Chapter 14 - Finance

Question 1

When a company wants to raisefunds from outside investors it has to choose what kind of security it wants to issue. The most common choices are:

Answer 1

-Financing through equity alone
-Financing through a combination of debt and equity.

Question 2

What are the three conditions for a perfect market?

Answer 2

1. Investors and firms can trade the same set of securities at competitive market prices equal to the present value of their future cash flows.
2. There are no taxes, transaction costs, or issuance costs associated with security trading.
3. A firm’s financing decisions do not change the cash flows generated by its investments, nor do they reveal new information about them.

Question 3

What is homemade leverage?

Answer 3

When investors use leverage in their own portfolios to adjust the leverage choice made by the firm. This works as long as investors can borrow or lend at the same interest rate as the firm

Question 4

Whats the market value balance sheet?

Answer 4

Similar to an accounting balance sheet, with two important distinctions: 1: all assets and liabilities of the firm are included (even intangible assets). 2: all values are current market values rather than historical costs. The total value of all securities issued by the firm must equal the total value of the firm’s assets.

Question 5

How do you compute the market value of equity?

Answer 5

Market Value of Equity = Market Value of Assets – Market Value of Debt and Other Liabilities

Question 6

What is leveraged recapitalization?

Answer 6

When a firm repurchases a significant percentage of its outstanding shares with debt.

Question 7

What is MM’s first proposition?

Answer 7

In a perfect capital market, the total value of a firm’s securities is equal to the market value of the total cash flows generated by its assets and is not affected by its choice of capital structure.

Question 8

What does the WACC consist of?

Answer 8

Debt cost of capital
Equity cost of capital

Question 9

Julian has invested in 3 securities; A with a beta of 1; B with a beta of 2; C with a beta of 2.5.
Which of the following statements is true?
A. A has the lowest total risk
B. B has the lowest market risk
C. Nothing can be said regarding market risk
D. Nothing can be said regarding total risk

Answer 9

D

Question 10

Which of the following is a part of M&M assumptions?

A. Firms only raise equity or debt
B. The capital structure of a company does not affect its value
C. The capital structure of a company does not send signals to the market
D. All the companies pay the same non-zero tax rate

Answer 10

C

Question 11

How can debt add value to the firm?
Answers
A. It is always more costly than equity and thus decreases the WACC
B. A company with high level of debt will always be trusted more easily by investors
C. It decreases EBIT and lowers the tax rate
D. It has the potential to decrease earnings before tax and thus the tax burden

Answer 11

D

Question 12

Which of the following statements is FALSE?
A) The relative proportions of debt, equity, and other securities that a firm has outstanding constitute its capital structure.
B) The most common choices are financing through equity alone and financing through a combination of debt and equity.
C) The project’s NPV represents the value to the new investors of the firm created by the project. D) When corporations raise funds from outside investors, they must choose which type of security to issue.

Answer 12

C

Question 13

Which of the following statements is FALSE?
A) The Law of One Price implies that leverage will affect the total value of the firm under perfect capital market conditions.
B) In the absence of taxes or other transaction costs, the total cash flow paid out to all of a firm’s security holders is equal to the total cash flow generated by the firm’s assets.
C) With perfect capital markets, leverage merely changes the allocation of cash flows between debt and equity, without altering the total cash flows of the firm.
D) In a perfect capital market, the total value of a firm is equal to the market value of the total cash flows generated by its assets and is not affected by its choice of capital structure.

Answer 13

A - The Law of One Price implies that leverage will not affect the total value of the firm under perfect capital market conditions.

Question 14

Which of the following statements is FALSE?
A) 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.
B) 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.
C) 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.
D) An investor who would like more leverage than the firm has chosen can lend and add leverage to his or her own portfolio.

Answer 14

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

Question 15

Which of the following statements is FALSE?
A) As long as investors can borrow or lend at the same interest rate as the firm, homemade leverage is a perfect substitute for the use of leverage by the firm.
B) When investors use leverage in their own portfolios to adjust the leverage choice made by the firm, we say that they are using homemade leverage.
C) The value of the firm is determined by the present value of the cash flows from its current and future investments.
D) The investor can re-create the payoffs of unlevered equity by borrowing and using the proceeds to purchase the equity of the firm.

Answer 15

D) The investor can re-create the payoffs of levered equity by borrowing and using the proceeds to purchase the equity of the firm.

Question 16

Which of the following statements is FALSE?
A) When a firm issues new shares that account for a significant percentage of its outstanding shares, the transaction is called a leveraged recapitalization.
B) MM Proposition I applies to capital structure decisions made at any time during the life of the firm.
C) By choosing positive-NPV projects that are worth more than their initial investment, the firm can enhance its value.
D) 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 16

A) 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.

Question 17

IF FBNA increases leverage so that its interest expense rises by $1 million, then the amount its unlevered EBIT will change is closest to:
A) $0
B) -$400,000
C) $600,000
D) $400,000

Answer 17

A) EBIT does not change with a change in interest expense.

Question 18

Which of the following is NOT one of Modigliani and Miller’s set of conditions referred to as perfect capital markets?
A) All investors hold the efficient portfolio of assets.
B) There are no taxes, transaction costs, or issuance costs associated with security trading.
C) A firm’s financing decisions do not change the cash flows generated by its investments, nor do they reveal new information about them.
D) 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 18

A

Question 19

Which of the following statements is FALSE?
A) Investors can alter the leverage choice of the firm to suit their personal tastes either by borrowing and reducing leverage or by holding bonds and adding more leverage.
B) On the market value balance sheet the total value of all securities issued by the firm must equal the total value of the firm’s assets.
C) The market value balance sheet captures the idea that value is created by a firm’s choice of assets and investments.
D) One application of MM Proposition I is the useful device known as the market value balance sheet of the firm.

Answer 19

A) Investors can alter the leverage choice of the firm to suit their personal tastes either by borrowing and increasing leverage or by holding bonds and reducing leverage.

Question 20

Galt Industries has no debt, total equity capitalization of $600 million, and an equity beta of 1.2. Included in Galt’s assets is $90 million in cash and risk-free securities. Assume the risk-free rate is 4% and the market risk premium is 6%.
3) Galt’s enterprise value is closest to: A) $90 million
B) $510 million
C) $600 million
D) $690 million

Answer 20

B) Enterprise value = equity + debt - cash = $600 million - $90 million = $510 million

Question 21

E+D=U=A
The U in this equation represents:
A) the value of the firm’s equity.
B) the market value of the firm’s assets.
C) the value of the firm’s unlevered equity.
D) the value of the firm’s debt.

Answer 21

C)

Question 22

Which of the following statements is FALSE?
A) While debt itself may be cheap, it increases the risk and therefore the cost of capital of the firm’s equity.
B) Although debt does not have a lower cost of capital than equity, we can consider this cost in isolation.
C) We can use Modigliani and Miller’s first proposition to derive an explicit relationship between leverage and the equity cost of capital.
D) 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 22

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

Question 23

Which of the following statements is FALSE?
A) The levered equity return equals the unlevered return, plus an extra “kick” due to leverage.
B) By holding a portfolio of the firm’s equity and its debt, we can replicate the cash flows from holding its levered equity.
C) The cost of capital of levered equity is equal to the cost of capital of unlevered equity plus a premium that is proportional to the market value debt-equity ratio.
D) If a firm is unlevered, all of the free cash flows generated by its assets are available to be paid out to its equity holders.

Answer 23

B) By holding a portfolio of the firm’s equity and its debt, we can replicate the cash flows from holding its unlevered equity.

Question 24

Which of the following statements is FALSE?
A) Holding cash has the opposite effect of leverage on risk and return.
B) 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.
C) 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.
D) 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 24

D

Question 25

Which of the following statements is FALSE?
A) The unlevered beta measures the market risk of the firm’s business activities, ignoring any additional risk due to leverage.
B) If a firm holds $1 in cash and has $1 of risk-free debt, then the interest earned on the cash will equal the interest paid on the debt. The cash flows from each source cancel each other, just as if the firm held no cash and no debt.
C) The unlevered beta measures the market risk of the firm without leverage, which is equivalent to the beta of the firm’s assets.
D) When a firm changes its capital structure without changing its investments, its levered beta will remain unaltered, however, its asset beta will change to reflect the effect of the capital structure change on its risk

Answer 25

D) When a firm changes its capital structure without changing its investments, its unlevered beta will remain unaltered, however, its equity beta will change to reflect the effect of the capital structure change on its risk.