Module 8: True (T) or False (F) Questions

For students

Last updated: 20/10/2025 11:36

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 1 (until Midterm)

Module	Chapter	Slides	T/F	MCQ	Numeric	Long	Self-quiz
8	ch15	🎞️	✅	❓	🔢	📝	🧪

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Mark T (True) or F (False) in each of the following sentences.

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Q1.

Holding stocks over bonds can provide a tax advantage due to the deferral of capital gains taxes until the asset is sold, which effectively lowers the capital gains tax rate.

TRUE. Capital gains are taxed when realized, so deferral lowers the effective rate via time value; bonds usually generate interest taxed annually.

Q2.

Unlevered beta measures the risk of a company’s stock against that of the broader market, including the impact of a company’s capital structure and leverage, while levered beta measures the market risk of a company without the impact of debt.

FALSE. Unlevered beta removes the effects of leverage; levered beta includes the impact of debt on equity risk.

Q3.

The interest tax shield with permanent debt implies that a company with a permanent level of debt will receive a consistent tax benefit due to the deductibility of interest expenses.

TRUE. With permanent debt, the annual tax shield is approximately interest × corporate tax rate, giving a level stream whose PV is τc × D (under standard assumptions).

Q4.

The effective tax advantage of debt can be calculated by multiplying the firm’s interest expense by the corporate tax rate.

FALSE. That product gives the annual tax shield. The effective advantage parameter uses τ* = 1 − (1 − τc)(1 − τe)/(1 − τi).

Q5.

The Optimal Capital Structure with Taxes refers to the best mix of debt and equity financing that maximizes a company’s market value while minimizing its cost of capital, taking into account the tax benefits of debt financing.

TRUE. Taxes make debt attractive up to the point other costs/constraints offset the benefit.

Q6.

The tax advantage of debt arises from the fact that interest payments are reducing the overall tax burden on the firm.

TRUE. Interest reduces taxable income, lowering corporate taxes.

Q7.

The Modigliani-Miller theorem with taxes states that the value of a levered firm is equal to the value of an unlevered firm plus the present value of the tax shield from debt

TRUE. V_L = V_U + PV(interest tax shield).

Q8.

A firm’s cost of debt typically decreases as its credit rating improves, reflecting the reduced risk of default associated with higher credit ratings.

TRUE. In practice, better ratings usually LOWER the cost of debt.

Q9.

The tax shield from debt is equivalent to the amount of debt multiplied by the corporate tax rate.

TRUE in the permanent‑debt case: PV(tax shield) ≈ τc × D. The yearly shield is interest × τc.

Q10.

The weighted average cost of capital (WACC) decreases as the proportion of debt in a firm’s capital structure increases due to the tax shield provided by debt financing.

TRUE. The (1 − τc) term on rD lowers after‑tax WACC as leverage rises, holding other frictions constant.

Q11.

The cost of equity typically increases as a firm’s leverage ratio increases due to the higher risk perceived by equity investors.

TRUE. As leverage rises, equity becomes riskier, increasing required return (βE > βU).

Q12.

Equity financing always provides a tax shield similar to debt financing.

FALSE. Only interest on debt is tax-deductible; dividends are not.

Q13.

Debt financing can lead to financial distress if a company cannot meet its debt obligations.

TRUE. Default or distress risk rises with leverage.

Q14.

The tax shield from debt financing is only applicable if the company is profitable and pays taxes.

FALSE. The exception is when interest equals zero.

Q15.

The Modigliani-Miller theorem without taxes states that the value of a firm is dependent on its capital structure.

FALSE. In a world without taxes or frictions, firm value is independent of leverage.

Q16.

Tax-deductible interest on debt can make borrowing a more attractive option for companies.

TRUE. Deductible interest lowers after‑tax cost of debt.

Q17.

Interest payments on debt are not tax-deductible for corporations.

FALSE. They generally are deductible, which creates the tax shield.

Q18.

An increase in the corporate tax rate generally increases the value of the interest tax shield.

TRUE. The tax benefit scales with τc × Interest.

Q19.

In the presence of corporate taxes, the value of a levered firm is higher than the value of an unlevered firm due to the tax shield provided by debt.

TRUE. V_L = V_U + PV(interest tax shield).

Q20.

Personal taxes have no impact on the value of a firm’s debt and equity.

FALSE. Personal tax rates can offset or reduce corporate tax benefits of leverage.

Q21.

Retained earnings do not provide a tax shield similar to that provided by debt financing.

TRUE. Retained earnings have no interest deduction; only debt interest is deductible.

Q22.

Preferred stock dividends provide the same tax benefits as interest on debt.

FALSE. Dividends are not tax-deductible to the firm; interest typically is.

Q23.

Firms with higher marginal tax rates benefit more from the interest tax shield than firms with lower marginal tax rates.

TRUE. The shield scales with the corporate tax rate τc.

Q24.

The corporate tax shield from debt financing is irrelevant in determining a firm’s capital structure.

FALSE. With taxes, the shield is a central driver of value/leverage incentives.

Q25.

Issuing new equity shares will generally increase a firm’s interest tax shield.

FALSE. The tax shield comes from interest on debt, not equity issuance.

Q26.

Debt financing can result in restrictive covenants that limit a company’s operational flexibility.

TRUE. Loan covenants can constrain payouts, investments, and leverage.

Q27.

All companies, regardless of their profitability, can equally benefit from the tax shield provided by debt.

FALSE. Firms need taxable income to use the shield; otherwise it is limited or deferred.

Q28.

A high debt ratio can increase a company’s financial risk and affect its stock price volatility.

TRUE. More leverage amplifies equity volatility via financial risk.

Q29.

Companies in highly cyclical industries might use less debt to avoid financial distress during downturns.

TRUE. Cyclical cash flows reduce debt capacity.

Q30.

The value of a firm’s tax shield is independent of the corporate tax rate.

FALSE. For permanent debt, PV(shield) ≈ τc × D; it depends directly on τc.

Q31.

In the presence of taxes, issuing debt can be value-enhancing for firms with consistent profits.

TRUE. Stable profits ensure the firm can fully use the interest tax shield.

Q32.

Tax shields are equally valuable regardless of a firm’s ability to generate taxable income.

FALSE. The benefit depends on having taxable income to offset.

Q33.

The more predictable a firm’s earnings, the more it can benefit from the tax shield provided by debt.

TRUE. Stable EBIT increases certainty of realizing tax benefits.

Q34.

A firm with negative earnings can still benefit from an interest tax shield in the current year.

FALSE. No current taxes → no current shield; may carry forward losses though.

Q35.

In a world with corporate taxes, the WACC initially declines as leverage increases, due to the tax shield of debt.

TRUE. The (1 − τc) term lowers after‑tax cost of debt, reducing WACC.

Q36.

If a firm uses 100% equity financing, it still benefits from an interest tax shield.

FALSE. Without debt, no interest deduction exists.

Q37.

Interest payments reduce taxable income, which in turn reduces taxes paid by the firm.

TRUE. That’s the mechanical source of the tax shield.

Q38.

If a firm expects to have taxable income in the future, it may choose to increase leverage to take advantage of tax shields.

TRUE. Anticipated profits make future shields valuable.

Q39.

The benefit of the tax shield is unaffected by how much interest a company actually pays.

FALSE. The shield equals τc × Interest; depends directly on interest paid.

Q40.

The MM Proposition with taxes implies that the tax shield increases firm value by the present value of future tax savings.

TRUE. V_L = V_U + PV(τc × Interest).

Q41.

The personal tax rate on debt and equity returns has no impact on the optimal capital structure.

FALSE. Personal taxes affect relative attractiveness of debt vs equity, changing τ* and optimal leverage.

Q42.

Firms with stable cash flows are generally more suited to benefit from the tax shield of debt.

TRUE. Predictable cash flows reduce risk of unused shields or distress.

Q43.

The value of the firm decreases as the present value of the interest tax shield increases.

FALSE. More tax shield increases firm value, all else equal.

Q44.

Debt creates value in the presence of corporate taxes because it generates a tax shield.

TRUE. The tax deduction on interest adds firm value via lower taxes.

Q45.

The benefit from the tax shield is realized only if the firm has positive taxable income.

TRUE. No taxable income → no current tax benefit.

Q46.

A firm that does not pay taxes benefits from the same tax shield as a profitable firm.

FALSE. Without taxes, there’s no benefit from interest deductibility.

Q47.

As leverage increases, the marginal benefit of the interest tax shield eventually declines.

TRUE. Diminishing marginal benefit due to limited taxable income and risk of distress.

Q48.

The interest tax shield increases firm value only in theory and has no effect on actual market value.

FALSE. Empirical evidence shows the tax shield has measurable effects on valuation.

Q49.

Firms that anticipate future losses may avoid taking on more debt despite the tax benefits.

TRUE. Expected losses mean the shield cannot be fully utilized.

Q50.

Debt becomes less attractive if the corporate tax rate is reduced.

TRUE. Lower τc decreases the value of the tax shield (τc × D).

Q51.

When valuing a levered firm, the present value of the interest tax shield should be discounted at a rate that reflects the risk of the tax shield itself.

TRUE. If the shield is as risky as the debt, discount at r_d; if linked to firm risk, use r_u. The correct discount rate depends on the correlation between the tax benefit and firm cash flows.

Q52.

The value of the tax shield is always exactly equal to τcD, regardless of the risk of debt or variability in future interest payments.

FALSE. τcD applies under perpetual, risk-free, constant-debt assumptions. If debt or taxes change, the shield’s PV deviates from τcD.

Q53.

If a firm maintains a constant debt-to-equity ratio, the value of the interest tax shield can be captured by discounting free cash flows using the after-tax WACC.

TRUE. The WACC framework already embeds the present value of tax shields when leverage is proportional to firm value.

Q54.

Recapitalizing a firm by replacing equity with permanent debt changes total firm value even if corporate taxes are absent.

FALSE. Without taxes, Modigliani–Miller Proposition I states that leverage does not affect total value; only distribution between debt and equity changes.

Q55.

Under personal taxes, the net tax advantage of debt depends on the relationship between (1−τc)(1−τe) and (1−τi).

TRUE. The effective advantage of debt is τ* = 1 − ((1−τc)(1−τe))/(1−τi); if both sides are equal, leverage has no net tax effect.

Q56.

The interest tax shield increases with both the corporate tax rate and the amount of debt.

TRUE. The value of the tax shield is \(τ_c \times \text{Interest}\), so higher tax rates or greater debt amplify the benefit from interest deductibility.

Q57.

When a firm increases leverage, the total value of the firm always increases, regardless of potential bankruptcy or personal taxes.

FALSE. The benefit from the interest tax shield can be offset by expected bankruptcy costs and personal tax disadvantages of debt, so firm value does not always rise with leverage.

Q58.

The decline in WACC with leverage continues indefinitely as firms increase debt ratios.

FALSE. Although WACC declines initially due to the tax shield, at high leverage the rising cost of equity and potential distress offset the benefit.

Q59.

The interest tax shield can be interpreted as a cash flow equivalent to the tax savings that would result from paying interest instead of taxes.

TRUE. The shield represents a reduction in taxes, effectively an additional cash flow to investors each period.

Q60.

A reduction in the corporate tax rate decreases both the value of the interest tax shield and the incentive for firms to use debt.

TRUE. Since the shield equals τc × D, a lower τc directly reduces its value.

Q61.

The tax deductibility of interest implies that a firm’s free cash flow to investors is higher when debt is used compared to an identical unlevered firm.

TRUE. The interest tax shield increases total cash available to investors by reducing taxes paid.

Q62.

If a firm has volatile earnings, the expected value of its interest tax shield is higher because of the possibility of large tax savings in good years.

FALSE. Volatile earnings increase the probability that interest deductions exceed taxable income, lowering the expected tax shield.

Q63.

When a firm uses permanent debt, the value of the interest tax shield can be viewed as a perpetuity with annual benefit equal to τ_c × r_d × D.

TRUE. Assuming constant debt and tax rates, the PV of the shield is τ_c × D.

Q64.

The Modigliani–Miller theorem with taxes suggests that an optimal capital structure does not exist.

FALSE. With taxes, there is an incentive to use debt; thus, in theory, the optimal structure is 100% debt unless other frictions exist.

Q65.

When personal taxes are introduced, the net tax advantage of debt may be reduced or even eliminated.

TRUE. The effective tax advantage τ* can fall to zero or negative if personal taxes on interest are high relative to equity.

Q66.

Firms should increase leverage indefinitely to exploit the tax advantage of debt.

FALSE. Beyond a certain point, costs of financial distress and agency problems outweigh tax benefits.

Q67.

In the MM model with taxes, the value of a levered firm equals the unlevered value plus the PV of interest tax shields.

TRUE. V_L = V_U + PV(τ_c × Interest) is the central result of MM with taxes.

Q68.

The effective after-tax cost of debt is given by r_d(1−τ_c), capturing the tax savings from interest deductibility.

TRUE. The interest tax shield lowers the effective financing cost of debt by the corporate tax rate.

Q69.

Corporate taxes make the cost of debt higher than the cost of equity for most firms.

FALSE. Taxes make debt cheaper, since interest is deductible while equity returns are not.

Q70.

A recapitalization that substitutes debt for equity increases the firm’s total value by the PV of the new tax shield, assuming no distress costs.

TRUE. The increase in firm value equals τ_c × D under the assumptions of perpetual, risk-free debt.

Q71.

When a firm issues debt, the reduction in corporate taxes effectively transfers value from the government to the firm’s investors.

TRUE. The tax shield represents a value transfer from the state to shareholders and debtholders.

Q72.

The interest tax shield benefits only bondholders because they receive interest payments directly.

FALSE. The benefit accrues to shareholders, as firm value rises when taxes are reduced.

Q73.

The assumption of perpetual debt is critical to valuing the tax shield as τ_c × D.

TRUE. That formula holds only when debt is risk-free and permanent; otherwise the PV changes.

Q74.

The expected value of the interest tax shield depends on the probability that the firm will be able to use the deductions in the future.

TRUE. When debt is risky, the firm may not fully utilize interest deductions in states of distress, so the expected tax shield reflects the likelihood of remaining profitable enough to benefit from it.

Q75.

If a firm anticipates periods of losses, the effective tax benefit of debt may be delayed or reduced.

TRUE. Tax shields are valuable only when the firm has taxable income to offset.

Q76.

The WACC formula with taxes is identical to the one derived under perfect capital markets without taxes.

FALSE. With taxes, the after‑tax cost of debt r_d(1−τ_c) must replace r_d in WACC.

Q77.

The presence of personal taxes can explain why firms do not reach the 100% debt levels predicted by MM with corporate taxes only.

TRUE. Personal taxes reduce the net advantage of debt, limiting optimal leverage.

Q78.

If a firm uses debt to repurchase shares, its total value declines because interest payments reduce after-tax profits.

FALSE. Although interest reduces taxable income, the deductibility of interest creates a tax shield that can increase firm value.

Q79.

When interest rates decline, the annual interest tax shield automatically decreases even if the firm’s debt coupon is fixed.

FALSE. The coupon payment determines the shield, not market rates.

Q80.

If a firm replaces equity with debt of equal market value, the share price increases by the per‑share value of the new tax shield.

TRUE. The total value gain equals PV(tax shield), captured proportionally per share.

Q81.

The interest tax shield adds value to the firm because it increases the after-tax cash flow to investors without changing pre-tax operating income.

TRUE. Taxes are reduced, leaving more cash for investors while EBIT remains the same.

Q82.

When valuing a levered firm, the interest tax shield should always be discounted at the cost of equity.

FALSE. The correct rate depends on the risk of the shield; often approximated by the cost of debt if the shield is as risky as debt.

Q83.

If interest payments are tax deductible but dividends are not, debt financing becomes more attractive relative to equity.

TRUE. This asymmetry in tax treatment creates a benefit for using debt.

Q84.

Reducing leverage increases the total value of the firm because it lowers bankruptcy risk and preserves the tax shield.

FALSE. Reducing leverage lowers financial risk but also diminishes the tax benefit of debt.

Q85.

When corporate taxes exist and there are no personal taxes, the value of the firm increases by the present value of the interest tax shield.

TRUE. With only corporate taxes, debt provides a perpetual tax benefit equal to \(V_L = V_U + τ_c D\), reflecting the present value of interest deductibility.

Q86.

The benefit of the tax shield is maximized when the firm’s expected interest expense equals its expected taxable income.

TRUE. Beyond that point, unused deductions generate no incremental benefit.

Q87.

If the firm’s debt is entirely risk-free, the tax shield should be discounted at the cost of equity to reflect ownership risk.

FALSE. For risk-free debt, the appropriate rate is the cost of debt, not the cost of equity.

Q88.

Tax shields that depend on uncertain future profits are riskier than those tied to fixed interest payments.

TRUE. Variable taxable income increases the risk that shields will not be realized.

Q89.

A lower marginal tax rate increases the value of the tax shield for any given amount of debt.

FALSE. A lower tax rate decreases the shield since it scales with τ_c.

Q90.

A firm with volatile earnings may prefer short-term or adjustable-rate debt to maintain flexibility in managing tax shields and distress risk.

TRUE. Short-term debt reduces long-term commitment and risk exposure under uncertain earnings.

Q91.

If a firm increases its leverage while keeping EBIT constant, the total value of the firm will rise due to the present value of the new interest tax shields.

TRUE. The tax shield increases firm value by reducing taxes without affecting EBIT.

Q92.

The presence of personal taxes on interest income amplifies the corporate tax advantage of debt.

FALSE. Personal taxes on interest reduce the effective tax advantage of debt by decreasing investors’ after-tax returns.

Q93.

If personal taxes on interest income are higher than those on equity income, the overall tax advantage of debt increases.

FALSE. Higher personal taxes on interest reduce the effective tax benefit of debt, since investors receive less after-tax income from debt securities.

Q94.

The corporate tax deduction for interest payments is the main reason why debt financing can increase firm value relative to equity financing.

TRUE. Interest payments reduce taxable income, creating a tax shield that increases the after-tax value of the firm compared to an all-equity structure.

Q95.

If corporate income were not subject to taxation, firms would still gain a tax advantage from using debt.

FALSE. Without corporate taxes, interest deductibility provides no benefit — the tax shield would not exist.

Q96.

When evaluating a recapitalization, the value gain from the tax shield is independent of how the debt proceeds are used.

TRUE. As long as debt is permanent, the PV(τ_c × D) is unaffected by the specific use of funds.

Q97.

If a firm permanently maintains a fixed interest payment each year, the PV of the tax shield is τ_c × r_d / D.

FALSE. The PV of a perpetual shield equals τ_c × D, not τ_c × r_d / D.

Q98.

The effective corporate tax rate relevant for valuation should reflect the firm’s ability to actually use tax deductions over time.

TRUE. Temporary losses or tax credits can reduce the realizable tax benefit.

Q99.

A firm’s WACC always decreases when it issues additional debt, regardless of other conditions.

FALSE. Beyond moderate leverage, higher equity and distress costs offset tax advantages, potentially increasing WACC.

Q100.

If the corporate tax rate decreases, the value of the interest tax shield increases.

FALSE. The value of the interest tax shield is \(τ_c \times D\), so a lower corporate tax rate reduces the benefit from debt financing.

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