Question 1

State the law of conservation of value.

Accepted Answer

The law of conservation of value states that the value of an asset is preserved regardless of the nature of claims against it.

Question 2

A firm's asset beta equals the weighted average of the betas on its debt and equity, given the assumption of no taxes.

Accepted Answer

A) True 
 B)False  True

Question 3

Which of the following is true?

Accepted Answer

A) bD > bA > bE 
B) bE > bA > bD 
C) bA > bE > bD 
D) bA > bD > bE 
A) bD > bA > bE 
B) bE > bA > bD 
C) bA > bE > bD 
D) bA > bD > bE B

Question 4

The effect of financial leverage on the performance of the firm depends on the

Accepted Answer

A) expected rate of return on equity. 
B) firm's level of operating income. 
C) current market value of the debt. 
D) rate of dividend growth. 
A) expected rate of return on equity. 
B) firm's level of operating income. 
C) current market value of the debt. 
D) rate of dividend growth.

Question 5

If an investor buys a portion (X)of both the debt and equity of a levered firm, then his/her payoff is

Accepted Answer

A) (X)× (profits). 
B) (X)× (interest). 
C) (X)× (profits − interest). 
D) None of these options. 
A) (X)× (profits). 
B) (X)× (interest). 
C) (X)× (profits − interest). 
D) None of these options.

Question 6

Learn and Earn Company is financed entirely by common stock that is priced to offer a 20 percent expected rate of return. The stock price is $60 and the earnings per share are $12. The company wishes to repurchase 50 percent of the stock and substitutes an equal value of debt yielding 8 percent. Suppose that before refinancing, an investor owned 100 shares of Learn and Earn common stock. What should he do if he wishes to ensure that risk and expected return on his investment are unaffected by this refinancing?

Accepted Answer

A) Borrow $3,000 and buy 50 more shares. 
B) Continue to hold 100 shares. 
C) Sell 50 shares and purchase $3,000 of 8 percent debt (bonds). 
D) Sell 8 percent of his stock and invest in bonds. 
A) Borrow $3,000 and buy 50 more shares. 
B) Continue to hold 100 shares. 
C) Sell 50 shares and purchase $3,000 of 8 percent debt (bonds). 
D) Sell 8 percent of his stock and invest in bonds.

Question 7

For a levered firm,

Accepted Answer

A) as earnings before interest and taxes (EBIT)increases, earnings per share (EPS)increases by the same percentage. 
B) as EBIT increases, EPS increases by a larger percentage. 
C) as EBIT increases, EPS decreases by the same percentage. 
D) as EBIT increases, EPS decreases by a larger percentage. 
A) as earnings before interest and taxes (EBIT)increases, earnings per share (EPS)increases by the same percentage. 
B) as EBIT increases, EPS increases by a larger percentage. 
C) as EBIT increases, EPS decreases by the same percentage. 
D) as EBIT increases, EPS decreases by a larger percentage.

Question 8

MM's Proposition is violated when the firm, by imaginative design of its capital structure, can offer some financial service that meets the unmet needs of such a clientele.

Accepted Answer

A) True 
 B)False

Question 9

According to Modigliani and Miller Proposition II, since the expected rate of return on debt is less than the expected rate of return on equity, the weighted average cost of capital declines as more debt is issued.

Accepted Answer

A) True 
 B)False

Question 10

A firm has a debt-to-equity ratio of 1. Its levered cost of equity is 16 percent, and its cost of debt is 8 percent. If there were no taxes, what would be its cost of equity if the debt-to-equity ratio were zero?

Accepted Answer

A) 8 percent 
B) 10 percent 
C) 12 percent 
D) 14 percent 
A) 8 percent 
B) 10 percent 
C) 12 percent 
D) 14 percent

Question 11

State and explain MM's Proposition II.

Accepted Answer

The expected rate of return on the commo

Question 12

Explain the concept of value additivity.

Accepted Answer

If we have two streams of cash

Question 13

For a levered firm where bA = beta of assets and bD = beta of debt, the return on equity (rE)is equal to

Accepted Answer

A) rE = rA. 
B) rE = rA + (D/
E) × [rA − rD] 
C) rE = rA + (D/(D +
E) )× [rA - rD] 
D) None of these options. 
A) rE = rA. 
B) rE = rA + (D/
E) × [rA − rD] 
C) rE = rA + (D/(D +
E) )× [rA - rD] 
D) None of these options.

Question 14

A firm has a debt-to-equity ratio of 0.50. Its cost of debt is 10 percent. Its overall cost of capital is 14 percent. What is its cost of equity if there are no taxes?

Accepted Answer

A) 13 percent 
B) 16 percent 
C) 15 percent 
D) 18 percent 
A) 13 percent 
B) 16 percent 
C) 15 percent 
D) 18 percent

Question 15

If an investor buys a portion (X)of the equity of a levered firm, then his/her payoff is

Accepted Answer

A) (X)× (profits). 
B) (X)× (interest). 
C) (X)× (profits − interest). 
D) (1/X)× (profits − interest). 
A) (X)× (profits). 
B) (X)× (interest). 
C) (X)× (profits − interest). 
D) (1/X)× (profits − interest).

Question 16

If MM's Proposition I holds, minimizing the weighted average cost of capital (WACC)is the same as maximizing the

Accepted Answer

A) market value of the firm. 
B) book value of the firm. 
C) profits of the firm. 
D) liquidating value of the firm. 
A) market value of the firm. 
B) book value of the firm. 
C) profits of the firm. 
D) liquidating value of the firm.

Question 17

For a levered firm where bA = beta of assets and bD = beta of debt, the equity beta (bE)equals

Accepted Answer

A) bE = bA 
B) bE = bA + (D/
E) × [bA - bD] 
C) bE = bA + (D/(D +
E) )× [bA − bD] 
D) None of these options. 
A) bE = bA 
B) bE = bA + (D/
E) × [bA - bD] 
C) bE = bA + (D/(D +
E) )× [bA − bD] 
D) None of these options.

Question 18

If the debt beta is zero, then the relationship between the equity beta and the asset beta is given by

Accepted Answer

A) equity beta = 1 + [(beta of assets)/(debt-equity ratio)]. 
B) equity beta = (1 − debt-equity ratio)(beta of assets). 
C) equity beta = (1 + debt-equity ratio)(beta of assets). 
D) equity beta = 1 + (debt-equity ratio/ beta of assets). 
A) equity beta = 1 + [(beta of assets)/(debt-equity ratio)]. 
B) equity beta = (1 − debt-equity ratio)(beta of assets). 
C) equity beta = (1 + debt-equity ratio)(beta of assets). 
D) equity beta = 1 + (debt-equity ratio/ beta of assets).

Question 19

The law of conservation of value implies that
I.the mix of common stock and preferred stock does not affect the value of the firm;
II.the mix of long-term and short-term debt does not affect the value of the firm;
III.the mix of secured and unsecured debt does not affect the value of the firm

Accepted Answer

A) I only 
B) II only 
C) III only 
D) I, II, and III 
A) I only 
B) II only 
C) III only 
D) I, II, and III

Question 20

The M&M Company is financed by $4 million (market value)in debt and $6 million (market value)in equity. The cost of debt is 5 percent and the cost of equity is 10 percent. Calculate the weighted average cost of capital. (Assume no taxes.)

Accepted Answer

A) 10 percent 
B) 15 percent 
C) 8 percent 
D) 7 percent 
A) 10 percent 
B) 15 percent 
C) 8 percent 
D) 7 percent

Exam 17: Does Debt Policy Matter

State the law of conservation of value.

A firm's asset beta equals the weighted average of the betas on its debt and equity, given the assumption of no taxes.

Which of the following is true?

The effect of financial leverage on the performance of the firm depends on the

If an investor buys a portion (X)of both the debt and equity of a levered firm, then his/her payoff is

For a levered firm,

MM's Proposition is violated when the firm, by imaginative design of its capital structure, can offer some financial service that meets the unmet needs of such a clientele.

According to Modigliani and Miller Proposition II, since the expected rate of return on debt is less than the expected rate of return on equity, the weighted average cost of capital declines as more debt is issued.

A firm has a debt-to-equity ratio of 1. Its levered cost of equity is 16 percent, and its cost of debt is 8 percent. If there were no taxes, what would be its cost of equity if the debt-to-equity ratio were zero?

State and explain MM's Proposition II.

Explain the concept of value additivity.

For a levered firm where bA = beta of assets and bD = beta of debt, the return on equity (rE)is equal to

A firm has a debt-to-equity ratio of 0.50. Its cost of debt is 10 percent. Its overall cost of capital is 14 percent. What is its cost of equity if there are no taxes?

If an investor buys a portion (X)of the equity of a levered firm, then his/her payoff is

If MM's Proposition I holds, minimizing the weighted average cost of capital (WACC)is the same as maximizing the

For a levered firm where bA = beta of assets and bD = beta of debt, the equity beta (bE)equals

If the debt beta is zero, then the relationship between the equity beta and the asset beta is given by

The law of conservation of value implies that I.the mix of common stock and preferred stock does not affect the value of the firm; II.the mix of long-term and short-term debt does not affect the value of the firm; III.the mix of secured and unsecured debt does not affect the value of the firm

The M&M Company is financed by $4 million (market value)in debt and $6 million (market value)in equity. The cost of debt is 5 percent and the cost of equity is 10 percent. Calculate the weighted average cost of capital. (Assume no taxes.)

Introduction to Corporate Finance

How to Calculate Present Values

Valuing Bonds

The Value of Common Stocks

Net Present Value and Other Investment Criteria

Making Investment Decisions With the Net Present Value Rule

Introduction to Risk and Return

Portfolio Theory and the Capital Asset Pricing Model

Risk and the Cost of Capital

Project Analysis

How to Ensure That Projects Truly Have Positive Npvs

Agency Problems and Investment

Efficient Markets and Behavioral Finance

An Overview of Corporate Financing

How Corporations Issue Securities

Payout Policy

How Much Should a Corporation Borrow

Financing and Valuation

Understanding Options

Valuing Options

Real Options

Credit Risk and the Value of Corporate Debt

The Many Different Kinds of Debt

Leasing

Managing Risk

Managing International Risks

Financial Analysis

Financial Planning

Working Capital Management

Mergers

Corporate Restructuring

Governance and Corporate Control Around the World

Filters

For a levered firm where b_A = beta of assets and b_D = beta of debt, the return on equity (r_E)is equal to

For a levered firm where b_A = beta of assets and b_D = beta of debt, the equity beta (b_E)equals