5283answers9.feb273 - 1 End of Chapter 9 Questions Problems...

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End of Chapter 9 Questions, Problems and Solutions CORPORATE FINANCE Professor Megginson February 27, 2003 Questions [See problems in book] *** *** *** *** *** *** *** *** *** *** *** *** *** *** *** *** *** *** *** Answers to End of Chapter 9 Questions 1. Only firms with no debt in their capital structure should use the cost of equity to discount project cash flows, and only those projects that are very similar to a firm’s existing assets should be discounted using that rate. Firms with both debt and equity should use the WACC as long as they are evaluating a project that is similar to their existing assets. When a firm is making an investment that is very different from its existing investments, then it shouldn’t use the company’s cost of equity or its WACC. 2. Operating leverage makes a firm’s profits and cash flows more variable and more sensitive to changes in sales. An increase in operating leverage will therefore make a firm’s stock price more sensitive to general economic conditions, and the stock’s beta will increase. 3. If the rate of return on the investment is 7%, then both firms will have an ROE of 7%. 4. Market values provide a better gauge of the true degree of leverage that a firm employs. A personal finance analogy may help drive this point home. Suppose someone buys a new home for $100,000, using $90,000 of borrowed money and $10,000 of personal funds to finance the purchase. Suppose the value of the home doubles soon thereafter. The value of outstanding debt is $90,000, but the market value of the home is $200,000. If we were measuring leverage in this example using “book value” or historical cost, the percentage of debt financing would be 90%. However, using the market value of the home rather than its cost, the fraction of the home financed through debt is just 45%. The owner of this home could easily borrow even more against the new, higher value of the home. 5. With no taxes, if you plug a firm’s asset beta into the CAPM equation the resulting rate of return is the WACC. We can see this by starting with the equation for the WACC: E D D r E D E r WACC d e + + + = Next, plug in the CAPM expression for r e and r d : E D D R R E R E D E R R E R WACC f m d f f m e f + - + + + - + = )] ) ( ( [ )] ) ( ( [ β A little manipulation of this expression yields: 1
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) ) ( ]( [ f m d e f R R E E D D E D E R WACC - + + + + = β And this in turn simplifies to: ) ) ( ( f m a f R R E R WACC - + = The intuition here is simply that, in the absence of taxes, the WACC measures the rate of return
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5283answers9.feb273 - 1 End of Chapter 9 Questions Problems...

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