Deck 14: How Taxes Affect Financing Choices

Question 1

Which of the following is a reason why personal taxes tend to favour the use of equity in a firm's capital structure?

A)Large portion of the returns on equity are taxed at a rate lower than ordinary tax rates.
B)Dividend payments are not tax deductible for equity holders,and are taxed at the capital gains rate.
C)Interest income is not tax deductible at the ordinary tax rate which is generally more favourable.
D)Interest income is tax deductible and leads firms to favour debt over equity financing.

Answer 1

A

Question 2

Explain the effect of personal taxes on debt and equity rates of return.

Answer 2

In general,debt is less risky than equity,and thus requires a lower expected rate of return.To simplify this analysis,it is assumed that debt is risk-free with a promised coupon and return of r_D.It is also assumed that investors are risk neutral,so that the expected return on equity which more generally can be viewed as a pre-tax zero-beta expected return,differs from r_D only because of taxes.In the absence of taxes and other market frictions,the expected return of zero-beta equity equals the return on riskless debt.With personal taxes,however,it is necessary to account for the fact that the returns to equity,which often come in the form of capital gains,are generally taxed less heavily than the returns to debt.To compensate taxable investors for its relative tax disadvantage,the pre-tax return on debt should exceed the pre-tax zero-beta expected return on equity.This pre-tax return difference leads tax-exempt investors to prefer debt to equity.However,if the return difference is not too large,investors in the highest tax brackets should prefer equity to debt.There will also be investors who are indifferent between holding debt and equity.

Question 3

Corporate taxes are said favour debt financing if:

A)returns on debt instruments are mostly by way of capital gains.
B)interest income is tax exempt for bondholders.
C)interest is a tax-deductible corporate expense.
D)the periodic interest is less than the cost of equity funds.

Answer 3

B

Question 4

Which of the following is the correct algebraic expression of a firm's cash flows (C_t),after interest payments and corporate tax payments,to its debt and equity holders? (The corporate tax rate is T_C ,the pre-tax cash flows is X_t,and interest payments of r_DD)

A)C_t= (X_t - r_DD)(1 - T_C)+ r_DD
B)C_t= (X_t + r_DD)(1 - T_C)+ r_DD
C)C_t= (X_t - r_DD)(1 - T_C)- r_DD
D)C_t= (X_t - r_DD)(1 + T_C)+ r_DD

Question 5

Explain the effect of a possible bankruptcy on the leverage.

Question 6

The Modigliani-Miller Theorem states that,in the absence of transaction costs:

A)if the capital structure decision has no effect on the total cash flows that a firm can distribute to its debt and equity holders,the levered cash flows will be lower than the unlevered cash flows.
B)if the capital structure decision has no effect on the total cash flows that a firm can distribute to its debt and equity holders,the unlevered cash flows will be lower than the levered cash flows.
C)if the capital structure decision has no effect on the total cash flows that a firm can distribute to its debt and equity holders,the decision will only affect the firm's equity.
D)if the capital structure decision has no effect on the total cash flows that a firm can distribute to its debt and equity holders,the decision also will have no effect on the total value of the firm's debt and equity.

Question 7

Explain the Modigliani-Miller Theorem with the assumptions.

Question 8

Which of the following is true of levered firms if they pay a corporate tax and no personal tax?

A)The value of a levered firm with static risk-free perpetual debt is the value of an otherwise equivalent unlevered firm divided by the product of the corporate tax rate and the market value of the firm?s debt.
B)The value of a levered firm with static risk-free perpetual debt is the value of an otherwise equivalent unlevered firm plus the product of the corporate tax rate and the market value of the firm?s debt.
C)The value of a levered firm with static risk-free perpetual debt is the value of an otherwise equivalent unlevered firm minus the product of the corporate tax rate and the market value of the firm?s debt.
D)The value of a levered firm with static risk-free perpetual debt is the value of an otherwise equivalent unlevered firm plus the product of (1- corporate tax rate)and the market value of the firm?s debt.

Question 9

Which of the following is an assumption of the Modigliani-Miller theorem?

A)The dividend growth rate is equal to the expected rate of return.
B)No arbitrage opportunities exist in the economy.
C)All firms are financed using equity.
D)All borrowing and lending activity is at the risk-free rate.

Question 10

Do firms with more taxable earnings use more debt financing? Explain.

Question 11

Which of the following assumptions in asset pricing under the Modigliani-Miller theorem that is consistent with all pricing models?

A)Return on assets is always by the way of capital gains.
B)The dividend growth rate is equal to the expected rate of return.
C)Firms are either financed by debt or by equity.
D)Equilibrium prices cannot provide opportunities for riskless arbitrage profits.

Question 12

Which of the following is the condition for compensating taxable investors for the relative tax disadvantage of debt interest payments?

A)The expected return of zero-beta equity equals the return on riskless debt.
B)The after-tax return on debt should equal the pre-tax zero-beta expected return on equity.
C)The pre-tax return on debt should exceed the pre-tax zero-beta expected return on equity.
D)The after-tax zero-beta expected return on equity should exceed the after-tax return on debt.

Question 13

If investors all have personal tax rates on debt and equity income of T_D and T_E,respectively,and if the corporate tax rate is T_C,then the value of a levered firm exceeds the value of an otherwise equivalent unlevered firm by T_gD.Which of the following is the correct algebraic expression of T_g?

A)
B)
C)
D)

Question 14

Which of the following is the correct algebraic expression for lease payment that allow the lessor to break even in each year?

A)[Debt repayment - (Depreciation deduction $\times$ T_C) $\div$ (1 - T_C)] + Interest
B)[Debt repayment - (Depreciation deduction $\times$ T_C) $\div$ (1 - T_C)] - Interest
C)[Debt repayment - Depreciation deduction $\times$ (1-T_C) $\div$ T_C] + Interest
D)[Debt repayment - Depreciation deduction $\times$ (1-T_C) $\div$ T_C] + Interest.

Question 15

Which of the following is true of the Modigliani-Miller theorem in case of costless bankruptcy?

A)The loss to the old debt holders would be offset by a gain to the equity holders,leaving the total value of the firm unaltered by this type of capital structure change.
B)If a firm's existing debt holders have a senior claim in the event of bankruptcy,a new debt issue can increase the value of existing debt.
C)The sum of all future cash flows distributed to the firm's debt and equity investors is unaffected by capital structure.
D)If a firm's existing debt holders have a junior claim in the event of bankruptcy,a new debt issue can increase the value of existing equity.

Question 16

Which of the following is true of the capital structure irrelevance theorem?

A)If two firms are identical in their capital structures,there is no opportunity to earn arbitrage profits exists if the total values of the two firms are not the same.
B)If the capital structure decision has no effect on the total cash flows that a firm can distribute to its debt and equity holders the decision will only affect the firm?s equity.
C)If two firms are identical except for their capital structures,an opportunity to earn arbitrage profits exists if the total values of the two firms are not the same.
D)If the capital structure decision has no effect on the total cash flows that a firm can distribute to its debt and equity holders then the levered cash flows will be less than the unlevered cash flows.

Question 17

The Modigliani-Miller theorem with costless bankruptcy assumes that:

A)if a firm is unable to meet its debt obligations and goes bankrupt,the equity holders can costlessly transfer ownership and control of the firm's assets at the cost of the debt holders.
B)if a firm is unable to meet its debt obligations and goes bankrupt,the ownership and control of the firm's assets move from the equity holders to the debt holders without costing either.
C)if a firm is unable to meet its debt obligations and goes bankrupt,the debt holders can costlessly takeover the ownership and control of the firm's assets at the cost of the equity holders.
D)if a firm is unable to meet its debt obligations and goes bankrupt,the ownership and control of the firm's assets move from the equity holders to the debt holders at the cost of the government.

Question 18

Which of the following methods of depreciation results in most of the depreciation expense being charged in the earliest years of the asset's depreciable life?

A)Straight line depreciation
B)Accelerated depreciation
C)MACRS method
D)ADS method

Question 19

With corporate taxes but no personal taxes,a firm's optimal capital structure is the one in which _____.

A)the cost of equity is equal to cost of debt
B)no transaction costs or opportunities for arbitrage exist
C)enough debt is included to completely eliminate the firm's tax liabilities
D)the capital gains rate is lower or equal to the ordinary tax rates for corporates