Part 1

The assets and operations of two firms are the same in a world without taxes. Firm 1 is all equity financed, while firm 2 uses debt and equity.

a)The value of both firms is the same

b)Value depends on cash flows, which we don't know

c)The all-equity firm is more valuable

d)The firm using debt and equity is more valuable

Part 2

The stock of a levered firm is ______ the stock of an unlevered firm because _____.

a)as risky as; of M&M proposition 2

b)as risky as; of M&M proposition 1

c)riskier than; leverage increases financial risk

d)riskier than; leverage increases business risk

Part 3

When a company takes on more and more debt,

a)the benefits of debt will eventually be offset by the cost of bankruptcy

b)the value of the firm will decrease consistently

c)the cost of bankruptcy will eventually be offset by the benefits of debt

d)the value of the firm will increase consistently

Part 4

How does the WACC change as a company takes on more and more debt?

a)It rises first, then falls

b)It gets higher and higher

c)It falls first, then rises

d)It gets lower and lower

Part 5

Starting from a position without debt, increasing financial leverage _____ the cost of debt and _____ the cost of equity, while ________ the WACC.

a)decreases; decreases; increasing

b)decreases; increases; decreasing

c)increases; increases; increasing

d)increases; decreases; increasing

e)increases; decreases; decreasing

f)decreases; increases; increasing

g)increases; increases; decreasing

h)decreases; decreases; decreasing

Part 6

Starting from a position without debt, increasing financial leverage _____ the value of the firm because of the ______.

a)increases; present value of the interest tax shield

b)decreases; costs of financial distress

c)increases; costs of financial distress

d)decreases; present value of the interest tax shield

Part 7

The optimal capital structure maximizes the value of the firm, which is the same as

a)minimizing the cost of capital

b)maximizing the book value of assets

c)maximizing the book value of equity

d)minimizing the market value of debt

Part 8

In a world with taxes but without financial distress, the optimal capital structure consists of

a)only debt

b)only equity

c)a mix of debt and equity that minimizes the WACC

d)equal shares of debt and equity

Part 9

The business risk of a firm's equity depends on the _____ of the firm's assets, while the financial risk of the firm's equity depends on the _____.

a)systematic risk; risk of default

b)systematic risk; firm's financial structure

c)total risk; risk of default

d)total risk; firm's financial structure