increased use of homemade leverage.
D)the increase in taxes.
E)decreasing earnings as EBIT increases.

Accepted Answer

Financial leverage, or the use of debt to finance the firm's operations or growth, increases the variability of earnings per share (EPS) due to the fixed interest payments on the debt. When operating profits (EBIT) are high, earnings per share are leveraged upwards, but when operating profits are low, EPS can be negative, leading to increased risk for shareholders. Option A is not true because higher EPS as EBIT increases is a general pattern that holds for both levered and unlevered firms. Option C is not relevant to the increase in risk for shareholders but refers to the notion that individuals can adjust their personal leverage to match their risk preferences. Option D is incorrect because taxes do not directly relate to the introduction of financial leverage. Option E is incorrect, as it implies a negative relationship between EBIT and earnings, which is not necessarily true.

Quiz 16: Capital Structure: Basic Concepts

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

MM Proposition I with no tax supports the argument that:

A firm should always select the capital structure which:

The unlevered cost of capital is:

The concept of homemade leverage is most associated with:

According to MM Proposition II with no taxes,the:

When comparing levered versus unlevered capital structures,leverage works to increase EPS for high levels of EBIT because interest payments on the debt:

MM Proposition I without taxes proposes that:

A key underlying assumption of MM Proposition I without taxes is that:

The effects of financial leverage depend on the operating earnings of the company.Based on this relationship,assume you graph the EPS and EBI for a firm,while ignoring taxes.Which one of these statements correctly states a relationship illustrated by the graph?

The firm's capital structure refers to the:

A manager should attempt to maximize the value of the firm by changing the capital structure if and only if the value of the firm increases:

A levered firm is a company that has:

In an EPS-EBI graphical relationship,the slope of the debt ray is steeper than the equity ray.The debt ray has a lower intercept because:

In the absence of taxes,the capital structure chosen by a firm doesn't really matter because of:

The use of personal borrowing to change the overall amount of financial leverage to which an individual is exposed is called:

The proposition that the value of the firm is independent of its capital structure is called:

Bryan invested in Bryco stock when the firm was financed solely with equity.The firm now has a debt-equity ratio of .3.To maintain the same level of leverage he originally had,Bryan needs to:

A general rule for managers to follow is to set the firm's capital structure such that the firm's:

The increase in risk to shareholders when financial leverage is introduced is best evidenced by: