FINA 365 FINAL

TRUE about firm's cost of debt

-The cost of debt must be adjusted lower due to the firm's tax deductibility of interest expense. -The firm's cost of debt based on its past borrowing is known as its embedded debt cost. -It is possible to determine a firm's cost of debt by using the SML. -The coupon rate on outstanding debt is not necessarily the firm's current cost of debt.

Assume there are no personal or corporate income taxes and that the firm's WACC is unaffected by its capital structure. Which of the following are FALSE?

-The value of the firm is dependent on its capital structure. -The cost of equity increases as the firm's leverage decreases.

Following are TRUE about financial leverage

-Whenever a firm's debt increases faster than its equity, financial leverage increases. -Leverage is most beneficial when EBIT is relatively high. -Investors can undo the effects of the firm's capital structure by using homemade leverage. -The level of financial leverage that produces the highest firm value is the one most beneficial to stockholders

The interest rate that should be used when evaluating a capital investment project is sometimes called the ___________________.

-appropriate discount rate -cost of capital

Which of the following is true about the dividend growth model when estimating the cost of equity?

-estimated cost of equity is highly sensitive to the estimated growth of dividends

Assume there are no personal or corporate income taxes and that the firm's WACC is unaffected by its capital structure. Which of the following is true?

A firm's cost of equity depends on the firm's business and financial risk

Which of the following is NOT correct?

Book value capital structure weights should be used to calculate the WACC rather than market value weights.

According to M&M Prop. I and II, as debt increases, the increase in the cost of equity is more than offset by the lower cost of debt and the WACC falls.

FALSE

According to M&M Proposition I, the total value of the firm depends on how cash flows are divided up between stockholders and bondholders.

FALSE

The WACC is virtually impossible to calculate for a firm with multiple divisions.

FALSE

dividend growth model applies only to companies which are not currently paying

FALSE

dividend growth model applies only to firms whose dividend growth rate fluctuates significantly

FALSE

dividend growth model does not use discounted cash flow techniques.

FALSE

The WACC is the appropriate discount rate for all new projects of the firm.

FALSE -WACC is appropriate discount rate on the firm as a whole

The optimal capital structure is the one that maximizes the WACC.

FALSE -minimizes

Since discount rates and firm value move in the same direction, minimizing the WACC will minimize the value of the firm.

FALSE -minimizing WACC increase firm value because lower discount rates increase NPV and firm value is the sum of NPV components

According to M&M Prop. I, a firm's capital structure is relevant.

FALSE -value of the firm is unaffected by its capital structure, irrelevant

Which of the following statements regarding leverage is false?

If things go poorly for the firm, increased leverage provides greater returns to shareholders (as measured by ROE and EPS).

Which of the following is NOT accurate regarding financial leverage?

Increasing financial leverage will always increase the EPS for stockholders.

According to __________ , the value of the firm is independent of its capital structure

M&M Proposition I without taxes

The optimal capital structure is the mixture of debt and equity which:

Maximizes the value of the firm AND Minimizes the firm's weighted average cost of capital.

Assume there are no corporate or personal taxes. According to M&M Proposition:

Prop. II, the cost of equity rises as the firm increases its use of debt

As a firm levers up, shareholders are exposed to greater risk.

TRUE

Beyond a certain point, the costs of financial distress outweigh the benefit of leverage

TRUE

If the firm has preferred stock in its capital structure, the cost of preferred stock should be included in the cost of capital.

TRUE

The benefits of leverage will not be as great in a firm with substantial accumulated losses or other types of tax shields compared to a firm without many tax shields.

TRUE

The cost of debt is the return that lenders require on the firm's debt.

TRUE

The cost of equity can be found by either the dividend growth approach or the SML approach

TRUE

The cost of equity is the return that equity investors require on their investment in the firm.

TRUE

The ultimate effect of leverage depends on the firm's EBIT.

TRUE

Which of the following is true about the WACC?

The value of the firm will be maximized when the WACC is minimized. -because decreasing the discount rate increases the company's equity / NPVs

static theory of capital structure

a firm borrows up to the point where the difference between the tax benefit of debt and the cost of financial distress reaches maximum

The equity risk derived from the firm's operating activities is called ______________ risk

business

non marketed claims

cannot be bought or sold, which are taxes and bankruptcy costs -higher financial leverage firms have LOWER non market claims which is the optimal capital structure

marketed claims

claims against cash for that can be bought and sold (equity and debt- stock, bond)

All else the same, the financial leverage of a firm will _________________

decrease as the firm's retained earnings account grows

These days the stock market is worried that Federal Reserve is expected to take actions that cause the risk-free rate to increase. If all else the same, including the level of market required return, we would expect a firm's cost of equity to ____________________.

either increase or decrease if we are using the SML, but we can't determine which without information about the firm's beta

financial risk

equity risk that comes from the capital structure of the firm equation= (Ra-Rd) * (D/E)

business risk

equity risks that comes from the nature of the firm's operating activities Ra

Which of the following is NOT true regarding a firm's cost of debt?

firm's cost of equity is generally easier to calculate than the firm's cost of debt

You need to calculate the cost of equity capital for a firm that is traded on the New York Stock Exchange. Which of the following would likely be least helpful to you?

knowledge of stocks price 6 months ago

indirect bankruptcy costs

larger than direct costs but more difficult to measure and estimate -also have lost sales, interrupted operations loss of valuable employees

direct bankruptcy costs

legal and administrative expenses directly associated with bankruptcy

systematic risk

market risk, undiversifiable risk risk that effects the entirety of the market

cost of capital

minimum expected return an investment must generate -also known as required return, appropriate discount rate, cost of money

financial distress

significant problems in meeting debt obligations

According to the static theory of capital structure, ____________________.

the value of the firm in M&M with taxes is overstated by the amount of financial distress costs

Which of the following correctly completes the following: M&M I with taxes shows ___________________________________.

there is a linear relationship between the amount of debt in a levered firm and its value