Question

 

The reason that MM Proposition I hold in the presence of corporate taxation is because:

Levered firms pay less taxes compared with identical unlevered firms.

Bondholders require higher rates of return than stockholders do.

Debt is more expansive than equity.

Dividends become a tax shield.

According to MM Proposition II with tax, the:

Return on assets is determined by financial risk.

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

Cost of equity is inversely related to the firm’s debt-equity ratio.

Cost of debt must equal the cost of equity.

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

the firm’s debt-equity ratio is exactly equal to 1.

the firm’s debt-equity ratio is exactly 0.5.

the firm is unlevered.

The WACC equals R0.

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

Higher EPS as EBIT increases.

a higher variability of EPS with debt than with all-equity financing.

Increased use of homemade leverage.

Decreasing earnings as EBIT increases.

Bryan invested in Bryco stock when the firm was financed 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: discount rate which the firm should apply to all of the projects it undertakes.

[Hint: Bryan could do a homemade leverage]

borrow some money and purchase additional shares of Bryco stock.

maintain his current position in Bryco stock.

Sell some shares of Bryco stock and hold the proceeds in cash.

sell some shares of Bryco stock and loan out the proceeds.

Indirect costs of bankruptcy are born principally by:

Bondholders.

Stockholders.

Managers.

Customers.

If a firm issues debt and includes protective covenants in the indenture, then the firm's debt will probably be issued at _________________ similar debt without the covenants.

a higher interest rate than

a lower interest rate than

an interest rate equal to that of

a slightly higher interest rate than

When firms issue more debt, the present value of the tax shield on debt __________ while the financial distress costs___________.

decreases; decreases

increases; increases

increase; remains constant

decreases; increases

One of the agency cost between shareholders and bondholder is the incentive to take large risks. When following this strategy:

the firm will rank all projects and select the project which results in the highest expected firm value.

bondholders expropriate value from stockholders by selecting high-risk projects.

stockholders expropriate value from bondholders by selecting high-risk projects.

the firm will always select the lowest-risk project available.

Which one of these best exemplifies “milking the property”?

a firm paying a premium to acquire a competitor.

a firm demanding a premium to be acquired without a proxy fight.

A firm with high financial distress paying additional dividends.

All equity firm repurchasing shares.

Which could NOT help us reduce the agency problem?

Issuing debt with strict covenants could help to reduce the agency cost between shareholder and debtholder.

Issuing debt and paying dividend could help to reduce the agency cost between shareholder and debtholder.

Having higher dual-holders ownership (bondholders also purchase stocks) could mitigate agency cost between shareholder and debtholder.

Issuing debt and paying dividend could help to reduce the agency cost between shareholder and manger.

The free cash flow hypothesis states:

that firms with greater free cash flow will pay more in dividends thereby reducing the risk of financial distress.

that issuing debt requires interest and principal payments to be paid thereby reducing the potential of management to waste resources.

that firms with higher levels of free cash flow should reward their managers with bonuses.

that firms will higher levels of free cash flow should reduce their debt levels.

The pecking order states that firms should:

Use internal financing first.

Always issue debt then the market won’t know when management thinks the security is overvalued.

Issue new equity first.

Issue new debt first.

Which one of the following is NOT generally correct in practice?

Most nonfinancial firms have low debt to equity ratio.

Debt ratios in most countries are considerably less than 100 percent.

Firm’s debt to equity ratio vary with industry. For example, firms with larger tangible assets tend to have higher leverage.

There is evidence that firm behaves as if they had no target debt to equity ratio.

Section II. Short Answer Questions:

Graham and Harvey (2001)’s Survey evidence on 392 CFOs find the following factors are important when deciding capital structure decision. Link these factor with the related theory and briefly explain what is the relation between the factor and the theory.

Factors: Financial flexibility; Insufficient internal funds; Interest tax savings; Credit rating; Bankruptcy or distress costs; Equity undervaluation or overvaluation

Theories: MM without tax; MM with tax; Static (Tradeoff); Free cash flow; Signaling; Pecking Order

 

 

 

 

 

 

 

 

The numbers of company going public (IPO) is dropping recently, could you think of a reason why? [Hint: those new form of capital structure]

 

 

 

 

 

 

 

Rosita's has a cost of equity of 13.76 percent and a pretax cost of debt of 8.5 percent. The debt-equity ratio is .60 and the tax rate is 34 percent.

What is Rosita's cost of capital if there is no debt unlevered cost of capital?

What is Rosita’s WACC if his debt to equity ratio is 0.3?

TL Company has expected earnings of $75 in one year if it does well and $25 if it does poorly. The firm has outstanding debt of $50 that is due in one year. However, given the financial distress costs, the debtholders will only receive $40 in one year if the firm does well and $15 if it does poorly. There is a 60 percent chance the firm will do well and a 40 percent chance that it will do poorly. What is the current value of the debt if the interest rate on bonds is 8 percent?

 

 

 

 

Suppose a firm need to pay back $1 million to his debtholder next year and he will distribute the rest of the payoff to the shareholders. He faces two mutual exclusive projects. The payoff is listed in the following.

Which project will bondholder choose?

Which project will shareholder choose?

Which project should manager choose if he/she wants to maximize the firm’s value?

	Good condition-50% probability	Bad condition-50% probability
Project A's payoff to the firm	1.5 million	1.2 million
Project B's payoff to the firm	2 million	0.2 million

 

Answer 1

MCQ 1:
The reason that MM Proposition I hold in the presence of corporate taxation is because:
Correct answer:Levered firms pay less taxes compared with identical unlevered firms.

Explainations for wrong answers:

Bondholders require higher rates of return than stockholders do- wrong because is not usually the case because usually return on equity is higher and bondholders are guranteed to have cash flows first

Debt is more expansive than equity- wrong because Equity is more expensive

Dividends become a tax shield.wrong because debt repayment*tax rate is the tax shield

MCQ 2:According to MM Proposition II with tax, the:
Correct option: Required return on equity is a linear function of the firm’s debt-equity ratio.

Return on assets is determined by financial risk- wrong because return on asset is determined by total risk

Cost of equity is inversely related to the firm’s debt-equity ratio- wrong because cost of equity is directly related to debt equity ratio

Cost of debt must equal the cost of equity- wrong because it is not necessary and mostly debt is cheaper

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

Correct option-the firm is unlevered.

The WACC equals R0- wrong because still there is debt

the firm’s debt-equity ratio is exactly equal to 1- wrong because there is 50% DEBT AND debt will lead to debt shield

the firm’s debt-equity ratio is exactly 0.5- wrong because 33.33% is debt and debt shalll lead to debt shield

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

Correct option:.a higher variability of EPS with debt than with all-equity financing.