Chapter 21: Dynamic Capital Structures and Corporate Valuation
23. Angelou Corporation has debt worth $150,000, with a yield of 8%, and equity worth $350,000. It is growing at a 5%
rate, and its tax rate is 25%. A similar firm with no debt has a cost of equity of 13%. Using the compressed adjusted
present value model, what is the value of the firm’s tax shield, i.e., how much value does the use of debt add?
a. $33,750
b. $37,500
c. $41,250
d. $45,375
e. $49,913
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%.
24. Refer to data for Kitto Electronics. Using the compressed adjusted present value model, what is the value of Kitto’s tax
shield?
a. $97,741
b. $102,885
c. $108,300
d. $114,000
e. $120,000
Chapter 21: Dynamic Capital Structures and Corporate Valuation
25. Refer to data for Kitto Electronics. Using the compressed adjusted present value model, what is Kitto’s value of
equity?
a. $2,020,000
b. $2,070,500
c. $2,122,263
d. $2,175,319
e. $2,229,702
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
Chapter 21: Dynamic Capital Structures and Corporate Valuation
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 $20.00 $25.00 $30.00 $35.00
Unlevered horizon value $366.00
Tax shield $2.10 $2.20 $2.30 $2.40
Horizon value of tax shield $25.00
Assume that all cash flows occur at the end of the year. SGP is currently financed with 25% debt at a rate of 10%. The
acquisition would be made immediately, and if it is undertaken, SGP would retain its current debt and issue enough new
debt to continue at the 25% 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 25%. 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? (Show your answer in millions of dollars.)
a. $210
b. $233
c. $256
d. $282
e. $310
Chapter 21: Dynamic Capital Structures and Corporate Valuation
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
b. $1,177
c. $1,295
d. $1,424
e. $1,567
29. Gators Incorporated has the following information for the current year and projected for next year. Calculate its
projected free cash flow to equity. (Assume new debt is added at the beginning of the year.)
Current year Projected
FCF NA $1,000
Total debt $400 $600
Interest rate on debt 6% 6%
Tax rate 25% 25%
Chapter 21: Dynamic Capital Structures and Corporate Valuation
a. $1,066
b. $1,173
c. $1,290
d. $1,419
e. $1,561
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
Chapter 21: Dynamic Capital Structures and Corporate Valuation
31. Alpha Manufacturing has the following financial information for the current year and projected for next year.
Calculate its projected free cash flow to equity.
Current year Projected
EBIT $1,500 $1,800
Operating assets $3,000 $3,400
Operating liabilities $200 $220
Total debt $1,500 $1,800
Interest rate on debt 6% 6%
Tax rate 25% 25%
a. $893
b. $983
c. $1,081
d. $1,189
e. $1,308
Chapter 21: Dynamic Capital Structures and Corporate Valuation
32. Eta Edibles had free cash flow to equity, required return, and long-term growth rate as indicated below. Eta has no
non-operating assets. Calculate Eta’s intrinsic value of equity using the FCFE model.
Most recent FCFE $1000
Required return on equity 9%
Long-term growth rate 4%
a. $18,909
b. $20,800
c. $22,880
d. $25,168
e. $27,685
33. Epsilon Consultants has the following projected free cash flows to equity and other information. It has no non-
operating assets. Calculate Epsilon’s intrinsic value of equity using the FCFE model.
Year 1 Year 2 Year 3
FCFE $1,000 $1,200 $1,260
Long-term FCFE growth 5%
Required return on equity 9%
a. $28,440
b. $31,284
c. $34,413
d. $37,854
e. $41,640
Chapter 21: Dynamic Capital Structures and Corporate Valuation
34. Zeta Technologies has the following projections. It has no non-operating assets. Calculate Zeta’s intrinsic value of
equity using the FCFE model.
Current year Year 1 Year 1 Year 3
FCF NA $1,000 $1,200 $1,248
Total debt $3,000 $3,900 $4,290 $4,462
Interest rate on debt 6% 6% 6% 6%
Tax rate 25% 25% 25% 25%
Long-term growth rate 4%
Required return on equity 9%
a. $21,165
b. $23,282
c. $25,610
d. $28,171
e. $30,988
Chapter 21: Dynamic Capital Structures and Corporate Valuation
35. Theta Therapeutics has the following information and projections. Use the FCFE model to calculate the intrinsic value
of Theta’s equity.
Current year Year 1 Year 2 Year 3
EBIT (operating profit) NA $1,000 $1,100 $1,200
Operating assets $1,200 $1,300 $1,500 $1,600
Operating liabilities $300 $300 $400 $500
Total Debt $1,000 $900 $1,100 $1,200
Tax rate NA 25% 25% 25%
Interest rate on debt NA 6% 6% 6%
long-term growth rate 4%
Required return on equity 9%
a. $14,156
b. $15,572
c. $17,129
d. $18,842
e. $20,726
Chapter 21: Dynamic Capital Structures and Corporate Valuation
36. Holland Auto Parts is considering a merger with Workman Car Parts. Workman’s market-determined beta is 0.9, and
the firm currently is financed with 20% debt, at an interest rate of 8%, and its tax rate is 25%. If Holland acquires
Workman, it will increase the debt to 60%, at an interest rate of 9%, and the tax rate will increase to 35%. The risk-free
rate is 6% and the market risk premium is 4%. Using the Compressed APV Model, what will Workman’s required rate of
return on equity be after it is acquired?
a. 7.4%
b. 8.9%
c. 9.3%
d. 9.6%
e. 9.7%