Chapter 10 Review Session

Chapter 10 Review Session - Chapter 10 Review Session 2007...

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© 2007 Robert H. Smith School of Business University of Maryland “Chapter 10 Review Session”
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© 2007 Robert H. Smith School of Business University of Maryland Chapter 10 Review Session 1. Which of the following could be true concerning the costs of debt and equity? a. The cost of debt for Firm A is greater than the cost of equity for Firm A b. The cost of debt for Firm A is greater than the cost of equity for Firm B. c. The cost of retained earnings for Firm A is less than the cost of debt for Firm A. d. The cost of retained earnings for Firm A is more than its cost of new outside equity.
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© 2007 Robert H. Smith School of Business University of Maryland Chapter 10 Review Session 1. b is correct. The cost of debt is always less than the cost of equity for a particular firm. Firm A could have a cost of debt greater than the cost of equity for Firm B if Firm A has a great deal of business risk and could only borrow at a very high interest rate. The cost of retained earnings is always more than the cost of debt. The cost of new outside equity is more than the cost of retained earnings for a given firm.
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© 2007 Robert H. Smith School of Business University of Maryland Chapter 10 Review Session 2. Which of the following statements is true? a. If Congress raised the corporate tax rate, this would lower the effective cost of debt. b. If Congress raised the personal income tax rate, investors would demand more corporate debt financing, and companies’ debt ratios would increase. c. The calculation for a firm’s WACC includes an adjustment to the cost of debt for taxes, since interest is deductible, and includes the cost of all current liabilities. d. Since the money is readily available, the cost of retained earnings is usually a lot cheaper than the cost of debt financing.
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University of Maryland Chapter 10 Review Session 2. A is correct. If Congress were to raise the tax rate, this would increase the value of the corporate tax shield, and overall, more corporate debt would be demanded. If Congress increased the personal tax rate, investors would be taxed more on debt income and would demand less corporate debt income and more equity income, which is taxed at a lower rate. B is incorrect. Statement c is false because the debt considered in the calculation of WACC includes only long-term debt and bank debt (notes payable). Statement d is incorrect – retained earnings are more costly
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This note was uploaded on 02/22/2011 for the course BMGT 340 taught by Professor White during the Spring '08 term at Maryland.

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Chapter 10 Review Session - Chapter 10 Review Session 2007...

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