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Exam 17: Does Debt Policy Matter

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Question 21

Multiple Choice

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The law of conservation of value implies that

A) the return on a firm's common stock is unchanged when debt is added to its capital structure.
B) the value of any asset is preserved regardless of the nature of the claims against it.
C) the return on a firm's debt is unchanged when common stock is added to its capital structure.
D) the value of an asset increases as debt is reduced.

E) C) and D)
F) All of the above

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Question 22

Multiple Choice

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The asset beta of a levered firm is 1.1. The beta of debt is 0.3. If the debt equity ratio is 0.5, what is the equity beta? (Assume no taxes.)

A) 1.50
B) 1.10
C) 0.30
D) 0.15

E) None of the above
F) A) and C)

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Question 23

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Investors require higher returns on levered equity than on equivalent unlevered equity.

The firm's asset beta is usually higher than the firm's equity beta.

The capital structure of the firm can be defined as I.the firm's mix of different debt securities; II.the firm's mix of different securities used to finance assets; III.the market imperfection that the firm's managers can exploit

Describe the break-even point, as displayed on an EPS-operating income graph.

Assume the following data for U&P Company: Debt (D) = $100 million; Equity (E) = $300 million; r_D = 6%; r_E = 12%; and T_C = 30%. Calculate the after-tax weighted average cost of capital (WACC) :

According to Modigliani and Miller Proposition II, the firm's expected return on assets depends on several factors including the firm's capital structure.

According to Modigliani and Miller Proposition II, the rate of return required by debtholders linearly increases as the firm's debt-equity ratio increases.

The principle of value additivity holds for the aggregation of assets but does not apply to the division of assets.

A firm has zero debt in its capital structure. Its overall cost of capital is 10 percent. The firm is considering a new capital structure with 60 percent debt. The interest rate on the debt would be 8 percent. Assuming there are no taxes, its cost of equity capital with the new capital structure would be

Generally, which of the following is true?

If a firm is financed with both debt and equity, the firm's equity is known as

The law of conservation of value does not apply to the mix of a firm's debt securities.

A policy of maximizing the value of the firm is the same as a policy of minimizing the weighted average cost of capital providing that I.the firm's investment policy is settled; II.there are no taxes; III.an issue of new debt does not affect the market value of existing debt

Briefly discuss some of the applications of the law of conservation of value.

If an investor buys a portion (X) of an unlevered firm's equity, then his/her payoff is

Capital structure is irrelevant if I.capital markets are efficient; II.each investor can borrow/lend on the same terms as the firm; III.there are no tax benefits to debt

Value additivity works for I.combining assets; II.splitting up of assets; III.the mix of debt securities issued by the firm

The M&M Company is financed by $10 million in debt (market value) and $40 million in equity (market value) . The cost of debt is 10 percent and the cost of equity is 20 percent. Calculate the weighted average cost of capital assuming no taxes.