Select all that is not true about capital structure theory (MM theory). (2 answers) Under perfect capital market assumptions with no corporate tax, equity holder’s risk increases with leverage. Under perfect capital market assumptions with no corporate tax, cost of equity increases with leverage. Under perfect capital market assumptions with no corporate tax, there is an optimal capital structure that maximizes the firm value. Under perfect capital market assumptions with no corporate tax, cost of capital for all equity (unlevered) firm is equal to cost of capital for levered firm.

Select all that is not true about capital structure theory (MM theory). (2 answers) Under perfect capital market assumptions with no corporate tax, equity holder’s risk increases with leverage. Under perfect capital market assumptions with no corporate tax, cost of equity increases with leverage. Under perfect capital market assumptions with no corporate tax, there is an optimal capital structure that maximizes the firm value. Under perfect capital market assumptions with no corporate tax, cost of capital for all equity (unlevered) firm is equal to cost of capital for levered firm.

Financial Reporting, Financial Statement Analysis and Valuation

8th Edition

ISBN:9781285190907

Author:James M. Wahlen, Stephen P. Baginski, Mark Bradshaw

Publisher:James M. Wahlen, Stephen P. Baginski, Mark Bradshaw

Chapter11: Risk-adjusted Expected Rates Of Return And The Dividends Valuation Approach

Section: Chapter Questions

Problem 6QE

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Which of the following statements is correct? a. As Modigliani and Miller made clear in their original work, capital structure does not matter in perfect capital markets. Thus, if capital structure does matter, then it must stem from a market imperfection. b. Because corporations pay taxes on their profits after interest payments are deducted, interest expenses increase the amount of corporate tax firms must pay. c. To determine the loss due the leverage for the value of the firm, we must compute the present value of the stream of future interest tax shields the firm will receive minus the stream of future dividends. d. By increasing the amount paid to debt holders through interest payments, the amount of the pre-tax cash flows that must be paid as taxes increases. e. In general, the gain to lenders from the tax deductibility of interest payments is referred to as the interest tax benefit.
According to Modigliani and Miller Proposition II: A. WACC curve is flat and hence no optimal capital structure exists B. WACC curve is upward slopping , indicating the equity financing exclusively being the optimal capital structure of a company C. WACC curve is downward slopping, hence the perfect capital structure is 100% debt D. An optimal capital structure exists as it is the balance between the tax benefit and the bankruptcy costs
The MM irrelevance capital structure theory proved that a firm’s value is unaffected by its capital structure.But their study was based on all of the following strong assumptions excluding: a. There are no brokerage costs. b. There are no corporate taxes and personal taxes. c. There are bankruptcy costs and agency costs. d. There is no asymmetric information problem, and all investors can borrow at the same rate as corporations.
For each statement indicate whether it is true or false and briefly explain why. a) In a perfect capital market with no corporate taxes, as a firm takes on more and more debt its weighted average cost of capital remains unchanged while its required return on equity rises. b) If a firm issues riskfree debt the risk of the firm’s equity will not change. So, riskfree debt allows the firm to get the benefit of a low cost of debt without raising its cost of equity. c) In the context of firms’ capital structure decisions, the theory predicts that the value of a firm’s equity will rise in direct proportion to the level of debt in its capital structure.
The following are the assumptions of the Modigliani and Miller approach, EXCEPT A. Investors think logicallyB. Dividends are fully declaredC. Capital Markets are PerfectD. No corporate taxes exist
Which of the following is most correct about the cost of capital? The cost of debt reflects the interest rates on debt capital before taking into account the tax effects. Cost of capital is affected by the required rates of return of each of the source of capital, regardless of the capital structure. The capital asset pricing model is the most widely used model to estimate the cost of common equity. To minimize the cost of capital, firms should borrow more than their capacity because increasing the lower cost of debt yields the lowest cost of capital, thus, enhances shareholder value.
Consider the following statements: The main lesson to be learned from the Modigliani and Miller theory of capital structure assuming perfect markets and no taxation is that: I. a firm cannot affect its value by changing its capital structure II. the value of the firm is determined by its total cash flows III. the weighted average cost of capital increases as financial leverage decreases IV. the weighted average cost of capital decreases as financial leverage decreases V. the weighted average cost of capital remains the same whatever the level of financial leverage. Which of the statements is true? Select an answer and submit. For keyboard navigation, use the up/down arrow keys to select an answer. a I and V only I, Il and V only II, II and IV only None of the above I and Il only
Consider the following statements: The main lesson to be learned from the Modigliani and Miller theory of capital structure assuming perfect markets and no taxation is that: I. a firm cannot affect its value by changing its capital structure II. the value of the firm is determined by its total cash flows III. the weighted average cost of capital increases as financial leverage decreases IV. the weighted average cost of capital decreases as financial leverage decreases V. the weighted average cost of capital remains the same whatever the level of financial leverage. Which of the statements is true? Select an answer and submit. For keyboard navigation, use the up/down arrow keys to select an answer. a I and V only b I, II and V only c II, III and IV only d None of the above e I and II only
According to the trade-off theory of capital structure which of the following statements is true (only one is): (a) The optimal capital structure is such that the marginal tax benefits from debt are equal to the marginal costs of bankruptcy. (b) There is no optimal capital structure. (c) More debt is always better as it increases tax shields. (d) More debt is always worse as it increases bankruptcy costs. (e) Retained earnings are the best financing method.
How many statements below are correct about the Modigliani-Miller theorem? i. The theorem is not an exact description of reality. ii. The theorem provides a benchmark to understand how the capital structure could affect WACC. iii. The theorem implies that firms have benefited from financing with debt due to a higher required rate of return on debt compared with equity. iv. The value of the firm is not affected by its capital structure under any assumptions.
Under Modigliani and Miller's assumption of perfect capital markets, which of the following is NOT CORRECT? A) The proper WACC equation under perfect capital markets is the "pre-tax" WACC B) Taxes are irrelevant C) Reducing the debt ratio can cause the cost of debt and the cost of equity to decline, even as the WACC stays the same. D) The WACC does not change as the weights of debt and equity change E) Bankruptcy costs reduce the amount bondholders receive when bankruptcy occurs
Which of the following statements is CORRECT? a. WACC calculations should be based on the before-tax costs of all the individual capital components. b. Flotation costs associated with issuing new common stock normally reduce the WACC. c. An increase in the risk-free rate will normally lower the marginal costs of both debt and equity financing. d. A change in a company's target capital structure cannot affect its WACC. e. If a company's tax rate increases, then, all else equal, its weighted average cost of capital will decline.

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		Under perfect capital market assumptions with no corporate tax, equity holder’s risk increases with leverage.
		Under perfect capital market assumptions with no corporate tax, cost of equity increases with leverage.
		Under perfect capital market assumptions with no corporate tax, there is an optimal capital structure that maximizes the firm value.
		Under perfect capital market assumptions with no corporate tax, cost of capital for all equity (unlevered) firm is equal to cost of capital for levered firm.
		Under perfect capital market assumptions with no corporate tax, cost of debt capital is higher than cost of equity capital.