Exam 11: Understanding Financing and Payout Decisions

Modigliani and Miller (M&M)Proposition II states:

A firm's risk level will fluctuate as its ________ changes.

The author cites a global study by Servaes and Tufano from 2006 which shows ________ as the dividend policy preferred by the vast majority (76%)of the firms surveyed.

A firm's capital structure combines all forms of financing on which the firm relies including:

$\begin{array}{c}\begin{array}{|l|}\hline \\\hline \\ \hline \text {Anticipated operating income }\\ \hline \text {Interest}\\ \hline \text {Earnings before tax}\\ \hline \text {Tax at 30 \% }\\ \hline \text {Earnings after tax}\\\hline \\ \hline \text {Combined debt and equity income }\\ \text {(interest plus earnings after tax)}\\ \hline \end{array}\begin{array}{l|} \hline \text {ALL EQUTTY}\\ \hline \\ \hline \$ 1,000,000 \\\hline\underline{\quad\quad}\\ \hline\$1,00,000\\ \hline\underline{\$300,000}\\ \hline \$ 700,000 \\ \hline\\ \hline\\\$700,000\\ \hline\end{array}\begin{array}{l|} \hline \text {EQUITY AND DEBT}\\\hline\\\hline\$ 1,000,000 \\\hline\underline{\$ 200,000} \\\hline\$ 800,000 \\\hline\underline{\$-}\\\hline\$\\\hline\\\hline\\\$\\\hline\end{array}\end{array}$ -In a world with taxes,M&M's second proposition defines the expected return on equity as:

The beauty of the Modigliani and Miller model is that if you relax the restrictive assumptions,it still demonstrates that capital structure does not impact the value of the firm.

A firm's capital structure combines all forms of long-term financing on which the firm relies EXCEPT:

The major real-world benefit of debt is that interest payments are a tax-deductible expense.

Flyover Airlines Inc.has a cost of equity equal to 24.67%.If the firm is financed with 40% debt and 60% equity and has an average cost of capital of 18%,what is the cost of debt? Assume perfect capital markets.

Under conditions of perfect capital markets,M&M insist that the value of the levered firm is greater than the value of the unlevered firm.

Modigliani and Miller each won a Nobel prize in economics in at least in part because of their work with capital structure.

________ refers to the difficulties experienced by firms as they attempt to meet financial commitments to their creditors.

Which type of firm described is likely to have a high dividend payout ratio policy?

Spectronix Inc.operates in a world of perfect capital markets,has no debt,and has a required rate of return on equity of 10%.An executive manager has suggested that borrowing money to buy back outstanding stock is a good idea because it would replace equity financing with less expensive debt financing,thus increasing the value of the firm.Assume the firm issues new debt with a required return of of 5% to repurchase 30% of the outstanding stock.What is the cost of equity at the conclusion of this transaction?

Which of the following statements regarding a share repurchase is NOT true?

Assume an M&M world with taxes where the corporate tax rate is 25%,the before tax required return on debt is 8%,the required return on the unlevered firm is 12%,and the firm is financed 20% with debt and 80% with equity.What is the required return on equity?

In M&M Proposition II the cost of equity changes with changes in the amount of debt financing.Which of the following is the correct formula for Proposition II?

Which of the following statements is NOT correct? Under conditions of perfect capital markets:

Under conditions of perfect capital markets,M&M suggest that the average cost of capital for the firm will increase with the addition of debt.

Figure 11.1: Selected information for Silicon Solutions Inc. ALL EQUITY EQUTTY AND DEBT Number of shares 1,000,000 750,000 Price per share \ 10 \ 10 Market value of shares \ 10,000,000 \ 7,500,000 Market value of debt - \ 2,500,000 Anticipated operating income \ 1,000,000 \ 1,000,000 Interest - \ 150,000 Earnings (after interest) \ 1,000,000 \ 850,000 Earnings per share \ 1.00 \ 1.13 Return on shares Average cost of capital Return on debt -According to Modigliani and Miller (M&M),in a world of perfect capital markets,what will be the expected equity return (or cost of equity)for a firm that has a cost of capital of 14 percent,a cost of debt of 8 percent,debt valued at $3.0 million,and equity valued at $4.0 million? What would happen to the cost of equity as the amount of debt increased? What would happen to the cost of debt if the amount of debt was increased?