23) Based upon the three comparable firms, what asset beta would you recommend using for
your firm’s new project?
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%.
24) Suppose that you borrow $30,000 in financing the project. According to MM proposition II,
the firm’s equity cost of capital will be closest to:
A) 21%
B) 15%
C) 20%
D) 25%
25) Suppose that you borrow $60,000 in financing the project. According to MM proposition II,
the firm’s equity cost of capital will be closest to:
A) 45%
B) 30%
C) 25%
D) 35%
36
Use the information for the question(s) below.
Luther Industries has no debt, a total equity capitalization of $20 billion, and a beta of 1.8.
Included in Luther’s assets are $4 billion in cash and risk-free securities.
26) What is Luther’s enterprise value?
A) $16 billion
B) $10.5 billion
C) $24 billion
D) $20 billion
27) Considering the fact that Luther’s Cash is risk-free,Luther’s unlevered beta is closest to:
A) 1.90
B) 2.25
C) 1.50
D) 1.45
28) Suppose that you borrow only $45,000 in financing the project. According to MM
proposition II, calculate the firm’s equity cost of capital.
29) 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.
14.4 Capital Structure Fallacies
Use the following information to answer the question(s) below.
Nielson Motors is currently an all equity financed firm. It expects to generate EBIT of $20
million over the next year. Currently Nielson has 8 million shares outstanding and its stock is
trading at $20.00 per share. Nielson is considering changing its capital structure by borrowing
$50 million at an interest rate of 8% and using the proceeds to repurchase shares. Assume
perfect capital markets.
1) Nielson’s EPS if they choose not to change their capital structure is closest to:
A) $2.00
B) $2.30
C) $2.50
D) $2.90
2) Nielson’s EPS if they change their capital structure is closest to:
A) $2.00
B) $2.30
C) $2.50
D) $2.90
3) Which of the following statements is FALSE?
A) The money taken in by the firm as a result of the share issue exactly offsets the dilution of the
shares.
B) Most analysts prefer to use performance measures and valuation multiples that are based on
the firm’s earnings before interest has been deducted.
C) Because the firm’s earnings per share and price-earnings ratio are affected by leverage
implies that we can always reliably compare these measures across firms with different capital
structures.
D) In general, as long as the firm sells the new shares of equity at a fair price, there will be no
gain or loss to shareholders associated with the equity issue itself.
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.
4) Prior to any borrowing and share repurchase, RC’s EPS is closest to:
A) $0.60
B) $1.00
C) $1.20
D) $0.50
5) Prior to any borrowing and share repurchase, the equity cost of capital for RC is closest to:
A) 11%
B) 10%
C) 12%
D) 9%
6) Following the borrowing of $12 and subsequent share repurchase, the number of shares that
RC will have outstanding is closest to:
A) 4.0 million
B) 6.0 million
C) 4.9 million
D) 4.5 million
7) Following the borrowing of $12 and subsequent share repurchase, the equity cost of capital for
RC is closest to:
A) 12%
B) 9%
C) 11.0%
D) 10%
8) Following the borrowing of $12 and subsequent share repurchase, the expected earnings per
share for RC is closest to:
A) $1.32
B) $1.44
C) $1.40
D) $1.20
9) Following the borrowing of $12 and subsequent share repurchase, the value of a share for RC
is closest to:
A) $14.00
B) $13.20
C) $12.00
D) $10.80
Use the information for the question(s) below.
Rockwood Enterprises is currently an all equity firm and has just announced plans to expand
their current business. In order to fund this expansion, Rockwood will need to raise $100 million
in new capital. After the expansion, Rockwood is expected to produce earnings before interest
and taxes of $50 million per year in perpetuity. Rockwood has already announced the planned
expansion, but has not yet determined how best to fund the expansion. Rockwood currently has
16 million shares outstanding and following the expansion announcement these shares are
trading at $25 per share. Rockwood has the ability to borrow at a rate of 5% or to issue new
equity at $25 per share.
10) If Rockwood finances their expansion by issuing new stock, what will Rockwood’s cost of
equity capital be?
A) 12%
B) 15%
C) 8%
D) 10%
11) If Rockwood finances their expansion by issuing $100 million in debt at 5%, what will
Rockwood’s cost of equity capital be?
A) 11.25%
B) 10.70%
C) 12.50%
D) 12.00%
12) Show mathematically that the stock price of Rockwood does not depend on whether they
issue new stock or borrow to fund their expansion.
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.
13) Show mathematically that the stock price of RC won’t change following the debt issuance
and share repurchase.
14.5 MM: Beyond the Propositions
1) Which of the following statements is FALSE?
A) Since the publication of their original paper, Modigliani and Miller’s ideas have greatly
influenced finance research and practice.
B) 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.
C) The conservation of value principle extends far beyond questions of debt versus equity
or even capital structure.
D) 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).
2) The beginning of the modern theory of finance was marked by:
A) the approach used by Modigliani and Miller.
B) the approach used by John and Williams.
C) the approach taken by Berk and DeMarzo.
D) the approach taken by Dan Harris.
3) What is the conservation of value principle?