Question

Identify whether each statement below is TRUE or FALSE. (20 pts)

a)In a world with no taxes, a firm’s capital structure is irrelevent meaning that WACC is constant for all levels of D/E. True  False

b)WACC always reflects the fair value return on a firm’s assets regardless of whether or not interest expense is tax deductible

True  False

c)If interest expense is tax deductible, issuing debt creates a new asset whose value equals the present value of the avoided tax due to the interest expense. True  False

d)In a world where interest expense is tax deductibile and bank-ruptcy costs are significant, there is an optimal capital structure is when the marginal increase in the tax shield is offset by marginal bankprutcy costs. True  False

e)A firm’s cost of equity (r_e) increases with increasing D/E due to greater business risk. True  False

f)Firms having the same business risk must also have the same beta (e.g. systematic risk). True  False

g)In a world with no taxes, the firm’s cost of equity is constant across all D/E ratios less than 1.0.  True  False

h)A firm should use its WACC to evaluate all capital projects regardless of their nature and how they are financed.  True  False

i) The greater a stock’s total risk as measured by its standard deviation, the higher its expected return. True False  

j)A project’s IRR is the rate which makes the NPV = 0.  True False    

Answer 1

a)In a world with no taxes, a firm’s capital structure is irrelevent meaning that WACC is constant for all levels of D/E.
True

b)WACC always reflects the fair value return on a firm’s assets regardless of whether or not interest expense is tax deductible
False

c)If interest expense is tax deductible, issuing debt creates a new asset whose value equals the present value of the avoided tax due to the interest expense.
True

d)In a world where interest expense is tax deductibile and bank-ruptcy costs are significant, there is an optimal capital structure is when the marginal increase in the tax shield is offset by marginal bankprutcy costs.
False

e)A firm’s cost of equity (re) increases with increasing D/E due to greater business risk.
True

f)Firms having the same business risk must also have the same beta (e.g. systematic risk).
False

g)In a world with no taxes, the firm’s cost of equity is constant across all D/E ratios less than 1.0.
False

h)A firm should use its WACC to evaluate all capital projects regardless of their nature and how they are financed.
False

i) The greater a stock’s total risk as measured by its standard deviation, the higher its expected return.
False

j)A project’s IRR is the rate which makes the NPV = 0.
True