c2-finance

[retaker]

What do y'all think about this one?


When a firm increases its financial leverage, which of the following are true?

1. The expected return on equity should increase.
2. The expected return on the firm’s assets should be unchanged.
3. The expected return on the firm’s debt should increase.


A. 1 B. 3 C. 1, 2 D. 2, 3 E. 1, 2, 3

[c3 taker]

What do y'all think about this one?


When a firm increases its financial leverage, which of the following are true?

1. The expected return on equity should increase.
2. The expected return on the firm’s assets should be unchanged.
3. The expected return on the firm’s debt should increase.


A. 1 B. 3 C. 1, 2 D. 2, 3 E. 1, 2, 3

I like answer A. I'm assuming MM1 for number 2 (although, I know there is some part of the book where they do change the asset return when leverage changes). For 3, don't they normally try to keep the return on debt steady also. It always seems to me that when leverage changes in those problems that the return on equity changes because stockholders expect a higher return with more risk/more leverage.

[retaker]

They say E)

I think this is a bad question.

A) and B) are true from the text, but according to my joy filled intensive studies of this business crap, r_d usually doesn't increase unless you really lever up, and in the answer choice they say "which should increase".

[Lex]

Hey,

I would probably answer E on a test, but I do agree that this question is flawed.

I remember reading from the text (somewhere) that when a firm increases it's debt, debtholder's will demand a bigger return because risk has now increased.

I think that in a question like this however, they should specify that there are no corporate taxes and that r_d is constant.

[retaker]

Good, we agree.

.. but if you look at the graph they have in the book r_d does not start increasing until you really rack up the debt. At least I think I remember that. I remember running across another problem which shed light on this subtle detail previously, and coming to the conclusion that r_d didn't always necessarily increase, and I know for a fact that I have seen some old CAS problems where they want you to assume that r_d doesn't increase in order to get the right answer.

I will look this up again over the weekend. That's two Finance things I need to re-examine.

I hope the people on the exam committee for course 2 are paying attention to these details! We are the experts (only because we are forced to be) on this material.

Another major problem is WACC. It is very important to specify whether the number given for WACC includes the effect of taxes, or if you want us to calculate WACC with taxes.
Brealy & Meyers is bad about the use of the abbreviation WACC. Sometimes it includes taxes, sometimes not. I think (for our purposes) everybody should agree to the convention that the abbreviation WACC always includes taxes.
This means you especially, exam committee.
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