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LOS h: Discuss the Modigliani and Miller (MM) propositions concerning capital structure irrelevance and describe the relation between the cost of equity and financial leverage. ffice ffice" />
Q1. Which of the following statements about a firm's capital structure is FALSE?
A) The firm's share price is maximized when the firm maximizes its earnings per share while it minimizes its cost of capital.
B) The optimal capital structure is the one that minimizes the weighted average cost of capital and consequently maximizes the value of the firm's share price.
C) If bankruptcy costs were included into the M&M analysis of capital structure in a tax world there would be an optimal capital structure between no debt and all debt.
Correct answer is A)
The optimal capital structure is the one that maximizes stock price and minimizes the WACC. The optimal capital structure is not the one that maximizes the firm’s EPS.
Q2. Which of the following statements about capital structure theories is most accurate?
A) Based on signaling theory, if a firm issues new common stock it means that the firm thinks future investment prospects are better than normal.
B) In a world with taxes and bankruptcy costs one would expect there to be an optimal capital structure where the cost of capital is minimized and share price is maximized.
C) In a Modigliani and Miller (MM) world with taxes, but no bankruptcy cost, you would expect to see firms taking on very little debt.
Correct answer is B)
The other statements are false. In a tax world without bankruptcy the optimal capital structure is 100% debt. When firms issue new equity investment projects look poor.
Q3. Modigliani and Miller demonstrated that if corporate taxes and bankruptcy costs are introduced into an otherwise perfect world the weighted average cost of capital (WACC) will:
A) fall continuously as more debt is added to the capital structure.
B) fall, then bottom out, and finally start to rise.
C) rise, then plateau, and finally start to fall.
Correct answer is B)
The WACC first falls because bondholders take less risk and, consequently, have a lower required rate of return. In addition, interest expenses are tax deductible. However, as the amount of debt rises, financial risk rises, and the chance for bankruptcy increases. If there are positive bankruptcy costs, both bondholders and stockholders will require increasingly higher rates of return as financial risk increases causing the WACC to rise. This rise offsets the benefits of using the cheaper source of financing.
Q4. Modigliani and Miller demonstrated that if corporate taxes are introduced into an otherwise perfect world, the optimal capital structure would be:
A) all debt.
B) an equal amount of debt and equity.
C) all equity.
Correct answer is A)
In this almost perfect world, the tax deductibility of interest payments encourages firms to use more debt in their capital structures. Since the more the firm borrows the greater the tax write-offs, the firm is encouraged to hold the maximum amount of debt possible. There could essentially be a single equity share, making up a very small portion of the financing, and the remainder, essentially 100%, would be financed with debt.
Q5. Bavarian Crème Pies (BCP) has been baking and selling cakes, pies, and other confectionary items for more than 150 years. The company started out, like many firms, as a small Mom and Pop operation. Today the firm has more than 4500 employees at 10 facilities in ffice:smarttags" />Germany, France, Belgium, and Holland. BCP’s stock has recently been under considerable pressure, and is trading at a 15-year low. The Bank of Munich, the firm’s primary lender and also a major stockholder, has succeeded in forcing BCP’s CEO into accepting an early retirement package.
The new CEO, Dietmar Schulz, is attempting to turn around the firm’s loss of market value, and reviving the attractiveness of the firm as an investment. BCP’s sales have been strong, growing by more than 5 percent during the past year to a new record. Firm profits, while not growing at the pace he believes that they can, remain positive, and measures of profitability remain within what he considers to be acceptable bounds. Therefore, he believes that the firm’s valuation problem may emanate from the choice of capital structure, which is currently 30 percent equity and 70 percent debt.
Because of their financial interest in the firm, the Bank of Munich has made it clear that they will provide whatever assistance they can to help the effort. Schulz has enlisted the services of one of the bank’s corporate finance team, Katarina Iben, CFA. Iben has advised other bank customers regarding capital structure, and has helped them to devise plans to improve shareholder value. Schulz has begun to prepare a list of topics that he wants to address with Iben when she meets with BCP’s finance staff on Friday.
On the top of the list of questions is the matter of whether or not the sources of a firm’s capital can affect firm value. Schulz recalls that during his days as a master’s degree student at the London School of Economics his professors told about the M and M theories regarding capital structure. As it has been some time since he has thought about these theories, he plans to ask Iben to discuss them with his staff.
Schulz also recalls that many theoretical concepts are based upon assumptions about markets and market frictions. He is concerned that, whatever the outcome of the finance staff’s discussions with Iben, any decisions made by BCP must remain grounded in the real world so that he can defend them to his board and to shareholders. To this end, he plans to foster a discussion with Iben and his staff concerning some of the practical matters that pertain to the firm’s capital structure in the real world.
Three days later Iben has arrived at BCP’s headquarters for the big meeting. Schulz opens the discussion by asking Iben to characterize the main objective concerning capital structure, and how one might go about assessing whether or not BCP was anywhere near meeting this objective.
Which of the following statements correctly characterizes the main objective of the capital structure decision?
A) Maximize the WACC.
B) Maximize firm value.
C) Minimize firm risk.
Correct answer is B)
The objective of the firm’s capital structure decision should be to maximize firm value.
Q6. Which of the following statements most correctly characterizes MM proposition 1?
A) Firms have a preference ordering for capital sources, preferring internally-generated equity first, new debt capital second, and externally-sourced equity as a last resort.
B) Regardless of how the firm is financed, the overall value of the firm and aggregate value of the claims issued to finance it remain the same.
C) Increasing the use of relatively lower cost debt causes the required return on equity to increase such that the overall cost of capital is unchanged.
Correct answer is B)
MM proposition 1 states that regardless of how the firm is financed, the overall value of the firm and aggregate value of the claims issued to finance it remain the same.
Q7. Which of the following statements most correctly characterizes MM proposition 2?
A) Increasing the use of relatively lower cost debt causes the required return on equity to increase such that the overall cost of capital is unchanged.
B) Firms will seek to use debt financing up to the point that the value of the tax shield benefit is outweighed by the costs of financial distress.
C) Regardless of how the firm is financed, the overall value of the firm and aggregate value of the claims issued to finance it remain the same.
Correct answer is A)
MM proposition 2 states that increasing the use of relatively lower cost debt causes the required return on equity to increase such that the overall cost of capital is unchanged.
Q8. Which of the following items is least likely to be a cost that has the potential to influence capital structure decisions?
A) Agency.
B) Financial distress.
C) Homogeneous expectations.
Correct answer is C)
Financial distress costs, agency costs, and the costs associated with asymmetric information are all factors that have the potential to influence capital structure. Homogeneous expectations is an assumption that underlies the MM capital structure propositions.
Q9. The main outcome of the static trade-off theory is:
A) there is no optimal capital structure.
B) the value of the firm is not affected by the choice of capital structure.
C) there is an optimal capital structure.
Correct answer is C)
The main conclusion of the static trade-off theory is that there is an optimal capital structure, and that this is based upon the firm’s characteristics. Firms will seek to use debt financing up to the point that the value of the tax shield benefit is outweighed by the costs of financial distress. The value of the tax shield is a function of the firms’ tax rate, and the costs of financial distress are a function of the nature of the firm’s business.
Q10. Which of the following factors is least applicable when an analyst is attempting to assess whether a firm’s capital structure is value maximizing?
A) The quality of the firm’s corporate governance.
B) The proximity of the current structure to the stated target.
C) Changes in the structure over time.
Correct answer is B)
Even if the current structure is consistent with the firm’s stated target capital structure, this does not ensure that it is value maximizing. The other items listed can provide useful information regarding whether the firm’s existing capital structure is optimal.
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发表于 2009-3-4 13:15
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