3. Which of the following statements is FALSE?Video: 5.F. P54-72 (Capital structure with other market imperfections 1)Group of answer choicesD) Firms have an incentive to increase leverage to exploit the tax benefits of debt. But with too much debt, they are more likely to risk default and incur financial distress costs.A) The tradeoff theory weighs the costs of debt that result from shielding cash flows from taxes against the benefits from the effects of financial distress associated with leverage.C) According to the tradeoff theory, the total value of a levered firm equals the value of the firm without leverage plus the present value of the tax savings from debt, less the present value of financial distress costs.B) Leverage has costs as well as benefits.
Question
- Which of the following statements is FALSE?Video: 5.F. P54-72 (Capital structure with other market imperfections 1)Group of answer choicesD) Firms have an incentive to increase leverage to exploit the tax benefits of debt. But with too much debt, they are more likely to risk default and incur financial distress costs.A) The tradeoff theory weighs the costs of debt that result from shielding cash flows from taxes against the benefits from the effects of financial distress associated with leverage.C) According to the tradeoff theory, the total value of a levered firm equals the value of the firm without leverage plus the present value of the tax savings from debt, less the present value of financial distress costs.B) Leverage has costs as well as benefits.
Solution
All of the statements provided are true.
Statement A) is true because the tradeoff theory does indeed weigh the costs of debt that result from shielding cash flows from taxes against the benefits from the effects of financial distress associated with leverage.
Statement B) is true because leverage does have both costs and benefits. The benefits come from the tax shield provided by interest payments, while the costs come from the increased risk of financial distress and bankruptcy.
Statement C) is true because according to the tradeoff theory, the total value of a levered firm does equal the value of the firm without leverage plus the present value of the tax savings from debt, less the present value of financial distress costs.
Statement D) is also true because firms do have an incentive to increase leverage to exploit the tax benefits of debt. However, with too much debt, they are more likely to risk default and incur financial distress costs.
Therefore, none of the statements are false.
Similar Questions
Which of the following statements is FALSE?A.Franco Modigliani and Merton Miller argued that with perfect capital markets, the total value of a firm should not depend on its capital structure.B.It is inappropriate to discount the cash flows of levered equity at the same discount rate that we use for unlevered equity.C.Leverage decreases the risk of the equity of a firm.D.Because the cash flows of the debt and equity sum to the cash flows of the project, by the Law of One Price the combined values of debt and equity must be equal to the cash flows of the project.
MM Proposition II shows that Blank______.Multiple choice question.the market value of the firm is unaffected by its capital structurethere is no risk involved with leverage when there are no corporate taxesthe cost of equity rises with leverageequity is less expensive than debt
4. Which of the following statements is FALSE?Video: 6.D. P26-33 (Other considerations)Group of answer choicesD After adjusting for investor taxes, there remains a substantial tax advantage for the firm to retain excess cash.C) In perfect capital markets, if a firm invests excess cash flows in financial securities, the firm’s choice of payout versus retention is irrelevant and does not affect the initial share price.A) A firm must balance the tax costs of holding cash with the potential benefits of financial flexibility to profit from future growth opportunities.B) Paying out excess cash through dividends or share repurchases can boost the stock price by reducing managers’ ability and temptation to waste resources.
What are the two components of the trade-off theory?Multiple choice question.The tax benefits of financial distress and the cost of debtHigh leverage and low leverageHigh equity and low equityThe tax benefits of debt and the costs of financial distress
Which of the following statements is NOT TRUE?Debt is costlier than equity.For the same business the firm can choose between the use of debt capital versus equity capital.Net profit can be substantially higher if debt is usedAll of the above
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