Finance 300: Chapter 16 Quiz
Assume a world with a tax rate of 16% and no bankruptcy. If WSB Inc. was an all-equity firm its return would be 11.7% per year. However, it does have bonds that currently have a YTM of 7%. By how many basis points would WSB's WACC change if it changes from its current debt-to-equity of 0.8 to its optimal one? Remember, a change is ending value minus beginning value.
-499
You project that WSB Inc. will have earnings before interest and taxes of $455 thousand per quarter in perpetuity. You also believe an all-equity WSB should have a return of 14.0% APR with quarterly compounding. WSB has perpetual bonds with a face value of $4 million that yield 8.5% per year with quarterly compounding. Assuming a world without bankruptcy and a corporate tax rate of 33%, what do you think WSB is worth?
10,030,000
WSB Inc is an all-equity company with a market capitalization of $342 million and an expected return of 9.65% per year. WSB is considering issuing 549 thousand bonds. At issuance, WSB will set the coupon rate to the YTM on bonds with similar characteristics and risks, which is 6.55%. The result will be the bonds will issue at their full face value of $1,000. Assuming a world with no taxes and no bankruptcy, what financial risk premium should WSB's shareholders expect if WSB levers up?
498
According to the Static Theory of Capital Structure, a highly profitable firm with stable cash flows across many states of the world should have a relatively low debt-to-equity ratio.
False
According to the Static Theory of Capital Structure, a manager need not understand their firm and industry because tax liabilities and probabilities of bankruptcy are pretty much the same across the market.
False
According to the Static Theory of Capital Structure, an unprofitable firm with unstable cash flows across many states of the world, such as a startup, should have a relatively high debt-to-equity ratio.
False
According to the Static Theory of Capital Structure, it is optimal for all firms to have some debt, though the amount varies.
False
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.
False
According to the Static Theory of Capital Structure, the expected costs of financial distress and bankruptcy do not vary much across firms and industries, so the optimal leverage choice will not vary much either.
False
All firms have the same equity beta but different levered betas.
False
Assume a world with taxes and no bankruptcy. For stylized perpetual cash flows, annual interest tax shield = Debt × rU × t
False
Case III Proposition II states that a firm's WACC is not affected by changes in the capital structure.
False
Different businesses have different assets resulting in different financial risks.
False
Different businesses have different assets resulting in different levered betas.
False
Expected distress and bankruptcy costs are types of traded claim.
False
If interest is not tax deductible, then adding debt increases the cash available to pay the capital providers, all else equal.
False
In M&M Case I, the firm's cost of equity is fixed.
False
In a world with no taxes and no bankruptcy, changing leverage does change the riskiness of the cash flows from assets, but WACC remains constant.
False
In a world with no taxes and no bankruptcy, changing the company's capital structure does not change the size of the slices of the value pie going to stockholders and bondholder.
False
In a world with no taxes and no bankruptcy, if the CFO levers down and the shareholder doesn't like it, they can use homemade leverage to increase the volatility of their portfolio by using their own money to invest in company's stock and bonds.
False
In a world with no taxes and no bankruptcy, the denominators in the DCF equation change when leverage changes.
False
In a world with no taxes and no bankruptcy, there is a unique capital structure that maximizes value.
False
In a world with no taxes and no bankruptcy, there is a unique capital structure that minimizes WACC.
False
In a world with no taxes and no bankruptcy, this is the firm's WACC, rA =(E/V) × rE + (D/V) × rD × (1 - t)
False
In a world with taxes and bankruptcy, changes in leverage do not change the cash flows from assets.
False
In a world with taxes and bankruptcy, the denominators in the DCF equation do not change when leverage changes.
False
In a world with taxes and bankruptcy, there is not a unique capital structure that maximizes value.
False
In a world with taxes and bankruptcy, there is not a unique capital structure that minimizes WACC.
False
In a world with taxes and no bankruptcy, changes in leverage do not change the cash flows from assets.
False
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, but not the size of the pie available to both.
False
In a world with taxes and no bankruptcy, the denominators in the DCF equation do not change when leverage changes.
False
In part, Case I Proposition II states that the a firm's cost of debt is affected by changes in the capital structure.
False
Indirect costs are lower in bankruptcy than in financial distress.
False
Levering down means issuing bonds in the primary market then using the proceeds to buy stocks in the secondary market.
False
Levering up changes the left hand side of the balance sheet but not the right.
False
Levering up means issuing bonds in the secondary market then using the proceeds to buy stocks in the primary market.
False
M&M Case I and III assumes a world with taxes, financial distress, and bankruptcy.
False
M&M Case I and III assumptions are same except when it comes to taxes.
False
M&M Case I makes the same assumptions as Case II, but does not allow for bankruptcy.
False
The Static Theory of Capital Structure predicts we should see different optimal levels of debt for different firms in different industries. Unfortunately, we do not see industry differences in the data.
False
The financial risk premium is rU in a world with no taxes and no bankruptcy.
False
The firm in financial distress incurs both direct and indirect costs.
False
The impact of leverage on WACC shows up in M&M proposition ones.
False
The impact of leverage on returns shows up in M&M proposition ones.
False
The impact of leverage on the return on assets shows up in M&M proposition ones.
False
The impact of leverage on value shows up in M&M proposition twos.
False
The optimal capital structure is all equity when there are taxes and no bankruptcy.
False
There is a unique minimum WACC that maximizes the value of the firm when there are no taxes and no bankruptcy.
False
There is no unique optimal capital structure when there are taxes and bankruptcy.
False
There is risk because the firm's EBIT varies across different states of the world that reflect the systematic risk of the assets. This risk is known as financial risk.
False
This represents Miller and Modigliani case three proposition two.
False
This represents Miller and Modigliani case two proposition one. (rD bottom, WACC = rA above, rE base of WACC)
False
When a firm levers up the variability of ROE decreases.
False
According to the Static Theory of Capital Structure, the gain from the tax shield on debt is offset by expected financial and distress costs.
True
All else equal, a change in the business risk premium has no effect on the cost of debt in a world without bankruptcy.
True
All else equal, a change in the financial risk premium due to a change in the firm's capital structure has no effect on the business risk premium.
True
As the capital structure weight of equity decreases the probability of incurring financial distress costs increases.
True
As the firm's debt-to-equity ratio decreases, its stock beta decreases as well.
True
As the firm's debt-to-equity ratio increases, its stock beta increases as well.
True
Assume a world with taxes and no bankruptcy. For stylized perpetual cash flows, ValueLevered = ValueUnlevered + Debt × t
True
Assume a world with taxes and no bankruptcy. For stylized perpetual cash flows, annual interest tax shield = Debt × rD × t
True
Bankruptcy imposes indirect costs on the firm.
True
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 levered.
True
Consider the following information about WSB Inc.: Unlevered: Recession Expected Expansion Sales 900,000 1,300,000 1,600,000 - Costs 400,000 700,000 900,000 EBIT 500,000 600,000 700,000 Levered: Recession Expected Expansion Sales 600,000 1,300,000 1,600,000 - Costs 500,000 700,000 900,000 EBIT 100,000 600,000 700,000 Interest 300,000 250,000 250,000 WSB could face direct legal and administrative costs due to bankruptcy.
True
Different businesses have different assets resulting in different business risks.
True
From the shareholders point of view, the CFO's capital structure choice is relevant in a world with bankruptcy but no taxes.
True
Homemade leverage does not work in a world with taxes and bankruptcy.
True
Homemade leverage works in a world with no taxes and no bankruptcy.
True
In M&M Case II, the firm's cost of debt is fixed.
True
In M&M Case III, as the firm levers down the slice of the value pie going to expected distress and bankruptcy costs gets smaller while the slice going to the tax claims gets bigger.
True
In a world with no taxes and no bankruptcy, leverage does not change the business risk premium contained in rU.
True
In a world with no taxes and no bankruptcy, this is the firm's WACC, rA =(E/V) × rE + (D/V) × rD
True
In a world with taxes and bankruptcy, changes in capital structure change all returns.
True
In a world with taxes and bankruptcy, changes in capital structure change some returns.
True
In a world with taxes and bankruptcy, changes in leverage change the cash flows from assets.
True
In a world with taxes and no bankruptcy, the size of the value pie available to the capital providers changes.
True
In a world with taxes and no bankruptcy, the value of the levered firm equals the value of the unlevered firm plus the present value of the interest tax shield.
True
In a world with taxes and no bankruptcy, this is the firm's WACC, rA =(E/V) × rE + (D/V) × rD × (1 - t)
True
In a world with taxes and no bankruptcy, value does change because of the CFO's leverage choice because both the numerators and denominators in the DCF equation change.
True
M&M Case I assumes a world with no taxes and no bankruptcy.
True
M&M Case I makes the same assumptions as Case II, but does not allow for taxes.
True
M&M Case II and III assumptions are same except when it comes to financial distress and bankruptcy.
True
M&M Case III assumes a world with taxes, financial distress, and bankruptcy.
True
The compensation for financial risk is (rU - rD) × (D/E) in a world with no taxes and no bankruptcy.
True
The compensation for financial risk is (rU - rD) × (D/E) × (1 - t) in a world with taxes and no bankruptcy.
True
The firm in financial distress incurs indirect but not direct costs.
True
The impact of leverage on the return on assets shows up in M&M proposition twos.
True
The unlevered beta measures only the business risk.
True
There is risk because the firm's EBIT varies across different states of the world that reflect the systematic risk of the assets. This risk is known as business risk.
True
There is variability of EBIT because of undiversifiable risk, which we call, in this context, business risk.
True
This represents Miller and Modigliani case two proposition two.
True
When a firm levers down the variability of ROE decreases.
True
You can maximize value by maximizing the cash flows available to pay the capital providers.
True