Corporate Finance (4th Edition) (Pearson Series in Finance) - Standalone book
4th Edition
ISBN: 9780134083278
Author: Jonathan Berk, Peter DeMarzo
Publisher: PEARSON
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Textbook Question
Chapter 14, Problem 10P
Explain what is wrong with the following argument: “If a firm issues debt that is risk free, because there is no possibility of default, the risk of the firm’s equity does not change. Therefore, risk-free debt allows the firm to get the benefit of a low cost of capital of debt without raising its cost of capital of equity.”
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Students have asked these similar questions
Which of the following statements is FALSE?
A.
Equity cost of capital is normally higher then cost of debt, thus cost of debt can be examined in isolation.
B.
No matter if a firm is unlevered or levered, there is no difference in the market value of the firms total securities and market value of the firm’s assets.
C.
Introducing debt increases the risk even though it may be cheap and consequently increases firms equity cost of capital.
D.
Cost of Capital of equity and Leverage can be explicitly explained by first proposition that Modigliani and Miller introduced.
Critique this statement: “The use of debt financing lowers the net income of the firm, and hence debt financing should be used only as a last resort.”
"If the firm's ROE is too low, the firm's debt ratio must be too low." True or false?
Select one:
O a. True
O b. False
Chapter 14 Solutions
Corporate Finance (4th Edition) (Pearson Series in Finance) - Standalone book
Ch. 14.1 - How does the risk and cost of capital of levered...Ch. 14.2 - Why are investors indifferent to the firms capital...Ch. 14.2 - What is a market value balance sheet?Ch. 14.2 - In a perfect capital market, how will a firms...Ch. 14.3 - How do we compute the weighted average cost of...Ch. 14.3 - With perfect capital markets, as a firm increases...Ch. 14.4 - If a change in leverage raises a firm's earnings...Ch. 14.4 - True or False: When a firm issues equity, it...Ch. 14.5 - Consider the questions facing Dan Harris, CFO of...Ch. 14.5 - Prob. 2CC
Ch. 14 - Consider a project with free cash flows in one...Ch. 14 - You are an entrepreneur starting a biotechnology...Ch. 14 - Acort Industries owns assets that will have an 80%...Ch. 14 - Wolfrum Technology (WT) has no debt. Its assets...Ch. 14 - Suppose there are no taxes. Firm ABC has no debt,...Ch. 14 - Suppose Alpha Industries and Omega Technology have...Ch. 14 - Prob. 7PCh. 14 - Prob. 8PCh. 14 - Zetatron is an all-equity firm with 100 million...Ch. 14 - Explain what is wrong with the following argument:...Ch. 14 - Consider the entrepreneur described in Section...Ch. 14 - Hardmon Enterprises is currently an all-equity...Ch. 14 - Suppose Visa Inc. (V) has no debt and an equity...Ch. 14 - Prob. 14PCh. 14 - Prob. 15PCh. 14 - Hartford Mining has 50 million shares that are...Ch. 14 - Mercer Corp. has 10 million shares outstanding and...Ch. 14 - In mid-2015 Qualcomm Inc. had 11 billion in debt,...Ch. 14 - Prob. 19PCh. 14 - Prob. 20PCh. 14 - Yerba Industries is an all-equity firm whose stock...Ch. 14 - Prob. 22PCh. 14 - Prob. 23PCh. 14 - Prob. 24P
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Need a deep-dive on the concept behind this application? Look no further. Learn more about this topic, finance and related others by exploring similar questions and additional content below.Similar questions
- Consider the trade-off theory of capital structure and the market timing theory in answering this question. A company can borrow at a favourable rate due to low interest rates but chooses not to do so due to the increased financial risk. Instead, it issues equity, despite the market not valuing its equity in excess of the company’s internal valuation. Required: Discuss which of the two abovementioned theories prevailed and provide a motivation for your answer.arrow_forwardWhich statement is most correct? * A. Since debt financing raises the firm’s financial risk, increasing debt ratio will increase WACC. B. Since debt financing is cheaper than equity financing, increasing debt ratio will reduce WACC. C. Increasing a firm’s debt ratio will typically reduce the marginal costs of both debt and equity financing; however, it still may raise the firm’s WACC. D. Statements a and c are correct. E. None of the abovearrow_forwardThere are advantages and disadvantages of debt financing in contrast to equity financing. Which of the following is less likely to represent an advantage of debt financing? a. The cost of debt should be lower than the cost of equity for most companies due to the lower risk to the lender and the tax deductibility of interest b. The repayment of debt capital may affect the liquidity of the company c. If the return on assets exceeds the cost of debt, then this will result in a higher return on shareholders’ funds as compared to the return on assets d. The increase in borrowings will not normally affect the voting control of the current shareholders as compared to the issue of shares e. Fixed interest rate loans will result in the variability in the market value of such loans over time which will normally be less than the variability in the value of the equity of the companyarrow_forward
- 4. Which of the following is false about the risk-shifting problem? Risk-shifting leads to a transfer of value from debt-holders to equity holders Risk-shifting leads prospective lenders to pay less for debt and require higher interest payments Risk-shifting arises when shareholders choose negative NPV projects with higher risk Risk-shifting is an example of an agency cost of debt Risk-shifting is greater in firms with low leveragearrow_forwardWhich of the follwong is a true statement about Risk Capital or Owner's Equity? There is no legal obligtion to pay it back It is usually the largest asset held by a firm If dividands are not paid in a consistant and timely fashion the shareholders can force the firm into bankrupcy. It is a much riskier means of financing an embrionic organization than debt. All of the above are correct statementsarrow_forwardWhich of the following statements is FALSE? As debt increases, the risk associated with bankruptcy and agency costs is reduced. Debt is often the least costly form of financing for a firm. Firms should probably use some debt in their capital structure. Different firms are subject to different levels of risk.arrow_forward
- In the conflicts between equity holders and bond holders, 1).Why would equity investors want to forego good project with positive NPV (“debt overhang”) and rather take risky projects with negative NPV? (“risk shifting”) 2).What is an example of “asset stripping” from equity holders in case of high financial distress?arrow_forwardWhich of the following statement is false? a. None of above b. The capital structure should be flexible. c. A firm having operating loss would find it worthwhile to incorporate debt in the capital structure in a greater measure. d. The use of excessive debt threatens the solvency of the company.arrow_forward3.If the interest rate on debt is lower than ROA, then a firm will __________ by increasing the useof debt in the capital structure.a. increase the ROE b. not change the ROE c. decrease the ROEd. change the ROE in an indeterminable manner e. none of the abovearrow_forward
- Is this statement true or false? Please explain in detail As debt-financing is usually cheaper than equity financing, debt-financing will lower risk for transnational company.arrow_forwardWhich of the following is an advantage of debt financing? a. Excessive debt increases the risk of equity holders and therefore depresses share price. b. The obligation is generally fixed in terms of interest and principal payments. c. Interest and principal obligations must be paid regardless of the economic position of the firm. d. Debt agreements contain covenants.arrow_forwardWhich of the following statement is correct? O A. Firms that do not take on debt as part of their capital structure are known as leveraged firms. O B. Pecking order theory implies that profitable company will have more debt capacity. OC. According to pecking order theory, firms prefer external financing first. O D. The greater amount of debt carried by a firm, the lesser chance of bankruptcy.arrow_forward
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