CH16 Quick Quiz #1
According to the Static Theory of Capital Structure, the amount of leverage that maximizes the value of the firm is where the marginal benefit from another dollar of debt due to the tax shield is less than that dollar of debt's marginal cost due to expected financial distress and bankruptcy costs.
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All else equal, minimizing WACC has an indeterminate impact on value becasue you need to know the size of the cash flows from assets.
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As the debt-to-equity ratio increases the probability of incurring bankruptcy costs decreases.
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Assume a world with taxes and no bankruptcy. For stylized perpetual cash flows, ValueL = EBIT(1 — t) ÷ rU
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Assume a world with taxes and no bankruptcy. For stylized perpetual cash flows, ValueU = EBIT(1 — t) × rU
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Assume a world with taxes and no bankruptcy. For stylized perpetual cash flows, present value of the interest tax shield = Debt ÷ t
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Case I Proposition I states that the value of the firm is affected by changes in the capital structure.
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Consider the following information about WSB Inc.: Recession Expected Expansion EBIT 900,000 1,300,000 1,600,000 Interest 100,000 100,000 100,000 WSB could incur costs associated with financial distress.
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Consider the following information about WSB Inc.: Recession Expected Expansion EBIT 900,000 1,300,000 1,600,000 Interest 100,000 100,000 100,000 WSB is unlevered.
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In M&M Case III, the optimal capital structure minimizes the tax claims slice of the value pied.
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In a world with no taxes and no bankruptcy, as the firm levers up its value increases by the present value of the annual interest tax shield.
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In a world with no taxes and no bankruptcy, changes in capital structure change no returns.
F
In a world with no taxes and no bankruptcy, the shareholders care if the CFO levers up and the variability of the ROE increases.
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In a world with no taxes and no bankruptcy, the value pie is divided among the stockholders, bondholders, tax claims, and expected bankruptcy costs.
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In a world with taxes and bankruptcy, as the firm levers up its value increases by the present value of the annual interest tax shield.
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In a world with taxes and bankruptcy, changing leverage does not change the cash flows from assets, therefore the riskiness of those cash flows does not change either.
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In a world with taxes and bankruptcy, the denominators in the DCF equation do not change when leverage changes.
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In a world with taxes and no bankruptcy, the value of the levered firm equals the value of the unlevered firm plus the annual interest tax shield.
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In part, Case II Proposition II states that a firm's cost of equity is not affected by changes in the capital structure.
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Levering up changes both the right and left hand sides of the balance sheet.
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M&M Case I and III assumptions are same except when it comes to taxes.
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Shareholder and bondholder values are non-traded claims.
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The compensation for business risk is (rU - rD) × (D/E) × (1 - t) in a world with taxes and no bankruptcy.
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The compensation for financial risk is (rU - rD) × (D/E) in a world with taxes and no bankruptcy.
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The financial risk premium is (rU - rD) × (D/E) × (1 - t) in a world with no taxes and no bankruptcy.
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The firm in financial distress incurs both direct and indirect costs.
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The impact of leverage on the cost of debt shows up in M&M proposition ones.
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The impact of leverage on the cost of equity shows up in M&M proposition ones.
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There is volatility in a firm's EBIT across different states of the world due to financial risk.
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This represents Miller and Modigliani case three proposition two. (PIC ON PHONE)
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This represents Miller and Modigliani case two proposition one. (PIC ON PHONE)
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This represents Miller and Modigliani case two proposition two. (PIC ON PHONE)
F
In a world with no taxes and no bankruptcy, the entire value pie is divided between the stockholders and bondholders.
T
In a world with taxes and bankruptcy, the value pie is divided among the stockholders, bondholders, tax claims, and expected bankruptcy costs.
T
In a world with taxes and no bankruptcy, as the firm levers up its value increases by the present value of the annual interest tax shield.
T
In a world with taxes and no bankruptcy, changing the company's capital structure changes the size of the slices of the value pie going to stockholders and bondholder, as well as the size of the pie available to both.
T
In part, Case II Proposition II states that a firm's cost of debt is not affected by changes in the capital structure.
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In part, Case III Proposition II states that a firm's cost of equity is affected by changes in the capital structure.
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M&M Case III assumes a world with taxes and financial distress.
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The business risk premium is contained in rU in a world with no taxes and no bankruptcy.
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The business risk premium is contained in rU in a world with taxes and no bankruptcy.
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The impact of leverage on the return on assets shows up in M&M proposition twos.
T
There is volatility in a firm's EBIT across different states of the world due to business risk.
T
You can maximize value by maximizing the cash flows available to pay the capital providers.
T