Corporate Finance Chapter 17 Exam Questions with Complete Solutions

According to Modigliani and Miller Proposition II, the firm's expected return on assets depends on several factors including the firm's capital structure. T or F - ANSWER-FALSE According to Modigliani and Miller Proposition II, since the expected rate of return on debt is less than the expected rate of return on equity, the weighted average cost of capital declines as more debt is issued. T or F - ANSWER-FALSE Financial leverage increases the expected return and risk of the shareholder. T or F - ANSWER-TRUE Modigliani and Miller's Proposition I states that the market value of any firm is independent of its capital structure. T or F - ANSWER-TRUE Modigliani and Miller Proposition II states that the rate of return required by shareholders increases steadily as the firm's debt-equity ratio increases. T or F - ANSWER-TRUE The firm's asset beta is usually higher than the firm's equity beta. T or F - ANSWER-FALSE The principle of value additivity holds for the aggregation of assets but does not apply to the division of assets. T or F - ANSWER-FALSE According to the graph of WACC for Union Pacific, which of the following is (are) true? I) The cost of equity is an increasing function of the debt-equity ratio. II) The cost of debt is an increasing function of the debt-equity ratio. III) The weighted average cost of capital (WACC) is a decreasing function of the debt-equity ratio. - ANSWER-I, II, III A firm's equity beta is 1.2 and its debt is risk free. Given a 0.7 debt to equity ratio, what is the firm's asset beta? (Assume no taxes.) - ANSWER-0.7 An EPS-operating income graph, for different debt ratios, shows the: I) greater risk associated with debt financing, which is evidenced by a greater slope; II) the break-even point where EPS of two different debt ratios are equal; III) the minimum earnings needed to pay the debt financing for a given level of debt - ANSWER-I, II, III An investor can create the effect of leverage on his/her account by: I) buying equity of an unlevered firm;