Chapter 21: 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
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
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
Chapter 21: Dynamic Capital Structures and Corporate Valuation
4. MM showed that in a world with taxes, a firm’s optimal capital structure would be almost 100% debt.
a. True
b. False
5. MM showed that in a world without taxes, a firm’s value is not affected by its capital structure.
a. True
b. False
Kitto Electronics Data
Kitto Electronics expects an EBIT of $200,000 for Year-1. EBIT is expected to grow at 6% thereafter. The tax rate is
25%. 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. $1,782,000
b. $1,980,000
c. $2,200,000
d. $2,420,000
e. $2,662,000
Chapter 21: Dynamic Capital Structures and Corporate Valuation
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
8. In the compressed adjusted present value model, the appropriate discount rate for the tax shield is the WACC.
a. True
b. False
Chapter 21: Dynamic Capital Structures and Corporate Valuation
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.
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
Chapter 21: Dynamic Capital Structures and Corporate Valuation
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.
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 25%. The risk-free rate is 6%, and the market risk premium is 5%.
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?
Chapter 21: Dynamic Capital Structures and Corporate Valuation
a. 12.0%
b. 13.9%
c. 14.4%
d. 16.0%
e. 16.9%
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
Chapter 21: Dynamic Capital Structures and Corporate Valuation
Glassmaker Corporation Data
Glassmaker Corporation has a currentcapital structure consisting of $100 million (market value) of 9% bonds and $300
million (market value) of common stock. Glassmaker’s beta is 1.5. Glassmaker faces a 25% 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 $29 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 $487 million at Year 4. Glass maker will increase its debt to $140 million in the recapitalization. This will
cause the estimatedtax savings due to interest expenses areestimatedto be$3.2 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 $53 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 current levered cost of equity based on its current
capital structure?
a. 11.00%
b. 11.50%
c. 12.00%
d. 12.50%
e. 13.00%
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. 10.00%
b. 11.00%
c. 11.25%
Chapter 21: Dynamic Capital Structures and Corporate Valuation
d. 12.03%
e. 13.11%
17. Refer to data for Glassmaker Corporation. Using the compressed adjusted present value model, how much will
Glassmaker’s equity be worth after completing the recapitalization? (Round your answer to the closest thousand dollars.)
a. $316
b. $340
c. $348
d. $366
e. $380
Chapter 21: Dynamic Capital Structures and Corporate Valuation
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.
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.
Chapter 21: Dynamic Capital Structures and Corporate Valuation
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.
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.
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.
21. The market value of Rudyard Incorporated’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 rate of 5%, and its tax rate is 25%. A similar firm with no debt has a cost of
equity of 12%. Using the compressed adjusted present value model, what is Rudyard’s cost of equity?
a. 11.4%
b. 12.0%
c. 12.6%
d. 13.3%
Chapter 21: Dynamic Capital Structures and Corporate Valuation
e. 14.0%
22. The market value of DeLoach Photography’s debt is $200,000 and its yield is 8%. The firm’s equity has a market
value of $800,000, its free cash flows are growing at a 4% rate, and its tax rate is 25%. A similar firm with no debt has a
cost of equity of 12%. Using the compressed adjusted present value (CAPV) model, what would its total value be if it had
no debt?
a. $878,750
b. $925,000
c. $950,000
d. $997,500
e. $1,050,000