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L. For a firm with zero or negative earnings, the tax-optimal capital structure does not include debt.
TRUE: In order for the interest tax shield to deliver a benefit, there first of all needs to be taxable income (p. 576).
F. We do not include the interest tax shield as one of the firm's assets on its market value balance sheet.
FALSE: The interest tax shield should be considered as part of the firm’s total value because it effectively increases the value of the firm by reducing taxes (p. 567 Balance Sheet)
M. For a firm with positive earnings, the tax-optimal capital structure includes debt at a level that is proportional to the firm’s current earnings
TRUE: no tax shield is needed as taxes are only paid on earnings.
A. Because interest expense is tax deductible, leverage increases the total amount of income available to all investors
TRUE: Because firms pay taxes on their profit after interest payments are deducted, interest expenses reduce the amount of corporate tax firms must pay. (p. 556)
D. For unlevered firms, the firm’s WACC, pre-tax WACC, and equity cost of capital are equal
TRUE: pre-, and after-tax are the same because the firm does not pay interest on debt
H. Once investors know the recapitalization will occur, the share price will rise immediately to a level that reflects the value of the interest tax shield that the firm will receive from its recapitalization.
TRUE: Because people will by shares in anticipation of the increased market value of the firm
I. Just like corporate taxes, personal taxes reduce the cash flows to investors and diminish firm value
TRUE: As a result, the actual interest tax shield depends on the reduction in the total taxes (both corporate and personal) that are paid. (15.4)
P. The Low Leverage Puzzle states that firms choose capital structures with low leverage levels that do not fully exploit the tax advantage of debt
TRUE: There are other costs — Increasing the level of debt increases the probability of bankruptcy (p. 580)
R. Increasing the level of debt increases the probability of bankruptcy
TRUE: The more debt a company takes the more likely it is to fail if the company cannot pay back its debt.
B. The firm’s WACC does not change when the firm’s target debt-to-value ratio changes.
FALSE: the M&M Proposition I with taxes implies that a firms WACC decreases due to the tax benefits of debt.
G. We can analyze the recapitalization using the market value balance sheet; it states that the total market value of a firm's securities must equal the total market value of the firm's assets.
TRUE: This holds true before and after recapitalization, reflecting that recapitalization changes the compensation of financing but not the total value of the firm’s assets
J. From the point of view of the investor, the actual interest tax shield depends on the reduction in the total taxes (both corporate and personal) that are paid.
TRUE: Personal taxes have the potential to offset some of the corporate tax benefits of leverage that we have described.
O. The optimal fraction of debt, as a proportion of a firm’s capital structure, increases with the growth rate of the firm
FALSE: The optimal proportion of debt in the firm’s capital structure D/(E+D) will be lower, the higher the firm’s growth rate - reducing the need for debt financing
Q. Aside from taxes, another important difference between debt and equity financing is that debt payments must be made to avoid bankruptcy, whereas firms have no similar obligation to pay dividends or realize capital gains
TRUE: If bankruptcy is costly, these costs might offset the tax advantages of debt financing (p. 580)
C. When the firm’s target debt-to-value ratio increases and the firm approaches a 100% debt-to-value ratio, the firm’s after-tax cost of debt rise
TRUE: An increasing debt means an increasing risk by lenders, leading to higher interest rates - after tax cost of debt also rises, despite the tax shield from interest deductibility
E. When securities are fairly priced, the original shareholders of a firm capture the full benefit of the interest tax shield from an increase in leverage
TRUE: Once the investors know the recap will occur, the share price will rise immediately to a level that reflects the value of the interest tax shield that the firm will receive. Because the firm’s securities are fairly priced, this increase is fully captured by the original shareholders
K. We can interpret t* as the effective tax advantage of debt: If the firm paid (1-t*) in interest, debt holders would receive the same amount after taxes as equity holders if the firm paid $1 in profits to equity holders.
TRUE: The firm can either pay this $1 to debt holders as interest, or it can use the $1 to pay equity holders directly, with a dividend, or indirectly, by retaining earnings so that shareholders receive a capital gain. (p. 568)
N. From a tax savings perspective, the firm has attained its optimal level of debt when interest just equals the income limit
TRUE: In a MM world with taxes, the firm attains its optimal level of debt when the interest expense equals the firm’s taxable income. At this point, the firm maximizes its tax-shield benefits without incurring additional costs of financial distress.