CFA Practice Question

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CFA Practice Question

In a world with no taxes, the introduction of a small amount of debt into the capital structure of an all-equity firm would ______

A. decrease the risk of the firm.
B. not impact the risk of the firm.
C. increase the risk of the firm.
Correct Answer: B

In a world with no taxes, adding debt to the capital structure does not impact the risk of the firm's assets.

User Contributed Comments 20

User Comment
kalps Debt is cheaper with taxes becos of tax shield on interest
Arron then how about in a world with tax?
mtcfa I kind of disagree with this. Although there are no taxes, what happens if the firm's sales decrease? Because they now have higher fixed interest expense, there is still less residual earnings available to shareholders, regardless of taxes???
ramborob I agree with mtcfa. Just because there are no taxes, does not mean that there wont be a coupon to pay on the debt.
nike For the firm as a whole, the risk remains the same. For shareholders, borrowing always increases risks (leveraging). I agree with the answer.
SueLiu I think the key is they say small amount of debt.
01121975 Borrowing increase the financial leverage, but not affect the return on asset that is the company's cost of capital
01121975 Modigliani and Miller (MM theory) - the value of a firm does not depend on its capital structure, when there are no taxes and well-functioning capital markets exist. ( Value of a firm = D+E)
In other words, the value of a pizza does not depend on how it is sliced.
Shelton ROI=NI/E=[EBIT-Asset(1-pct)*i]*(1-t)/(Asset*pct)
=> when pct->1, ROI~EBIT*(1-t)/Asset.
ehc0791 I think the question is testing you know MM theory or not
gth763s Tax rate doesn't affect DFL. So even tax rate is zero, adding debt still increase sensitivity of cash flow, i.e. financial risks.
cp24 I agree with gth763s. Increasing debt adds leverage to the firm, which makes it more sensitive to changes in EBIT and sales (i.e. increases financial risk).
nike no guys. adding debt increases risks for shareholders. for the FIRM it does not matter.
steved333 But the definition of financial risk shows that it is derived from a company using debt. Maybe that is, again, just for the shareholders...
olmo No taxes affect firm's profitability because there are no fiscal deductions due to interest expenses. However, if you get an amount of debt you financial risk increases
Nightsurfer The key is that the question asks if the risk of the "firm" changes, not the risk of just the "equity". The M&M example using the pie is correct to apply here. When a small amount of debt is put into the firm, it's basically like equity (i.e. doesn't increase risk of bankruptcy or add variability to CF). In a world with taxes, there would be a preference for debt over equity. Without taxes, there would be no bias, so the cost of equity would be equal to the cost debt.
johntan1979 You guys made great arguments, but I am inclined to agree with SueLiu, because I think it is as simple as it is supposed to be... "small" amount of debt.

I believe there's no such thing as risk-free debt, not even US Treasuries.
Shaan23 If you use the equation again...

Bl = Bu ( 1 + (1 - t) D/E) you can see debt does affect it regardless of if there is taxes.

Going with johntan as well. Assume a small really small amount of debt then r on equity not affected.
fabsan No matter the amount of debt, I ain't sure if a firm with debt and one with zero debt should have the same credit rating.
fabsan if I have zero debt, I can raise more money than if I have one.
If I have zero debt, I face less responsability than if I have one.
Debt no matter the amount will increase the risk for the firm and for the shareholders.
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