CHAPTER 14 Flashcards
Equity in a firm with debt is called levered equity.
YES
Leverage increases the risk of equity even when there is no risk that the firm will default.
YES
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.
YES
Investors in levered equity require a higher expected return to compensate for its increased risk.
YES
Modigliani and Miller’s conclusion verified the common view, which stated that even with perfect capital markets, leverage would affect a firm’s value.
NO
Modigliani and Miller’s conclusion went against the common view that even with
perfect capital markets, leverage would affect a firm’s value.
YES
One of Modigliani and Miller’s set of conditions referred to as perfect
capital markets is: All investors hold the efficient portfolio of assets.
NO
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.
YES
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.
YES
A firm’s financing decisions do not change the cash flows generated by its investments, nor do they reveal new information about them.
YES
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.
YES
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.
YES
An investor who would like more leverage than the firm has chosen can lend and add leverage to his or her own portfolio.
NO
An investor who would like more leverage than the firm has chosen can borrow and add leverage to his or her own portfolio.
YES
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.
YES
When a firm issues new shares that account for a significant percentage of its outstanding shares, the transaction is called a leveraged recapitalization.
NO
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.
YES
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.
YES
MM Proposition I applies to capital structure decisions made at any time during the life of the firm.
YES
By choosing positive-NPV projects that are worth more than their initial investment, the firm can enhance its value.
YES
Consider the following equation:
E+D=U=A
The U in this equation represents the value of the firm’s unlevered equity.
YES
We can use Modigliani and Miller’s first proposition to derive an explicit relationship between leverage and the equity cost of capital.
YES
Although debt does not have a lower cost of capital than equity, we can consider this cost in isolation.
NO
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.
YES
While debt itself may be cheap, it increases the risk and therefore the cost of capital of the firm’s equity.
YES
Although debt has a lower cost of capital than equity, we can consider this cost in isolation.
YES
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.
YES
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.
NO
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.
YES
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).
YES
The portfolio of a firm’s equity and debt replicates the returns we would earn if the firm were unlevered.
YES
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.
NO
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.
YES
Holding cash has the opposite effect of leverage on risk and return.
YES
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.
YES
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.
YES
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.
YES
The money taken in by the firm as a result of the share issue exactly offsets the dilution of the shares.
YES
Most analysts prefer to use performance measures and valuation multiples that are based on the firm’s earnings before interest has been deducted.
YES
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.
YES
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.
NO
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.
YES
The conservation of value principle extends far beyond questions of debt versus equity or even capital structure.
NO
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).
YES
Since the publication of their original paper, Modigliani and Miller’s ideas have greatly influenced finance research and practice.
YES
