Unlevered Firm and a Levered Firm Assignment

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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 E and debt D.(>0). Firm U has equity Ey. 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 0.1 EL

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.

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. Get Finance homework help today