Financial Leverage and Capital Structure Policy

Which of the following statements are true regarding the effect of financial leverage and the firm's operating earnings (EBI)?

1. Below the indifference or break-even point in EBIT, an unlevered capital structure is best 2. Financial leverage increases the slope of the EPS line 3. The rate of return on assets is unaffected by the leverage.

In the absence of taxes, the value of a firm is the same with debt financing as it is with equity financing because __________________-

1. MM demonstrated that debt financing is neither better nor worse than equity financing in the absence of taxes 2. The asset to be financed is the same

Alpha Co. has a debt-equity ratio of 0.6, a pretax cost of debt of 7.5%, and an unlevered cost of equity of 12%. What is Alpha's cost of equity if you ignore taxes?

12%+.6(12%-7.5%)=14.7%

Calculate the cost of capital for an all-equity firm with equity of $12,500 and expected earnings of $1,900.

1900/12500= 15.2%

An investor who invests in the stock of a levered firm rather than in an all-equity firm will require _______________________--

A higher expected return

The equity risk that comes from the nature of a firm's operating activities is known as

Business risk

The value of a firm is equal to the value of its:

Debt plus equity

The WACC is the cost of __________ times its weight in the capital structure plus the cost of _______________ times its weight in the capital structure.

Debt; equity

According to M&M Proposition I, a firm's capital structure choices:

Do not affect the value of the firm

True or False: Holding equity in an unlevered firm has no risk.

False

The equity risk that comes from the financial policy or capital structure decisions of the firm is known as:

Financial risk

The value of the firm is given by the following expression:

Firm Value = Value of Equity + Value of Debt

A beneficial rule to follow is to set the firm's capital structure so that

The firm's value is maxmized

Under MM propositions with no taxes, managers cannot change the value of the firm by repackaging its securities because _________________

The overall cost of capital cannot be reduced. As debt is added, the equity becomes more risky

Under MM Proposition II with no taxes, the WACC is invariant to the debt level because:

The return on assets (Ra) is unchanged.

MM Proposition II shows that

the cost of equity rises with leverage

An unlevered firm _________________

Has an all-equity capital structure

The cost of equity is generally _____________________ _________________ the cost of debt

Higher than

An individual can duplicate a levered firm through a strategy called _________________ where the investor uses his own funds plus borrowed funds to buy stocks.

Homemade leverage

With _______, an investor is able to replicate a corporation's capital structure by borrowing funds and using those funds along with her own money to buy the company's stock.

Homemade leverage

Which of the following assumptions is necessary for MM Proposition I to hold?

Individuals can borrow on their own at an interest rate equal to that of the firm

The manager of a firm should change the capital structure if and only if ______________

It increases the value of the firm

A company should select the capital structure that _____________

Maximizes the company's value

The value of the firm is maximized when the WACC is:

Minimized

Under MM Proposition II, a firm's cost of equity capital is ________________ related to the firm's debt equity ratio

Positively