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%
41)
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 present value of Aardvark’s interest tax shield is
closest to:
41)
A)
$5.90
B)
$5.15
C)
$5.25
D)
$5.00
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.
42)
The Free Cash Flow to Equity (FCFE) for the acquisition in year 0 is closest to:
42)
A)
–$50 million
B)
$5 million
C)
$100 million
D)
–$100 million
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.
43)
If KT expects to maintain a debt to equity ratio for this project of .6 then KT’s equity cost of capital,
rE, for this project is closest to:
43)
A)
17.0%
B)
12%
C)
5.0%
D)
15.0%
44)
Which of the following statements is false?
44)
A)
A target leverage ratio means that the firm adjusts its debt proportionally to the project’s
value or its cash flows.
B)
To determine the project’s debt capacity for the interest tax shield calculation, we need to
know the value of the project.
C)
Because we don’t value the tax shield separately, with the APV method we need to include
the benefit of the tax shield in the discount rate as we do in the WACC method.
D)
To compute the present value of the interest tax shield, we need to determine the appropriate
cost of capital.
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.
45)
Given that Rose issues new debt of $50 million initially to fund the acquisition, the present value of
the interest tax shield for this acquisition is closest to:
45)
A)
$15 million
B)
$50 million
C)
$24 million
D)
$20 million
Use the information for the question(s) below.
Omicron Industries’ Market Value Balance Sheet ($ 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.
46)
The unlevered value of Omicron’s new project is closest to:
46)
A)
$96
B)
$126
C)
$124
D)
$25
47)
Which of the following questions is false?
47)
A)
If the financing of the project involves an equity issue, and if management believes that the
equity will sell at a price that is less than its true value, this mispricing is a cost of the project
for the existing shareholders.
B)
Sometimes management may believe that the securities they are issuing are priced at less than
(or more than) their true value. If so, the NPV of the transaction, which is the difference
between the actual money raised and the true value of the securities sold, should not be
included in the value of the project.
C)
An alternative method of incorporating financial distress and agency costs is to first value the
project ignoring these costs, and then value the incremental cash flows associated with
financial distress and agency problems separately.
D)
When the debt level—and, therefore, the probability of financial distress—is high, the
expected free cash flow will be reduced by the expected costs associated with financial
distress and agency problems.
48)
Which of the following is not a step in the adjusted present value method?
48)
A)
Calculating the after–tax WACC
B)
Deducting costs arising from market imperfections
C)
Calculating the value of the interest tax shield
D)
Calculating the unlevered value of the project
A
B
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%
49)
The unlevered value of Aardvark’s new project is closest to:
49)
A)
$202
B)
$205
C)
$100
D)
$164
Use the table for the question(s) below.
Consider the information for the following four firms:
Firm Cash Debt Equity rDrEc
Eenie 0150 150 5% 10% 40%
Meeni
e
0250 750 6% 12% 35%
Minie 25 175 325 6% 11% 35%
Moe 50 350 150 7.50% 15% 30%
50)
The weighted average cost of capital for “Eenie” is closest to:
50)
A)
5.5%
B)
6.5%
C)
7.5%
D)
6.0%
Use the information for the question(s) below.
Omicron Industries’ Market Value Balance Sheet ($ 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.
51)
The interest tax shield provided by Omicron’s new project in year 1 is closest to:
51)
A)
$17.60
B)
$50.25
C)
$3.00
D)
$1.05
52)
Which of the following statements is false?
52)
A)
A firm’s levered cost of capital is a weighted average of its equity and debt costs of capital.
B)
The first step in the APV method is to calculate the value of free cash flows using the project’s
cost of capital if it were financed without leverage.
C)
The firm‘s unlevered cost of capital is equal to its pretax weighted average cost of capital–that
is, using the pretax cost of debt, rd , rather than its after–tax cost, rd (1 –c ).
D)
When the firm maintains a target leverage ratio, its future interest tax shields have similar risk
to the project’s cash flows, so they should be discounted at the project’s unlevered cost of
capital.
53)
Which of the following statements is false?
53)
A)
The intuition for the WACC method is that the firm’s weighted average cost of capital
represents the average return the firm must pay to its investors (both debt and equity holders)
on an after–tax basis.
B)
To be profitable, a project should generate an expected return of at least the firm’s weighted
average cost of capital.
C)
A disadvantage of the WACC method is that you need to know how the firm’s leverage policy
is implemented to make the capital budgeting decision.
D)
The WACC can be used throughout the firm as the company wide cost of capital for new
investments that are of comparable risk to the rest of the firm and that will not alter the firm’s
debt–equity ratio.
54)
Which of the following statements is false?
54)
A)
For alternative leverage policies, the FTE method is usually the most straightforward
approach.
B)
As a general rule, the WACC method is the easiest to use when the firm will maintain a fixed
debt–to–value ratio over the life of the investment.
C)
When used consistently, the WACC, APV, and FTE methods produce the same valuation for
the investment.
D)
The FTE method is typically used only in complicated settings for which the values of other
securities in the firm’s capital structure or the interest tax shield are themselves difficult to
determine.
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.
55)
If KT expects to maintain a debt to equity ratio for this project of 1, then KT’s equity cost of capital,
rE, for this project is closest to:
55)
A)
17.0%
B)
12%
C)
15.0%
D)
5.0%
56)
Consider the following equation:
rwacc = rU–cdrD
The term din this equation is
56)
A)
the project’s dollar amount of debt.
B)
the project‘s debt to value ratio.
C)
the project’s unlevered cost of capital.
D)
the firm’s unlevered cost of debt.
57)
Consider the following equation:
rwacc = rU–cdrD
The term rU in this equation is
57)
A)
the project‘s debt to value ratio.
B)
the project’s unlevered cost of capital.
C)
the firm‘s cost of debt.
D)
the firm’s unlevered cost of debt.
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.
58)
Omicron’s weighted average cost of capital is closest to:
58)
A)
8.75%
B)
7.50%
C)
7.10%
D)
9.60%
59)
Which of the following questions is false?
59)
A)
When a firm borrows funds, a mispricing scenario arises if the interest rate charged differs
from the rate that is appropriate given the actual risk of the loan.
B)
The WACC, APV, and FTE methods determine the value of an investment incorporating the
tax shields associated with leverage.
C)
The fees associated with the financing of the project are independent of the project‘s required
cash flows and should be ignored when calculating the NPV of the project.
D)
With perfect capital markets, all securities are fairly priced and issuing securities is a
zero–NPV transaction.
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%
60)
The weighted average cost of capital for “Moe” is closest to:
60)
A)
7.75%
B)
8.50%
C)
8.25%
D)
10.00%
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 $5 million the first year, and this contribution us expected to grow at a rate of 3%
every year there after. Rose currently maintains a debt to equity ratio of 1, its marginal tax rate is 40%, its cost of debt rD is
6%, and its cost of equity rE is 10%. Rose Industries will maintain a constant debt–equity ratio for the acquisition.
61)
Rose’s unlevered cost of capital is closest to:
61)
A)
8.0%
B)
7.5%
C)
9.0%
D)
7.0%
Use the information for the question(s) below.
Omicron Industries’ Market Value Balance Sheet ($ 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.
62)
The Debt Capacity for Omicron’s new project in year 0 is closest to:
62)
A)
$75.50
B)
$38.75
C)
$10.25
D)
$50.25