Which of the following statements is FALSE?
A) U.S. Treasury securities are widely regarded to be risk-free because there is virtually
no chance the government will default on these bonds.
B) In general, if the interest rate is r and the tax rate is Ï„, then for each $1 invested you
will earn interest equal to r and owe taxes of Ï„ × r on the interest.
C) Investors may receive less than the stated interest rate if the borrowing company has
financial difficulties and is unable to fully repay the loan.
D) Taxes reduce the amount of interest the investor can keep, and we refer to this
reduced amount as the tax effective interest rate.
Consider a project with the following cash flows:
Assume the appropriate discount rate for this project is 15%. The IRR for this project is
closest to:
A) 21%
B) 22%
C) 15%
D) 60%
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.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:
A) 17.0%
B) 5.0%
C) 15.0%
D) 12%
Which of the following is NOT a step in the WACC valuation method?
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) Compute the weighted average cost of capital.
C) Determine the free cash flow of the investment.
D) Adjust the WACC for the firm’s current debt/equity ratio.
Which of the following statements is FALSE?
A) A portfolio that consists of a long position in the risk-free investment is known as a
levered portfolio.
B) The optimal portfolio will not depend on the investor’s personal tradeoff between
risk and return.
C) The volatility of the risk-free investment is zero.
D) Our total volatility is only a fraction of the volatility of the efficient portfolio, based
on the amount we invest in the risk free asset.
Which of the following statements is FALSE?
A) Equity holders expect to receive dividends and the firm is legally obligated to pay
them.
B) A firm that fails to make the required interest or principal payments on the debt is in
default.
C) In the extreme case, the debt holders take legal ownership of the firm’s assets
through a process called bankruptcy.
D) After a firm defaults, debt holders are given certain rights to the assets of the firm.
Rearden Metal is evaluating a project that requires an investment of $150 million today
and provides a single cash flow of $180 million for sure one year from now. Rearden
decides to use 100% debt financing for this investment. The risk-free rate is 5% and
Rearden’s corporate tax rate is 40%. Assume that the investment is fully depreciated at
the end of the year.The NPV of this project using the APV method is closest to:
A) $10 million
B) $13 million
C) $42 million
D) $71 million
On the balance sheet, current maturities of long-term debt appears:
A) in the Stockholders’ Equity section.
B) in the Operating Expenses section.
C) in the Current Assets section.
D) in the Current Liabilities section.
In November 2009, Perrigo Co. (PRGO) had a share price of $39.20. They had 91.33
million shares outstanding, a market-to-book ratio of 3.76. In addition, PRGO had
$845.01 million in outstanding debt, $163.82 million in net income, and cash of
$257.09 million.
Perrigo’s market capitalization is closest to:
A) $952.16 million
B) $3,580.14 million
C) $4,168.06 million
D) $4,425.15 million
If the value of security “C” is $180, then what must be the value of security “A”?
A) $80
B) $90
C) $100
D) Unable to determine without the risk-free rate.
Monsters Incorporated (MI) in ready to launch a new product. Depending upon the
success of this product, MI will have a value of either $100 million, $150 million, or
$191 million, with each outcome being equally likely. The cash flows are unrelated to
the state of the economy (i.e. risk from the project is diversifiable) so that the project
has a beta of 0 and a cost of capital equal to the risk-free rate, which is currently 5%.
Assume that the capital markets are perfect.
Assume that in the event of default, 20% of the value of MI’s assets will be lost in
bankruptcy costs and suppose that MI has zero-coupon debt with a $125 million face
value due next year. The total value of MI with leverage is closest to:
A) $140 million
B) $100 million
C) $125 million
D) $134 million
The Sisyphean Corporation is considering investing in a new cane manufacturing
machine that has an estimated life of three years. The cost of the machine is $30,000
and the machine will be depreciated straight line over its three-year life to a residual
value of $0.
The cane manufacturing machine will result in sales of 2,000 canes in year 1. Sales are
estimated to grow by 10% per year each year through year three. The price per cane that
Sisyphean will charge its customers is $18 each and is to remain constant. The canes
have a cost per unit to manufacture of $9 each.
Installation of the machine and the resulting increase in manufacturing capacity will
require an increase in various net working capital accounts. It is estimated that the
Sisyphean Corporation needs to hold 2% of its annual sales in cash, 4% of its annual
sales in accounts receivable, 9% of its annual sales in inventory, and 6% of its annual
sales in accounts payable. The firm is in the 35% tax bracket, and has a cost of capital
of 10%.
The incremental unlevered net income in the first year for the Sisyphean Corporation’s
project is closest to:
A) $8,000
B) $18,000
C) $5,200
D) $11,700
Suppose that you have received two job offers. Rearden Metal offers you a contract for
$75,000 per year for the next two years while Wyatt Oil offers you a contract for
$90,000 per year for the next two years. Both jobs are equivalent. Suppose that Rearden
Metal’s contract is certain, but Wyatt Oil has a 60% chance of going bankrupt at the end
of the year. In the event that Wyatt Oil files for bankruptcy, it will cancel your contract
and pay you the lowest amount possible for you to not quit. If you do quit, you expect
you could find an new job paying $75,000 per year, but you would be unemployed for
four months while searching for this new job.Assuming your cost of capital is 6
percent, the present value of your expected wage if you accept Wyatt Oil’s offer is
closest to:
A) $138,000
B) $140,000
C) $144,000
D) $150,000
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.
Which of the following is NOT an indirect cost of bankruptcy?
A) Legal fees
B) Delayed liquidation
C) Costs to creditors
D) Loss of customers