Use the information for the question(s) below.
Consider a project with free cash flows in one year of $90,000 in a weak economy or $117,000 in a strong economy, with each
outcome being equally likely. The initial investment required for the project is $80,000, and the project’s cost of capital is
15%. The risk–free interest rate is 5%.
46)
Suppose that you borrow only $60,000 in financing the project. According to MM proposition II,
the firm’s equity cost of capital will be closest to:
46)
A)
45%
B)
25%
C)
30%
D)
35%
47)
Consider the following equation:
E+D=U=A
The E in this equation represents
47)
A)
the market value of the firm’s assets.
B)
the value of the firm’s equity.
C)
the value of the firm’s debt.
D)
the value of the firm’s unlevered equity.
Use the information for the question(s) below.
Luther is a successful logistical services firm that currently has $5 billion in cash. Luther has decided to use this cash to
repurchase shares from its investors, and has already announced the stock repurchase plan. Currently Luther is an all equity
firm with 1.25 billion shares outstanding. Luther‘s shares are currently trading at $20 per share.
48)
The market value of Luther’s non–cash assets is closest to:
48)
A)
$20 billion
B)
$25 billion
C)
$19 billion
D)
$24 billion
49)
Which of the following statements is false?
49)
A)
By holding a portfolio of the firm’s equity and its debt, we can replicate the cash flows from
holding its levered equity.
B)
The levered equity return equals the unlevered return, plus an extra “kick” due to leverage.
C)
If a firm is unlevered, all of the free cash flows generated by its assets are available to be paid
out to its equity holders.
D)
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.
Use the information for the question(s) below.
Consider a project with free cash flows in one year of $90,000 in a weak economy or $117,000 in a strong economy, with each
outcome being equally likely. The initial investment required for the project is $80,000, and the project’s cost of capital is
15%. The risk–free interest rate is 5%.
50)
The NPV for this project is closest to:
50)
A)
$14,100
B)
$10,000
C)
$6,250
D)
$18,600
51)
Which of the following statements is false?
51)
A)
One application of MM Proposition I is the useful device known as the market value balance
sheet of the firm.
B)
The market value balance sheet captures the idea that value is created by a firm‘s choice of
assets and investments.
C)
Investors can alter the leverage choice of the firm to suit their personal tastes either by
borrowing and reducing leverage or by holding bonds and adding more leverage.
D)
On the market value balance sheet the total value of all securities issued by the firm must
equal the total value of the firm’s assets.
Use the information for the question(s) below.
Luther is a successful logistical services firm that currently has $5 billion in cash. Luther has decided to use this cash to
repurchase shares from its investors, and has already announced the stock repurchase plan. Currently Luther is an all equity
firm with 1.25 billion shares outstanding. Luther‘s shares are currently trading at $20 per share.
52)
With perfect capital markets, what is the market price per share of Luther’s stock after the share
repurchase?
52)
A)
$20
B)
$15
C)
$24
D)
$25
53)
The following equation:
X=E
E+DrE+D
E+DrD
can be used to calculate all of the following except:
53)
A)
The unlevered cost of equity.
B)
The cost of capital for the firm’s assets.
C)
The levered cost of equity.
D)
The weighted average cost of capital.
54)
Which of the following statements is false?
54)
A)
The conservation of value principle for financial markets states that with perfect capital
markets, financial transactions neither add nor destroy value, but instead represent a
repackaging of risk (and therefore return).
B)
The conservation of value principle extends far beyond questions of debt versus equity
or even capital structure.
C)
Proposition I was one of the first arguments to show that the Law of One Price could have
strong implications for security prices and firm values in a competitive market; it marks the
beginning of the modern theory of corporate finance.
D)
Since the publication of their original paper, Modigliani and Miller’s ideas have greatly
influenced finance research and practice.
Use the information for the question(s) below.
Consider a project with free cash flows in one year of $90,000 in a weak economy or $117,000 in a strong economy, with each
outcome being equally likely. The initial investment required for the project is $80,000, and the project’s cost of capital is
15%. The risk–free interest rate is 5%.
55)
Suppose that to raise the funds for the initial investment the firm borrows $80,000 at the risk free
rate, then the cash flow that equity holders will receive in one year in a weak economy is closest to:
55)
A)
$0
B)
$33,000
C)
$10,000
D)
$6,000
56)
Suppose that to raise the funds for the initial investment the firm borrows $40,000 at the risk free
rate and issues new equity to cover the remainder. In this situation, the value of the firm’s levered
equity from the project is closest to:
56)
A)
$90,000
B)
$0
C)
$50,000
D)
$40,000
57)
Which of the following statements is false?
57)
A)
In a perfect capital market, the total value of a firm is equal to the market value of the total
cash flows generated by its assets and is not affected by its choice of capital structure.
B)
In the absence of taxes or other transaction costs, the total cash flow paid out to all of a firm’s
security holders is equal to the total cash flow generated by the firm’s assets.
C)
With perfect capital markets, leverage merely changes the allocation of cash flows between
debt and equity, without altering the total cash flows of the firm.
D)
The Law of One Price implies that leverage will affect the total value of the firm under perfect
capital market conditions.
58)
Which of the following statements is false?
58)
A)
Investors in levered equity require a higher expected return to compensate for its increased
risk.
B)
We can evaluate the relationship between risk and return more formally by computing the
sensitivity of each security’s return to the systematic risk of the economy.
C)
Leverage increases the risk of equity even when there is no risk that the firm will default.
D)
Modigliani and Miller‘s conclusion verified the common view, which stated that even with
perfect capital markets, leverage would affect a firm’s value.
Use the information for the question(s) below.
You are evaluating a new project and need an estimate for your project’s beta. You have identified the following information
about three firms with comparable projects:
Firm
Name
Equity
Beta
Debt
Beta
Debt to
Equity Ratio
Lincoln 1.25 00.25
Blinkin 1.6 0.2 1
Nod 2.3 0.3 1.5
59)
The unlevered beta for Nod is closest to:
59)
A)
1.10
B)
1.00
C)
0.90
D)
0.95
Use the information for the question(s) below.
Consider two firms, With and Without, that have identical assets that generate identical cash flows. Without is an all–equity
firm, with 1 million shares outstanding that trade for a price of $24 per share. With has 2 million shares outstanding and $12
million dollars in debt at an interest rate of 5%.
60)
Assume that MM’s perfect capital markets conditions are met and that you can borrow and lend at
the same 5% rate as with. You have $5000 of your own money to invest and you plan on buying
With stock. Using homemade (un)leverage you invest enough at the risk–free rate so that the
payoff of your account will be the same as a $5000 investment in Without stock? The number of
shares of With stock you purchased is closest to:
60)
A)
1650
B)
100
C)
425
D)
825
61)
Consider the following equation:
E+D=U=A
The U in this equation represents
61)
A)
the market value of the firm’s assets.
B)
the value of the firm’s unlevered equity.
C)
the value of the firm’s debt.
D)
the value of the firm’s equity.
62)
Which of the following statements is false?
62)
A)
Although debt does not have a lower cost of capital than equity, we can consider this cost in
isolation.
B)
We can use Modigliani and Miller’s first proposition to derive an explicit relationship
between leverage and the equity cost of capital.
C)
While debt itself may be cheap, it increases the risk and therefore the cost of capital of the
firm’s equity.
D)
The total market value of the firm’s securities is equal to the market value of its assets,
whether the firm is unlevered or levered.
63)
Which of the following statements is false?
63)
A)
The most common choices are financing through equity alone and financing through a
combination of debt and equity.
B)
When corporations raise funds from outside investors, they must choose which type of
security to issue.
C)
The relative proportions of debt, equity, and other securities that a firm has outstanding
constitute its capital structure.
D)
The project’s NPV represents the value to the new investors of the firm created by the project.
ESSAY. Write your answer in the space provided or on a separate sheet of paper.
Use the information for the question(s) below.
Consider a project with free cash flows in one year of $90,000 in a weak economy or $117,000 in a strong economy, with each
outcome being equally likely. The initial investment required for the project is $80,000, and the project’s cost of capital is
15%. The risk–free interest rate is 5%.
64)
Two separate firms are considering investing in this project. Firm unlevered plans to fund the entire $80,000
investment using equity, while firm levered plans to borrow $45,000 at the risk–free rate and use equity to
finance the remainder of the initial investment. Calculate the risk premiums for both the levered and unlevered
firm.
65)
What is a market value balance sheet and how does it differ from a book value balance sheet?
Use the information for the question(s) below.
Consider two firms: firm Without has no debt, and firm With has debt of $10,000 on which it pays interest of 5% per year.
Both companies have identical projects that generate free cash flows of $1000 or $2000 each year. Suppose that there are no
taxes, and after paying any interest on debt, both companies use all remaining cash free cash flows to pay dividends each
year.
66)
Suppose you own 10% of the equity of With. What is another portfolio you could hold that would provide you
with the same exact cash flows?
Use the information for the question(s) below.
Consider a project with free cash flows in one year of $90,000 in a weak economy or $117,000 in a strong economy, with each
outcome being equally likely. The initial investment required for the project is $80,000, and the project’s cost of capital is
15%. The risk–free interest rate is 5%.
67)
Two separate firms are considering investing in this project. Firm unlevered plans to fund the entire $80,000
investment using equity, while firm levered plans to borrow $45,000 at the risk–free rate and use equity to
finance the remainder of the initial investment. Construct a table detailing the percentage returns to the equity
holders of both the levered and unlevered firms for both the weak and strong economy.
Use the information for the question(s) below.
Consider two firms: firm Without has no debt, and firm With has debt of $10,000 on which it pays interest of 5% per year.
Both companies have identical projects that generate free cash flows of $1000 or $2000 each year. Suppose that there are no
taxes, and after paying any interest on debt, both companies use all remaining cash free cash flows to pay dividends each
year.
68)
Suppose you own 10% of the equity of Without. What is another portfolio you could hold that would provide
you with the same exact cash flows?
Use the information for the question(s) below.
Assume that Rose Corporation’s (RC) EBIT is not expected to grow in the future and that all earnings are paid out as
dividends. RC is currently an all equity firm. It expects to generate earnings before interest and taxes (EBIT) of $6 million
over the next year. Currently RC has 5 million shares outstanding and its stock is trading for a price of $12.00 per share. RC
is considering borrowing $12 million at a rate of 6% and using the proceeds to repurchase shares at the current price of
$12.00.
69)
Show mathematically that the stock price of RC won’t change following the debt issuance and share repurchase.
Use the information for the question(s) below.
Consider a project with free cash flows in one year of $90,000 in a weak economy or $117,000 in a strong economy, with each
outcome being equally likely. The initial investment required for the project is $80,000, and the project’s cost of capital is
15%. The risk–free interest rate is 5%.
70)
Suppose that you borrow only $45,000 in financing the project. According to MM proposition II, calculate the
firm’s equity cost of capital.
71)
Sisyphean Bolder Movers Incorporated has no debt, a total equity capitalization of $50 billion, and a beta of 2.0.
Included in Sisyphean‘s assets are $12 billion in cash and risk–free securities. Calculate Sisyphean’s enterprise
value and unlevered cost of equity considering the fact that Sisyphean’s cash is risk–free.