ADM 3350 Study Guide - Final Guide: Marginal Utility, Nonrecourse Debt, Put Option
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When the assumptions of Modigliani and Millerâs Irrelevance Hypothesis regarding corporate capital structure are relaxed so that they are more consistent with real-world conditions, i.e. there are corporate taxes (and interest payments are tax deductible) and there are costs of financial distress, then which of the following is true?
Firm value and WACC are independent of the firm's capital structure. | ||
Firm value increases and WACC decreases initially as more debt is added to the firm's capital structure, however, there comes a point where adding additional debt generates potential costs of financial distress that outweigh the benefits of further reducing taxes. After this point, firm value starts to decrease and WACC starts toincrease as more debt is added. | ||
Each firm has an optimal capital structure where WACC is maximized. | ||
Each firm has an optimal capital structure where firm value is minimized. | ||
Firm value increases and WACC increases initially as more debt is added to the firm's capital structure, however, there comes a point where adding additional debt generates potential costs of financial distress that outweigh the benefits of further reducing taxes. After this point, firm value and WACC start to decrease as more debt is added. |
Which of the following statements is most correct?
If a firm is exposed to a high degree of business risk as a result of its high operating leverage, then it probably should offset this risk by using a larger-than-average amount of financial leverage. This follows because debt has a lower after-tax cost than equity. | ||
Financial risk can be reduced by replacing common equity with preferred stock. | ||
The Hamada equation specifies the effect of financial leverage on beta. It shows how increases in the debt/equity ratio lowers beta. | ||
In the textbook, it was stated that the capital structure that minimizes the WACC also maximizes the firmâs stock price and its total value, but generally not its expected EPS. One reason given for why debt is beneficial is that it shelters operating income from taxes, while it was stated that a disadvantage of excessive debt has to do with costs associated with bankruptcy and financial distress generally. | ||
All of the above statements are false. |