FIN 3414 Final

Ch. 12, 14, 15

Which one of these statements related to beta is correct?

Beta measures systematic risk.

A firm with high operating leverage is best defined as a firm that has

High fixed costs relative to variable costs.

The use of WACC as the discount rate when evaluating a project is acceptable when the

Risk of the project is equal to the company’s overall level of risk.

Companies A and B are identical except for their capital structures. Company A is an all-equity company while Company B is levered. Given this, you can assume that Company B's equity beta is ______ Company A's beta and its debt beta is assumed to be ______.

greater than; equal to zero

Which of these are determinants of beta?

I . Financial leverage

II. Cyclicality of revenues

III. Total variation in revenues

IV. Operating leverage

I, II, and IV only

The terminal value of a firm is also commonly referred to as the:

horizon value

Assume an all-equity company is considering expanding its current operations by increasing the size of its warehouse. The discount rate used for this project should be the

company’s cost of equity capital.

The beta of a firm is more likely to be high under which two conditions?

High cyclical business activity and high operating leverage

The weighted average cost of capital for a firm is the

Overall rate which the firm must earn on its projects to maintain the value of its stock.

If you assume beta is greater than 1, then which of these will increase the cost of equity capital according to CAPM? Hint: Plug in numbers!

I. Increase in the risk-free rate

II. Decrease in the risk-free rate

III. Increase in the market rate of return

IV. Decrease in the market rate of return

II and III only

In the absence of taxes, MM argues that

no one capital structure for a firm is superior to any other capital structure for that firm.

You are writing a comparison of an all-equity structure to a levered capital structure for a firm. It is accurate to state in this comparison that

leverage lowers shareholders' returns in bad financial times.

MM Proposition II, without taxes, implies that the required return on equity is

directly affected by the firm's debt-to-equity ratio.

A firm’s capital structure refers to the

mix of debt and equity used to finance the firm's assets.

When comparing levered versus unlevered capital structures, leverage works to increase EPS for high levels of EBIT because interest payments on the debt

stay fixed, leaving more income to be distributed over fewer shares.

The interest tax shield is a key reason why

the net cost of debt to a firm is generally less than the cost of equity.

Which one of these argues than the value of a firm is independent of its capital structure?

MM Proposition I, without taxes

Which one of these proposes that the value of a levered firm exceeds the value of an unlevered firm by the present value of the tax shield?

MM Proposition I, with tax

An unlevered firm is a company that

has no debt

Which one of these presents the idea that the cost of equity is a positive linear function of capital structure?

MM Proposition II, without taxes

Managers should select the capital structure that

maximizes the value of the firm.

Which one of these statements is a correct implication of the pecking order theory?

Companies like financial slack so they can reduce their external capital needs.

In general, the capital structures of U.S. firms:

vary significantly across industries.

Conflicts of interest between stockholders and bondholders are known as

agency problems.

The explicit and implicit costs associated with corporate default are referred to as the _____ costs of a firm.

financial distress

The optimal capital structure has been achieved when the

debt-equity ratio selected results in the lowest possible weighted average cost of capital.

The optimal capital structure will tend to include more debt for firms with

lower probability of financial distress.

Corporations in the U.S. tend to

underutilize debt.

The pecking order theory states that when external funds are required, a firm should

only issue equity securities after the firm’s debt capacity is reached.

Investors will generally view an increase in leverage as a positive sign of the firm's value.

true

cost of capital

the discount rate or required rate of return on a project

beta

measures systematic risk relative to the economy

cost of equity

the required rate of return that the shareholders demand because they bear the risk

cost of debt

interest rate required on new debt issuance (YTM on outstanding debt)

Business risk is comprised of

cyclicality of revenues and operating leverage

cyclicality of revenues

revenue follows a cycle (seasonal)
ex: retailers, high tech, automotive fluctuate with the business cycle

railroads, utilities, and food companies are ______ dependent on business cycle

less

highly cyclical stocks have higher betas

true

operating leverage

measures how sensitive a firm/ project is to its fixed costs

operating leverage ______ as fixed costs increase and variable costs fall

increase

if operating leverage is high then beta is _____

high

financial leverage

sensitivity to a firm's fixed cost of financing

increase in financial leverage then equity beta ______

increases because shareholders bear the risk

WACC

the overall rate of return you need to earn for your firm, reflects risk and capital structure of firm's existing assets