Multiple Choice - Part 6: Capital Structure with Taxes, WACC, APV, FTE

5.1 Which of the following statements is FALSE about the interest tax shield?

A) The gain to investors from the tax deductibility of interest is called the interest tax shield

B) The interest tax shield equals the extra taxes a firm would have paid without leverage

C) Because corporations pay tax on profits after interest interest reduces corporate tax paid

D) As Modigliani and Miller made clear in perfect capital markets capital structure matters; thus if capital structure does not matter it must stem from a market imperfection

D) As Modigliani and Miller made clear in perfect capital markets capital structure matters; thus if capital structure does not matter it must stem from a market imperfection

5.2 Which of the following statements is FALSE about valuing tax shields?

A) To measure the benefit of leverage we compute the present value of future interest tax shields

B) Because levered firm cash flows equal unlevered cash flows plus the tax shield the same must hold for present values

C) By increasing interest payments the pre tax cash flows that must be paid as taxes increase

D) When a firm uses debt the interest tax shield provides a corporate tax benefit each year

C) By increasing interest payments the pre tax cash flows that must be paid as taxes increase

5.3 Which of the following statements is FALSE about firm value with leverage and taxes?

A) Given a forecast of interest payments we can compute the tax shield and discount it at a rate reflecting its risk

B) The total value of the unlevered firm exceeds the value of the levered firm due to the present value of tax savings from debt

C) To compute the increase in total firm value from the tax shield we need to forecast debt and interest payments

D) There is an important tax advantage to using debt financing

B) The total value of the unlevered firm exceeds the value of the levered firm due to the present value of tax savings from debt

5.4 Which of the following statements is FALSE about permanent debt and tax shields?

A) With a 35 percent corporate tax rate each 1 of new permanent debt increases firm value by 0.65

B) The firm’s marginal tax rate may change due to tax code changes or income level

C) Many large firms target a certain amount of debt on their balance sheets

D) Future interest payments vary with changes in debt outstanding interest rates and default risk

A) With a 35 percent corporate tax rate each 1 of new permanent debt increases firm value by 0.65

5.5 Which of the following statements is FALSE about after tax cost of debt and WACC?

A) Tax deductibility of interest lowers the effective cost of debt

B) When a firm uses debt the interest cost is partly offset by tax savings from the interest tax shield

C) With tax deductible interest the effective after tax borrowing rate is r times the corporate tax rate τC

D) The WACC represents the cost of capital for the free cash flow generated by the firm’s assets

C) With tax deductible interest the effective after tax borrowing rate is r times the corporate tax rate τC

5.6 Which of the following statements is FALSE about WACC with corporate taxes?

A) Higher leverage lets the firm exploit the tax advantage of debt more and lowers its WACC

B) Corporate taxes lower the effective cost of debt and reduce WACC

C) Because free cash flow is computed ignoring leverage we account for the tax shield by using the before tax cost of debt in WACC

D) The reduction in WACC increases as the amount of debt financing rises

C) Because free cash flow is computed ignoring leverage we account for the tax shield by using the before tax cost of debt in WACC

5.7 Which of the following statements is FALSE about recapitalizations with taxes?

A) Once investors know a recap will occur the share price rises immediately to reflect the value of the interest tax shield

B) When securities are fairly priced the original shareholders capture the full benefit of the interest tax shield from higher leverage

C) In the presence of corporate taxes we do not include the interest tax shield as one of the firm’s assets on the market value balance sheet

D) We can analyze a recap with the market value balance sheet which states that total market value of securities equals total market value of assets

C) In the presence of corporate taxes we do not include the interest tax shield as one of the firm’s assets on the market value balance sheet

In the standard corporate tax model with permanent debt what is the value of a levered firm?

A) VL = VU − PV(Interest tax shields)

B) VL = VU + PV(Interest tax shields)

C) VL = VU × (1 − τC)

D) VL = VU × (1 + τC)

B) VL = VU + PV(Interest tax shields)

If a firm maintains a constant amount of debt forever and the debt is risk free what is the PV of the interest tax shield?

A) τC × Equity value

B) τC × Debt value

C) τC × Free cash flow

D) τC divided by the cost of equity

B) τC × Debt value

If a firm keeps a constant debt ratio rather than a constant debt level how is the tax shield usually discounted?

A) At the cost of debt because the shield is as risky as debt

B) At the risk free rate because taxes are certain

C) At the unlevered cost of capital because the shield has the same risk as the firm’s assets

D) It is not discounted at all

C) At the unlevered cost of capital because the shield has the same risk as the firm’s assets

Which expression best describes the after tax WACC with corporate taxes?

A) WACC = rE × E/V + rD × D/V

B) WACC = rE × E/V + rD × D/V × (1 − τC)

C) WACC = rD × (1 − τC)

D) WACC = rA × (1 − τC)

B) WACC = rE × E/V + rD × D/V × (1 − τC)

When is it particularly convenient to use the APV (Adjusted Present Value) method?

A) When leverage is fixed and always proportional to firm value

B) When the project is all equity financed

C) When the financing side effects such as subsidies or changing leverage are complex and easier to value separately

D) When the firm has no taxes

C) When the financing side effects such as subsidies or changing leverage are complex and easier to value separately

Which statement correctly compares WACC and APV methods?

A) Both always require the same forecast of debt levels each year

B) WACC folds the tax shield into the discount rate whereas APV values the unlevered project and tax shields separately

C) APV ignores the tax shield while WACC values only the tax shield

D) APV is only valid without taxes

B) WACC folds the tax shield into the discount rate whereas APV values the unlevered project and tax shields separately

When using WACC to value a project what leverage should be used in the WACC calculation?

A) The project’s book leverage

B) The firm’s current market leverage even if it will change dramatically

C) The firm’s target or long run leverage appropriate for that project’s risk

D) Zero leverage

C) The firm’s target or long run leverage appropriate for that project’s risk

How do personal taxes on interest and equity income affect the tax advantage of debt in Miller’s extended model?

A) Personal taxes on interest make debt more attractive

B) Personal taxes on interest can offset or even reverse the corporate tax advantage of debt

C) Personal taxes have no effect on capital structure incentives

D) Personal taxes always make equity more tax favored

B) Personal taxes on interest can offset or even reverse the corporate tax advantage of debt

In practice which of the following is a typical reason firms do not fully exploit the corporate tax shield by using 100 percent debt?

A) Equity is cheaper than debt pre tax

B) Borrowing is impossible for large firms

C) Expected distress and agency costs from high leverage offset the marginal tax benefits

D) Tax authorities forbid leverage above a threshold

C) Expected distress and agency costs from high leverage offset the marginal tax benefits

When using the Flow to Equity (FTE) method how are cash flows and discount rate defined?

A) Use free cash flow and discount at WACC

B) Use free cash flow and discount at the risk free rate

C) Use cash flows available to equity after interest and debt repayments and discount at rE

D) Use cash flows to debt holders only and discount at rD

C) Use cash flows available to equity after interest and debt repayments and discount at rE