Chapter 16

MM Proposition II is the proposition that:

A firm's cost of equity capital depends solely on the return on debt, the debt-equity ratio, and the tax rate.

In an EPS-EBI graphical relationship, the slope of the debt ray is steeper than the equity ray. The debt ray has a lower intercept because:

A fixed interest charge must be paid even at low earnings.

The increase in risk to shareholders when financial leverage is introduced is best evidenced by:

A higher variability of EPS with debt than with all-equity financing

Which one of the following will tend to increase the benefit of the interest tax shield given a progressive tax rate structure?

A sizable increase in taxable income.

A manager should attempt to maximize the value of the firm by changing the capital structure if and only if the value of the firm increases:

As a result of the change

MM Proposition II with taxes:

Has the same general implications as MM Proposition II without taxes.

The use of personal borrowing to change the overall amount of financial leverage to which an individual is exposed is called:

Homemade Leverage

In the absence of taxes, the capital structure chosen by a firm doesn't really matter because of:

Homemade leverage

MM Proposition I with taxes states that:

Increasing the debt equity-ratio increases firm value

A key underlying assumption of MM Proposition I without taxes is that:

Individuals and corporations borrow at the same rate.

The tax savings of the firm derived from the deductibility of interest expense is called the:

Interest Tax Shield

MM Proposition I with no taxes supports the argument that:

It is completely irrelevant how a firm arranges its finances.

MM Proposition I without taxes proposes that:

Leverage does not affect the value of the firm.

The effects of financial leverage depend on the operating earnings of the company. Based on this relationship, assume you graph the EPS and EBI for a firm, while ignoring taxes. Which one of these statements correctly states a relationship illustrated by the graph?

Leverage only provides value above the break even point.

The reason that MM Proposition I does not hold in the present of corporate taxation is because

Levered firms pay less taxes compared with identical unlevered firms.

The proposition that the value of the firm is independent of its capital structure is called:

MM Proposition I (no taxes)

The proposition that the value of a levered firm is equal to the value of an unlevered firm is known as:

MM Proposition I with no tax.

The proposition that the cost of equity is a positive linear function of capital structure is called:

MM Proposition II (no taxes)

The concept of homemade leverage is most associated with:

MM Proposition with no tax

A firm should select the capital structure which:

Maximizes the value of the firm.

The firm's capital structure refers to the:

Mix of debt and equity used in the firms assets.

According to MM Proposition II with no taxes, the:

Required return on equity is a linear function of the firm's debt-equity ratio.

Bryan invested in Bryce stock when the firm was finance solely with equity. The firm now has a debt-equity ratio of .3. To maintain the same level of leverage he originally had, Bryan needs to:

Sell some shares of Bryce stock and can out of the proceeds.

A levered firm is a company that has:

Some debt in its capital structure.

When comparing levered versus unlevered capital structures, leverage works to increase EPS for high levels of EBIT because interest payments on the debt:

Stay fixed, leaving more income to be distributed over fewer shares.

The unlevered cost of capital is:

The cost of capital for a firm with no debt in its capital structure.

The interest tax shield has no value for a firm when:

The firm is unlevered

The interest tax shield is a key reason why:

The net cost of debt to a firm is generally less than the cost of equity.

MM Proposition I with taxes is based on the concept that:

The value of the firm increases as total debt increases because of the interest tax shield.

MM Proposition I with taxes supports the theory that:

There is a positive linear relationship between the amount of debt in a levered firm and its value.

A general rule for managers to follow is to set the firm's capital structure such that the firm's:

Value is maximized