Check your knowledge about different capital structure theories and their assumptions
Debt is cheaper than equity because
dividends are tax deductible and interest payments are not.
debtors have a lower claim to assets at liquidation than do shareholders.
debt is less risky than equity.
dividend payments on common share are optional.
The presence of which one of the following costs is not used as a major argument against the M&M arbitrage process?
The cost of capital for a firm -- when we allow for taxes, bankruptcy, and agency costs -- remains constant with increasing levels of financial leverage.
first declines and then ultimately rises with increasing levels of financial leverage.
increases with increasing levels of financial leverage.
decreases with increasing levels of financial leverage.
decreases with increasing levels of operating leverage.
The discount rate used to determine the present value of a stream of expected future cash flows is referred to as the __________.
net operating income
yield on the company's market value of common equity
The Modigliani-Miller theory says that
if there are no taxes, firms are indifferent concerning the method of financing.
taking taxes into consideration, firms should maximize the use of debt.
taking taxes into consideration, firms should maximize the use of equity.
both a and b
The term "capital structure" refers to:
long-term debt, and common stock equity.
current assets and current liabilities.
total assets minus liabilities.
A critical assumption of the net operating income (NOI) approach to valuation is:
that debt and equity levels remain unchanged.
that dividends increase at a constant rate.
that Ko (WACC) remains constant regardless of changes in leverage.
that interest expense and taxes are included in the calculation.
The existence of __________ on the balance sheet generates tax advantages that directly influence the capital structure of the firm.
a large proportion of fixed assets
All of the above answers are
The traditional approach towards the valuation of a company assumes:
that the overall capitalization rate holds constant with changes in financial leverage.
that there is an optimum capital structure.
that total risk is not altered by changes in the capital structure.
that markets are perfect.
Two firms that are virtually identical except for their capital structure are selling in the market at different values. According to M&M
one will be at greater risk of bankruptcy.
the firm with greater financial leverage will have the higher value.
this proves that markets cannot be efficient.
this will not continue because arbitrage will eventually cause the firms to sell at the same value.
The cost of capital is best calculated with:
market value weightings
book value weightings
Modigliani and Miller weightings
It doesn't matter.
When the manager of a firm uses capital structure changes to convey information about the profitability and risk of the firm, then the manager is engaging in __________.
the net operating income approach to capital structure
the traditional approach to capital structure
Which of the following statements regarding the net operating income approach is incorrect?
The overall capitalization rate, Ko (WACC), is constant.
The cost of debt funds, Ki, is constant.
The required return on equity, Ke, is constant.
The total value of the firm is unaffected by changes in financial leverage.
The traditional approach towards the valuation of a company assumes that __________.
the cost of capital is independent of the capital structure of the firm
the firm maintains constant risk regardless of the type of financing employed
there exists no optimal capital structure
that management can increase the total value of the firm through the judicious use of financial leverage
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