T or F: Debt is less risky than preferred stock, therefore, the pre-tax cost of
ID: 2732465 • Letter: T
Question
T or F: Debt is less risky than preferred stock, therefore, the pre-tax cost of debt is always lower than the pre-tax cost of preferred stock
T or F: In the trade-off theory of leverage, firms trade off the benefits of debt financing (favorable corporate tax treatment) against higher interest rates and bankruptcy costs
T or F: Conflicts between two mutually exclusive projects occasionally occur, where the NPV method ranks one project higher but the IRR method ranks the other one first. Such conflicts should be resolved in favor of the project with the higher positive NPV.
T or F: The equivalent annual annuities (EAA) method is preferred to the replacement chains method because 1) it is easier to explain the EAA method to those who are responsible for approving capital budgets, and 2) it is easier to build inflation and other modifications into a spreadsheet and go on to do the calculations
Explanation / Answer
1. Debt is less risky than preferred stock, therefore, the pre-tax cost of debt is always lower than the pre-tax cost of preferred stock - FALSE
Preferred stock often has a lower Before Tax (BT) yield than the B-T yield on debt.
2. In the trade-off theory of leverage, firms trade off the benefits of debt financing (favorable corporate tax treatment) against higher interest rates and bankruptcy costs TRUE
3. Conflicts between two mutually exclusive projects occasionally occur, where the NPV method ranks one project higher but the IRR method ranks the other one first. Such conflicts should be resolved in favor of the project with the higher positive NPV. TRUE
4.The equivalent annual annuities (EAA) method is preferred to the replacement chains method because (1) it is easier to explain the EAA method to those who are responsible for approving capital budgets, (2)The equivalent annual annuities (EAA) method is preferred to the replacement chains method because it is easier to build inflation and other modifications into a spreadsheet and go on to do the calculations TRUE
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