Cash Flow Assignment

Suppose that we have an unlevered firm U and a levered firm L, which differ only in terms of the capital structure. Firm L has equity Ej and debt D > 0). Firm U has equity Eu. Suppose the assumptions of M&M theorem holds. Both investors and the firm have the same lending and borrowing rate r. Then answer questions 13 to 16.

10. How many statements below about cash flows are correct? i. The two firms have the same amount of taxation. ii. The two firms have the same cash flow from assets (CFFA). iii. The two firms have the same cash flow to equity holders. iv. The two firms have the same cash flow to creditors.

Your choice: a. one; b. two; c. three; d. four.

11. How many statements below about firm value and cost of capital are correct? i. The levered firm value is E + D, and the unlevered firm value is Ey ii. The levered firm’s value is equal to the unlevered firm’s value. iii. The levered firm’s WACC is equal to the unlevered firm’s WACC. iv. The levered firm’s equity return is different from the unlevered firm’s equity return.

Your choice: a. one; b. two; c. three; d. four.

12. Suppose you want to implement the following two strategies: (1) Buy 10% equity of firm L; (2) Buy 10% equity of firm U, and borrow for an amount 0.1D, (i.e., the same amount as 10% of the levered firm’s debt). Which statement below is wrong?

a. The cost of the two strategies are different.

b. The cost of the first strategy is 0.1E

c. The two strategies generate the same cash flows to you.

d. If the two strategies have different initial costs, then there is an arbitrage opportunity.

e. You create leverage by borrowing for yourself in the second strategy.

13. Suppose we are in the M&M world. For firm X, the cost of equity is 17%, the required return on the assets is 12%, and the debt to equity ratio is 1:2. What is the firm’s cost of equity if the debt-to-equity ratio becomes 1:1 while assets are unchanged?

a. 12% b. 17% c. 20% d. 22% e. 24%

14. Which ones below are correct about the bankruptcy? i. A firm is bankrupt when it is unable to fulfill its debt obligations ii. Equity holders are in control during bankruptcy. iii. Creditors are in control during bankruptcy. iv. The firm is liquidated in a bankruptcy.

Your choice: a. i and ii; b. i and iii; c. i, ii, and iv; d. i, iii, iv; e. ii and iv

15. If we introduce positive tax rate to the M&M world, which statement below is incorrect?

a. The cost of equity is above the after-tax cost of debt.

b. As leverage increases, the required rate of return for equity increases.

C. As leverage increases, WACC remains the same.

d. As leverage increases, the after-tax cost of debt remains the same.

e. As leverage increases, the value of the firm increases.

16. Suppose we introduce bankruptcy to the M&M world, which statement below is incorrect?

a. As leverage increases, the probability of bankruptcy increases.

b. As leverage increases, WACC increases.

c. As leverage increases, the value of the firm increases.

d. As leverage increases, the required rate of return for equity increases.

17. The tradeoff theory of capital structure states that:

a. The capital structure of a firm does not matter.

b. The optimal capital structure is the one that is totally financed with equity.

c. WACC increases as the firm’s debt-equity ratio increases.

d. The cost of equity must decrease as the debt-equity ratio of a firm increases.

e. The value of a firm increases with leverage if the tax shield effect is stronger than the bankruptcy effect.

18. How many of the statements about corporate finance and capitalism are correct?

i. A reduction of central bank policy rate increases the number of possible NPV projects, therefore stimulating the economy.

ii. Higher entry barriers into an industry may increase existing firms’ market power and reduced welfare

iii. Efficient capital allocation is an essential part of capitalism.

iv. Proper corporate governance can reduce the conflict of interest between corporate managers and shareholders, therefore improving the efficiency of the system.

Your choice: a. zero; b. one; c. two; d. three; e. four. Get Finance homework help today

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