Question

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.

1. If a bond sells at a discount, yield to call is more likely to occur.
2. A firm should select the capital structure that is fully unlevered.
3. Leveraged beta represents fundamental operational risk.
4. All other things held constant; the future value of an ordinary annuity is always having a higher future value than annuity due.
5. MM Proposition I with no tax supports the argument thata 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. Agree- A bond sells at a discount means the market price is below the face value, so investors are more likely to purchase the bond since it will repay the face value at maturity. Yield to call likely happen because the issuer will pay off the bonds before maturity (callable bond) in order to refinance the bonds at a lower rate if interest rates are dropping. Callable bonds carry a higher yields.   

b. Agree- Fully unlevered capital structure means the cost of capital company financing the project from equity, without incurring debt. It provides a better rate of return that helps investors make decisions on whether to invest.

c. Agree-  Leverage beta includes debt and equity in its capital structure. If more debt a company have most of the earnings are used to pay back that debt and it will then increases the risk associated with the stock.

d. Disagree- the future value of an annuity due will have higher future value than ordinary annuity because it has an extra period to accumulate compounded interest.

e. Disagree- Extra debt increases the chance of a company’s default, investors are less prone to negatively reacting to the company taking additional leverage.