CHAPTER 14

Question 1

Equity in a firm with debt is called levered equity.

Answer 1

YES

Question 2

Leverage increases the risk of equity even when there is no risk that the firm will default.

Answer 2

YES

Question 3

We can evaluate the relationship between risk and return more formally by computing the sensitivity of each security’s return to the systematic risk of the economy.

Answer 3

YES

Question 4

Investors in levered equity require a higher expected return to compensate for its increased risk.

Answer 4

YES

Question 5

Modigliani and Miller’s conclusion verified the common view, which stated that even with perfect capital markets, leverage would affect a firm’s value.

Answer 5

NO

Question 6

Modigliani and Miller’s conclusion went against the common view that even with
perfect capital markets, leverage would affect a firm’s value.

Answer 6

YES

Question 7

One of Modigliani and Miller’s set of conditions referred to as perfect
capital markets is: All investors hold the efficient portfolio of assets.

Answer 7

NO

Question 8

One of Modigliani and Miller’s set of conditions referred to as perfect
capital markets is: There are no taxes, transaction costs, or issuance costs associated with security trading.

Answer 8

YES

Question 9

One of Modigliani and Miller’s set of conditions referred to as perfect
capital markets is: Investors and firms can trade the same set of securities at competitive market prices equal to the present value of their future cash flows.

Answer 9

YES

Question 10

A firm’s financing decisions do not change the cash flows generated by its investments, nor do they reveal new information about them.

Answer 10

YES

Question 11

If securities are fairly priced, then buying or selling securities has an NPV of zero and, therefore, should not change the value of a firm.

Answer 11

YES

Question 12

As long as the firm’s choice of securities does not change the cash flows generated by its assets, the capital structure decision will not change the total value of the firm or the amount of capital it can raise.

Answer 12

YES

Question 13

An investor who would like more leverage than the firm has chosen can lend and add leverage to his or her own portfolio.

Answer 13

NO

Question 14

An investor who would like more leverage than the firm has chosen can borrow and add leverage to his or her own portfolio.

Answer 14

YES

Question 15

The future repayments that the firm must make on its debt are equal in value to the amount of the loan it receives up front.

Answer 15

YES

Question 16

When a firm issues new shares that account for a significant percentage of its outstanding shares, the transaction is called a leveraged recapitalization.

Answer 16

NO

Question 17

When a firm borrows money to repurchase shares that account for a significant percentage of its outstanding shares, the transaction is called a leveraged recapitalization.

Answer 17

YES

Question 18

Holding fixed the cash flows generated by the firm’s assets, however, the choice of capital structure does not change the value of the firm.

Answer 18

YES

Question 19

MM Proposition I applies to capital structure decisions made at any time during the life of the firm.

Answer 19

YES

Question 20

By choosing positive-NPV projects that are worth more than their initial investment, the firm can enhance its value.

Answer 20

YES

Question 21

Consider the following equation:
E+D=U=A
The U in this equation represents the value of the firm’s unlevered equity.

Answer 21

YES

Question 22

We can use Modigliani and Miller’s first proposition to derive an explicit relationship between leverage and the equity cost of capital.

Answer 22

YES

Question 23

Although debt does not have a lower cost of capital than equity, we can consider this cost in isolation.

Answer 23

NO

Question 24

The total market value of the firm’s securities is equal to the market value of its assets, whether the firm is unlevered or levered.

Answer 24

YES

Question 25

While debt itself may be cheap, it increases the risk and therefore the cost of capital of the firm’s equity.

Answer 25

YES

Question 26

Although debt has a lower cost of capital than equity, we can consider this cost in isolation.

Answer 26

YES

Question 27

When evaluating any potential investment project, we must use a discount rate that is appropriate given the risk of the project’s free cash flow.

Answer 27

YES

Question 28

If we can identify a comparison firm whose assets have the same risk as the project being evaluated, and if the comparison firm is levered, then we can use its equity cost of capital as the cost of capital for the project.

Answer 28

NO

Question 29

If we can identify a comparison firm whose assets have the same risk as the project being evaluated, and if the comparison firm is levered, then we can use its unlevered equity cost of capital as the cost of capital for the project.

Answer 29

YES

Question 30

We can calculate the cost of capital of the firm’s assets by computing the weighted average of the firm’s equity and debt cost of capital, which we refer to as the firm’s weighted average cost of capital (WACC).

Answer 30

YES

Question 31

The portfolio of a firm’s equity and debt replicates the returns we would earn if the firm were unlevered.

Answer 31

YES

Question 32

Even if the firm’s capital structure is more complex, the WACC is calculated by computing the weighted average cost of only the firm’s debt and equity.

Answer 32

NO

Question 33

We use the market value of the firm’s net debt when computing its WACC and unlevered beta to measure the cost of capital and market risk of the firm’s business assets.

Answer 33

YES

Question 34

Holding cash has the opposite effect of leverage on risk and return.

Answer 34

YES

Question 35

Since the WACC does not change with the use of leverage, the value of the firm’s free cash flow evaluated using the WACC does not change, and so the enterprise value of the firm does not depend on its financing choices.

Answer 35

YES

Question 36

Consider the following equation:
Beta U= E / (E+D) Beta E + D / (E+D) Beta D
The term E / E+D in the equation is the proportion of the firm financed with equity.

Answer 36

YES

Question 37

Consider the following equation:
Beta U= E/(E+ D) BetaE +D/(E+D) BetaD
The term BetaU in the equation is the same as the beta of the firm’s assets.

Answer 37

YES

Question 38

The money taken in by the firm as a result of the share issue exactly offsets the dilution of the shares.

Answer 38

YES

Question 39

Most analysts prefer to use performance measures and valuation multiples that are based on the firm’s earnings before interest has been deducted.

Answer 39

YES

Question 40

In general, as long as the firm sells the new shares of equity at a fair price, there will be no gain or loss to shareholders associated with the equity issue itself.

Answer 40

YES

Question 41

Because the firm’s earnings per share and price-earnings ratio are affected by leverage implies that we can always reliably compare these measures across firms with different capital structures.

Answer 41

NO

Question 42

Proposition I was one of the first arguments to show that the Law of One Price could have strong implications for security prices and firm values in a competitive market; it marks the beginning of the modern theory of corporate finance.

Answer 42

YES

Question 43

The conservation of value principle extends far beyond questions of debt versus equity or even capital structure.

Answer 43

NO

Question 44

The conservation of value principle for financial markets states that with perfect capital markets, financial transactions neither add nor destroy value, but instead represent a repackaging of risk (and therefore return).

Answer 44

YES

Question 45

Since the publication of their original paper, Modigliani and Miller’s ideas have greatly influenced finance research and practice.

Answer 45

YES