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In reality, the cost of equity is always less than the cost of debt because firms are not obligated to pay out cash to shareholders.

True or False.

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Trinidad Tremblay
Trinidad TremblayLv2
28 Sep 2019

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F2 Q1-5

1.

The return on equity of a typical firm may change over time because of changes in business and economic conditions, but it is unlikely to change based on the financing or capital structure of the firm.

a. False.

b. True.

2.

Your firm has been plodding along without much attention from the stock market. Your boss insists that he can (a) increase the return on assets to shareholders by taking on more debt, and (b) attract new investors to the firm due to the higher returns.

a. False.

b. Partly true, partly false.

c. True.

3.

Even in a world with no frictions – that is, taxes, costs of bankruptcy, asymmetric information – debt will always be preferred because cost of debt is always lower than cost of equity for a firm.

a. True.

b. False.

c. Partly true, partly false.

4.

In a world with taxes and bankruptcy costs, and in which interest on debt is tax deductible, if a firm has some debt:

a. The return on equity is less than the weighted average cost of capital (WACC).

b. The return on equity is greater than the weighted average cost of capital (WACC).

c. The relationship between return on equity and the WACC cannot be determined because it depends on several factors.

5.

In the real world, where there are taxes and interest on debt is tax deductible, if two firms have the same cash flows as each other in all possible scenarios in the future, the returns on equity of the two firms will:

a. Will depend on the capital structures adopted by the firms.

b. Will depend on the capital structures adopted by the firms and the valuation method used.

c. Always be equal to each other.

d. Will depend on the method of valuation used.

Which of the following are true about the relation between debt and equity financing? (choose all that apply)

The cost of debt is always less than the cost of equity.

The cost of equity always decreases as the debt-to-equity ratio increases.

Increasing the use of debt does not always decrease the weighted average cost of capital.

Highly levered firms do better in recessions than all equity firms.

Increasing the tax rate will increase the value of the interest tax shield but lower the value of equity.

Increasing the tax rate will increase the cost of equity.

According to the Pecking order hypothesis, increasing the tax rate will cause firms to issue more debt.

true and false

. The cost of equity is expected to be higher than the after-taxcost of debt. Therefore, increasing the debt ratio will alwayslower the cost of capital.

  1. Firms with more uncertainty about future investment needs (bothin terms of magnitude and type) should generally borrow more moneythan firms with less uncertainty
  2. Debt is cheaper source of financing than Equity. Explain thepotential reasons this may be true or false

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