Part 7 (ch14) Questions T/F & Multiple Choice

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

1 With perfect capital markets, financial transactions are a zero-NPV activity that neither add nor destroy value on their own.

2 When equity is used without debt, the firm is said to be levered.

3 Leverage can raise a firm’s expected earnings per share and its return on equity, but it also increases the volatility of earnings per share and the riskiness of its equity.

4 Leverage increases the risk of equity and raises the equity cost of capital.

5 A firm can change its capital structure at any time by issuing new securities and using the funds to pay its existing investors.

6 According to MM Proposition I, with perfect capital markets, the value of a firm is independent of its capital structure.

7 A firm’s net debt is equal to its debt plus its holdings of cash and other risk-free securities.

8 The owner of a firm should choose the capital structure that maximizes the total value of the securities issued.

9 The relative proportions of debt, equity, and other securities make up a firm’s investment policy.

10 The premium that investors demand for holding the company’s equity increases as the company’s D/E ratio increases, which leads to an increase in the cost of capital of levered equity.

11 Leverage refers to the practice of using debt or other financial instruments to magnify returns on equity investments, while unlevered equity means using only equity capital without debt.

12 According to Modigliani-Miller and the Law of One Price, in a world of perfect capital markets, two identical firms with the same cash flows should have the same market value, regardless of their capital structures.

13 Debt financing is a less expensive source of capital for a firm compared to equity financing.

14 With perfect capital markets, the risk of bankruptcy does not affect the value of the firm.

15 According to MM Proposition II, the cost of equity decreases as the firm’s debt-to-equity ratio increases.

16 In perfect capital markets, all investors can borrow and lend at the same risk-free rate.

17 In a perfect capital market, the capital structure of a firm affects the overall cost of capital.

18 In perfect capital markets, firms do not face transaction costs when issuing or repurchasing securities.

19 In a world of perfect capital markets, the financing decision is irrelevant to the firm’s investment decision.

20 Perfect capital markets assume that investors have different information than the firm’s managers.

21 In perfect capital markets, firms are able to rebalance their capital structure costlessly.

22 In a world of perfect capital markets, there is an optimal capital structure that maximizes firm value.

23 Under MM Proposition I, the value of the firm is determined solely by its real assets, not by the securities it issues.

24 In perfect capital markets, the firm’s choice of capital structure does not affect its investment policy.

25 Perfect capital markets consider taxes and bankruptcy costs when determining the value of the firm.

26 The irrelevance proposition of Modigliani and Miller assumes no agency costs in a world of perfect capital markets.

27 In a perfect capital market, any gains from leverage are exactly offset by increased equity risk, leaving the firm’s overall cost of capital unchanged.

28 According to MM Proposition II, with perfect capital markets, the firm’s weighted average cost of capital (WACC) decreases as more debt is added to the capital structure.

29 In perfect capital markets, changes in capital structure affect the risk and return of the equity but do not affect the total value of the firm.

30 The Modigliani-Miller propositions assume that all investors have access to the same set of investment opportunities.