SelectedConceptQuestions_Chapter16

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CONCEPT QUESTIONS – SELECTED. CHAPTER 16 16.1 • What is the pie model of capital structure? It is a model in which the value of the firm is pictured as a pie cut into debt and equity slices. 16.2 • Why should financial managers choose the capital structure that maximizes the value of the firm? Because this capital structure also maximizes the value of equity. 16.3 • Describe financial leverage . It is the extent to which a company relies on debt in its capital structure. • What is levered equity? The equity of a firm that has debt in its capital structure. • What is MM Proposition I with no taxes? The value of the levered firm is the same as the value of the unlevered firm. 16.4 • Why does the expected return on equity rise with firm leverage? Because debtholders must be paid first, the cash flows to the shareholders become more variable, increasing the risk for the shareholders. • What is the exact relationship between the expected return on equity and firm leverage? r s = r o + (B/S)(r o – r B ) • How are market-value balance sheets set up? They are set up the same way as historical accounting balance sheets with assets on the left side and liabilities on the right side. However, instead of valuing assets in terms of historical values, market values are used. • What is MM Proposition II with no taxes? r S = r 0 + (B/S) (r 0 – r B ) 16.5 • What makes a levered firm more valuable than an otherwise-identical unlevered firm? Interest payments are tax deductible and dividend payments are not. Therefore, there is a tax benefit with interest which can be retained by the shareholders. • What is MM Proposition I under corporate taxes? V L = V U + T C B • What MM Proposition II under corporate taxes? r s = r o + (B/S)(1-T c )(r o – r B )
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