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%
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
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%.
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 million 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 million 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 million 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 million 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 applies only to questions of debt versus equity
or 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?