Debt Policy 2

Question 1

Financial leverage impacts the performance of the firm by:

Answer 1

Increasing the volatility of the firm’s net income.

Question 2

The reason that MM Proposition I does not hold in the presence of corporate taxation is because:

Answer 2

Levered firms pay less taxes compared with identical unlevered firms.

Question 3

A firm should select the capital structure which:

Answer 3

Maximizes the value of the firm

Question 4

Bryan invested in company when the firm was financed solely with equity. The firm is now utilizing debt in its capital structure. To un-lever his position, Bryan needs to:

Answer 4

Sell some shares of Bryco stock and loan it out such that he created debt-equity ratio equal to that of the firm.

Question 5

The proposition that the value of a levered firm is equal to the value of an unlevered firm is known as:

Answer 5

MM Proposition I with no tax

Question 6

The concept of homemade leverage is most associated with:

Answer 6

MM Proposition I with no tax

Question 7

The following statements are correct in relation to MM Proposition II with no tax:

Answer 7

• The required return on assets is equal to the weighted average cost of capital
• Financial risk is determined by the debt-equity ratio

Question 8

MM Proposition 1 with taxes is based on the concept that:

Answer 8

The value of the firm increases as total debt increases because of the interest tax shield

Question 9

MM Proposition 2 with taxes:

Answer 9

Has the same general implications as MM proposition 2 without taxes.

Question 10

The interest-tax shield has no value for a firm when:

Answer 10

• Tax rate is equal to 0
• The firm is unlevered
• A firm elects 100% equity as its capital structure

Question 11

The interest tax shield is a key reason why:

Answer 11

• The next cost of debt to a firm is generally less than the cost of equity

Question 12

Given a progressive tax rate structure, the following will tend to diminish the benefit of the interest tax shield:

Answer 12

• A reduction in tax rates
• A large tax loss carry forward
• A large depreciation tax deduction

Question 13

In a world with taxes and financial distress, when a firm is operating with the optimal capital structure:

Answer 13

• The Debt-Equity ratio will also be optimal
• The weighted average cost of capital will be at its minimal point
• The increased benefit from additional debt is equal to the increased bankruptcy costs of that debt.

Question 14

The MM Theory with taxes implies that firms should issue maximum debt. In practice, this is not true because:

Answer 14

Bankruptcy is a disadvantage to debt.

Question 15

Given realistic estimates of the probability and costs of bankruptcy, the future costs of a possibly bankruptcy are borne by:

Answer 15

Shareholders because debt holders will pay less for the debt providing less cash for the shareholders.

Question 16

When shareholders pursue selfish strategies such as taking large risks or paying excessive dividends, these will result in:

Answer 16

Positive agency costs, as bondholders impose various restrictions and covenants which will diminish firm value.

Question 17

When firms issue more debt, “increases,” “increases,” and the “decreases.”

Answer 17

the tax shield on debt
the agency costs on debt (cost of financial distress)
agency costs on equity

Question 18

Growth opportunities decrease the

Answer 18

advantage of debt financing.

Question 19

The introduction of personal taxes may reveal a disadvantage to the use of debt if the:

Answer 19

Personal tax rate on the distribution of income to stockholders is less than the personal tax rate on interest income.

Question 20

When comparing levered vs. un-levered capital structures, leverage works to increase EPS for high levels of EBIT because:

Answer 20

interest payments on the debt stay fixed, leaving more income to be distributed over less shares.