Lecture 9 - Capital structure in a perfect market

What does Modigliani-Miller I (MM I) in a world with no taxes states?

• The value of a firm increases with its level of debt

• The value of a firm is unaffected by its capital structure

• The value of a firm decreases with its level of debt

• The value of a firm depends entirely on its capital structure

According to the second Modigliani-Miller theorem (MM II) in a world with no taxes, what happens to the cost of equity as a firm increases its level of debt

• It decreases

• It remains constant

• It increases

• It becomes negative

What is business risk in the context of a firm's cost of equity?

• The risk related to the firm's decision to use debt financing

• The inherent risk in the firm's operations and activities

• The risk that a firm cannot meet its short-term financial obligations

• The risk that comes from changes in interest rates

What is the concept of 'tax shield' in the context of MM's theorem with taxes (1963)?

• It shields a firm all tax obligations

• It refers to the tax advantages due to deductible interest payments on debt, making debt financing more attractive

• It refers to tax deductions on equity financing, making equity financing more attractive

• It allows a firm to transform all its taxes into tax-free income

The conclusion of Modigliani-Miller's capital structure model with taxes is that

• There is a trade-off between tax savings on debt increased and increased risk of bankruptcy

• Firm should be financed with all debt

• Capital structure decisions do not affect the value of a firm

Answer explanation

Because MM with taxes does not consider costs of financial distress, it concludes that tax savings of debt financing are maximised at 100% debt

Which of the following is NOT an assumption made by the Modigliani-Miller theorem?

• There are no transaction costs

• Firms can borrow at the risk-free rate

• All firms have the same risk level

• There are no bankruptcy cost

How does the use of leverage impact the risk for equity holders?

• It decreases the risk as it allows for more flexibility in financing

• It increases the risk as it magnifies both potential returns and losses

• It does not affect the risk as debt and equity are unrelated

• It diversifies the risk as it introduces another source of financing

What is considered an optimal capital structure of a company?

• The capital structure that maximises company value while minimising the cost of capital

• The capital structure that includes only equity

• The capital structure that includes only debt

• The capital structure that provides the highest returns regardless of risk

How does the tax shield effect influence a firm's overall cost of capital when financial gearing is increased?

• It increases the cost of capital by increasing tax liabilities

• It has no effect on the cost f capital

• It reduces the cost of capital by lowering tax liabilities

• It increases the risk of bankruptcy, thereby increasing the cost of capital

What is a leveraged recapitalisation?

• Its when a company issues new shares to decrease its debt

• It's when a company borrows money to repurchase its own shares

• It's when a company sells assets to repay its debts

• It's when a company uses its cash reserves to increase its debt