3) The NPV of this project using the WACC method is closest to:
A) $10 million
B) $13 million
C) $42 million
D) $71 million
4) Which of the following statements is FALSE?
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 equity cost of capital and WACC
for a project will change over time as the debt-equity ratio changes.
C) When we relax the assumption of a constant debt-equity ratio, the APV and FTE methods are
difficult to implement.
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.
5) Which of the following statements is FALSE?
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) 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.
C) With a constant interest coverage policy, the value of the interest tax shield is proportional to the
project’s unlevered value.
D) When the firm keeps its interest payments to a target fraction of its FCF, we say it has a constant
interest coverage ratio.
6) Which of the following statements is FALSE?
A) 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.
B) 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.
C) For alternative leverage policies, the FTE method is usually the most straightforward approach.
D) When used consistently, the WACC, APV, and FTE methods produce the same valuation for the
investment.
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
0
Debt
400
Debt
7%
Other Assets
1000
Equity
600
Equity
12%
τc
35%
7) Aardvark’s unlevered cost of equity is closest to:
A) 10.0%
B) 10.4%
C) 9.5%
D) 9.0%
8) The unlevered value of Aardvark’s new project is closest to:
A) $205
B) $100
C) $164
D) $202
9) 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:
A) $5.15
B) $5.00
C) $5.90
D) $5.25
39
10) 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:
A) $210.15
B) $207.35
C) $207.00
D) $210.50
11) Suppose that to fund this new project, Aardvark borrows $150 with the principal to be paid in three
equal installments at the end each year. Calculate the present value of Aardvark’s interest tax shield.
40
12) Suppose that to fund this new project, Aardvark borrows $150 with the principal to be paid in three
equal installments at the end each year. Calculate the The levered value of Aardvark’s new project.
18.7 Other Effects of Financing
Use the following information to answer the question(s) below.
Taggart Transcontinental is considering a $250 million investment to launch a new rail line. The project
is expected to generate a free cash flow of $32 million per year, and its unlevered cost of capital is 8%.
Taggart’s marginal corporate tax rate is 35%.
1) Assuming that to fund the investment Taggart will take on $250 million in permanent debt and
ignoring issuance costs, the NPV of Taggart’s new rail line is closest to:
A) $195 million
B) $200 million
C) $235 million
D) $240 million
2) Assuming that to fund the investment Taggart will take on $250 million in permanent debt and
assuming Taggart will incur a 2% (after-tax) underwriting fee on the new debt issue, the NPV of
Taggart’s new rail line is closest to:
A) $195 million
B) $200 million
C) $235 million
D) $240 million
3) Assume that to fund the investment Taggart will take on $150 million in permanent debt with the
remainder of the investment funded by a cut in dividends. Assuming Taggart will incur a 2% (after-tax)
underwriting fee on the new debt issue, the NPV of Taggart’s new rail line is closest to:
A) $195 million
B) $200 million
C) $235 million
D) $240 million
4) Assume that to fund the investment Taggart will take on $150 million in permanent debt with the
remainder of the investment funded through issuance of new equity. Assuming Taggart will incur a 2%
(after-tax) underwriting fee on the new debt issue and a 5% underwriting fee on the issuance of new
equity, the NPV of Taggart’s new rail line is closest to:
A) $195 million
B) $200 million
C) $235 million
D) $240 million
5) Assume that to fund the investment Taggart will take on $150 million in permanent debt with the
remainder of the investment funded through issuance of new equity. Assume Taggart will incur a 2%
(after-tax) underwriting fee on the new debt issue and a 5% underwriting fee on the issuance of new
equity. If management believes Taggart’s current share price of $25 is $3 less than its true value, then the
NPV of Taggart’s new rail line is closest to:
A) $185 million
B) $195 million
C) $200 million
D) $235 million
6) Which of the following questions is FALSE?
A) With perfect capital markets, all securities are fairly priced and issuing securities is a zero-NPV
transaction.
B) 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.
C) 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.
D) The WACC, APV, and FTE methods determine the value of an investment incorporating the tax
shields associated with leverage.
7) Which of the following questions is FALSE?
A) 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.
B) 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.
C) 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.
D) 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.
8) 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:
A) $22 million
B) $34 million
C) $35 million
D) $24 million
9) Dusty Donuts has zero coupon debt with a face value of $10 million due in 3 years, and no other debt
outstanding. The risk-free rate is 4%, but due to default risk the yield to maturity on the debt is 10%.
Dusty’s believes that in the event of default, 10% of the losses are attributable to bankruptcy and distress
costs. Estimate the present value of the distress costs.
A) $138 million
B) $138 thousand
C) $1.38 million
D) $1.38 thousand
18.8 Advanced Topics in Capital Budgeting
Use the following information to answer the question(s) below.
Wyatt Oil is considering an investment in a new project with an unlevered cost of capital of 11%.
Wyatt’s marginal corporate tax rate is 35% and its debt cost of capital is 6%. The project has free cash
flows of $25 million per year which are expected to decline by 3% per year.
1) If Wyatt adjusts its debt continuously to maintain a constant debt-equity ratio of 50%, then the
appropriate WACC for this new project is closest to:
A) 7.5%
B) 8.6%
C) 10.3%
D) 10.8%
2) If Wyatt adjusts its debt once per year to maintain a constant debt-equity ratio of 50%, then the
appropriate WACC for this new project is closest to:
A) 7.5%
B) 8.67%
C) 10.27%
D) 10.8%
3) If Wyatt adjusts its debt continuously to maintain a constant debt-equity ratio of 50%, then the value
of this new project is closest to:
A) $188 million
B) $188.5 million
C) $320 million
D) $340 million
4) If Wyatt adjusts its debt once per year to maintain a constant debt-equity ratio of 50%, then the value
of this new project is closest to:
A) $188 million
B) $188.5 million
C) $320 million
D) $340 million
Use the following information to answer the question(s) below.
Galt Industries is expected to generate free cash flows of $24 million per year. Galt has permanent debt
of $80 million, a corporate tax rate of 40%, and an unlevered cost of capital of 12% and its cost of debt
capital is 6%.
5) The value of Galt’s equity using the APV method is closest to:
A) $150 million
B) $180 million
C) $230 million
D) $240 million
6) Galt’s WACC is closest to:
A) 6.0%
B) 9.6%
C) 10.3%
D) 10.7%
7) The value of Galt’s equity using the WACC method is closest to:
A) $150 million
B) $180 million
C) $230 million
D) $240 million
8) If Galt’s debt cost of capital is 6%, then Galt’s equity cost of capital is closest to:
A) 11.2%
B) 12.0%
C) 14.8%
D) 15.2%
9) Galt’s free cash flow to equity (FCFE) is closest to:
A) $19.2 million
B) $20.4 million
C) $21.2 million
D) $24.0 million
10) Consider the following equation for the Project WACC with a fixed debt schedule:
rwacc = rU – dτc[rD + f(rU – rD)]
The term d in this equations represents:
A) a measure of the permanence of the debt level.
B) the annual adjustment percentage to the amount of debt.
C) the debt-to-value ratio.
D) the dollar amount of debt outstanding.
11) Consider the following equation for the Project WACC with a fixed debt schedule:
rwacc = rU – dτc[rD + f(rU – rD)]
The term f in this equations represents:
A) the annual adjustment percentage to the amount of debt.
B) a measure of the permanence of the debt level.
C) the dollar amount of debt outstanding.
D) the debt-to-value ratio.