26) Assume that in addition to 1.25 billion common shares outstanding, Luther has stock options
given to employees valued at $2 billion. The market value of Luther’s non-cash assets is closest
to:
A) $22 billion
B) $20 billion
C) $25 billion
D) $18 billion
27) Assume that in addition to 1.25 billion common shares outstanding, Luther has stock options
given to employees valued at $2 billion. After the repurchase how many shares will Luther have
outstanding?
A) 1.0 billion
B) 1.2 billion
C) 0.75 billion
D) 1.1 billion
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.
28) Fill in the table below showing the payments debt and equity holders of each firm will
receive given each of the two possible levels of free cash flows:
Without
With
Free Cash
Flow
Interest
Payments
Equity
Dividends
Interest
Payments
Equity
Dividends
1000
2000
With
Flow
1000
2000
29) 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?
Flow
100
200
30) 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?
31) What is a market value balance sheet and how does it differ from a book value balance
sheet?
14.3 Modigliani-Miller II: Leverage, Risk, and the Cost of Capital
1) Suppose that Taggart Transcontinental currently has no debt and has an equity cost of capital
of 10%. Taggart is considering borrowing funds at a cost of 6% and using these funds to
repurchase existing shares of stock. Assume perfect capital markets. If Taggart borrows until
they achieved a debt –to-value ratio of 20%, then Taggart’s levered cost of equity would be
closest to:
A) 8.0%
B) 9.2%
C) 10.0%
D) 11.0%
2) Suppose that Rearden Metal currently has no debt and has an equity cost of capital of 12%.
Rearden is considering borrowing funds at a cost of 6% and using these funds to repurchase
existing shares of stock. Assume perfect capital markets. If Taggart borrows until they achieved
a debt –to-equity ratio of 50%, then Rearden’s levered cost of equity would be closest to:
A) 10.0%
B) 12.0%
C) 15.0%
D) 16.0%
Use the following information to answer the question(s) below.
Galt Industries has no debt, total equity capitalization of $600 million, and an equity beta of 1.2.
Included in Galt’s assets is $90 million in cash and risk-free securities. Assume the risk-free rate
is 4% and the market risk premium is 6%.
3) Galt’s enterprise value is closest to:
A) $90 million
B) $510 million
C) $600 million
D) $690 million
4) Galt’s asset beta (ie the beta of its operating assets) is closest to:
A) 1.1
B) 1.2
C) 1.3
D) 1.4
5) Galt’s WACC is closest to:
A) 10.6%
B) 11.2%
C) 11.8%
D) 12.5%
6) Consider the following equation:
E + D = U = A
The E in this equation represents:
A) the value of the firm’s equity.
B) the value of the firm’s debt.
C) the value of the firm’s unlevered equity.
D) the market value of the firm’s assets.
7) Consider the following equation:
E + D = U = A
The U in this equation represents:
A) the value of the firm’s equity.
B) the market value of the firm’s assets.
C) the value of the firm’s unlevered equity.
D) the value of the firm’s debt.
8) Consider the following equation:
E + D = U = A
The A in this equation represents:
A) the value of the firm’s debt.
B) the market value of the firm’s assets.
C) the value of the firm’s equity.
D) the value of the firm’s unlevered equity.
9) Which of the following statements is FALSE?
A) While debt itself may be cheap, it increases the risk and therefore the cost of capital of the
firm’s equity.
B) Although debt does not have a lower cost of capital than equity, we can consider this cost in
isolation.
C) We can use Modigliani and Miller’s first proposition to derive an explicit relationship
between leverage and the equity cost of capital.
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.
10) 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 the firm’s equity and its debt, we can replicate the cash flows 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 firm is unlevered, all of the free cash flows generated by its assets are available to be paid
out to its equity holders.
11) Which of the following statements is FALSE?
A) If we can identify a comparison firm whose assets have the same risk as the project being
evaluated, and if the comparison firm is levered, then we can use its equity cost of capital as the
cost of capital for the project.
B) We can calculate the cost of capital of the firm’s assets by computing the weighted average of
the firm’s equity and debt cost of capital, which we refer to as the firm’s weighted average cost
of capital (WACC).
C) The portfolio of a firm’s equity and debt replicates the returns we would earn if the firm 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 flow.
12) 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 firm’s WACC is dependent of its capital structure and is equal
to its equity cost of capital only the firm it is unlevered.
C) As the firm borrows at the low cost of capital for debt, its equity cost of capital rises, but the
net effect is that the firm’s WACC is unchanged.
D) Although debt has a lower cost of capital than equity, leverage does not lower a firm’s
WACC.
13) Which of the following statements is FALSE?
A) Holding cash has the opposite effect of leverage on risk and return.
B) We use the market value of the firm’s net debt when computing its WACC and unlevered beta
to measure the cost of capital and market risk of the firm’s business assets.
C) Since the WACC does not change with the use of leverage, the value of the firm’s free cash
flow evaluated using the WACC does not change, and so the enterprise value of the firm does
not depend on its financing choices.
D) Even if the firm’s capital structure is more complex, the WACC is calculated by computing
the weighted average cost of only the firm’s debt and equity.
14) Which of the following statements is FALSE?
A) The unlevered beta measures the market risk of the firm’s business activities, ignoring any
additional risk due to leverage.
B) If a firm 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 flows from each source cancel each other, just as if
the firm held no cash and no debt.
C) The unlevered beta measures the market risk of the firm without leverage, which is equivalent
to the beta of the firm’s assets.
D) When a firm changes its capital structure without changing its investments, its levered beta
will remain unaltered, however, its asset beta will change to reflect the effect of the capital
structure change on its risk.
15) The following equation:
X = rE + rD
can be used to calculate all of the following EXCEPT:
A) the cost of capital for the firm’s assets.
B) the levered cost of equity.
C) the unlevered cost of equity.
D) the weighted average cost of capital.
16) Which of the following equations would NOT be appropriate to use in a firm with risky
debt?
A) βE = βU + (βU – βD)
B) βU = βE+ (βU – βD)
C) βE = βU + βU
D) βU = βE + βD
17) Consider the following equation:
βU = βE + βD
The term in the equation is:
A) the required return on the firm’s equity.
B) the same as the beta of the firm’s assets.
C) equal to zero if the firm’s debt is riskless.
D) the proportion of the firm financed with equity.
18) Consider the following equation:
βU = βE + βD
The term βD in the equation is:
A) the same as the beta of the firm’s assets.
B) the required return on the firm’s equity.
C) the proportion of the firm financed with equity.
D) equal to zero if the firm’s debt is riskless.
19) Consider the following equation:
βU = βE + βD
The term βU in the equation is:
A) the same as the beta of the firm’s assets.
B) the required return on the firm’s equity.
C) the proportion of the firm financed with equity.
D) equal to zero if the firm’s debt is riskless.
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
0
0.25
Blinkin
1.6
0.2
1
Nod
2.3
0.3
1.5
20) The unlevered beta for Lincoln is closest to:
A) 0.95
B) 1.00
C) 1.05
D) 0.90
Name
Lincoln
1
Blinkin
1
0.9
Nod
1.1
21) The unlevered beta for Blinkin is closest to:
A) 0.95
B) 1.10
C) 1.00
D) 0.90
22) The unlevered beta for Nod is closest to:
A) 1.00
B) 0.90
C) 0.95
D) 1.10