Question

3 Explain Why you agree or disagree with the following statements. The answer should not be more than 3 sentences. Be specific in your answer and write only the most relevant explanations (Total Marks 7.5, Each 1.5).

a. If a bond sells at a discount, yield to call is more likely to occur.
b. A firm should select the capital structure that is fully unlevered.
c. Leveraged beta represents fundamental operational risk.
d. All other things held constant; the future value of an ordinary annuity is always having a higher future value than annuity due.
e. MM Proposition I with no tax supports the argument that a firm should borrow money to the point where the tax benefit from debt is equal to the cost of the increased probability of financial distress.

Answer 1

a. Agree: A bond will trade at a discount when it offers a coupon rate that is lower than prevailing interest rates. Since investors always want a higher yield, they will pay less for a bond with a coupon rate lower than the prevailing rates. So they are buying it at a discount to make up for the lower coupon rate

b. Disagree: The firm always select the capital structure that maximizes the value of the firm.

c. Disagree: Levered beta calculates the systematic risk of a company with respect to the market. Systematic risk is the risk that affects the whole market and is not confined to a specific company or industry.

d. Agree: In ordinary annuities, payments are made at the end of each period. With annuities due, they're made at the beginning of the period.

e. Agree