Exam
Name___________________________________
MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question.
Use the information for the question(s) below.
Omicron Industries’ Market Value Balance Sheet ($ Millions)
and Cost of Capital
Assets Liabilities Cost of Capital
Cash 0Debt 200 Debt 6%
Other Assets 500 Equity 300 Equity 12%
c35%
Omicron Industries New Project Free Cash Flows
Year 0 1 2 3
Free Cash Flows ($100) $40 $50 $60
Assume that this new project is of average risk for Omicron and that the firm wants to hold constant its debt to equity ratio.
1)
The Debt Capacity for Omicron’s new project in year 2 is closest to:
1)
A)
$55.25
B)
$38.75
C)
$33.00
D)
$22.00
2)
Which of the following is not a step in the WACC valuation method?
2)
A)
Compute the value of the investment, including the tax benefit of leverage, by discounting the
free cash flow of the investment using the WACC.
B)
Determine the free cash flow of the investment.
C)
Compute the weighted average cost of capital.
D)
Adjust the WACC for the firm’s current debt/equity ratio.
3)
Consider the following equation for the Project WACC with a fixed debt schedule:
rwacc = rU– dc[rD +f(rU–rD)]
The term d in this equations represents
3)
A)
the debt–to–value ratio.
B)
the annual adjustment percentage to the amount of debt.
C)
a measure of the permanence of the debt level.
D)
the dollar amount of debt outstanding.
4)
Which of the following statements is false?
4)
A)
Implementing the APV approach with a constant debt–equity ratio requires solving for the
project’s debt and value simultaneously.
B)
The APV approach explicitly values the market imperfections and therefore allows managers
to measure their contribution to value.
C)
The WACC method is more complicated than the APV method because we must compute
two separate valuations: the unlevered project and the interest tax shield.
D)
We need to know the debt level to compute the APV, but with a constant debt–equity ratio we
need to know the project’s value to compute the debt level.
Use the information for the question(s) below.
Iota Industries Market Value Balance Sheet ($ Millions) and Cost of Capital
Assets Liabilities Cost of Capital
Cash 250 Debt 650 Debt 7%
Other Assets 1200 Equity 800 Equity 14%
c35%
Iota Industries New Project Free Cash Flows
Year 0 1 2 3
Free Cash Flows ($250) $75 $150 $100
Assume that this new project is of average risk for Iota and that the firm wants to hold constant its debt to equity ratio.
5)
Iota’s weighted average cost of capital is closest to:
5)
A)
8.40%
B)
9.75%
C)
11.70%
D)
10.85%
Use the table for the question(s) below.
Consider the information for the following four firms:
Firm Cash Debt Equity rDrEc
Eenie 0150 150 5% 10% 40%
Meeni
e
0250 750 6% 12% 35%
Minie 25 175 325 6% 11% 35%
Moe 50 350 150 7.50% 15% 30%
6)
The unlevered cost of capital for “Moe” is closest to:
6)
A)
10.00%
B)
8.50%
C)
7.75%
D)
8.25%
Use the information for the question(s) below.
KT Enterprises is considering undertaking a new project. Based upon analysis of firms with similar projects, KT has
determined that an unlevered cost of equity of 12% is suitable for their project. KT‘s marginal tax rate is 35%, its borrowing
rate is 7%, and KT does not believe that its borrowing rate will change if the new project is accepted.
7)
If KT expects to maintain a debt to equity ratio for this project of 1 then KT’s project based WACC,
rwacc, for this project is closest to:
7)
A)
9.6%
B)
11.1%
C)
10.8%
D)
10.5%
Use the information for the question(s) below.
Iota Industries Market Value Balance Sheet ($ Millions) and Cost of Capital
Assets Liabilities Cost of Capital
Cash 250 Debt 650 Debt 7%
Other Assets 1200 Equity 800 Equity 14%
c35%
Iota Industries New Project Free Cash Flows
Year 0 1 2 3
Free Cash Flows ($250) $75 $150 $100
Assume that this new project is of average risk for Iota and that the firm wants to hold constant its debt to equity ratio.
8)
The NPV for Iota’s new project is closest to:
8)
A)
$25.25
B)
$13.25
C)
$18.50
D)
$9.00
9)
Consider the following equation:
rwacc =E
E + D rE+D
E + D rD(1 –c)
the term rE in this equation is?
9)
A)
the required rate of return on equity
B)
the after tax required rate of return on debt
C)
the required rate of return on debt
D)
the dollar amount of equity.
Use the information for the question(s) below.
The Aardvark Corporation is considering launching a new product and is trying to determine an appropriate discount rate
for evaluating this new product. Aardvark has identified the following information for three single division firms that offer
products similar to the one Aardvark is interested in launching:
Comparable Firm
Equity Cost
of Capital
Debt Cost
of Capital
Debt–to–Value
Ratio
Anteater Enterprises 12.50% 6.50% 50%
Armadillo Industries 13% 6.10% 40%
Antelope Inc. 14% 7.10% 60%
10)
The unlevered cost of capital for Antelope Incorporated is closest to:
10)
A)
10.1%
B)
10.3%
C)
9.9%
D)
9.5%
Use the information for the question(s) below.
Omicron Industries’ Market Value Balance Sheet ($ Millions)
and Cost of Capital
Assets Liabilities Cost of Capital
Cash 0Debt 200 Debt 6%
Other Assets 500 Equity 300 Equity 12%
c35%
Omicron Industries New Project Free Cash Flows
Year 0 1 2 3
Free Cash Flows ($100) $40 $50 $60
Assume that this new project is of average risk for Omicron and that the firm wants to hold constant its debt to equity ratio.
11)
The NPV for Omicron’s new project is closest to:
11)
A)
$23.75
B)
$25.75
C)
$28.75
D)
$27.50
12)
Omicron’s Unlevered cost of capital is closest to:
12)
A)
7.10%
B)
8.75%
C)
7.50%
D)
9.60%
13)
Which of the following statements is false?
13)
A)
Rather than set debt according to a target debt–equity ratio or interest coverage level, a firm
may adjust its debt according to a fixed schedule that is known in advance.
B)
When we relax the assumption of a constant debt–equity ratio, the APV and FTE methods are
difficult to implement.
C)
When we relax the assumption of a constant debt–equity ratio, the equity cost of capital and
WACC for a project will change over time as the debt–equity ratio changes.
D)
If a firm is using leverage to shield income from corporate taxes, then it will adjust its debt
level so that its interest expenses grow with its earnings.
Use the table for the question(s) below.
Consider the information for the following four firms:
Firm Cash Debt Equity rDrEc
Eenie 0150 150 5% 10% 40%
Meeni
e
0250 750 6% 12% 35%
Minie 25 175 325 6% 11% 35%
Moe 50 350 150 7.50% 15% 30%
14)
The weighted average cost of capital for “Meenie” is closest to:
14)
A)
8.8%
B)
10.0%
C)
10.5%
D)
7.4%
15)
Which of the following is not a step in valuation using the flow to equity method?
15)
A)
Determine the free cash flow to equity of the investment.
B)
Determine the equity cost of capital, rE.
C)
Determine the before–tax cost of capital, rU.
D)
Compute the equity value, E, by discounting the free cash flow to equity using the
equity cost of capital.
16)
Which of the following statements is false?
16)
A)
A project’s cost of capital depends on its risk.
B)
When the market risk of the project is similar to the average market risk of the firm’s
investments, then its cost of capital is equivalent to the cost of capital for a portfolio of all of
the firm’s securities; that is, the project’s cost of capital is equal to the firm’s weighted average
cost of capital (WACC).
C)
Because the WACC incorporates the tax savings from debt, we can compute the levered value
of an investment, which is its value including the benefit of interest tax shields given the
firm’s leverage policy, by discounting its future free cash flow using the WACC.
D)
The WACC incorporates the benefit of the interest tax shield by using the firm’s before–tax
cost of capital for debt.
Use the information for the question(s) below.
Suppose that Rose Industries is considering the acquisition of another firm in its industry for $100 million. The acquisition is
expected to increase Rose’s free cash flow by $5 million the first year, and this contribution us expected to grow at a rate of 3%
every year there after. Rose currently maintains a debt to equity ratio of 1, its marginal tax rate is 40%, its cost of debt rD is
6%, and its cost of equity rE is 10%. Rose Industries will maintain a constant debt–equity ratio for the acquisition.
17)
The unlevered value of Rose’s acquisition is closest to:
17)
A)
$63 million
B)
$100 million
C)
$167 million
D)
$50 million
Use the information for the question(s) below.
Aardvark Industries is considering a project that will generate the following free cash flows:
Year 0 1 2 3
Free Cash Flows ($200) $100 $80 $60
You are also provided with the following market value balance sheet and information regarding Aardvark’s cost of capital:
Assets Liabilities Cost of Capital
Cash 0Debt 400 Debt 7%
Other Assets 1000 Equity 600 Equity 12%
c35%
18)
Suppose that to fund this new project, Aardvark borrows $120 with the principal to be paid in
three equal installments at the end each year. The levered value of Aardvark’s new project is
closest to:
18)
A)
$210.15
B)
$207.00
C)
$210.50
D)
$207.35
10
19)
Luther Industries is considering borrowing $500 million to fund a new product line. Given
investors’ uncertainty regarding its prospects, Luther will pay a 7% interest rate on this loan. The
firm’s management knows, that the actual risk of the loan is extremely low and that the appropriate
rate on the loan is 5%. Suppose the loan is for four years, with all principal being repaid in the
fourth year. If Luther’s marginal corporate tax rate is 35%, then the net effect of the loan on the
value of the new product line is closest to:
19)
A)
$34 million
B)
$22 million
C)
$35 million
D)
$24 million
20)
Which of the following statements is false?
20)
A)
Projects with safer cash flows can support more debt before they increase the risk of financial
distress for the firm.
B)
If the positive free cash flow from a project will increase the firm’s cash holdings, then this
growth in cash is equivalent to a reduction in the firm’s leverage.
C)
The incremental financing of a project corresponds directly to the financing that is directly
tied to the project.
D)
For capital budgeting purposes, the project’s financing is the incremental financing that
results if the firm takes on the project.
21)
Consider the following equation:
rwacc =E
E + D rE+D
E + D rD(1 –c)
the term E in this equation is?
21)
A)
the dollar amount of debt
B)
the required rate of return on equity
C)
the required rate of return on debt
D)
the dollar amount of equity.
22)
Which of the following statements is false?
22)
A)
When we relax the assumption of a constant debt–equity ratio, the FTE method is relatively
straightforward to use and is therefore the preferred method with alternative leverage
policies.
B)
With a constant interest coverage policy, the value of the interest tax shield is proportional to
the project’s unlevered value.
C)
When the firm keeps its interest payments to a target fraction of its FCF, we say it has a
constant interest coverage ratio.
D)
When debt levels are set according to a fixed schedule, we can discount the predetermined
interest tax shields using the debt cost of capital, rD.
23)
Consider the following equation:
Dt= d ×VL
t
the term Dt in this equation is?
23)
A)
the dollar amount of debt outstanding at time t.
B)
the firms target debt to value ratio.
C)
the investment’s debt capacity.
D)
the firms target debt to equity ratio.
Use the information for the question(s) below.
Aardvark Industries is considering a project that will generate the following free cash flows:
Year 0 1 2 3
Free Cash Flows ($200) $100 $80 $60
You are also provided with the following market value balance sheet and information regarding Aardvark’s cost of capital:
Assets Liabilities Cost of Capital
Cash 0Debt 400 Debt 7%
Other Assets 1000 Equity 600 Equity 12%
c35%
24)
Aardvark’s unlevered cost of equity is closest to:
24)
A)
9.5%
B)
9.0%
C)
10.4%
D)
10.0%
Use the information for the question(s) below.
Suppose that Rose Industries is considering the acquisition of another firm in its industry for $100 million. The acquisition is
expected to increase Rose’s free cash flow by $5 million the first year, and this contribution us expected to grow at a rate of 3%
every year there after. Rose currently maintains a debt to equity ratio of 1, its marginal tax rate is 40%, its cost of debt rD is
6%, and its cost of equity rE is 10%. Rose Industries will maintain a constant debt–equity ratio for the acquisition.
25)
Given that Rose issues new debt of $50 million initially to fund the acquisition, the total value of
this acquisition using the APV method is closest to:
25)
A)
$120 million
B)
$100 million
C)
$124 million
D)
$115 million
26)
The Free Cash Flow–to–Equity (FCFE) for the acquisition in year 1 is closest to:
26)
A)
$6.5 million
B)
$8.3 million
C)
$6.8 million
D)
$4.7 million
Use the information for the question(s) below.
Omicron Industries’ Market Value Balance Sheet ($ Millions)
and Cost of Capital
Assets Liabilities Cost of Capital
Cash 0Debt 200 Debt 6%
Other Assets 500 Equity 300 Equity 12%
c35%
Omicron Industries New Project Free Cash Flows
Year 0 1 2 3
Free Cash Flows ($100) $40 $50 $60
Assume that this new project is of average risk for Omicron and that the firm wants to hold constant its debt to equity ratio.
27)
The Debt Capacity for Omicron’s new project in year 1 is closest to:
27)
A)
$58.00
B)
$48.25
C)
$50.25
D)
$38.75
Use the table for the question(s) below.
Consider the information for the following four firms:
Firm Cash Debt Equity rDrEc
Eenie 0150 150 5% 10% 40%
Meeni
e
0250 750 6% 12% 35%
Minie 25 175 325 6% 11% 35%
Moe 50 350 150 7.50% 15% 30%
28)
The weighted average cost of capital for “Minie” is closest to:
28)
A)
8.25%
B)
8.75%
C)
6.75%
D)
9.50%
29)
Which of the following statements is false?
29)
A)
The value of the project’s FCFE represents the gain to shareholders from the project.
B)
Because interest payments are deducted before taxes, we adjust the firm’s FCF by their
before–tax cost.
C)
The project‘s free cash flow to equity shows the expected amount of additional cash the firm
will have available to pay dividends (or conduct share repurchases) each year.
D)
The value of the project’s FCFE should be identical to the NPV computed using the WACC
and APV methods.
Use the table for the question(s) below.
Consider the information for the following four firms:
Firm Cash Debt Equity rDrEc
Eenie 0150 150 5% 10% 40%
Meeni
e
0250 750 6% 12% 35%
Minie 25 175 325 6% 11% 35%
Moe 50 350 150 7.50% 15% 30%
30)
The unlevered cost of capital for “Eenie” is closest to:
30)
A)
6.5%
B)
5.5%
C)
7.5%
D)
6.0%
31)
Which of the following is not one of the simplifying assumptions made for the three main methods
of capital budgeting?
31)
A)
The firm’s debt–equity ratio is constant.
B)
Corporate taxes are the only market imperfection.
C)
The project has average risk.
D)
The firm pays out all earnings as dividends.
32)
Which of the following statements is false?
32)
A)
In the WACC and APV methods, we value a project based on its free cash flow, which is
computed ignoring interest and debt payments.
B)
In the flow–to–equity (FTE) valuation method, we explicitly calculate the free cash flow
available to equity holders taking into account all payments to and from debt holders.
C)
In the flow–to–equity valuation method, the cash flows to equity holders are then discounted
using the weighted average cost of capital.
D)
The first step in the FTE method is to determine the project’s free cash flow to equity (FCFE).
33)
Which of the following statements is false?
33)
A)
The WACC and APV methods compute the firm’s enterprise value, so that a separate
valuation of the other components of the firm’s capital structure is needed to determine the
value of equity.
B)
The FTE approach does not have the same disadvantage associated with the APV approach:
We don’t need to compute the project’s debt capacity to determine interest and net borrowing
before we can make the capital budgeting decision.
C)
The FTE method can offer an advantage when calculating the value of equity for the entire
firm, if the firm’s capital structure is complex and the market values of other securities in the
firm’s capital structure are not known.
D)
If the debt–equity ratio changes over time, the risk of equity–and, therefore, its cost of capital
–will change as well.
34)
Consider the following equation for the Project WACC with a fixed debt schedule:
rwacc = rU– dc[rD +f(rU–rD)]
The term f in this equations represents
34)
A)
a measure of the permanence of the debt level.
B)
the dollar amount of debt outstanding.
C)
the debt–to–value ratio.
D)
the annual adjustment percentage to the amount of debt.
35)
Consider the following equation:
rwacc =E
E + D rE+D
E + D rD(1 –c)
the term D in this equation is?
35)
A)
the dollar amount of equity.
B)
the required rate of return on equity
C)
the dollar amount of debt
D)
the required rate of return on debt
Use the information for the question(s) below.
Suppose Luther Industries is considering divesting one of its product lines. The product line is expected to generate free cash
flows of $2 million per year, growing at a rate of 3% per year. Luther has an equity cost of capital of 10%, a debt cost of
capital of 7%, a marginal tax rate of 35%, and a debt–equity ratio of 2. This product line is of average risk and Luther plans
to maintain a constant debt–equity ratio.
36)
Luther’s Unlevered cost of capital is closest to:
36)
A)
8.0%
B)
6.4%
C)
8.5%
D)
9.0%
Use the information for the question(s) below.
Iota Industries Market Value Balance Sheet ($ Millions) and Cost of Capital
Assets Liabilities Cost of Capital
Cash 250 Debt 650 Debt 7%
Other Assets 1200 Equity 800 Equity 14%
c35%
Iota Industries New Project Free Cash Flows
Year 0 1 2 3
Free Cash Flows ($250) $75 $150 $100
Assume that this new project is of average risk for Iota and that the firm wants to hold constant its debt to equity ratio.
37)
The Debt Capacity for Iota’s new project in year 0 is closest to:
37)
A)
$263.25
B)
87.75
C)
$118.00
D)
$50.25
Use the information for the question(s) below.
KT Enterprises is considering undertaking a new project. Based upon analysis of firms with similar projects, KT has
determined that an unlevered cost of equity of 12% is suitable for their project. KT‘s marginal tax rate is 35%, its borrowing
rate is 7%, and KT does not believe that its borrowing rate will change if the new project is accepted.
38)
If KT expects to maintain a debt to equity ratio for this project of .6 then KT’s project based WACC,
rwacc, for this project is closest to:
38)
A)
11.1%
B)
10.5%
C)
9.6%
D)
10.8%
Use the information for the question(s) below.
The Aardvark Corporation is considering launching a new product and is trying to determine an appropriate discount rate
for evaluating this new product. Aardvark has identified the following information for three single division firms that offer
products similar to the one Aardvark is interested in launching:
Comparable Firm
Equity Cost
of Capital
Debt Cost
of Capital
Debt–to–Value
Ratio
Anteater Enterprises 12.50% 6.50% 50%
Armadillo Industries 13% 6.10% 40%
Antelope Inc. 14% 7.10% 60%
39)
The unlevered cost of capital for Armadillo Industries is closest to:
39)
A)
9.5%
B)
9.9%
C)
10.1%
D)
10.3%
40)
The unlevered cost of capital for Anteater Enterprises is closest to:
40)
A)
9.5%
B)
10.1%
C)
9.9%
D)
10.3%