Corporate Finance Unit 2

If an investor buys a portion (X) of an unlevered firm's equity, then his/her payoff is:

(X) * Profits

If an investor buys a portion (X) of both the debt and equity of a levered firm, then his/her payoff is:

(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)

An investor can create the effect of leverage on his/her account by

Buying equity of an unlevered firm & Borrowing on his/her own account

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.

FALSE

According to Modigliani and Miller Proposition II, the firm's expected return on assets depends on several factors including the firm's capital structure.

FALSE

According to Modigliani and Miller Proposition II, the rate of return required by debtholders linearly increases as the firm's debt-equity ratio increases.

FALSE

The firm's asset beta is usually higher than the firm's equity beta.

FALSE

The firm's debt beta is usually approximately 1.0.

FALSE

The law of conservation of value does not apply to the mix of a firm's debt securities.

FALSE

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 & II

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

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

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

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

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,III

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

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,III

The law of conservation of value implies that: I) the mix of common stock and preferred stock does not affect the value of the firm; II) the mix of long-term and short-term debt does not affect the value of the firm; III) the mix of secured and unsecured debt does not affect the value of the firm

I,II,III

The capital structure of the firm can be defined as:

II) the firm's mix of different securities used to finance assets;

If a firm is financed with both debt and equity, the firm's equity is known as:

Levered Equity

Minimizing the weighted average cost of capital (WACC) is the same as maximizing the:

MKT Value

A firm's asset beta equals the weighted average of the betas on its debt and equity, given the assumption of no taxes.

TRUE

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.

TRUE

Financial leverage increases the expected return and risk of the shareholder.

TRUE

Investors require higher returns on levered equity than on equivalent unlevered equity.

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.

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.

TRUE

Modigliani and Miller's Proposition I states that the market value of any firm is independent of its capital structure.

TRUE

The firm's mix of securities used to finance its assets is called the firm's capital structure.

TRUE

The total market value (V) of the securities of a firm that has both debt (D) and equity (E) is:

V = D + E

The after-tax weighted average cost of capital (WACC) is given by (corporate tax rate = TC):

WACC = (rD)(1 - TC)(D/V) + (rE)(E/V)

Modigliani and Miller's Proposition I states that:

a. the market value of any firm is independent of its capital structure

For a levered firm:

as EBIT increases, EPS increases by a larger percentage.

For an all-equity firm,

as earnings before interest and taxes (EBIT) increases, the earnings per share (EPS) increases by the same percentage.

Generally, which of the following is true? (b = beta)

bD < bA < bE

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]

Which of the following is true?

bE > bA > bD

If an individual wants to borrow with limited liability, he/she should:

c. invest in the equity of a levered firm.

Under what conditions would a policy of maximizing the value of the firm not be the same as a policy of maximizing shareholders' wealth?

d. If an issue of debt affects the market value of existing debt

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

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.

The law of conservation of value implies that:

the value of any asset is preserved regardless of the nature of the claims against it.