7. Provided a firm does not use an extreme amount of debt, operating leverage typically affects only EPS, while financial leverage affects both EPS and EBIT.
Answer Choices:
a. Trueb. False
Answer: b. False
8. The trade-off theory states that capital structure decisions involve a tradeoff between the costs and benefits of debt financing.
Answer Choices:
a. Trueb. False
Answer: a. True
9. Different borrowers have different risks of bankruptcy, and if a borrower goes bankrupt, its lenders will probably not get back the full amount of funds that they loaned. Therefore, lenders charge higher rates to borrowers judged to be more likely to go bankrupt.
Answer Choices:
a. Trueb. False
Answer: a. True
10. Modigliani and Miller (MM) won Nobel Prizes for their work on capital structure theory.
Answer Choices:
a. Trueb. False
Answer: a. True
11. Modigliani and Miller’s first article led to the conclusion that capital structure is “irrelevant” because it has no effect on a firm’s value.
Answer Choices:
a. Trueb. False
Answer: a. True
12. Modigliani and Miller’s first article led to the conclusion that capital structure is extremely important, and that every firm has an optimal capital structure that maximizes its value and minimizes its cost of capital.
Answer Choices:
a. Trueb. False
Answer: b. False
13. Is it possible for Firms A and B to have identical financial and operating leverage, yet for Firm A to have more risk as measured by the variability of EPS. This would occur if Firm A has more business risk than Firm B.
Answer Choices:
a. Trueb. False
Answer: a. True
14. As the text indicates, a firm’s financial risk can and should be divided into separate market and diversifiable risk components.
Answer Choices:
a. Trueb. False
Answer: b. False
15. If two firms have the same expected earnings per share (EPS) and the same standard deviation of expected EPS, then they must have the same amount of business risk.
Answer Choices:
a. Trueb. False
Answer: b. False
16. In a world with no taxes, Modigliani and Miller (MM) show that a firm’s capital structure does not affect its value. However, when taxes are considered, MM show a positive relationship between debt and value, i.e., the firm’s value rises as it uses more and more debt, other things held constant.
Answer Choices:
a. Trueb. False
Answer: a. True
17. According to Modigliani and Miller (MM), in a world without taxes the optimal capital structure for a firm is approximately 100% debt financing.
Answer Choices:
a. Trueb. False
Answer: b. False
18. According to Modigliani and Miller (MM), in a world with corporate income taxes the optimal capital structure calls for approximately 100% debt financing.
Answer Choices:
a. Trueb. False
Answer: a. True
19. According to Modigliani and Miller (MM), in a world without corporate income taxes the use of debt has no effect on the firm’s value.
Answer Choices:
a. Trueb. False
Answer: a. True
20. Modigliani and Miller’s first article led to the conclusion that capital structure is “irrelevant” because it has no effect on a firm’s value. However, that article was criticized because it assumed that no taxes existed. MM then revised their original article to include corporate taxes, and this model led to the conclusion that a firm’s value would be maximized if it used (almost) 100% debt.
Answer Choices:
a. Trueb. False
Answer: a. True
21. Modigliani and Miller’s second article, which assumed the existence of corporate income taxes, led to the conclusion that a firm’s value would be maximized, and its cost of capital minimized, if it used (almost) 100% debt. However, this model did not take account of bankruptcy costs. The existence of bankruptcy costs leads to the assumption of an optimal capital structure where the debt ratio is less than 100%.
Answer Choices:
a. Trueb. False
Answer: a. True
22. The Miller model begins with the Modigliani and Miller (MM) model with corporate taxes and then adds personal taxes.
Answer Choices:
a. Trueb. False
Answer: a. True
23. The Miller model begins with the Modigliani and Miller (MM) model without corporate taxes and then adds personal taxes.
Answer Choices:
a. Trueb. False
Answer: b. False
24. The Modigliani and Miller (MM) articles implicitly assumed that bankruptcy did not exist. That led to the development of the “trade-off” model, where the firm’s value first rises with the use of debt due to the tax shelter of debt, but later falls as more debt is added because the potential costs of bankruptcy begin to more than offset the tax shelter benefits. Under the trade-off theory, an optimal capital structure exists.
Answer Choices:
a. Trueb. False
Answer: a. True
25. Modigliani and Miller (MM), in their second article, took account of taxes, bankruptcy, and other factors that were assumed away in their original article. Once they took account of all these assumptions, they concluded that every firm has a unique optimal capital structure. Moreover, a manager can use the second MM model to determine his or her firm’s optimal debt ratio.
Answer Choices:
a. Trueb. False
Answer: b. False