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45) Which of the following statements is FALSE?
A) The levered equity return equals the unlevered return plus an extra "kick" due to
leverage.
B) By holding a portfolio of a irm's equity and its debt, we can replicate the cash lows
from holding its levered equity.
C) The cost of capital of levered equity is equal to the cost of capital of unlevered equity
plus a premium that is proportional to the market value debt-equity ratio.
D) If a irm is unlevered, all of the free cash lows generated by its assets are available to
be paid out to its equity holders.
AACSB Objective: Relective Thinking Skills
Author: JN
Question Status: Previous Edition
46) Which of the following statements is FALSE?
A) If we can identify a comparison irm whose assets have the same risk as the project
being evaluated, and if the comparison irm is levered, then we can use its cost of debt as
the cost of capital for the project.
B) We can calculate the cost of capital of a irm's assets by computing the weighted
average of the irm's equity and debt cost of capital, which we refer to as the irm's
weighted average cost of capital.
C) The portfolio of a irm's equity and debt replicates the returns we would earn if the irm
were unlevered.
D) When evaluating any potential investment project, we must use a discount rate that is
appropriate given the risk of the project's free cash low.
AACSB Objective: Relective Thinking Skills
Author: JN
Question Status: Previous Edition
21
47) Which of the following statements is FALSE?
A) With no debt, the WACC is equal to the unlevered equity cost of capital.
B) With perfect capital markets, a irm's WACC is dependent on its capital structure and is
equal to its equity cost of capital only if the irm is unlevered.
C) As the irm borrows at the low cost of capital for debt, its equity cost of capital rises, but
the net efect is that the irm's WACC is unchanged.
D) As debt has a lower cost of capital than equity, higher leverage lowers a irm's WACC.
AACSB Objective: Relective Thinking Skills
Author: JN
Question Status: Revised
48) Which of the following statements is TRUE?
A) Holding cash has the opposite efect of leverage on risk and return.
B) We use the market value of a irm's net debt when computing its WACC and unlevered
beta to measure the cost of capital and market risk of the irm's business assets.
C) Since the WACC does not change with the use of leverage, the value of a irm's free cash
low evaluated using the WACC does not change, and so the enterprise value of the irm
does not depend on its inancing choices.
D) Even if a irm's capital structure is more complex, the WACC is calculated by computing
the weighted average cost of only the irm's debt and equity.
AACSB Objective: Relective Thinking Skills
Author: JN
Question Status: Previous Edition
22
49) Which of the following statements is FALSE assuming a perfect market?
A) The unlevered beta measures the market risk of a irm's business activities, ignoring any
additional risk due to leverage.
B) If a irm holds $1 in cash and has $1 of risk-free debt, then the interest earned on the
cash will equal the interest paid on the debt. The cash lows from each source cancel each
other, just as if the irm held no cash and no debt.
C) The unlevered beta measures the market risk of a irm without leverage, which is
equivalent to the beta of the irm's assets.
D) As the amount of debt decreases, the debt becomes riskier because there is a chance the
irm will default.
AACSB Objective: Relective Thinking Skills
Author: JN
Question Status: Revised
50) The following equation:
X = rE + rD
can be used to calculate all of the following EXCEPT ________.
A) the cost of capital for a irm's assets
B) the levered cost of preferred equity
C) the unlevered cost of equity
D) the weighted average cost of capital
AACSB Objective: Analytic Skills
Author: JN
Question Status: Previous Edition
51) Which of the following equations would NOT be appropriate to use in a irm with risky
debt?
A) rE = rU + (D / E) × (rU - rD)
B) rU = rD + (D / E) × (rU - rD)
C) rE = rU + (D / E) × rU
D) rU = [E / (E + D)]rE +[D / (E + D)]rD
AACSB Objective: Analytic Skills
Author: JN
Question Status: Previous Edition
23
Use next year's Cash Flow Forecast for Blank Company to answer the question(s) below.
Demand Cash Flow
Weak $25,000
Expected $35,000
Strong $45,000
52) Suppose Blank Company has only one project, as forecast above, and an unlevered cost
of equity of 8%. What is the value of the company if the demand is as expected?
A) $23,148.15
B) $32,407.40
C) $41,666.67
D) Cannot be determined with the information given.
AACSB Objective: Analytic Skills
Author: JP
Question Status: Revised
53) Suppose Blank Company has only one project, as forecast above, and an unlevered cost
of equity of 8%. If the company uses no leverage, what is expected return to equity
holders?
A) 8.0%
B) 11.6%
C) 9.33%
D) 30.0%
AACSB Objective: Analytic Skills
Author: JP
Question Status: Revised
24
54) Suppose Blank Company has only one project, as forecast above, and an unlevered cost
of equity of 8%. If the company borrows $10,000 at 5% to make the investment, what is
expected return to equity holders? Assume the demand is as expected.
A) 8.0%
B) 11.6%
C) 9.33%
D) 30.0%
AACSB Objective: Analytic Skills
Author: JP
Question Status: Revised
55) Suppose Blank Company has only one project, as forecast above, and an unlevered cost
of equity of 8%. If the company borrows $10,000 at 5% to make the investment, what is the
return to equity holders if demand is weak?
A) 8.0%
B) -37.5%
C) -58.6%
D) 10.28%
AACSB Objective: Analytic Skills
Author: JP
Question Status: Revised
25
56) Suppose Blank Company has only one project, as forecast above, and an unlevered cost
of equity of 8%. If the company borrows $10,000 at 5% to make the investment, what is the
return to equity holders if demand is strong?
A) 8.0%
B) 8.95%
C) 28.6%
D) 38.0%
AACSB Objective: Analytic Skills
Author: JP
Question Status: Revised
16.3 Debt and Taxes
1) In general, the gain to investors from the tax deductibility of interest payments is
referred to as the interest rate tax shield.
AACSB Objective: Analytic Skills
Author: KB
Question Status: Previous Edition
2) Suppose a project inanced via an issue of debt requires ive annual interest payments of
$12 million each year. If the tax rate is 35% and the cost of debt is 5%, what is the value of
the interest rate tax shield?
A) 14.55 million
B) $21.82 million
C) $36.37 million
D) $18.18 million
AACSB Objective: Analytic Skills
Author: KB
Question Status: Previous Edition
26
3) Suppose a project inanced via an issue of debt requires six annual interest payments of
$18 million each year. If the tax rate is 35% and the cost of debt is 8%, what is the value of
the interest rate tax shield?
A) $23.30 million
B) $29.12 million
C) $34.95 million
D) $58.25 million
AACSB Objective: Analytic Skills
Author: KB
Question Status: Previous Edition
4) Suppose a project inanced via an issue of debt requires ive annual interest payments of
$18 million each year. If the tax rate is 35% and the cost of debt is 7%, what is the value of
the interest rate tax shield?
A) $20.66 million
B) $31.00 million
C) $25.83 million
D) $51.66 million
AACSB Objective: Analytic Skills
Author: KB
Question Status: Previous Edition
27
5) A irm requires an investment of $30,000 and borrows $20,000 at 9%. If the return on
equity is 15% and the tax rate is 30%, what is the irm's WACC?
A) 9.20%
B) 7.36%
C) 11.04%
D) 18.40%
AACSB Objective: Analytic Skills
Author: KB
Question Status: Previous Edition
6) A irm requires an investment of $60,000 and borrows $30,000 at 9%. If the return on
equity is 22% and the tax rate is 35%, what is the irm's WACC?
A) 11.1%
B) 13.9%
C) 16.7%
D) 27.9%
AACSB Objective: Analytic Skills
Author: KB
Question Status: Previous Edition
28
7) A irm requires an investment of $60,000 and borrows $20,000 at 8%. If the return on
equity is 14% and the tax rate is 30%, what is the irm's WACC?
A) 11.2%
B) 9.0%
C) 13.4%
D) 22.4%
AACSB Objective: Analytic Skills
Author: KB
Question Status: Revised
8) What are some implications of market imperfections?
AACSB Objective: Analytic Skills
Author: SS
Question Status: Previous Edition
9) How does the interest paid by a irm afect its value to investors?
AACSB Objective: Relective Thinking Skills
Author: SS
Question Status: Previous Edition
10) What efect does debt have on a irm's weighted average cost of capital?
AACSB Objective: Relective Thinking Skills
Author: SS
Question Status: Previous Edition
29
16.4 The Costs of Bankruptcy and Financial Distress
1) A irm that does not have trouble meeting its debt obligations is said to be in inancial
distress.
AACSB Objective: Analytic Skills
Author: KB
Question Status: Previous Edition
2) The direct costs of bankruptcy are estimated to be far greater, as a percent of assets,
than the indirect costs of bankruptcy.
AACSB Objective: Analytic Skills
Author: JP
Question Status: Previous Edition
3) A bankruptcy process is complex, time-consuming, and costly. The costs of bankruptcy
include ________.
A) dividend payments
B) raw material costs
C) costs of hiring legal experts, appraisers, and auctioneers
D) taxes
AACSB Objective: Analytic Skills
Author: KB
Question Status: Previous Edition
4) Aside from direct costs of bankruptcy, a irm may also incur other indirect costs such as
________.
A) loss of customers and loss of suppliers
B) loss of interest receipts
C) loss of dividend receipts
D) increase in raw material costs
AACSB Objective: Analytic Skills
Author: KB
Question Status: Previous Edition
30
