Chapter 13 Questions: Capital Structure and Leverage

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CHAPTER 13: CAPITAL STRUCTURE AND LEVERAGE

1. A firm's business risk is largely determined by the financial characteristics of its industry, especially by the amount of debt the average firm in the industry uses.
a. True
b. False

ANSWER: False

2. Financial risk refers to the extra risk borne by stockholders as a result of a firm's use of debt as compared with their risk if the firm had used no debt.
a. True
b. False

ANSWER: True

3. A firm's capital structure does not affect its free cash flows as discussed in the text, because FCF reflects only operating cash flows, which are available to service debt, to pay dividends to stockholders, and for other purposes.
a. True
b. False

ANSWER: True

4. If a firm borrows money, it is using
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a. True
b. False

ANSWER: True

20. Modigliani and Miller's first article led to the conclusion that capital structure is "irrelevant" because it has no effect on a firm's value. However, that article was criticized because it assumed that no taxes existed. MM then revised their original article to include corporate taxes, and this model led to the conclusion that a firm's value would be maximized if it used (almost) 100% debt.
a. True
b. False

ANSWER: True
21. Modigliani and Miller's second article, which assumed the existence of corporate income taxes, led to the conclusion that a firm's value would be maximized, and its cost of capital minimized, if it used (almost) 100% debt. However, this model did not take account of bankruptcy costs. The existence of bankruptcy costs leads to the assumption of an optimal capital structure where the debt ratio is less than 100%.
a. True
b. False

ANSWER: True

22. The Miller model begins with the Modigliani and Miller (MM) model with corporate taxes and then adds personal taxes.
a. True
b. False

ANSWER: True

23. The Miller model begins with the Modigliani and Miller (MM) model without corporate taxes and then adds personal taxes.
a. True
b. False

ANSWER: False

24. The Modigliani and Miller (MM) articles implicitly assumed that bankruptcy did not exist. That led to the development of the "trade-off" model, where the firm's value first rises with the use of debt due to the tax
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