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Chp15_ReviewAnswers - Chapter 15 Capital Structure Answers...

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Chapter 15 Capital Structure Answers to Chapter 15 Review Questions 1. When you shift financing from equity financing to debt financing (absent tax effects), the cost of equity increases (due to the increased riskiness of the equity cash flows). This increase in the cost of equity capital offsets any reduction in the cost of capital due to using debt financing. 2. The fact that the debt is risk-free does not mean that the risk of the equity does not increase. The volatility of the equity cash flows will increase because debt payments are made first (due to the seniority of debt claims). Therefore, even though the debt is risk-free, equity is more risky. 3. Financing choices affect firm value through the following channels: Taxes Transaction/Issuance costs Investment policy Imperfect information 4. Taxes make debt a more attractive financing option than equity. Interest expense on debt capital can be used to shield operating income from taxes, which increases the value of the firm.
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