02 Jan A biotech firm might be

1. Question :

Nielson Motors (NM) has no debt. Its assets will be worth $600 million in one year if the economy is strong, but only $300 million if the economy is weak. Both events are equally likely. The market value today of Nielson’s assets is $400 million. The expected return for Nielson Motors stock without leverage is closest to __________.

-25.0%

-17.5%

-12.5%

12.5%

Question 2. Question :

Which of the following is not one of Modigliani and Miller’s sets of conditions referred to as perfect capital markets?

All investors hold the efficient portfolio of assets.

There are no taxes, transaction costs, or issuance costs associated with security trading.

A firm’s financing decisions do not change the cash flows generated by its investments, nor do they reveal new information about them.

Investors and firms can trade the same set of securities at competitive market prices equal to the present value of their future cash flows.

Question 3. Question :

Consider the following equation: E + D = U = A. The U in this equation represents:

the value of the firm’s equity.

the market value of the firm’s assets.

the value of the firm’s unlevered equity.

the value of the firm’s debt.

Question 4. Question :

Which of the following statements is false?

Since the publication of their original paper, Modigliani and Miller’s ideas have greatly influenced finance research and practice.

Modigliani and Miller’s Proposition I was one of the first arguments to show that the Law of One Price could have strong implications for security prices and firm values in a competitive market; it marks the beginning of the modern theory of corporate finance.

Modigliani and Miller’s Proposition I holds even with taxes and transaction costs.

The conservation of value principle for financial markets states that with perfect capital markets, financial transactions neither add nor destroy value, but instead represent a repackaging of risk (and therefore return).

Question 5. Question :

Kroger has EBIT of $2,035 million, interest expense of $510 million, and a 35% tax rate. The interest rate tax shield for Kroger is closest to __________.

$187 million

$332 million

$534 million

$179 million

Question 6. Question :

Which of the following statements is false?

Given a 35% corporate tax rate, for every $1 in new permanent debt that the firm issues, the value of the firm increases by $0.65.

The firm’s marginal tax rate may fluctuate due to changes in the tax code and changes in the firm’s income bracket.

Many large firms have a policy of maintaining a certain amount of debt on their balance sheets.

Typically, the level of future interest payments varies due to changes the firm makes in the amount of debt outstanding, changes in the interest rate on that debt, and the risk that the firm may default and fail to make an interest payment.

Question 7. Question :

KD Industries has 30 million shares outstanding with a market price of $20 per share and no debt. KD has had consistently stable earnings, and pays a 35% tax rate. Management plans to borrow $200 million on a permanent basis through a leveraged recapitalization in which they would use the borrowed funds to repurchase outstanding shares. The present value of KD’s interest tax shield is closest to __________.

$130 million

$200 million

$400 million

$70 million

Question 8. Question :

Which of the following statements regarding recapitalizations is false?

With a recapitalization, even though leverage reduces the total value of equity, shareholders capture the benefits of the interest tax shield up front.

Some of the original shareholders, those that sell their shares, do not benefit from the interest tax shield involved in a recapitalization.

Leveraged recaps were especially popular in the mid- to late-1980s, when many firms found that these transactions could reduce their tax payments.

When a firm makes a significant change to its capital structure, the transaction is called a recapitalization.

Question 9. Question :

Which of the following statements is false?

The value of a firm is equal to the amount of money the firm can raise by issuing securities.

By reducing a firm’s corporate tax liability, debt allows the firm to pay more of its cash flows to investors.

Equity investors must pay taxes on dividends but not capital gains.

For individuals, interest payments received from debt are taxed as income.

Question 10. Question :

Which of the following statements is false?

A biotech firm might be developing drugs with tremendous potential, but it has yet to receive any revenue from these drugs. Such a firm will not have taxable earnings. In that case, a tax-optimal capital structure does not include debt.

No corporate tax benefit arises from incurring interest payments that regularly exceed EBIT.

The optimal level of leverage from a tax saving perspective is the level such that interest equals EBIT.

In general, as a firm’s interest expense approaches its expected taxable earnings, the marginal tax advantage of debt increases, limiting the amount of equity the firm should use.