Question

3 Explain Why you agree or disagree with the following statements. The answer should not be more than 3 sentences. Be specific in your answer and write only the most relevant explanations (Total Marks 7.5, Each 1.5).

a. If a bond sells at a discount, yield to call is more likely to occur.
b. A firm should select the capital structure that is fully unlevered.
c. Leveraged beta represents fundamental operational risk.
d. All other things held constant; the future value of an ordinary annuity is always having a higher future value than annuity due.
e. MM Proposition I with no tax supports the argument that a firm should borrow money to the point where the tax benefit from debt is equal to the cost of the increased probability of financial distress.

Answer 1

a. If a bond sells at a discount, yield to call is more likely to occur.

Disagree because bond is trading at discount which means the market interest rates are higher than coupon rate. Thus if company calls the bond then they have to issue further bonds at high interest rate which results in high interest cost

b. A firm should select the capital structure that is fully unlevered.

Disagree, The firm should select a capital structure where the cost of capital is low

c. Leveraged beta represents fundamental operational risk.

Disagree. Leveraged Beta represents the business risk it means the risk of the company ability to pay off debt holders

d. All other things held constant; the future value of an ordinary annuity is always having a higher future value than annuity due.

Disagree. Always future value of annuity due will be higher than  future value of an ordinary annuity if all other things are constant

e. MM Proposition I with no tax supports the argument that a firm should borrow money to the point where the tax benefit from debt is equal to the cost of the increased probability of financial distress.

Disagree. its not MM proposition I with no taxes, it is MM proposition II with taxes