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Corporate Finance Chapter 17
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Terms in this set (46)
According to Modigliani and Miller Proposition II, the firm's expected return on assets depends on several factors including the firm's capital structure. T or F
FALSE
According to Modigliani and Miller Proposition II, since the expected rate of return on debt is less than the expected rate of return on equity, the weighted average cost of capital declines as more debt is issued. T or F
FALSE
Financial leverage increases the expected return and risk of the shareholder. T or F
TRUE
Modigliani and Miller's Proposition I states that the market value of any firm is independent of its capital structure. T or F
TRUE
Modigliani and Miller Proposition II states that the rate of return required by shareholders increases steadily as the firm's debt-equity ratio increases. T or F
TRUE
The firm's asset beta is usually higher than the firm's equity beta. T or F
FALSE
The principle of value additivity holds for the aggregation of assets but does not apply to the division of assets. T or F
FALSE
According to the graph of WACC for Union Pacific, which of the following is (are) true?
I) The cost of equity is an increasing function of the debt-equity ratio.
II) The cost of debt is an increasing function of the debt-equity ratio.
III) The weighted average cost of capital (WACC) is a decreasing function of the debt-equity ratio.
I, II, III
A firm's equity beta is 1.2 and its debt is risk free. Given a 0.7 debt to equity ratio, what is the firm's asset beta? (Assume no taxes.)
0.7
An EPS-operating income graph, for different debt ratios, shows the:
I) greater risk associated with debt financing, which is evidenced by a greater slope;
II) the break-even point where EPS of two different debt ratios are equal;
III) the minimum earnings needed to pay the debt financing for a given level of debt
I, II, III
An investor can create the effect of leverage on his/her account by:
I) buying equity of an unlevered firm;
II) investing in risk-free debt like T-bills;
III) borrowing on his/her own account
I & III
A policy of maximizing the value of the firm is the same as a policy of minimizing the weighted average cost of capital providing that:
I) the firm's investment policy is settled;
II) there are no taxes;
III) an issue of new debt does not affect the market value of existing debt
I, II, III
For a levered firm:
as EBIT increases, EPS increases by a larger percentage.
If a firm is financed with both debt and equity, the firm's equity is known as:
levered equity.
If an investor buys a portion (X) of an unlevered firm's equity, then his/her payoff is:
(X) x (profits)
If an investor buys a portion (X) of the equity of a levered firm, then his/her payoff is:
(X) x (profits - interest)
If the debt beta is zero, then the relationship between the equity beta and the asset beta is given by:
Equity beta = (1 + debt-equity ratio)(beta of assets)
The capital structure of the firm can be defined as:
I) the firm's mix of different debt securities;
II) the firm's mix of different securities used to finance assets;
III) the market imperfection that the firm's managers can exploit
II only
The cost of capital for a firm, rWACC, in a tax-free environment is:
I) equal to the market value weighted average of the return on equity and the return on debt;
II) equal to rA, the rate of return for that business risk class;
III) equal to the overall rate of return required on the levered firm
I, II, and III
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?
0.87
Value additivity works for:
I) combining assets; II) splitting up of assets; III) the mix of debt securities issued by the firm
I, II, III
When comparing levered vs. unlevered capital structures, leverage works to increase EPS for high levels of operating income because interest payments on the debt:
stay fixed, leaving more income to be distributed over fewer shares.
For a levered firm where bA = beta of assets and bD = beta of debt, the return on equity (rE) is equal to
rE = rA + (D/E) × [rA - rB]
Generally, which of the following is true?
rE > rA > rD
According to Modigliani and Miller Proposition II, the rate of return required by debtholders linearly increases as the firm's debt-equity ratio increases. T or F
FALSE
According to Modigliani and Miller Proposition II, the cost of equity increases as more debt is issued, but the weighted average cost of capital remains unchanged. T or F
TRUE
A firm's asset beta equals the weighted average of the betas on its debt and equity, given the assumption of no taxes. T or F
TRUE
Investors require higher returns on levered equity than on equivalent unlevered equity. T or F
TRUE
MM's Proposition is violated when the firm, by imaginative design of its capital structure, can offer some financial service that meets the unmet needs of such a clientele. T or F
TRUE
The firm's mix of securities used to finance its assets is called the firm's capital structure. T or F
TRUE
Capital structure is irrelevant if:
I) capital markets are efficient;
II) each investor can borrow/lend on the same terms as the firm;
III) there are no tax benefits to debt.
I, II, and III
For an all-equity firm,
as earnings before interest and taxes (EBIT) increases, the earnings per share (EPS) increases by the same percentage.
If an individual wants to borrow with limited liability, he/she should:
invest in the equity of a levered firm.
Minimizing the weighted average cost of capital (WACC) is the same as maximizing the:
market value of the firm.
MM Proposition II states that:
I) the expected return on equity is positively related to leverage;
II) the required return on equity is a linear function of the firm's debt to equity ratio;
III) the risk to equity increases with leverage
I, II, III
Modigliani and Miller's Proposition I states that:
the market value of any firm is independent of its capital structure
The firm's debt beta is usually approximately 1.0. T or F
FALSE
The law of conservation of value implies that:
the value of any asset is preserved regardless of the nature of the claims against it.
Under what conditions would a policy of maximizing the value of the firm not be the same as a policy of maximizing shareholders' wealth?
If an issue of debt affects the market value of existing debt
When a firm has no debt, then such a firm is known as:
I) an unlevered firm; II) a levered firm; III) an all-equity firm
I & III
For a levered firm where bA = beta of assets and bD = beta of debt, the equity beta (bE) equals:
bE = bA + (D/E) x [bA - bD]
Generally, which of the following is true? (b = beta)
bD < bA < bE
If an investor buys a portion (X) of both the debt and equity of a levered firm, then his/her payoff is:
(X) x (profits)
If firm U is unlevered and firm L is levered, then which of the following is true:
I) VU = EU.
II) VL = EL + DL.
III) VL = EU + DL.
I and II only
Which of the following is true?
bE > bA > bD
Learn and Earn Company is financed entirely by common stock that is priced to offer a 20% expected rate of return. The stock price is $60 and the earnings per share are $12. The company wishes to repurchase 50% of the stock and substitutes an equal value of debt yielding 8%. Suppose that before refinancing, an investor owned 100 shares of Learn and Earn common stock. What should he do if he wishes to ensure that risk and expected return on his investment are unaffected by this refinancing?
The refinancing results in a D/E ratio of 1.0. The new expected return on the stock increases from 20% to 32%. With 50 shares (worth $3,000) and $3,000 of 8% debt, the expected return remains at 0.5 x 32% + 0.5 x 8% = 20%.
The correct answer is: Sell 50 shares and purchase $3,000 of 8% debt (bonds).
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