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Which of the following statements is FALSE?

Leverage decreases the risk of the equity of a firm

Because the cash flows of the debt and equity sum to the cash flows of the project, by the Law of One Price the combined values of debt and equity must be equal to the cash flows of the project

Modigliani and Miller argued that with perfect capital markets, the total value of a firm should not depend on its capital structure

It is inappropriate to discount the cash flows of levered equity at the same discount rate that we use for unlevered equity

Which of the following is NOT one of Modigliani and Miller’s set of conditions referred to as perfect capital markets?

All investors hold the efficient portfolio of assets

There are no taxes, transaction costs, or issuance costs associated with security trading.

A firm’s financing decisions do not change the cash flows generated by its investments, nor do they reveal new information about them.

Investors and firms can trade the same set of securities at competitive market prices equal to the present value of their future cash flows

Which of the following statements is FALSE?

As long as the firm’s choice of securities does not change the cash flows generated by its assets, the capital structure decision will not change the total value of the firm or the amount of capital it can raise

If securities are fairly priced, then buying or selling securities has an NPV of zero and, therefore, should not change the value of a firm

The future repayments that the firm must make on its debt are equal in value to the amount of the loan it receives up front.

In a MM I world, managers cannot destroy shareholder value through the issuance of claims

Which of the following statements is FALSE?

When a firm issues new shares that account for a significant percentage of its outstanding shares, the transaction is called a leveraged recapitalization

MM Proposition I applies to capital structure decisions made at any time during the life of the firm.

By choosing positive-NPV projects that are worth more than their initial investment, the firm can enhance its value.

Holding fixed the cash flows generated by the firm’s assets, however, the choice of capital structure does not change the value of the firm

Which of the following statements is FALSE?

The levered equity return equals the unlevered return, plus an extra “kick” due to leverage.

By holding a portfolio of the firm’s equity and its debt, we can replicate the cash flows from holding its levered equity.

The cost of capital of levered equity is equal to the cost of capital of unlevered equity plus a premium that is proportional to the market value debt-equity ratio

If a firm is unlevered, all of the free cash flows generated by its assets are available to be paid out to its equity holders

Which of the following statements is FALSE?

If we can identify a comparison firm whose assets have the same risk as the project being evaluated, and if the comparison firm is levered, then we can use its equity cost of capital as the cost of capital for the project.

We can calculate the cost of capital of the firm’s assets by computing the weighted average of the firm’s equity and debt cost of capital, which we refer to as the firm’s weighted average cost of capital (WACC).

The portfolio of a firm’s equity and debt replicates the returns we would earn if the firm were unlevered.

When evaluating any potential investment project, we must use a discount rate that is appropriate given the risk of the project’s free cash flow.

Which of the following statements is FALSE?

With no debt, theWACC is equal to the unlevered equity cost of capital.

With perfect capital markets, a firm’sWACC is dependent of its capital structure.

As the firm borrows at the low cost of capital for debt, its equity cost of capital rises, but the net effect is that the firm’s WACC is unchanged

Although debt has a lower cost of capital than equity, leverage does not lower a firm’s WACC

Which of the following statements is FALSE?

Holding cash has the opposite effect of leverage on risk and return.

We use the market value of the firm’s net debt when computing its WACC and unlevered beta to measure the cost of capital and market risk of the firm’s business assets

Since the WACC does not change with the use of leverage, the value of the firm’s free cash flow evaluated using the WACC does not change, and so the enterprise value of the firm does not depend on its financing choices.

Even if the firm’s capital structure is more complex, the WACC is calculated by computing the weighted average cost of only the firm’s debt and equity.

Which of the following statements is FALSE?

The unlevered beta measures the market risk of the firm’s business activities, ignoring any additional risk due to leverage.

If a firm holds $1 in cash and has $1 of risk-free debt, then the interest earned on the cash will equal the interest paid on the debt. The cash flows from each source cancel each other, just as if the firm held no cash and no debt.

The unlevered beta measures the market risk of the firm without leverage, which is equivalent to the beta of the firm’s assets.

When a firm changes its capital structure without changing its investments, its levered beta will remain unaltered, however, its asset beta will change to reflect the effect of the capital structure change on its risk

Which of the following statements is FALSE?

The money taken in by the firm as a result of the share issue exactly offsets the dilution of the shares.

Most analysts prefer to use performance measures and valuation multiples that are based on the firm’s earnings before interest has been deducted

Because the firm’s earnings per share and price-earnings ratio are affected by leverage implies that we can always reliably compare these measures across firms with different capital structures

In general, as long as the firm sells the new shares of equity at a fair price, there will be no gain or loss to shareholders associated with the equity issue itself.

Which of the following statements is FALSE?

In general, the gain to investors from the tax deductibility of interest payments is referred to as the interest tax shield.

The interest tax shield is the additional amount that a firm would have paid in taxes if it did not have leverage.

Because Corporations pay taxes on their profits after interest payments are deducted, interest expenses reduce the amount of corporate tax firms must pay

As Modigliani and Miller made clear in their original work, capital structure matters in perfect capital markets. Thus, if capital structure does not matter, then it must stem from a market imperfection.

Which of the following statements is FALSE?

To determine the benefit of leverage for the value of the firm, we must compute the present value of the stream of future interest tax shields the firm will receive

Because the cash flows of the levered firm are equal to the sum of the cash flows from the unlevered firm plus the interest tax shield, by the Law of One Price the same must be true for the present values of these cash flows.

By increasing the amount paid to debt holders through interest payments, the amount of the pre-tax cash flows that must be paid as taxes increases

When a firm uses debt, the interest tax shield provides a corporate tax benefit each year

Which of the following statements is FALSE?

Given a forecast of future interest payments, we can determine the interest tax shield and compute its present value by discounting it at a rate that corresponds to its risk.

The total value of the unlevered firm exceeds the value of the firm with leverage due to the present value of the tax savings from debt

To compute the increase in the firm’s total value associated with the interest tax shield, we need to forecast a firm’s debt and its interest payments.

There is an important tax advantage to the use of debt financing.

Which of the following statements is FALSE?

Given a 35% corporate tax rate, for every $1 in new permanent debt that the firm issues, the value of the firm increases by $0.65.

The firm’s marginal tax rate may fluctuate due to changes in the tax code and changes in the firm’s income bracket

Many large firms have a policy of maintaining a certain amount of debt on their balance sheets.

Typically, the level of future interest payments varies due to changes the firm makes in the amount of debt outstanding, changes in the interest rate on that debt, and the risk that the firm may default and fail to make an interest payment.

Which of the following statements is FALSE?

The tax deductibility of interest lowers the effective cost of debt financing for the firm.

When a firm uses debt financing, the cost of the interest it must pay is offset to some extent by the tax savings from the interest tax shield

With tax-deductible interest, the effective after-tax borrowing rate is r(τC).

The WACC represents the cost of capital for the free cash flow generated by the firm’s assets.

Which of the following statements is FALSE?

The higher the firm’s leverage, the more the firm exploits the tax advantage of debt, and the lower its WACC

Corporate taxes lower the effective cost of debt financing, which translates into a reduction in the weighted average cost of capital.

Because the firm’s free cash flow is computed without considering the firm’s leverage, we account for the benefit of the interest tax shield by calculating the WACC using the before tax cost of debt

The reduction in the WACC increases with the amount of debt financing.

Which of the following statements is FALSE?

Once investors know the recap will occur, the share price will rise immediately to a level that reflects the value of the interest tax shield that the firm will receive from its recapitalization

When securities are fairly priced, the original shareholders of a firm capture the full benefit of the interest tax shield from an increase in leverage.

In the presence of corporate taxes, we do not include the interest tax shield as one of the firm’s assets on its market value balance sheet.

We can analyze the recapitalization using the market value balance sheet; it states that the total market value of a firm’s securities must equal the total market value of the firm’s assets

Which of the following statements is FALSE?

In particular, because real options allow a decision maker to choose the most attractive alternative after new information has been learned, the presence of real options adds value to an investment opportunity

To make an investment decision correctly, the value of embedded real options must be included in the decision-making process

A key distinction between a real option and a financial option is that real options, and the underlying assets on which they are based, are often traded in competitive markets.

We can compute the value of the real option by comparing the expected profit without the real option to the value with the option

Which of the following is NOT a real option?

A stock option

An abandonment option

An investment timing option

An expansion option

Which of the following statements is FALSE?

One way to see why you sometimes choose not to invest in a positive- NPV project is to think about the decision of when to invest as a choice between two mutually exclusive projects: (1) invest today or (2) wait

You invest today only when the NPV of investing today exceeds the value of the option of waiting, which from option pricing theory we know to be always positive

When you do not have the option to wait, it is optimal to invest in any positive-NPV project.

When you have the option of deciding when to invest, it is usually optimal to invest only when the NPV is positive but close to zero

Which of the following statements is FALSE?

If there is a lot of uncertainty, the benefit of waiting is diminished

In the real option context, the dividends correspond to any value from the investment that we give up by waiting.

By delaying an investment, we can base our decision on additional information

Given the option to wait, an investment that currently has a negative NPV can have a positive value

Which of the following statements is FALSE?

Aside from the current NPV of the investment, other factors affect the value of an investment and the decision to wait

The option to wait is most valuable when there is a great deal of uncertainty regarding what the value of the investment will be in the future.

The smaller the cost of waiting, the less attractive the option to delay becomes.

It is always better to wait to invest unless there is a cost to doing so

Which of the following statements is FALSE

Often, the decision to abandon a project entails costs

When a firm has a real option to invest in the future it is known as a growth option.

Because growth options have value, they contribute to the value of any firm that has future possible investment opportunities

Future growth opportunities can be thought of as a collection of real put options on potential projects

Which of the following is an example of a way in which companies can create value by exploiting real options?

Abandoning good projects in favor of newer projects

Acting quickly to take on new projects, even if there is no cost to waiting

Exercising in-the-money real options immediately

Optimally delaying or abandoning projects

The idea that once a manager makes a large investment, he should not abandon the project is known as the

Negative NPV fallacy.

Abandonment fallacy.

Sunk cost fallacy.

Dependence fallacy.

Which of the following statements is FALSE?

Equity holders expect to receive dividends and the firm is legally obligated to pay them

A firm that fails to make the required interest or principal payments on the debt is in default.

In the extreme case, the debt holders take legal ownership of the firm’s assets through a process called bankruptcy.

After a firm default, debt holders are given certain rights to the assets of the firm.

Which of the following statements is FALSE?

Although indirect costs of bankruptcy are difficult to measure accurately, they are typically much smaller than the direct costs of bankruptcy

Bankruptcy protection can be used by management to delay the liquidation of a firm that should be shut down

Because many aspects of the bankruptcy process are independent of the size of the firm, the costs are typically higher, in percentage terms, for smaller firms

Aside from the direct legal and administrative costs of bankruptcy, many other indirect costs are associated with financial distress (whether or not the firm has formally filed for bankruptcy).

Which of the following statements is FALSE?

The costs of selling assets below their value are greatest for firms with assets that lack competitive, liquid markets

Firms in financial distress tend to have difficulty collecting money that is owed to them

Suppliers may be unwilling to provide a firm with inventory if they fear they will not be paid.

The loss of customers is likely to be large for producers of raw materials (such as sugar or aluminum), as the value of these goods, once delivered, depends on the seller’s continued success.

Which of the following is NOT an indirect cost of bankruptcy?

Legal fees

Delayed liquidation

Costs to creditors

Loss of customers

Which of the following is NOT an indirect cost of bankruptcy?

Loss of suppliers

Fire sales of assets

Costs of appraisers

Loss of employees

Which of the following is NOT a direct cost of bankruptcy?

Costs to creditors

Investment banking costs

Costs of accounting experts

Legal costs and fees

Which of the following statements is FALSE?

Debt holders are not foolish—they recognize that when the firm defaults, they will not be able to get the full value of the assets. As a result, they will pay less for the debt initially.

The costs of financial distress represent an important departure from Modigliani and Miller’s assumption of perfect capital markets

Financial distress costs reduce the cash flows available to investors

When securities are fairly priced, the original shareholders of a firm pay the future value of the costs associated with bankruptcy and financial distress.

Which of the following statements is FALSE?

Calculating the precise present value of financial distress costs is a relatively straightforward process

Two key qualitative factors determine the present value of financial distress costs: (1) the probability of financial distress and (2) the magnitude of the costs after a firm is in distress

Technology firms are likely to incur high costs when they are in financial distress, due to the potential for loss of customers and key personnel, as well as a lack of tangible assets that can be easily liquidated

The magnitude of the financial distress costs will depend on the relative importance of the sources of these costs and is likely to vary by industry.

Which of the following statements is FALSE?

The presence of financial distress costs can explain why firms choose debt levels that are too high to fully exploit the interest tax shield

With higher costs of financial distress, it is optimal for the firm to choose lower leverage

Differences in the magnitude of financial distress costs and the volatility of cash flows can explain the differences in the use of leverage across industries

At the point D∗, where VL is maximized, the tax savings that result from increasing leverage are just offset by the increased probability of incurring the costs of financial distress.

A type of agency problem that results in shareholders gaining from decisions that increase the risk of the firm sufficiently, even if they have negative NPV is:

asset substitution

debt overhang

underinvestment

cashing out

A type of agency problem that results in shareholders gaining by choosing not to finance new, positive-NPV projects is:

asset substitution.

debt overhang

excessive risk-taking

distress costs

Which of the following statements is FALSE?

When a firm faces financial distress, creditors can gain by making sufficiently risky investments, even if they have negative NPV

When a firm has leverage, a conflict of interest exists if investment decisions have different consequences for the value of equity and the value of debt.

In some circumstances, managers may take actions that benefit shareholders but harm the firm’s creditors and lower the total value of the firm.

Agency costs are costs that arise when there are conflicts of interest between stakeholders

The cost of _________ is highest for firms that are likely to have profitable future growth opportunities requiring large investments.

asset substitution

debt overhang

debt covenants

debt maturity

The cost of _____ is highest for firms that can easily
increase the risk of their investments.

asset substitution

debt overhang

debt covenants

debt maturity

Which of the following statements is FALSE?

One disadvantage of using leverage is that it does not allow the original owners of the firm to maintain their equity stake

The separation of ownership and control creates the possibility of management entrenchment; facing little threat of being fired and replaced, managers are free to run the firm in their own best interests.

Managers also have their own personal interests, which may differ from those of both equity holders and debt holders.

The costs of reduced effort and excessive spending on perks are another form of agency cost.

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