Document Type

Test Prep

Book Title

Intermediate Financial Management 13th Edition

Authors

Eugene F. Brigham, Phillip R. Daves

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Chapter 17: Dynamic Capital Structures and Corporate Valuation

1. The present value of the free cash flows discounted at the unlevered cost of equity is the value of the firm's operations if

it had no debt.

a.

True

b.

False

ANSWER:

True

2. In a world with no taxes, MM show that a firm's capital structure does not affect the firm's value. However, when taxes

are considered, MM show a positive relationship between debt and value, i.e., its value rises as its debt is increased.

a.

True

b.

False

ANSWER:

True

3. According to MM, in a world without taxes the optimal capital structure for a firm is approximately 100% debt

financing.

a.

True

b.

False

ANSWER:

False

4. MM showed that in a world with taxes, a firm's optimal capital structure would be almost 100% debt.

a.

True

b.

False

ANSWER:

True

5. MM showed that in a world without taxes, a firm's value is not affected by its capital structure.

a.

True

b.

False

ANSWER:

True

Chapter 17: Dynamic Capital Structures and Corporate Valuation

Kitto Electronics Data

Kitto Electronics has an EBIT of $200,000, a growth rate of 6%, and its tax rate is 40%. In order to support growth, Kitto

must reinvest 20% of its EBIT in net operating assets. Kitto has $300,000 in 8% debt outstanding, and a similar company

with no debt has a cost of equity of 11%.

6. Refer to data for Kitto Electronics. According to the compressed adjusted present value model, what is Kitto's

unlevered value?

a.

$1,296,000

b.

$1,440,000

c.

$1,600,000

d.

$1,760,000

e.

$1,936,000

ANSWER:

c

7. In the compressed adjusted present value model, the appropriate discount rate for the tax shield is the unlevered cost of

equity.

a.

True

b.

False

ANSWER:

True

8. In the compressed adjusted present value model, the appropriate discount rate for the tax shield is the WACC.

a.

True

b.

False

ANSWER:

False

9. Which of the following statements about valuing a firm using the compressed adjusted present value (CAPV) approach

is most CORRECT?

a.

The horizon value is calculated by discounting the free cash flows beyond the horizon date and any tax savings

at the cost of debt.

b.

The horizon value is calculated by discounting the expected earnings at the WACC.

c.

The horizon value is calculated by discounting the free cash flows beyond the horizon date and any tax savings

at the WACC.

d.

The horizon value must always be more than 20 years in the future.

e.

The horizon value is calculated by discounting the free cash flows beyond the horizon date and any tax savings

at the levered cost of equity.

ANSWER:

c

10. In the compressed adjusted present value model, the appropriate discount rate for the tax shield is the after-tax cost of

debt.

a.

True

b.

False

ANSWER:

False

11. Which of the following statements about valuing a firm using the compressed adjusted present value (CAPV)

approach is most CORRECT?

a.

The value of equity is calculated by discounting the horizon value, the tax shields, and the free cash flows at

the cost of equity.

b.

The value of operations is calculated by discounting the horizon value, the tax shields, and the free cash flows

before the horizon date at the unlevered cost of equity.

c.

The value of equity is calculated by discounting the horizon value and the free cash flows at the cost of equity.

d.

The CAPV approach stands for the accounting pre-valuation approach.

e.

The value of operations is calculated by discounting the horizon value, the tax shields, and the free cash flows

at the cost of equity.

ANSWER:

b

12. If the capital structure is stable, and free cash flows are expected to be growing at a constant rate at the horizon date,

then the compressed adjusted present value model calculates the horizon value by discounting the post-horizon free cash

flows and post-horizon expected future tax shields at the weighted average cost of capital.

a.

True

b.

False

Sallie's Sandwiches

Sallie's Sandwiches is financed using 20% debt at a cost of 8%. Sallie projects combined free cash flows and interest tax

savings of $2 million in Year 1, $4 million in Year 2, $5 million in Year 3, and $117 million in Year 4. (The Year 4 value

includes the combined horizon values of FCF and tax shields.) All cash flows are expected to grow at a 3% constant rate

after Year 4. Sallie's beta is 2.0, and its tax rate is 34%. The risk-free rate is 8%, and the market risk premium is 4%.

13. Using the data for Sallie's Sandwiches and the compressed adjusted present value model, what is the appropriate rate

for use in discounting the free cash flows and the interest tax savings?

a.

12.0%

b.

13.9%

c.

14.4%

d.

16.0%

e.

16.9%

ANSWER:

c

14. Using the data for Sallie's Sandwiches and the compressed adjusted present value model, what is the total value (in

millions)?

a.

$72.37

b.

$73.99

c.

$74.49

d.

$75.81

e.

$76.45

ANSWER:

e

Chapter 17: Dynamic Capital Structures and Corporate Valuation

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Glassmaker Corporation Data

Glassmaker Corporation has a current capital structure consisting of $5 million (market value) of 11% bonds and $10

million (market value) of common stock. Glassmaker's beta is 1.36. Glassmaker faces a 40% tax rate. Glassmaker plans

on making big changes in operation and capital structure during the next several years. (Its tax rate will remain

unchanged.) Under these plans, the free cash flows for Glassmaker are estimated to be $3.0 million for each of the next 4

years; the horizon value of the free cash flows (discounted at the rate assumed by the compressed adjusted present value

(CAPV) approach) is $10.0 million at Year 4. The estimated tax savings due to interest expenses are estimated to be $1

million for each of the next 4 years; the horizon value of the tax shields (discounted at the rate assumed by the CAPV

approach) is estimated to be $5 million at Year 4. Glassmaker has no nonoperating assets. Currently, the risk-free rate is

6.0% and the market risk premium is 4.0%.

15. Refer to data for Glassmaker Corporation. What is Glassmaker's WACC, based on its current capital structure?

a.

9.02%

b.

9.50%

c.

9.83%

d.

10.01%

e.

11.29%

ANSWER:

c

16. Refer to data for Glassmaker Corporation. According to the compressed adjusted present value model, what

discount rate should you use to discount Glassmaker's free cash flows and interest tax savings?

a.

10.01%

b.

10.06%

c.

11.29%

d.

11.44%

e.

13.49%

Chapter 17: Dynamic Capital Structures and Corporate Valuation

ANSWER:

c

17. Refer to data for Glassmaker Corporation. Using the compressed adjusted present value model, what will

Glassmaker's value of equity be if it successfully implements its planned changes in operations and capital structure?

(Round your answer to the closest thousand dollars.)

a.

$16,019,000

b.

$17,111,000

c.

$18,916,000

d.

$22,111,000

e.

$22,916,000

POINTS:

1

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Page 10

18. Which of the following statements concerning the compressed adjusted present value (APV) model is NOT

CORRECT?

a.

The value of a growing tax shield is greater than the value of a constant tax shield.

b.

For a given D/S, the levered cost of equity using the compressed APV model is greater than the levered cost of

equity under MM's original (with tax) assumptions.

c.

For a given D/S, the WACC in the compressed APV model is less than the WACC under MM's original (with

tax) assumptions.

d.

The total value of the firm increases with the amount of debt.

e.

The tax shields should be discounted at the unlevered cost of equity.

ANSWER:

c

19. Which of the following statements concerning the compressed adjusted present value (APV) model is NOT

CORRECT?

a.

The value of a growing tax shield is greater than the value of a constant tax shield.

b.

For a given D/S, the levered cost of equity is greater in the compressed APV model than the levered cost of

equity under MM's original (with tax) assumptions.

Chapter 17: Dynamic Capital Structures and Corporate Valuation

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Page 11

c.

For a given D/S, the WACC is greater in the compressed APV model than the WACC under MM's original

(with tax) assumptions.

d.

The total value of the firm increases with the amount of debt.

e.

The tax shields should be discounted at the cost of debt.

ANSWER:

e

20. Which of the following statements concerning the compressed adjusted present value (APV) model is NOT

CORRECT?

a.

The value of a growing tax shield is greater than the value of a constant tax shield.

b.

For a given D/S, the levered cost of equity in the compressed APV model is greater than the levered cost of

equity under MM's original (with tax) assumptions.

c.

For a given D/S, the WACC in the compressed APV model is greater than the WACC under MM's original

(with tax) assumptions.

d.

The total value of the firm is independent of the amount of debt it uses.

e.

The tax shields should be discounted at the unlevered cost of equity.

ANSWER:

d

21. The market value of Firm L's debt is $200,000 and its yield is 9%. The firm's equity has a market value of $300,000,

Chapter 17: Dynamic Capital Structures and Corporate Valuation

its earnings are growing at a rate of 5%, and its tax rate is 40%. A similar firm with no debt has a cost of equity of 12%.

Using the compressed adjusted present value model, what is Firm L's cost of equity?

a.

11.4%

b.

12.0%

c.

12.6%

d.

13.3%

e.

14.0%

ANSWER:

e

22. The market value of Firm L's debt is $200,000 and its yield is 9%. The firm's equity has a market value of $300,000,

its earnings are growing at a 5% rate, and its tax rate is 40%. A similar firm with no debt has a cost of equity of 12%.

Using the compressed adjusted present value model, what would Firm L's total value be if it had no debt?

a.

$358,421

b.

$377,286

c.

$397,143

d.

$417,000

e.

$437,850

ANSWER:

c

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Page 13

23. A local firm has debt worth $200,000, with a yield of 9%, and equity worth $300,000. It is growing at a 5% rate, and

its tax rate is 40%. A similar firm with no debt has a cost of equity of 12%. Using the compressed adjusted present value

model, what is the value of your firm's tax shield, i.e., how much value does the use of debt add?

a.

$92,571

b.

$102,857

c.

$113,143

d.

$124,457

e.

$136,903

Kitto Electronics Data

Kitto Electronics has an EBIT of $200,000, a growth rate of 6%, and its tax rate is 40%. In order to support growth, Kitto

must reinvest 20% of its EBIT in net operating assets. Kitto has $300,000 in 8% debt outstanding, and a similar company

with no debt has a cost of equity of 11%.

24. Refer to data for Kitto Electronics. Using the compressed adjusted present value model, what is the value of Kitto's

tax shield?

a.

$156,385

b.

$164,616

c.

$173,280

d.

$182,400

e.

$192,000

ANSWER:

e

25. Refer to data for Kitto Electronics. Using the compressed adjusted present value model, what is Kitto's value of

equity?

a.

$1,492,000

b.

$1,529,300

c.

$1,567,533

d.

$1,606,721

e.

$1,646,889

ANSWER:

a

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26. The rate used to discount projected merger cash flows should be the cost of capital of the new consolidated firm

because it incorporates the actual capital structure of the new firm.

a.

True

b.

False

ANSWER:

False

27. Raymond Supply, a national hardware chain, is considering purchasing a smaller chain, Strauss & Glazer Parts (SGP).

Raymond's analysts project that the merger will result in the following incremental free cash flows, tax shields, and

horizon values:

Year

1

2

3

4

Free cash flow

$1

$3

$3

$7

Unlevered horizon value

75

Tax shield

1

1

2

3

Horizon value of tax shield

32

Assume that all cash flows occur at the end of the year. SGP is currently financed with 30% debt at a rate of 10%. The

acquisition would be made immediately, and if it is undertaken, SGP would retain its current $15 million of debt and issue

enough new debt to continue at the 30% target level. The interest rate would remain the same. SGP's pre-merger beta is

2.0, and its post-merger tax rate would be 34%. The risk-free rate is 8% and the market risk premium is 4%. Using the

compressed adjusted present value approach, what is the value of SGP to Raymond?

a.

$53.40 million

b.

$61.96 million

Chapter 17: Dynamic Capital Structures and Corporate Valuation

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Page 16

c.

$64.64 million

d.

$76.96 million

e.

$79.64 million

POINTS:

1

28. Volunteer Enterprises has the following information for the current year. Calculate its free cash flow to equity.

FCF

1,000

Interest expense

40

Principal payments

200

New debt

300

Tax rate

25%

a.

$1,070

Chapter 17: Dynamic Capital Structures and Corporate Valuation

b.

$1,177

c.

$1,295

d.

$1,424

e.

$1,567

ANSWER:

a

29. Gators Incorporated has the following information for the current year and projected for next year. Calculate its

projected free cash flow to equity.

Current

year

Projected

FCF

NA

1,000

Total debt

400

600

Interest rate on debt

6%

6%

Tax rate

25%

25%

a.

$1,066

b.

$1,173

c.

$1,290

d.

$1,419

e.

$1,561

ANSWER:

b

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Page 18

30. Gamma Pharmaceuticals has the following financial information for the current year and projected for next year.

Calculate Gamma's projected free cash flow to equity.

Current

year

Projected

NOPAT

NA

1,000

Total operating capital

2,000

2,200

Total debt

900

800

Interest rate on debt

6%

6%

Tax rate

25%

25%

a.

$549

b.

$604

c.

$664

d.

$730

e.

$803

ANSWER:

c

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