Module 8: Multiple Choice Questions

For students

Last updated: 08/01/2026 17:48

The questions are based on or inspired by the following references:

• Berk & DeMarzo, Corporate Finance, 5th ed. (2020)
  
• Brealey & Myers, Principles of Corporate Finance, 13th ed. (2020)

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💡 You can also press Ctrl + P (or Cmd + P on Mac) to print or save your responses as a .pdf file.

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⚠️ These exercises are powered by AI-assisted technologies and may contain occasional formatting or logic errors. Please report any issues you encounter so I can improve the experience.

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📙 Part 2 (Midterm to Final)

Module	Chapter
8	ch15

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Select the correct answers.

Q1.

The main reason why debt financing can increase firm value is that:

A. It increases earnings per share
B. It reduces the firm’s business risk
C. It eliminates bankruptcy costs
D. Interest payments are tax-deductible
E. It increases total assets

✅ Correct: D. The tax deductibility of interest creates a positive value effect known as the interest tax shield.

Q2.

In the presence of corporate taxes, Modigliani and Miller’s Proposition I implies that:

A. Leverage has no effect on firm value
B. Firm value increases with debt due to the interest tax shield
C. Firm value decreases with leverage because of higher risk
D. The cost of equity remains constant regardless of leverage
E. Dividends become tax-deductible

✅ Correct: B. With taxes, the value of the levered firm equals the unlevered value plus the present value of the tax shield.

Q3.

The interest tax shield is best described as:

A. The reduction in corporate taxes due to deductible interest expenses
B. The difference between EBIT and EBT
C. The cost of debt net of taxes
D. The excess return on equity due to leverage
E. The amount of taxable dividends paid to shareholders

✅ Correct: A. Interest tax shield refers to the reduction in taxes resulting from the deductibility of interest.

Q4.

Which of the following statements about personal taxes is TRUE?

A. Personal taxes always increase the advantage of debt
B. Personal taxes do not affect capital structure decisions
C. Equity investors usually pay higher personal taxes than bondholders
D. Personal taxes make debt financing more attractive in all cases
E. Higher personal taxes on interest can reduce the net tax advantage of debt

✅ Correct: E. When interest income is taxed more heavily than equity income, the overall tax benefit of debt declines.

Q5.

If the corporate tax rate increases, ceteris paribus, the value of the interest tax shield:

A. Decreases
B. Remains constant
C. Increases
D. Becomes negative
E. Disappears

✅ Correct: C. The tax shield equals \(τ_c × ext{Interest}\), so higher tax rates raise its value.

Q6.

When there are no taxes, Modigliani and Miller’s Proposition I states that:

A. Firm value increases with leverage
B. Firm value is independent of leverage
C. The cost of equity is constant
D. The weighted average cost of capital rises with leverage
E. Dividends are tax-deductible

✅ Correct: B. Without taxes, MM Proposition I states that firm value does not depend on capital structure.

Q7.

If the personal tax rate on interest income is higher than on equity income, then:

A. The effective tax benefit of debt is reduced
B. The effective tax benefit of debt increases
C. Debt becomes more attractive
D. Equity becomes less attractive
E. The corporate tax rate must decrease

✅ Correct: A. Higher personal taxes on interest offset part of the corporate tax advantage of debt.

Q8.

The present value of the interest tax shield for perpetual debt equals:

A. \(D × (1 - τ_c)\)
B. \(r_D × (1 - τ_c)\)
C. \(EBIT × τ_c\)
D. \(τ_c × D\)
E. \(D / (1 - τ_c)\)

✅ Correct: D. For perpetual debt, the tax shield’s present value equals \(τ_c × D\) if debt is risk-free and permanent.

Q9.

When can the value of the interest tax shield be lower than expected?

A. When tax rates rise
B. When interest rates are stable
C. When leverage is constant
D. When the firm pays regular dividends
E. When the firm does not have enough taxable income to use the deductions

✅ Correct: E. The benefit of the tax shield depends on having sufficient taxable income to offset interest expenses.

Q10.

Which statement best summarizes the relationship between taxes and capital structure?

A. Taxes have no effect on financing decisions
B. Taxes make debt financing more attractive because interest is deductible
C. Taxes make equity financing always superior to debt
D. Taxes increase the cost of debt
E. Taxes are irrelevant under all conditions

✅ Correct: B. Because interest is tax-deductible, debt provides a fiscal advantage relative to equity.

Q11.

In a world with corporate taxes, the value of a levered firm (V_L) compared to an unlevered firm (V_U) is:

A. Always lower because of higher risk
B. The same regardless of taxes
C. Higher by the present value of the interest tax shield
D. Lower by the corporate tax rate
E. Higher by the total interest expense

✅ Correct: C. With taxes, \(V_L = V_U + PV(\text{Tax Shield})\), reflecting the value created by interest deductibility.

Q12.

If personal taxes on equity income are lower than on interest income, then:

A. The effective tax advantage of debt increases
B. The cost of equity decreases
C. The corporate tax rate must also fall
D. There is no effect on leverage incentives
E. The overall tax benefit of debt is reduced

✅ Correct: E. Lower personal taxes on equity reduce the net tax advantage of debt when both levels of taxation are considered.

Q13.

Which of the following statements about the corporate tax system is correct?

A. Both interest and dividends are deductible for tax purposes
B. Interest is deductible, but dividends are not
C. Neither interest nor dividends are deductible
D. Dividends are deductible, but interest is not
E. Dividends are taxed at the same rate as interest

✅ Correct: B. Only interest payments are tax-deductible, creating an advantage for debt over equity.

Q14.

The term “double taxation” of equity income refers to:

A. Corporate profits being taxed at the firm level and again at the shareholder level
B. Dividend income being taxed twice by the same entity
C. Interest being taxed by both the firm and the lender
D. Tax-exempt investors paying two rates on capital gains
E. Firms paying taxes on both gross and net income

✅ Correct: A. Equity returns are taxed twice—once at the corporate level and again when distributed as dividends or capital gains.

Q15.

Why does the interest tax shield create value for shareholders?

A. It increases the firm’s pre-tax profits
B. It raises dividends per share
C. It reduces corporate taxes, increasing after-tax cash flows
D. It eliminates equity risk
E. It lowers the cost of debt below zero

✅ Correct: C. The tax shield lowers taxes paid by the firm, increasing the cash flow available to shareholders.

Q16.

Which of the following correctly expresses the value of the interest tax shield for perpetual debt?

A. \((1 - τ_c) × D\)
B. \(τ_c / D\)
C. \(D / τ_c\)
D. \(r_D × τ_c\)
E. \(τ_c × D\)

✅ Correct: E. For permanent, risk-free debt, the tax shield’s value equals the tax rate multiplied by the debt amount.

Q17.

If a firm’s taxable income falls to zero, what happens to its interest tax shield?

A. It remains unchanged
B. It becomes worthless until the firm earns taxable income again
C. It increases because losses are deductible
D. It turns into a dividend tax credit
E. It is automatically refunded by the tax authority

✅ Correct: B. The firm cannot benefit from the interest tax deduction when it has no taxable income.

Q18.

Which of the following correctly describes the effect of a reduction in the corporate tax rate?

A. The value of the interest tax shield decreases
B. The value of the interest tax shield increases
C. The cost of debt rises
D. Debt becomes more attractive
E. The firm’s WACC decreases

✅ Correct: A. Since the tax shield is proportional to \(τ_c\), a lower tax rate reduces its value.

Q19.

Which of the following is NOT a reason the actual tax benefit from debt may be smaller than predicted?

A. The firm has tax loss carryforwards
B. Some interest payments are non-deductible
C. The firm always maintains full taxable income
D. Interest deductions exceed taxable income
E. Tax rules limit deductible interest

✅ Correct: C. Having full taxable income ensures full use of deductions — so it does NOT reduce the benefit.

Q20.

In Modigliani and Miller’s framework with taxes, the increase in firm value from debt equals:

A. The total amount of interest paid each year
B. The cost of debt multiplied by the equity value
C. The unlevered value times the corporate tax rate
D. The present value of the interest tax shield
E. The market value of equity only

✅ Correct: D. The tax shield’s present value directly increases the total firm value in the MM model with taxes.

Q21.

Which of the following best describes the impact of interest deductibility on firm value?

A. It reduces the firm’s total cash flow
B. It increases firm value by lowering taxes paid
C. It decreases the firm’s net present value
D. It raises the cost of capital
E. It makes dividends tax-deductible

✅ Correct: B. Deductible interest lowers taxes, creating a tax shield that raises firm value.

Q22.

What happens to the after-tax cost of debt when the corporate tax rate rises?

A. It increases
B. It remains unchanged
C. It decreases
D. It becomes equal to the cost of equity
E. It turns negative

✅ Correct: C. Higher taxes make interest deductions more valuable, reducing the effective after-tax cost of debt.

Q23.

Which of the following correctly expresses the after-tax cost of debt?

A. \(r_D + τ_c\)
B. \(r_D / τ_c\)
C. \(r_D × τ_c\)
D. \((1 - τ_c) / r_D\)
E. \(r_D(1 - τ_c)\)

✅ Correct: E. The after-tax cost of debt equals the pre-tax rate multiplied by \((1 - τ_c)\).

Q24.

When personal taxes are considered, the effective tax benefit of debt depends on:

A. Both corporate and personal tax rates on debt and equity
B. Only the corporate tax rate
C. Only personal taxes on dividends
D. The firm’s payout ratio
E. Market interest rates only

✅ Correct: A. The net tax advantage of debt reflects both corporate and personal taxation of debt and equity income.

Q25.

Which of the following policies would reduce the value of the interest tax shield?

A. Increasing corporate tax rates
B. Increasing the amount of permanent debt
C. Allowing loss carryforwards
D. Imposing limits on deductible interest
E. Paying interest annually

✅ Correct: D. Restrictions on deductible interest directly reduce the tax shield’s value.

Q26.

Why do in most countries equity investors face double taxation while debt investors usually do not?

A. Because debt income is exempt at the corporate level
B. Because dividends are deductible for firms
C. Because interest is deductible, but dividends are paid from after-tax income
D. Because debt is riskier than equity
E. Because capital gains are tax-free

✅ Correct: C. Interest payments reduce taxable income, but dividends are paid after taxes—creating double taxation for equity.

Q27.

If corporate taxes are eliminated, the difference between levered and unlevered firm values will:

A. Increase
B. Disappear
C. Become negative
D. Depend on the personal tax rate
E. Double

✅ Correct: B. Without corporate taxes, the interest tax shield vanishes, making leverage irrelevant to firm value.

Q28.

If both corporate and personal taxes exist, the effective tax advantage of debt (τ*) will be:

A. Equal to the corporate tax rate
B. Zero in all cases
C. Always greater than one
D. Independent of personal taxes
E. Lower than τ_c if interest income is taxed more heavily than equity income

✅ Correct: E. Personal taxes on interest reduce the effective tax advantage of debt below the corporate tax rate.

Q29.

Which of the following would increase the total value of the firm under Modigliani–Miller with taxes?

A. Increasing the level of debt
B. Reducing interest payments
C. Paying more dividends
D. Lowering the corporate tax rate
E. Paying less interest on equity

✅ Correct: A. More debt means more deductible interest, raising the present value of the tax shield.

Q30.

The total value of a levered firm equals:

A. The unlevered firm value minus the tax shield
B. The unlevered firm value only
C. The market value of equity plus interest payments
D. The unlevered firm value plus the present value of tax shields
E. The unlevered firm value plus total debt interest

✅ Correct: D. In MM with taxes, \(V_L = V_U + PV(\text{Tax Shields})\).

Q31.

Why do governments often limit the deductibility of interest expenses?

A. To encourage firms to borrow more
B. To reduce inflation
C. To prevent excessive tax avoidance through leverage
D. To increase firms’ WACC
E. To promote equity issuance

✅ Correct: C. Interest deduction caps are designed to limit the erosion of tax revenue from heavily leveraged firms.

Q32.

How does a reduction in corporate tax rates affect the incentive to use debt financing?

A. It weakens the incentive, since the value of the tax shield falls
B. It strengthens the incentive, since the after-tax cost of debt rises
C. It eliminates the incentive entirely
D. It makes equity financing more expensive
E. It has no effect on debt policy

✅ Correct: A. Lower tax rates reduce the benefit of deducting interest, making debt less attractive.

Q33.

Which of the following would most likely increase the net tax benefit of debt?

A. An increase in the personal tax rate on interest
B. A fall in corporate tax rates
C. A decline in firm profitability
D. A tightening of limits on interest deductibility
E. A rise in corporate tax rates

✅ Correct: E. Higher corporate taxes increase the value of interest deductions and the tax advantage of debt.

Q34.

What is the main reason dividends are not deductible for corporate tax purposes?

A. They represent interest paid to creditors
B. They are contractual obligations
C. They are taxed only at the investor level
D. They are distributions of after-tax profits, not operating expenses
E. They are tax credits

✅ Correct: D. Dividends are paid from after-tax earnings and thus do not reduce taxable income.

Q35.

The effective tax advantage of debt (τ*) is equal to zero when:

A. Corporate taxes are positive and personal taxes are zero
B. The total tax burden on equity equals that on debt
C. Personal taxes on interest are zero
D. The firm has no leverage
E. Interest rates fall

✅ Correct: B. When debt and equity face identical combined tax treatment, there is no net advantage to leverage.

Q36.

What is the primary source of the tax benefit of debt?

A. The reduction in bankruptcy risk
B. The exemption of dividends from taxation
C. The deductibility of interest expenses
D. The lower personal tax on debt income
E. The depreciation of assets

✅ Correct: C. The deductibility of interest payments under the corporate tax code creates the tax shield.

Q37.

Which of the following statements about the tax treatment of debt is TRUE?

A. Interest payments are taxed at both the firm and investor level
B. Interest is taxed only when debt matures
C. Interest is not deductible at the corporate level
D. The firm receives a tax credit for paying interest
E. Interest is deductible to the firm but taxable to the investor

✅ Correct: E. Interest reduces taxable income for firms but is taxed as ordinary income for investors.

Q38.

When a firm accumulates large deferred tax assets, what does this indicate about the current use of its interest tax shields?

A. The firm is fully using all interest deductions immediately
B. The firm cannot fully use its deductions now and is carrying them forward for future use
C. The firm has no taxable income or interest expenses
D. The firm is over-leveraged and loses tax benefits
E. The firm is paying higher current taxes due to deferred liabilities

✅ Correct: B. Deferred tax assets arise when a firm cannot use deductions immediately, allowing it to apply those tax shields in future profitable periods.

Q39.

Which of the following correctly describes the impact of corporate taxes on the value of a levered firm according to Modigliani–Miller Proposition I with taxes?

A. Taxes make equity more attractive than debt
B. Firm value increases by the present value of the interest tax shield
C. Taxes have no effect on firm value
D. Firm value decreases as debt increases
E. The cost of equity becomes lower than the cost of debt

✅ Correct: B. With corporate taxes, firm value rises by the present value of the interest tax shield, as interest is deductible and reduces taxable income.

Q40.

How does international tax arbitrage affect corporate leverage decisions?

A. Firms ignore differences in international tax regimes
B. Firms reduce leverage in all markets
C. Firms borrow in high-tax jurisdictions to maximize the value of the tax shield
D. Firms increase dividends to offset foreign taxes
E. Firms avoid issuing debt abroad

✅ Correct: C. Companies often shift debt to higher-tax countries to exploit larger tax shields.

Q41.

Which of the following statements best describes how taxes influence capital structure?

A. Taxes have no impact on financing decisions
B. Higher taxes make equity more attractive
C. Lower taxes increase the benefit of debt
D. Taxes increase the firm’s weighted average cost of capital
E. Higher corporate taxes increase the value of the debt tax shield

✅ Correct: E. The higher the corporate tax rate, the greater the value of interest deductibility and the incentive to use debt.

Q42.

If a government removes the deductibility of interest, what will happen to firms’ leverage?

A. Firms will increase their use of debt
B. Firms will reduce their use of debt
C. Leverage will remain constant
D. Equity will become more expensive
E. Dividend payments will increase

✅ Correct: B. Without interest deductibility, the tax advantage of debt disappears, leading firms to reduce leverage.

Q43.

What is the expected effect on the value of the tax shield if a firm becomes unprofitable?

A. It increases, since losses are tax deductible
B. It remains the same regardless of income
C. It decreases because the firm cannot use interest deductions immediately
D. It doubles in value if the firm carries forward losses
E. It becomes negative

✅ Correct: C. When the firm has no taxable income, it cannot benefit from interest deductions in the current period.

Q44.

What is the main consequence of having identical tax rates on corporate and personal income?

A. The net tax advantage of debt becomes zero
B. The firm’s equity value increases
C. The cost of debt exceeds the cost of equity
D. The WACC declines
E. Leverage becomes infinitely valuable

✅ Correct: A. When corporate and personal tax rates are identical, the effective tax benefit of debt is eliminated.

Q45.

Which of the following scenarios most reduces the value of the debt tax shield?

A. An increase in corporate tax rates
B. Stable profits and consistent interest deductions
C. Low personal taxes on equity income
D. High profitability with no tax loss carryforwards
E. Frequent losses that prevent the use of interest deductions

✅ Correct: E. If the firm cannot use interest deductions because of losses, the value of the tax shield is reduced.

Q46.

If a firm operates in a country where interest is not tax-deductible, what would be the expected impact on its capital structure?

A. The firm would increase leverage to boost returns
B. The firm would rely more heavily on short-term debt
C. The firm would use less debt because there is no tax advantage
D. The firm’s value would increase with more leverage
E. The firm would be indifferent between debt and equity financing

✅ Correct: C. When interest is not deductible, the tax benefit of debt disappears, leading firms to reduce their reliance on leverage.

Q47.

Which tax-related factor primarily explains differences in leverage across countries?

A. Accounting standards
B. Corporate tax rate differentials
C. Dividend policies
D. Firm size
E. Market regulation

✅ Correct: B. Cross-country differences in corporate tax rates lead to different incentives to use debt.

Q48.

If personal taxes on interest are higher than on dividends, the effective corporate tax benefit of debt:

A. Increases
B. Remains unchanged
C. Decreases
D. Doubles
E. Is unaffected by investor taxes

✅ Correct: C. Higher personal taxes on interest reduce investors’ after-tax returns, diminishing debt’s effective tax advantage.

Q49.

Which of the following represents a condition for the full realization of the debt tax shield?

A. The firm must have sufficient taxable income to offset interest expenses
B. The firm must pay dividends regularly
C. Interest must exceed EBIT
D. The firm must be unlevered
E. Corporate taxes must be zero

✅ Correct: A. Firms need positive taxable income to fully benefit from interest deductions.

Q50.

Why might policymakers consider limiting the tax advantage of debt?

A. To encourage firms to increase leverage
B. To reduce tax revenue
C. To make debt more risky
D. To discourage firms from issuing equity
E. To prevent excessive borrowing and protect financial stability

✅ Correct: E. High leverage increases systemic risk; limiting the tax advantage discourages excessive debt use.

Q51.

When is the corporate tax benefit of debt maximized?

A. When the firm is unprofitable
B. When tax rates are low
C. When the firm is profitable and interest is fully deductible
D. When the firm issues only equity
E. When interest is not deductible

✅ Correct: C. The benefit is highest when the firm can fully apply interest deductions to reduce taxable income.

Q52.

What is the main effect of corporate taxes on a firm’s weighted average cost of capital (WACC)?

A. WACC increases with higher taxes
B. WACC is unaffected by taxes
C. WACC rises with leverage
D. WACC equals the cost of equity
E. WACC declines because interest is tax-deductible

✅ Correct: E. Taxes make debt cheaper after tax, lowering the firm’s overall cost of capital.

Q53.

If a firm operates in a country with no corporate income tax, which statement is true?

A. Debt provides a tax shield
B. There is no tax-related advantage to debt
C. Interest becomes more valuable to investors
D. The firm’s cost of debt increases
E. Equity becomes tax deductible

✅ Correct: B. Without corporate income taxes, the interest tax shield disappears and debt offers no fiscal benefit.

Q54.

Why might a firm prefer equity financing even when interest is tax-deductible?

A. Because of non-tax factors like flexibility and lower financial risk
B. Because equity has higher after-tax returns
C. Because debt cannot be repaid
D. Because tax shields are always risky
E. Because dividends are tax-deductible

✅ Correct: A. Firms may avoid debt to maintain flexibility or reduce bankruptcy risk, even if taxes favor leverage.

Q55.

If tax rates decrease, how does this affect the value of the firm’s interest tax shield?

A. It increases
B. It remains constant
C. It decreases
D. It becomes zero
E. It becomes infinite

✅ Correct: C. Lower tax rates reduce the magnitude of the benefit from interest deductibility.

Q56.

A firm has a cost of equity of 10%, cost of debt of 6%, a debt-to-value ratio of 40%, and a corporate tax rate of 30%. What is its after-tax WACC?

A. 8.4%
B. 7.8%
C. 7.6%
D. 9.0%
E. 6.0%

✅ Correct: C.
WACC = 0.6(10%) + 0.4(6%)(1 − 0.3) = 6.0% + 1.68% = 7.68% ≈ 7.6%.

Q57.

A company finances itself with 50% equity and 50% debt. Its cost of equity is 12%, cost of debt is 8%, and corporate tax rate is 25%. What is its after-tax WACC?

A. 8.5%
B. 9.0%
C. 8.0%
D. 10.0%
E. 7.0%

✅ Correct: A.
WACC = 0.5(12%) + 0.5(8%)(1 − 0.25) = 6.0% + 3.0% = 8.5%.

Q58.

Which of the following describes a situation where the effective tax advantage of debt is negative?

A. Corporate taxes exceed personal taxes
B. The firm is profitable
C. Interest income is tax-free
D. Corporate tax rates are 100%
E. When personal taxes on interest exceed the corporate tax benefit

✅ Correct: E. If investors face high personal taxes on interest, debt may have a net negative tax impact.

Q59.

If dividends are taxed more heavily than interest income, which form of financing is preferred?

A. Debt financing
B. Equity financing
C. Retained earnings
D. Convertible securities
E. Preference shares

✅ Correct: A. Debt becomes more attractive when dividends are taxed more heavily.

Q60.

Which of the following is a direct implication of Modigliani–Miller Proposition I with taxes?

A. Firm value decreases with leverage
B. WACC remains constant regardless of leverage
C. Firm value increases with leverage due to the interest tax shield
D. Cost of equity decreases with leverage
E. Taxes have no effect on capital structure

✅ Correct: C. With taxes, firm value increases with leverage because interest reduces taxable income.

Q61.

A firm has an unlevered value of $500 million and permanent debt of $200 million. The corporate tax rate is 30%. According to Modigliani–Miller with taxes, what is the value of the levered firm?

A. $520 million
B. $560 million
C. $600 million
D. $650 million
E. $700 million

✅ Correct: B.
Under MM with taxes:
V_L = V_U + T_CD = 500 + (0.3 × 200) = $560 million.

Q62.

If the effective tax rate on equity is zero, what happens to the relative tax advantage of debt?

A. It increases
B. It remains constant
C. It doubles
D. It decreases
E. It becomes infinite

✅ Correct: D. When equity income is untaxed, the advantage of debt financing diminishes.

Q63.

Which of the following factors may reduce the effective use of debt tax shields?

A. Volatile earnings leading to years without taxable income
B. Constant profitability
C. High credit ratings
D. Positive net income
E. No interest-bearing debt

✅ Correct: A. Firms with unstable income may be unable to fully use tax deductions in low-profit years.

Q64.

When a firm shifts debt from a low-tax to a high-tax country within a multinational group, the likely effect is:

A. No change in total firm value
B. Higher tax payments overall
C. A decrease in after-tax profits
D. A reduction in global debt capacity
E. An increase in the overall value of tax shields

✅ Correct: E. Debt in high-tax countries generates larger interest deductions, increasing global after-tax value.

Q65.

If the government introduces a cap on interest deductibility, what is the direct consequence for leveraged firms?

A. Their WACC decreases
B. Their effective tax benefit from debt declines
C. They will increase debt to maintain tax shields
D. They become more profitable
E. They pay no taxes at all

✅ Correct: B. Limiting deductible interest directly reduces the value of the tax shield.

Q66.

A firm issues $100 million in perpetual debt with an interest rate of 5%. The corporate tax rate is 30%. What is the present value of the interest tax shield?

A. $30 million
B. $20 million
C. $25 million
D. $50 million
E. $15 million

✅ Correct: A.
For perpetual debt: PV(Tax Shield) = T_C × D = 0.30 × 100 = $30 million.

Q67.

Which of the following statements about the interaction of corporate and personal taxes is true?

A. Personal taxes have no effect on the advantage of debt
B. Only corporate taxes determine the effective tax shield
C. High personal taxes on equity make debt less attractive
D. The relationship is irrelevant in MM with taxes
E. High personal taxes on interest reduce the advantage of debt

✅ Correct: E. Because investors pay higher taxes on interest, the effective tax benefit of debt declines.

Q68.

Firm X increases its debt-to-equity ratio from 0.5 to 1.0 while maintaining a 30% tax rate and a cost of debt of 6%. By how much does its WACC change if the unlevered cost of capital is 10%?

A. WACC rises to 11%
B. WACC remains 10%
C. WACC decreases slightly to 9.7%
D. WACC decreases to about 9.3%
E. WACC falls below 8%

✅ Correct: D.
With taxes, WACC = r_U(1 − T_CD/V).
When D/V rises from 0.33 to 0.50,
WACC falls from 10 × (1 − 0.3 × 0.33) = 9.0%
to 10 × (1 − 0.3 × 0.50) = 9.3%, a small decrease due to higher leverage.

Q69.

How would a higher capital gains tax affect the relative attractiveness of debt financing?

A. It makes equity more attractive
B. It makes debt more attractive
C. It has no impact
D. It reduces both equity and debt appeal
E. It raises WACC

✅ Correct: B. Higher capital gains taxes reduce the after-tax return on equity, making debt relatively more attractive.

Q70.

A firm’s unlevered value is 600 million. It issues 200 million in perpetual debt at 5% interest. The corporate tax rate is 30%. What is the levered value of the firm?

A. $605 million
B. $610 million
C. $620 million
D. $660 million
E. $700 million

✅ Correct: D.
PV of the tax shield = T_C × D = 0.30 × 200 = $60 million.
Levered value = 600 + 60 = $660 million.

Q71.

In Modigliani–Miller with taxes, what happens to firm value as debt increases?

A. Firm value decreases
B. Firm value remains constant
C. Firm value increases due to the interest tax shield
D. Firm value declines due to higher interest costs
E. Firm value depends on dividends

✅ Correct: C. With taxes, debt adds value because interest is deductible, increasing firm value by the present value of tax shields.

Q72.

Which factor can cause two firms in the same industry to have different optimal debt levels despite facing identical tax rates?

A. Corporate tax rate
B. Industry regulations
C. Cost of equity
D. Dividend policy
E. Differences in expected profitability and loss carryforwards

✅ Correct: E. Firms with different profit profiles or tax loss carryforwards benefit differently from interest deductions.

Q73.

Which of the following best explains why high-growth firms often have lower leverage despite tax advantages of debt?

A. They prioritize financial flexibility over tax savings
B. They have higher marginal tax rates
C. They face fewer investment opportunities
D. They have larger interest deductions
E. They pay higher dividends

✅ Correct: A. Growth firms value flexibility and low distress risk more than the tax benefits of debt.

Q74.

A firm plans to issue $150 million of 10-year debt at 8% interest. The tax rate is 25%, and the discount rate for the tax shield is 8%. What is the present value of the tax shields over the debt’s life?

A. $25 million
B. $28.1 million
C. $32 million
D. $36 million
E. $40 million

✅ Correct: B.
Annual shield = 150 × 0.08 × 0.25 = 3.0 million.
PV = 3.0 × [1 − (1 / 1.08¹⁰)] / 0.08 = $28.1 million.

Q75.

If a firm pays no taxes due to permanent exemptions, what is the expected value of the interest tax shield?

A. Equal to the cost of debt
B. Negative
C. Equal to total interest
D. Zero
E. Doubled

✅ Correct: D. Without taxable income, there is no tax to offset—hence, no tax shield value.

Q76.

A firm with no debt has a value of 400 million. It introduces 100 million of perpetual debt at 6% interest. The corporate tax rate is 25%. What is the value of the tax shield and the new firm value?

A. 10M shield; firm value 405M
B. 15M shield; firm value 410M
C. 25M shield; firm value 425M
D. 30M shield; firm value 430M
E. 40M shield; firm value 440M

✅ Correct: C.
PV(Tax Shield) = T_C × D = 0.25 × 100 = 25M.
Firm value = 400 + 25 = $425M.

Q77.

Which of the following best explains why personal taxes may offset corporate tax benefits of debt?

A. Corporate taxes are paid on retained earnings
B. Interest is deductible at both levels
C. Interest income is taxed more heavily than equity income
D. Dividends are not taxed
E. Share repurchases are untaxed

✅ Correct: C. Higher personal taxation of interest reduces the net benefit of the corporate tax deduction.

Q78.

What does the term “full integration” of corporate and personal taxes mean?

A. Firms and individuals file joint tax returns
B. Corporate income is exempt from taxation
C. Dividends are taxed twice
D. Interest is taxed at a higher rate than dividends
E. Corporate and personal taxes are combined, eliminating double taxation

✅ Correct: E. Under full integration, investors are taxed only once on corporate income, removing the bias toward debt.

Q79.

A firm’s pre-tax cost of debt is 9%, its equity cost is 15%, and its debt-to-equity ratio is 1. The corporate tax rate is 30%. What is the after-tax weighted average cost of capital (WACC)?

A. 9.0%
B. 10.8%
C. 11.5%
D. 12.0%
E. 13.2%

✅ Correct: B.
Weights: 50% debt, 50% equity.
After-tax cost of debt = 9% × (1 − 0.30) = 6.3%.
WACC = 0.5 × 6.3% + 0.5 × 15% = 10.8%.

Q80.

How do taxes affect the cost of equity in a levered firm?

A. Taxes on interest do not directly change r_E, but the tax shield lowers WACC
B. The cost of equity always declines with taxes
C. The cost of equity equals the after-tax cost of debt
D. The cost of equity falls to zero
E. Taxes eliminate the need to estimate r_E

✅ Correct: A. Taxes do not directly affect r_E, but they reduce WACC by lowering the weighted cost through debt’s tax shield.

Q81.

A firm has perpetual debt of $300 million at 5% interest. If the corporate tax rate falls from 35% to 25%, by how much does the value of the interest tax shield change?

A. $7.5 million
B. $30 million
C. $45 million
D. $75 million
E. $105 million

✅ Correct: B.
Under MM with taxes, PV(Tax Shield) = T_C × D.
Before = 0.35 × 300 = 105 million
After = 0.25 × 300 = 75 million
Change = 105 − 75 = $30 million decrease.

Q82.

Two firms are identical except for their tax rates: Firm A pays 40% and Firm B pays 20%. Both have $100 million in perpetual debt. Which firm has the higher value of the tax shield, and by how much?

A. Firm A, by $20 million
B. Firm B, by $10 million
C. Firm A, by $10 million
D. Firm B, by $20 million
E. Both have equal tax shields

✅ Correct: A.
PV(Tax Shield) = T_C × D.
Firm A: 0.40 × 100 = 40 million
Firm B: 0.20 × 100 = 20 million
Difference = $20 million, so Firm A’s tax shield is higher.

Q83.

Which of the following best describes double taxation of corporate income?

A. Taxing only dividends twice
B. Corporate income is taxed once at the firm level
C. Only capital gains are taxed twice
D. Dividends are exempt from personal tax
E. Corporate profits are taxed at both corporate and personal levels

✅ Correct: E. Double taxation occurs when profits are taxed first as corporate income and again as personal income when distributed as dividends.

Q84.

A company issues $100 million of debt with a 5-year maturity and a 6% interest rate. The corporate tax rate is 30%. If the appropriate discount rate for the tax shield is also 6%, what is the present value of the total tax shields over the debt’s life (assume annual interest payments)?

A. $9 million
B. $15 million
C. $14.1 million
D. $18 million
E. $30 million

✅ Correct: C.
Annual tax shield = 100 × 0.06 × 0.30 = 1.8 million.
PV = 1.8 × [1 − (1 / 1.06⁵)] / 0.06 = $14.1 million.

Q85.

If a firm’s marginal tax rate fluctuates significantly, what is the likely effect on its capital structure?

A. The firm will increase leverage
B. The firm will use less debt to avoid losing tax benefits in low-tax years
C. The firm’s WACC increases
D. The firm pays more dividends
E. The firm becomes risk-free

✅ Correct: B. Volatile tax rates make it harder to consistently capture tax shields, discouraging high leverage.

Q86.

A firm’s unlevered cost of capital is 10%, and its after-tax cost of debt is 4%. If the firm’s capital structure is 60% equity and 40% debt, what is its weighted average cost of capital (WACC)?

A. 6.0%
B. 7.6%
C. 8.2%
D. 9.0%
E. 10.0%

✅ Correct: B.
WACC = (E/V) × r_E + (D/V) × r_D(1 − T_C).
Assuming the after-tax debt cost is already 4%,
WACC = 0.6 × 10% + 0.4 × 4% = 7.6%.

Q87.

A firm has EBIT of 500 million, pays interest of 150 million, and faces a 21% corporate tax rate. What is the value of the annual interest tax shield?

A. $21 million
B. $75 million
C. $31.5 million
D. $50 million
E. $10.5 million

✅ Correct: C.
The annual tax shield equals the interest expense multiplied by the corporate tax rate:
$150 × 0.21 = $31.5 million.
This represents the annual reduction in taxes due to interest deductibility.

Q88.

A firm has EBIT of 120 million and a statutory corporate tax rate of 30%. It considers issuing debt that will generate 30 million of annual interest expense (permanent). By how many percentage points does the firm’s effective tax rate on EBIT fall after introducing the interest deduction?

A. 3.0 percentage points
B. 5.0 percentage points
C. 7.5 percentage points
D. 10.0 percentage points
E. 12.0 percentage points

✅ Correct: C.
Without debt: Taxes = 0.30 × 120 = 36 → effective tax rate = 36/120 = 30%.
With debt: EBT = 120 − 30 = 90; Taxes = 0.30 × 90 = 27 → effective tax rate = 27/120 = 22.5%.
The firm’s effective tax rate therefore falls by 7.5 percentage points due to interest deductibility.

Q89.

A company has a perpetual debt of $80 million at an interest rate of 8% and faces a corporate tax rate of 25%. What is the present value of its annual interest tax shield?

A. $4 million
B. $6 million
C. $8 million
D. $20 million
E. $25 million

✅ Correct: D.
Annual interest = 0.08 × 80 = 6.4 million.
Annual tax shield = 6.4 × 0.25 = 1.6 million.
Since the debt is perpetual, the present value of the tax shield is $1.6 / 0.08 = $20 million.

Q90.

A firm’s corporate tax rate falls from 35% to 25%, while its debt remains at $200 million. By how much does the value of its interest tax shield change?

A. Increases by $20 million
B. Decreases by $15 million
C. Decreases by $20 million
D. Increases by $10 million
E. Remains unchanged

✅ Correct: C.
Under MM with taxes: PV(Tax Shield) = T_C × D.
Before: 0.35 × 200 = 70 million
After: 0.25 × 200 = 50 million
Change = 70 − 50 = $20 million decrease.

Q91.

A firm has debt of $400 million with an interest rate of 7%, and the corporate tax rate is 30%. What is the annual tax shield from interest deductibility?

A. $8.4 million
B. $10.5 million
C. $12 million
D. $16 million
E. $28 million

✅ Correct: A.
Interest expense = 400 × 0.07 = 28 million
Tax shield = 28 × 0.30 = $8.4 million annual tax benefit.

Q92.

In the Modigliani–Miller framework with corporate taxes, which expression best represents firm value?

A. V_L = V_U − T_CD
B. V_L = V_U × T_C
C. V_L = V_U
D. V_L = V_U − PV(Tax Shield)
E. V_L = V_U + T_CD

✅ Correct: E. MM with taxes shows that firm value increases by the present value of the interest tax shield, T_CD.

Q93.

A firm has debt of $250 million at an interest rate of 8% and faces a corporate tax rate of 25%. What is the annual value of its interest tax shield?

A. $5 million
B. $10 million
C. $15 million
D. $20 million
E. $25 million

✅ Correct: A.
Interest expense = 250 × 0.08 = 20 million
Tax shield = Interest × Tax rate = 20 × 0.25 = $5 million annual tax saving.

Q94.

Why does the existence of international tax havens complicate the analysis of debt tax benefits?

A. Firms can shift profits to low-tax jurisdictions, changing effective tax rates
B. Interest is not deductible anywhere
C. Equity income becomes untaxed
D. Tax havens eliminate bankruptcy risk
E. Firms must pay double taxes

✅ Correct: A. Profit shifting alters the location of taxable income, affecting how much of the interest deduction is actually useful.

Q95.

What is one implication of a territorial tax system for multinational debt policy?

A. All foreign profits are taxed at home
B. There is no incentive to shift debt across borders
C. It increases double taxation
D. Firms may borrow more in high-tax countries to maximize global tax shields
E. It prohibits internal lending

✅ Correct: D. Territorial systems tax income only where earned, so firms locate debt in high-tax countries to maximize deductions.

Q96.

A firm has an unlevered cost of capital of 10%. It has USD 200 million in debt at 6% interest, the corporate tax rate is 30%, and the total firm value (V_L) is 500 million. What is the levered cost of equity?

A. 10.8%
B. 11.5%
C. 12.0%
D. 12.3%
E. 13.0%

✅ Correct: D.
Using the after-tax MM relation:
r_E = r_U + (D/E)(1 − T_C)(r_U − r_D).
Here, E = V_L − D = 500 − 200 = 300.
So r_E = 10% + (200/300)(0.7)(10% − 6%) = 10% + 0.667 × 0.7 × 4% = 12.3%.

Q97.

A company earns $100 million in EBIT, pays $10 million in interest, and faces a 30% corporate tax rate. What is its after-tax income?

A. $63 million
B. $70 million
C. $60 million
D. $55 million
E. $65 million

✅ Correct: A.
Taxable income = EBIT − Interest = 100 − 10 = 90
Taxes = 90 × 0.30 = 27
After-tax income = 90 − 27 = $63 million.

Q98.

A firm has debt of $400 million at an interest rate of 6% and faces a corporate tax rate of 25%. If the government limits the deductibility of interest to 70% of total interest expense, what is the value of the firm’s annual tax shield?

A. $18 million
B. $20 million
C. $4.2 million
D. $6.0 million
E. $10.5 million

✅ Correct: C.
Interest = 400 × 6% = 24 million
Deductible portion = 70% × 24 = 16.8 million
Tax shield = 16.8 × 0.25 = $4.2 million.

Q99.

A firm expects to pay $12 million in annual interest on its debt. The corporate tax rate is 25%. What is the annual tax saving from the interest deduction?

A. $2 million
B. $3 million
C. $6 million
D. $9 million
E. $12 million

✅ Correct: B.
Tax saving = Interest × Tax rate = 12 × 0.25 = $3 million in annual savings from the interest tax shield.

Q100.

A firm has perpetual debt of $150 million with an interest rate of 8%. The corporate tax rate is 35%. What is the present value of the firm’s interest tax shield?

A. $35 million
B. $52.5 million
C. $12 million
D. $80 million
E. $150 million

✅ Correct: B.
For perpetual debt, the present value of the tax shield is:
PV(Tax Shield) = T_C × D = 0.35 × 150 = $52.5 million.

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