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Unformatted text preview: Chapter 18 Capital Budgeting and Valuation with Leverage 18.1 Overview 1) Which of the following is not one of the simplifying assumptions made for the three main methods of capital budgeting? A) The firm pays out all earnings as dividends. B) The project has average risk. C) Corporate taxes are the only market imperfection. D) The firm’s debt- equity ratio is constant. Answer: A Diff: 1 Skill: Conceptual 18.2 The Weighted Average Cost of Capital Method 1) Which of the following statements is false? A) Because the WACC incorporates the tax savings from debt, we can compute the levered value of an investment, which is its value including the benefit of interest tax shields given the firmʹs leverage policy, by discounting its future free cash flow using the WACC. B) The WACC incorporates the benefit of the interest tax shield by using the firmʹs before - tax cost of capital for debt. C) When the market risk of the project is similar to the average market risk of the firmʹs investments, then its cost of capital is equivalent to the cost of capital for a portfolio of all of the firmʹs securities; that is, the projectʹs cost of capital is equal to the firm’s weighted average cost of capital (WACC). D) A projectʹs cost of capital depends on its risk. Answer: B Diff: 1 Skill: Conceptual Chapter 18 Capital Budgeting and Valuation with Leverage 499 2) Which of the following statements is false? A) The WACC can be used throughout the firm as the company wide cost of capital for new investments that are of comparable risk to the rest of the firm and that will not alter the firm’s debt - equity ratio. B) A disadvantage of the WACC method is that you need to know how the firmʹs leverage policy is implemented to make the capital budgeting decision. C) The intuition for the WACC method is that the firmʹs weighted average cost of capital represents the average return the firm must pay to its investors (both debt and equity holders) on an after- tax basis. D) To be profitable, a project should generate an expected return of at least the firmʹs weighted average cost of capital. Answer: B Diff: 1 Skill: Conceptual 3) Which of the following is not a step in the WACC valuation method? A) Compute the value of the investment, including the tax benefit of leverage, by discounting the free cash flow of the investment using the WACC. B) Compute the weighted average cost of capital. C) Determine the free cash flow of the investment. D) Adjust the WACC for the firmʹs current debt/equity ratio. Answer: D Diff: 1 Skill: Conceptual 4) Consider the following equation: E D rwacc = r + r (1 - τc) E + D E E + D D the term E in this equation is? A) the dollar amount of equity. B) the dollar amount of debt C) the required rate of return on debt D) the required rate of return on equity Answer: A Diff: 1 Skill: Conceptual 500 Berk/DeMarzo · Corporate Finance 5) Consider the following equation: D E r + r (1 - τc) rwacc = E + D E E + D D the term D in this equation is? A) the dollar amount of debt B) the required rate of return on equity C) the required rate of return on debt D) the dollar amount of equity. Answer: A Diff: 1 Skill: Conceptual 6) Consider the following equation: E D rwacc = r + r (1 - τc) E + D E E + D D the term rE in this equation is? A) the after tax required rate of return on debt B) the required rate of return on debt C) the required rate of return on equity D) the dollar amount of equity. Answer: C Diff: 1 Skill: Conceptual 7) Consider the following equation: E D rwacc = r + r (1 - τc) E + D E E + D D the term rD(1 - τc) in this equation is? A) the required rate of return on debt B) the dollar amount of equity. C) the after tax required rate of return on debt D) the required rate of return on equity Answer: C Diff: 1 Skill: Conceptual Chapter 18 Capital Budgeting and Valuation with Leverage 501 8) Consider the following equation: L Dt = d × V t the term Dt in this equation is? A) the firms target debt to value ratio. B) the firms target debt to equity ratio. C) the investmentʹs debt capacity. D) the dollar amount of debt outstanding at time t. Answer: C Diff: 2 Skill: Conceptual 9) Consider the following equation: L Dt = d × V t the term d in this equation is? A) the firms target debt to value ratio. B) the dollar amount of debt outstanding at time t. C) the firms target debt to equity ratio. D) the investmentʹs debt capacity. Answer: A Diff: 2 Skill: Conceptual 502 Berk/DeMarzo · Corporate Finance Use the table for the question(s) below. Consider the information for the following four firms: Firm Cash Eenie Meenie Minie Moe Debt Equity 0 0 25 50 150 250 175 350 150 750 325 150 rD 5% 6% 6% 7.50% rE 10% 12% 11% 15% τc 40% 35% 35% 30% 10) The weighted average cost of capital for ʺEenieʺ is closest to: A) 6.0% B) 6.5% C) 7.5% D) 5.5% Answer: B Explanation: B) rwacc = Firm Eenie Meenie Minie Moe E D rE + r (1 - τc), where D = net debt = Debt - Cash E + D E + D D Cash Debt Equity 0 0 25 50 150 250 175 350 150 750 325 150 rD 5% 6% 6% 7.50% rE 10% 12% 11% 15% τc 40% 35% 35% 30% Wacc 6.50% 9.98% 8.76% 8.50% Diff: 1 Skill: Analytical 11) The weighted average cost of capital for ʺMeenieʺ is closest to: A) 10.5% B) 7.4% C) 10.0% D) 8.8% Answer: C Explanation: E D C) rwacc = r + r (1 - τc), where D = net debt = Debt - Cash E + D E E + D D Firm Eenie Meenie Minie Moe Diff: 1 Skill: Analytical Cash Debt Equity 0 0 25 50 150 250 175 350 150 750 325 150 rD 5% 6% 6% 7.50% rE 10% 12% 11% 15% τc 40% 35% 35% 30% Wacc 6.50% 9.98% 8.76% 8.50% Chapter 18 Capital Budgeting and Valuation with Leverage 503 12) The weighted average cost of capital for ʺMinieʺ is closest to: A) 9.50% B) 8.75% C) 6.75% D) 8.25% Answer: B Explanation: B) rwacc = Firm Eenie Meenie Minie Moe E D r + r (1 - τc), where D = net debt = Debt - Cash E + D E E + D D Cash Debt Equity 0 0 25 50 150 250 175 350 150 750 325 150 rD 5% 6% 6% 7.50% rE 10% 12% 11% 15% τc 40% 35% 35% 30% Wacc 6.50% 9.98% 8.76% 8.50% Diff: 2 Skill: Analytical 13) The weighted average cost of capital for ʺMoeʺ is closest to: A) 10.00% B) 7.75% C) 8.25% D) 8.50% Answer: D Explanation: D) rwacc = Firm Eenie Meenie Minie Moe Diff: 2 Skill: Analytical E D rE + r (1 - τc), where D = net debt = Debt - Cash E + D E + D D Cash Debt Equity 0 0 25 50 150 250 175 350 150 750 325 150 rD 5% 6% 6% 7.50% rE 10% 12% 11% 15% τc 40% 35% 35% 30% Wacc 6.50% 9.98% 8.76% 8.50% 504 Berk/DeMarzo · Corporate Finance Use the information for the question(s) below. Omicron Industriesʹ Market Value Balance Sheet ($ Millions) and Cost of Capital Assets Liabilities Cost of Capital Cash 0 Debt 200 Debt Other Assets 500 Equity 300 Equity τc Omicron Industries New Project Free Cash Flows Year 0 1 2 Free Cash Flows ($100) $40 $50 6% 12% 35% 3 $60 Assume that this new project is of average risk for Omicron and that the firm wants to hold constant its debt to equity ratio. 14) Omicronʹs weighted average cost of capital is closest to: A) 7.10% B) 7.50% C) 9.60% D) 8.75% Answer: D Explanation: D) rwacc = E D r + r (1 - τc), where D = net debt = Debt - Cash E + D E E + D D 300 200 rwacc = (.12) + (.06)(1 - .35) = .0876 300 + 200 300 + 200 Diff: 1 Skill: Analytical 15) The NPV for Omicronʹs new project is closest to: A) $23.75 B) $27.50 C) $28.75 D) $25.75 Answer: D Explanation: D) rwacc = E D r + r (1 - τc), where D = net debt = Debt - Cash E + D E E + D D 300 200 rwacc = (.12) + (.06)(1 - .35) = .0876 300 + 200 300 + 200 NPV = - 100 + Diff: 2 Skill: Analytical 40 (1.0876) 1 + 50 (1.0876) 2 + 60 (1.0876) 3 = $25.69 Chapter 18 Capital Budgeting and Valuation with Leverage 505 16) The Debt Capacity for Omicronʹs new project in year 0 is closest to: A) $38.75 B) $75.50 C) $50.25 D) $10.25 Answer: C Explanation: E D C) rwacc = r + r (1 - τc), where D = net debt = Debt - Cash E + D E E + D D 300 200 rwacc = (.12) + (.06)(1 - .35) = .0876 300 + 200 300 + 200 L V 0 = 40 (1.0876) 1 + 50 (1.0876) 2 + 60 (1.0876) 3 = $125.69 L D0 = d × V 0 200 ($125.69) = $50.28 D0 = 300 + 200 Diff: 3 Skill: Analytical 17) The Debt Capacity for Omicronʹs new project in year 1 is closest to: A) $38.75 B) $48.25 C) $50.25 D) $58.00 Answer: A Explanation: A) rwacc = E D r + r (1 - τc), where D = net debt = Debt - Cash E + D E E + D D 300 200 rwacc = (.12) + (.06)(1 - .35) = .0876 300 + 200 300 + 200 L V 1 = 50 (1.0876) 1 + 60 (1.0876) 2 = $96.70 L D1 = d × V 1 200 ($96.70) = $38.68 D1 = 300 + 200 Diff: 3 Skill: Analytical 506 Berk/DeMarzo · Corporate Finance 18) The Debt Capacity for Omicronʹs new project in year 2 is closest to: A) $55.25 B) $38.75 C) $22.00 D) $33.00 Answer: C Explanation: E D C) rwacc = r + r (1 - τc), where D = net debt = Debt - Cash E + D E E + D D 300 200 rwacc = (.12) + (.06)(1 - .35) = .0876 300 + 200 300 + 200 L V 2 = 60 (1.0876) 1 = $55.17 L D2 = d × V 2 200 ($55.17) = $22.06 D2 = 300 + 200 Diff: 2 Skill: Analytical Chapter 18 Capital Budgeting and Valuation with Leverage 507 Use the information for the question(s) below. Iota Industries Market Value Balance Sheet ($ Millions) and Cost of Capital Assets Liabilities Cost of Capital Cash 250 Debt 650 Debt 7% Other Assets 1200 Equity 800 Equity 14% τc 35% Iota Industries New Project Free Cash Flows Year 0 1 2 Free Cash Flows ($250) $75 $150 3 $100 Assume that this new project is of average risk for Iota and that the firm wants to hold constant its debt to equity ratio. 19) Iotaʹs weighted average cost of capital is closest to: A) 8.40% B) 9.75% C) 10.85% D) 11.70% Answer: C Explanation: D E r + r (1 - τc), where D = net debt = Debt - Cash C) rwacc = E + D E E + D D 800 400 rwacc = (.14) + (.07)(1 - .35) = .1085 800 + 400 800 + 400 Diff: 3 Skill: Analytical 20) The NPV for Iotaʹs new project is closest to: A) $25.25 B) $13.25 C) $9.00 D) $18.50 Answer: B Explanation: B) rwacc = E D rE + r (1 - τc), where D = net debt = Debt - Cash E + D E + D D 800 400 rwacc = (.14) + (.07)(1 - .35) = .1085 800 + 400 800 + 400 NPV = - 250 + Diff: 2 Skill: Analytical 75 (1.1085) 1 + 150 (1.1085) 2 + 100 (1.1085) 3 = $13.14 508 Berk/DeMarzo · Corporate Finance 21) The Debt Capacity for Iotaʹs new project in year 0 is closest to: A) $263.25 B) 87.75 C) $50.25 D) $118.00 Answer: B Explanation: B) rwacc = E D r + r (1 - τc), where D = net debt = Debt - Cash E + D E E + D D 800 400 rwacc = (.14) + (.07)(1 - .35) = .1085 800 + 400 800 + 400 V 0 L = 75 (1.1085) 1 + 150 (1.1085) 2 + 100 (1.1085) 3 = $263.14 L D0 = d × V 0 400 ($263.14) = $87.71 D0 = 800 + 400 Diff: 3 Skill: Analytical 22) Calculate the NPV for Iotaʹs new project. D E r + r (1 - τc), where D = net debt = Debt - Cash Answer: rwacc = E + D E E + D D 800 400 rwacc = (.14) + (.07)(1 - .35) = .1085 800 + 400 800 + 400 NPV = - 250 + 75 (1.1085) 1 + 150 (1.1085) 2 + 100 (1.1085) 3 = $13.14 Diff: 3 Skill: Analytical Use the information for the question(s) below. Omicron Industriesʹ Market Value Balance Sheet ($ Millions) and Cost of Capital Assets Liabilities Cost of Capital Cash 0 Debt 200 Debt Other Assets 500 Equity 300 Equity τc Omicron Industries New Project Free Cash Flows Year 0 1 2 Free Cash Flows ($100) $40 $50 6% 12% 35% 3 $60 Assume that this new project is of average risk for Omicron and that the firm wants to hold constant its debt to equity ratio. 23) Calculate the debt capacity of Omicronʹs new project for years 0, 1, and 2. Chapter 18 Capital Budgeting and Valuation with Leverage 509 E D Answer: rwacc = r + r (1 - τc), where D = net debt = Debt - Cash E + D E E + D D 300 200 rwacc = (.12) + (.06)(1 - .35) = .0876 300 + 200 300 + 200 Year 0 L V 0 = 40 (1.0876) 1 + 50 (1.0876) 2 + 60 (1.0876) 3 = $125.69 L D0 = d × V 0 200 ($125.69) = $50.28 D0 = 300 + 200 Year 1 L V 1 = 50 (1.0876) 1 + 60 (1.0876) 2 = $96.70 L D1 = d × V 1 200 ($96.70) = $38.68 D1 = 300 + 200 Year 2 L V 2 = 60 (1.0876) 1 = $55.17 L D2 = d × V 2 200 ($55.17) = $22.06 D2 = 300 + 200 Diff: 3 Skill: Analytical 24) Suppose Luther Industries is considering divesting one of its product lines. The product line is expected to generate free cash flows of $2 million per year, growing at a rate of 3% per year. Luther has an equity cost of capital of 10%, a debt cost of capital of 7%, a marginal tax rate of 35%, and a debt - equity ratio of 2. If this product line is of average risk and Luther plans to maintain a constant debt - equity ratio, what after- tax amount must it receive for the product line in order for the divestiture to be profitable? 2 1 Answer: rwacc = (.10) + (.07)(1 - .35) = .063667 3 3 L $2 million = $59.406 million V 0 = .063667 - .03 Diff: 2 Skill: Analytical 510 Berk/DeMarzo · Corporate Finance 18.3 The Adjusted Present Value Method 1) Which of the following is not a step in the adjusted present value method? A) Deducting costs arising from market imperfections B) Calculating the unlevered value of the project C) Calculating the after - tax WACC D) Calculating the value of the interest tax shield Answer: C Diff: 2 Skill: Conceptual 2) Which of the following statements is false? A) The firmʹs unlevered cost of capital is equal to its pretax weighted average cost of capital–that is, using the pretax cost of debt, rd , rather than its after - tax cost, rd (1 - τc ). B) A firmʹs levered cost of capital is a weighted average of its equity and debt costs of capital. C) When the firm maintains a target leverage ratio, its future interest tax shields have similar risk to the projectʹs cash flows, so they should be discounted at the projectʹs unlevered cost of capital. D) The first step in the APV method is to calculate the value of free cash flows using the projectʹs cost of capital if it were financed without leverage. Answer: B Diff: 2 Skill: Conceptual 3) Which of the following statements is false? A) To determine the projectʹs debt capacity for the interest tax shield calculation, we need to know the value of the project. B) To compute the present value of the interest tax shield, we need to determine the appropriate cost of capital. C) Because we don’t value the tax shield separately, with the APV method we need to include the benefit of the tax shield in the discount rate as we do in the WACC method. D) A target leverage ratio means that the firm adjusts its debt proportionally to the project’s value or its cash flows. Answer: C Diff: 2 Skill: Conceptual Chapter 18 Capital Budgeting and Valuation with Leverage 511 4) Which of the following statements is false? A) The APV approach explicitly values the market imperfections and therefore allows managers to measure their contribution to value. B) We need to know the debt level to compute the APV, but with a constant debt - equity ratio we need to know the projectʹs value to compute the debt level. C) The WACC method is more complicated than the APV method because we must compute two separate valuations: the unlevered project and the interest tax shield. D) Implementing the APV approach with a constant debt - equity ratio requires solving for the projectʹs debt and value simultaneously. Answer: C Diff: 2 Skill: Conceptual Use the table for the question(s) below. Consider the information for the following four firms: Firm Eenie Meenie Minie Moe Cash Debt Equity 0 0 25 50 150 250 175 350 150 750 325 150 rD 5% 6% 6% 7.50% rE 10% 12% 11% 15% τc 40% 35% 35% 30% 5) The unlevered cost of capital for ʺEenieʺ is closest to: A) 6.0% B) 5.5% C) 7.5% D) 6.5% Answer: C Explanation: E D C) runlevered = r + r (1 - τc), where D = net debt = Debt - Cash E + D E E + D D Firm Eenie Meenie Minie Moe Diff: 1 Skill: Analytical Cash 0 0 25 50 Debt Equity 150 250 175 350 150 750 325 150 rD 5% 6% 6% 7.50% rE 10% 12% 11% 15% τc 40% 35% 35% 30% runlevered 7.50% 10.50% 9.42% 10.00% 512 Berk/DeMarzo · Corporate Finance 6) The unlevered cost of capital for ʺMoeʺ is closest to: A) 8.25% B) 7.75% C) 8.50% D) 10.00% Answer: D Explanation: D) runlevered = Firm Eenie Meenie Minie Moe E D r + r (1 - τc), where D = net debt = Debt - Cash E + D E E + D D Cash 0 0 25 50 Debt Equity 150 250 175 350 150 750 325 150 rD 5% 6% 6% 7.50% rE 10% 12% 11% 15% τc 40% 35% 35% 30% runlevered 7.50% 10.50% 9.42% 10.00% Diff: 2 Skill: Analytical Use the information for the question(s) below. Suppose Luther Industries is considering divesting one of its product lines. The product line is expected to generate free cash flows of $2 million per year, growing at a rate of 3% per year. Luther has an equity cost of capital of 10%, a debt cost of capital of 7%, a marginal tax rate of 35%, and a debt - equity ratio of 2. This product line is of average risk and Luther plans to maintain a constant debt - equity ratio. 7) Lutherʹs Unlevered cost of capital is closest to: A) 8.0% B) 8.5% C) 9.0% D) 6.4% Answer: A Explanation: Diff: 2 Skill: Analytical 1 2 A) runlevered = (.10) + (.07) = .08 or 8% 3 3 Chapter 18 Capital Budgeting and Valuation with Leverage 513 8) The unlevered value of Lutherʹs Product Line is closest to: A) $25 million B) $60 million C) $45 million D) $40 million Answer: D Explanation: 1 2 D) runlevered = (.10) + (.07) = .08 or 8% 3 3 V U = $2 million = $40 million .08 - .03 Diff: 2 Skill: Analytical Use the information for the question(s) below. Omicron Industriesʹ Market Value Balance Sheet ($ Millions) and Cost of Capital Assets Liabilities Cost of Capital Cash 0 Debt 200 Debt Other Assets 500 Equity 300 Equity τc Omicron Industries New Project Free Cash Flows Year 0 1 2 Free Cash Flows ($100) $40 $50 6% 12% 35% 3 $60 Assume that this new project is of average risk for Omicron and that the firm wants to hold constant its debt to equity ratio. 9) Omicronʹs Unlevered cost of capital is closest to: A) 8.75% B) 7.10% C) 9.60% D) 7.50% Answer: C Explanation: E D C) runlevered = r + r , where D = net debt = Debt - Cash E + D E E + D D 300 200 runlevered = (.12) + (.06) = .096 300 + 200 300 + 200 Diff: 1 Skill: Analytical 514 Berk/DeMarzo · Corporate Finance 10) The unlevered value of Omicronʹs new project is closest to: A) $96 B) $124 C) $126 D) $25 Answer: B Explanation: B) runlevered = E D r + r , where D = net debt = Debt - Cash E + D E E + D D 300 200 runlevered = (.12) + (.06) = .096 300 + 200 300 + 200 V U = 40 (1.096)1 + 50 (1.096)2 + 60 (1.096)3 = $123.70 Diff: 2 Skill: Analytical 11) The interest tax shield provided by Omicronʹs new project in year 1 is closest to: A) $3.00 B) $1.05 C) $50.25 D) $17.60 Answer: B Explanation: B) rwacc = E D r + r (1 - τc), where D = net debt = Debt - Cash E + D E E + D D 300 200 rwacc = (.12) + (.06)(1 - .35) = .0876 300 + 200 300 + 200 L V 0 = 40 (1.0876) 1 + 50 (1.0876) 2 + 60 (1.0876) 3 = $125.69 L D0 = d × V 0 200 ($125.69) = $50.28 D0 = 300 + 200 So, Interest tax shield in year 1 = 50.28(.06)(.35) = 1.055880 or 1.06 Diff: 3 Skill: Analytical Chapter 18 Capital Budgeting and Valuation with Leverage 515 Use the information for the question(s) below. Suppose that Rose Industries is considering the acquisition of another firm in its industry for $100 million. The acquisition is expected to increase Roseʹs free cash flow by $5 million the first year, and this contribution us expected to grow at a rate of 3% every year there after. Rose currently maintains a debt to equity ratio of 1, its marginal tax rate is 40%, its cost of debt rD is 6%, and its cost of equity rE is 10%. Rose Industries will maintain a constant debt - equity ratio for the acquisition. 12) Roseʹs unlevered cost of capital is closest to: A) 8.0% B) 7.5% C) 7.0% D) 9.0% Answer: A Explanation: A) runlevered = E D r + r , where D = net debt = Debt - Cash E + D E E + D D 1 1 runlevered = (.10) + (.06) = .08 1 + 1 1 + 1 Diff: 1 Skill: Analytical 13) The unlevered value of Roseʹs acquisition is closest to: A) $63 million B) $50 million C) $167 million D) $100 million Answer: D Explanation: D) runlevered = E D r + r , where D = net debt = Debt - Cash E + D E E + D D 1 1 runlevered = (.10) + (.06) = .08 1 + 1 1 + 1 V U = Diff: 2 Skill: Analytical 5 = $100 million .08 - .03 516 Berk/DeMarzo · Corporate Finance 14) Given that Rose issues new debt of $50 million initially to fund the acquisition, the present value of the interest tax shield for this acquisition is closest to: A) $24 million B) $50 million C) $20 million D) $15 million Answer: A Explanation: A) runlevered = E D r + r , where D = net debt = Debt - Cash E + D E E + D D 1 1 runlevered = (.10) + (.06) = .08 1 + 1 1 + 1 Interest tax shield in first year = $50(.06)(.40) = $1.2 million 1.2 = $24 million PV (tax shield) = .08 - .03 Diff: 3 Skill: Analytical 15) Given that Rose issues new debt of $50 million initially to fund the acquisition, the total value of this acquisition using the APV method is closest to: A) $100 million B) $120 million C) $124 million D) $115 million Answer: C Explanation: E D C) runlevered = r + r (1 - τc), where D = net debt = Debt - Cash E + D E E + D D 1 1 runlevered = (.10) + (.06) = .08 1 + 1 1 + 1 V U = 5 = $100 million .08 - .03 Interest tax shield in first year = $50(.06)(.40) = $1.2 million 1.2 = $24 million PV (tax shield)= .08 - .03 V L = V U + PV (interest tax shield) = $100 million + $24 million = $124 million Diff: 3 Skill: Analytical Use the information for the question(s) below. Omicron Industriesʹ Market Value Balance Sheet ($ Millions) and Cost of Capital Assets Liabilities Cost of Capital Cash 0 Debt 200 Debt Other Assets 500 Equity 300 Equity τc 6% 12% 35% Chapter 18 Capital Budgeting and Valuation with Leverage 517 Omicron Industries New Project Free Cash Flows Year 0 1 2 Free Cash Flows ($100) $40 $50 3 $60 Assume that this new project is of average risk for Omicron and that the firm wants to hold constant its debt to equity ratio. 16) Calculate the present value of the interest tax shield provided by Omicronʹs new project. D E r + r (1 - τc), where D = net debt = Debt - Cash Answer: rwacc = E + D E E + D D 300 200 rwacc = (.12) + (.06)(1 - .35) = .0876 300 + 200 300 + 200 Year 0 L V 0 = 40 (1.0876) 1 + 50 (1.0876) 2 + 60 (1.0876) 3 = $125.69 L D0 = d × V 0 200 ($125.69) = $50.28 D0 = 300 + 200 Interest tax shield year 1 = 50.28(.06)(.35) = 1.055880 or 1.06 Year 1 L V 1 = 50 (1.0876) 1 + 60 (1.0876) 2 = $96.70 L D1 = d × V 1 200 ($96.70) = $38.68 D1 = 300 + 200 Interest tax shield year 2 = 38.68(.06)(.35) = 0.812280 or .81 Year 2 L V 2 = 60 (1.0876) 1 = $55.17 L D2 = d × V 2 200 ($55.17) = $22.06 D2 = 300 + 200 Interest tax shield year 3 = 22.06(.06)(.35) = 0.463260 or .46 D E r + r , where D = net debt = Debt - Cash runlevered = E + D E E + D D 300 200 runlevered = (.12) + (.06) = .096 300 + 200 300 + 200 PV of tax shield = 1.06 .81 .46 + + = 1.99 1.096 (1.096)2 (1.096)3 518 Berk/DeMarzo · Corporate Finance Diff: 3 Skill: Analytical Use the information for the question(s) below. Suppose that Rose Industries is considering the acquisition of another firm in its industry for $100 million. The acquisition is expected to increase Roseʹs free cash flow by $5 million the first year, and this contribution us expected to grow at a rate of 3% every year there after. Rose currently maintains a debt to equity ratio of 1, its marginal tax rate is 40%, its cost of debt rD is 6%, and its cost of equity rE is 10%. Rose Industries will maintain a constant debt - equity ratio for the acquisition. 17) Given that Rose issues new debt of $50 million initially to fund the acquisition, the total value of this acquisition using the APV method is equal to? D E r + r (1 - τc), where D = net debt = Debt - Cash Answer: runlevered = E + D E E + D D 1 1 runlevered = (.10) + (.06) = .08 1 + 1 1 + 1 V U = 5 = $100 million .08 - .03 Interest tax shield in first year = $50(.06)(.40) = $1.2 million 1.2 = $24 million PV (tax shield)= .08 - .03 V L = V U + PV (interest tax shield) = $100 million + $24 million = $124 million Diff: 3 Skill: Analytical 18.4 The Flow-to-Equity Method 1) Which of the following statements is false? A) In the flow - to- equity valuation method, the cash flows to equity holders are then discounted using the weighted average cost of capital. B) In the WACC and APV methods, we value a project based on its free cash flow, which is computed ignoring interest and debt payments. C) In the flow - to- equity (FTE) valuation method, we explicitly calculate the free cash flow available to equity holders taking into account all payments to and from debt holders. D) The first step in the FTE method is to determine the project’s free cash flow to equity (FCFE). Answer: A Diff: 1 Skill: Conceptual Chapter 18 Capital Budgeting and Valuation with Leverage 519 2) Which of the following statements is false? A) The projectʹs free cash flow to equity shows the expected amount of additional cash the firm will have available to pay dividends (or conduct share repurchases) each year. B) The value of the project’s FCFE should be identical to the NPV computed using the WACC and APV methods. C) The value of the project’s FCFE represents the gain to shareholders from the project. D) Because interest payments are deducted before taxes, we adjust the firmʹs FCF by their before- tax cost. Answer: D Diff: 2 Skill: Conceptual 3) Which of the following statements is false? A) If the debt- equity ratio changes over time, the risk of equity–and, therefore, its cost of capital –will change as well. B) The FTE method can offer an advantage when calculating the value of equity for the entire firm, if the firm’s capital structure is complex and the market values of other securities in the firm’s capital structure are not known. C) The FTE approach does not have the same disadvantage associated with the APV approach: We donʹt need to compute the projectʹs debt capacity to determine interest and net borrowing before we can make the capital budgeting decision. D) The WACC and APV methods compute the firmʹs enterprise value, so that a separate valuation of the other components of the firm’s capital structure is needed to determine the value of equity. Answer: C Diff: 2 Skill: Conceptual 4) Which of the following is not a step in valuation using the flow to equity method? A) Determine the equity cost of capital, rE. B) Compute the equity value, E, by discounting the free cash flow to equity using the equity cost of capital. C) Determine the free cash flow to equity of the investment. D) Determine the before- tax cost of capital, rU. Answer: D Diff: 1 Skill: Conceptual 520 Berk/DeMarzo · Corporate Finance Use the information for the question(s) below. Suppose that Rose Industries is considering the acquisition of another firm in its industry for $100 million. The acquisition is expected to increase Roseʹs free cash flow by $5 million the first year, and this contribution us expected to grow at a rate of 3% every year there after. Rose currently maintains a debt to equity ratio of 1, its marginal tax rate is 40%, its cost of debt rD is 6%, and its cost of equity rE is 10%. Rose Industries will maintain a constant debt - equity ratio for the acquisition. 5) The Free Cash Flow to Equity (FCFE) for the acquisition in year 0 is closest to: A) $5 million B) $100 million C) - $100 million D) - $50 million Answer: D Explanation: D) FCFE0 = - 100 (cost of acquisition) + 50 (issuance of new debt) = - $50 million Diff: 1 Skill: Analytical 6) The Free Cash Flow - to- Equity (FCFE) for the acquisition in year 1 is closest to: A) $4.7 million B) $6.5 million C) $8.3 million D) $6.8 million Answer: A Explanation: A) In one year the interest on the debt will be 6% × $50 = $3 million. Because Rose maintains a constant debt - equity ratio, the debt associated with the acquisition is also expected to grow at a 3% rate, so D1 = D0(1 + g ) = $50(1.03) = $51.5 million, therefore the net borrowing (lending) is $51.5 - 50 = $1.5 million FCFE1 = FCF from project - after tax interest payments + new borrowing FCFE1 = + 5.0 - (1 - .40)(3) + 1.5 = $4.7 million Diff: 2 Skill: Analytical 7) Describe the key steps in the flow to equity method for valuing a levered investment. Answer: The key steps in the flow - to- equity method for valuing a levered investment are as follows: 1. Determine the free cash flow to equity of the investment. 2. Determine the equity cost of capital, rE. 3. Compute the equity value, E, by discounting the free cash flow to equity using the equity cost of capital. Diff: 2 Skill: Conceptual Chapter 18 Capital Budgeting and Valuation with Leverage 521 18.5 Project-Based Costs of Capital 1) Which of the following statements is false? A) In the real world, specific projects should differ only slightly from the average investment made by the firm. B) We can estimate rU for a new project by looking at single - division firms that have similar business risks. C) The projectʹs equity cost of capital depends on its unlevered cost of capital, rU, and the debt - equity ratio of the incremental financing that will be put in place to support the project. D) Projects may vary in the amount of leverage they will support–for example, acquisitions of real estate or capital equipment are often highly levered, whereas investments in intellectual property are not. Answer: A Diff: 1 Skill: Conceptual 2) Which of the following statements is false? A) For capital budgeting purposes, the project’s financing is the incremental financing that results if the firm takes on the project. B) Projects with safer cash flows can support more debt before they increase the risk of financial distress for the firm. C) If the positive free cash flow from a project will increase the firmʹs cash holdings, then this growth in cash is equivalent to a reduction in the firm’s leverage. D) The incremental financing of a project corresponds directly to the financing that is directly tied to the project. Answer: D Diff: 1 Skill: Conceptual 3) Consider the following equation: rwacc = rU - τcdr D The term d in this equation is A) the projectʹs unlevered cost of capital. B) the projectʹs dollar amount of debt. C) the firmʹs unlevered cost of debt. D) the projectʹs debt to value ratio. Answer: D Diff: 1 Skill: Conceptual 522 Berk/DeMarzo · Corporate Finance 4) Consider the following equation: rwacc = rU - τcdr D The term rU in this equation is A) the firmʹs unlevered cost of debt. B) the firmʹs cost of debt. C) the projectʹs unlevered cost of capital. D) the projectʹs debt to value ratio. Answer: C Diff: 1 Skill: Conceptual Use the information for the question(s) below. The Aardvark Corporation is considering launching a new product and is trying to determine an appropriate discount rate for evaluating this new product. Aardvark has identified the following information for three single division firms that offer products similar to the one Aardvark is interested in launching: Comparable Firm Anteater Enterprises Armadillo Industries Antelope Inc. Equity Cost Debt Cost of Capital of Capital 12.50% 6.50% 13% 6.10% 14% 7.10% Debt -to -Value Ratio 50% 40% 60% 5) The unlevered cost of capital for Anteater Enterprises is closest to: A) 10.1% B) 9.5% C) 9.9% D) 10.3% Answer: B Explanation: B) rU = 1 - D D r + r D + E E D + E D Comparable Firm Anteater Enterprises Armadillo Industries Antelope Inc. Diff: 1 Skill: Analytical Equity Cost Debt Cost Debt -to -Value rU of Capital of Capital Ratio 12.50% 6.50% 50% 9.50% 13% 6.10% 40% 10.30% 14% 7.10% 60% 9.90% Chapter 18 Capital Budgeting and Valuation with Leverage 523 6) The unlevered cost of capital for Armadillo Industries is closest to: A) 10.3% B) 10.1% C) 9.5% D) 9.9% Answer: A Explanation: A) rU = 1 - D D r + r D + E E D + E D Comparable Firm Anteater Enterprises Armadillo Industries Antelope Inc. Equity Cost Debt Cost Debt -to -Value rU of Capital of Capital Ratio 12.50% 6.50% 50% 9.50% 13% 6.10% 40% 10.30% 14% 7.10% 60% 9.90% Diff: 1 Skill: Analytical 7) The unlevered cost of capital for Antelope Incorporated is closest to: A) 10.3% B) 9.9% C) 10.1% D) 9.5% Answer: B Explanation: B) rU = 1 - D D r + r D + E E D + E D Comparable Firm Anteater Enterprises Armadillo Industries Antelope Inc. Diff: 1 Skill: Analytical Equity Cost Debt Cost Debt -to -Value rU of Capital of Capital Ratio 12.50% 6.50% 50% 9.50% 13% 6.10% 40% 10.30% 14% 7.10% 60% 9.90% 524 Berk/DeMarzo · Corporate Finance Use the information for the question(s) below. KT Enterprises is considering undertaking a new project. Based upon analysis of firms with similar projects, KT has determined that an unlevered cost of equity of 12% is suitable for their project. KTʹs marginal tax rate is 35%, its borrowing rate is 7%, and KT does not believe that its borrowing rate will change if the new project is accepted. 8) If KT expects to maintain a debt to equity ratio for this project of 1, then KTʹs equity cost of capital, rE, for this project is closest to: A) 17.0% B) 5.0% C) 15.0% D) 12% Answer: A Explanation: A) rE = rU + D (r - r ) EUD rE = .12 + 1(.12 - .07) = .17 or 17% Diff: 1 Skill: Analytical 9) If KT expects to maintain a debt to equity ratio for this project of .6 then KTʹs equity cost of capital, rE, for this project is closest to: A) 5.0% B) 12% C) 15.0% D) 17.0% Answer: C Explanation: D C) rE = rU + (r U - rD) E rE = .12 + .6(.12 - .07) = .15 or 15% Diff: 1 Skill: Analytical Chapter 18 Capital Budgeting and Valuation with Leverage 525 10) If KT expects to maintain a debt to equity ratio for this project of .6 then KTʹs project based WACC, rwacc, for this project is closest to: A) 10.5% B) 11.1% C) 9.6% D) 10.8% Answer: B Explanation: B) rwacc = rU - dτ crD .6 (.35)(.07) = .1108 or 11.08% rwacc = .12 - 1 + .6 Diff: 2 Skill: Analytical 11) If KT expects to maintain a debt to equity ratio for this project of 1 then KTʹs project based WACC, rwacc, for this project is closest to: A) 11.1% B) 10.8% C) 9.6% D) 10.5% Answer: B Explanation: B) rwacc = rU - dτ crD 1 (.35)(.07) = .107750 or 10.8% rwacc = .12 - 1 + 1 Diff: 2 Skill: Analytical 526 Berk/DeMarzo · Corporate Finance Use the information for the question(s) below. The Aardvark Corporation is considering launching a new product and is trying to determine an appropriate discount rate for evaluating this new product. Aardvark has identified the following information for three single division firms that offer products similar to the one Aardvark is interested in launching: Comparable Firm Anteater Enterprises Armadillo Industries Antelope Inc. Equity Cost Debt Cost of Capital of Capital 12.50% 6.50% 13% 6.10% 14% 7.10% Debt -to -Value Ratio 50% 40% 60% 12) Based upon the three comparable firms, calculate that most appropriate unlevered cost of capital for Aardvark to use on this new product. D D r + r Answer: rU = 1 - D + E E D + E D Comparable Firm Anteater Enterprises Armadillo Industries Antelope Inc. Equity Cost Debt Cost Debt -to -Value rU of Capital of Capital Ratio 12.50% 6.50% 50% 9.50% 13% 6.10% 40% 10.30% 14% 7.10% 60% 9.90% average = 9.90% Diff: 2 Skill: Analytical 18.6 APV with Other Leverage Policies 1) 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. Answer: C Diff: 1 Skill: Conceptual Chapter 18 Capital Budgeting and Valuation with Leverage 527 2) 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 projectʹs 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. Answer: A Diff: 2 Skill: Conceptual 3) 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. Answer: C Diff: 2 Skill: Conceptual 528 Berk/DeMarzo · Corporate Finance Use the information for the question(s) below. Aardvark Industries is considering a project that will generate the following free cash flows: Year Free Cash Flows 0 ($200) 1 $100 2 $80 3 $60 You are also provided with the following market value balance sheet and information regarding Aardvarkʹs cost of capital: Assets Cash Other Assets 0 1000 Liabilities Debt Equity Cost of Capital Debt Equity τc 400 600 4) Aardvarkʹs unlevered cost of equity is closest to: A) 10.0% B) 10.4% C) 9.5% D) 9.0% Answer: A Explanation: A) rU = 1 - D D r + r D + E E D + E D 400 400 rU = 1 - + .07 = 10.0% 400 + 600 .12 400 + 600 Diff: 1 Skill: Analytical 5) The unlevered value of Aardvarkʹs new project is closest to: A) $205 B) $100 C) $164 D) $202 Answer: D Explanation: B) rU = 1 - D D rE + r D + E D + E D 400 400 rU = 1 - .12 + .07 = 10.0% 400 + 600 400 + 600 V U = Diff: 2 Skill: Analytical 100 (1.10) 1 + 80 (1.10) 2 + 60 (1.10) 3 = $202.10 7% 12% 35% Chapter 18 Capital Budgeting and Valuation with Leverage 529 6) 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 Aardvarkʹs interest tax shield is closest to: A) $5.15 B) $5.00 C) $5.90 D) $5.25 Answer: D Explanation: D) PV (interest tax shield) = PV (interest tax shield) = D1 rDτc D2 rDτc D0 rDτc + + (1 + rD)1 (1 + rD)2 (1 + rD)3 120(.07)(.35) 80(.07)(.35) 40(.07)(.35) + + = $5.2596 (1.07) 1 (1.07) 2 (1.07) 3 Diff: 3 Skill: Analytical 7) 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 Aardvarkʹs new project is closest to: A) $210.15 B) $207.35 C) $207.00 D) $210.50 Answer: B Explanation: B) rU = 1 - D D r + r D + E E D + E D 400 400 rU = 1 - .12 + 400 + 600 .07 = 10.0% 400 + 600 V U = 100 (1.10) 1 + 80 (1.10) 2 + 60 (1.10) 3 = $202.10 PV (interest tax shield) = D1 rDτc D2 rDτc D0 rDτc + + (1 + rD)1 (1 + rD)2 (1 + rD)3 PV (interest tax shield) = 120(.07)(.35) 80(.07)(.35) 40(.07)(.35) + + = $5.2596 (1.07) 1 (1.07) 2 (1.07) 3 V L = V U + PV (interest tax shield) = $202.10 + $5.26 = $207.36 Diff: 3 Skill: Analytical 530 Berk/DeMarzo · Corporate Finance 8) 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 Aardvarkʹs interest tax shield. Answer: PV (interest tax shield) = PV (interest tax shield) = D1 rDτc D2 rDτc D0 rDτc + + 1 (1 + rD)2 (1 + rD)3 (1 + rD) 150(.07)(.35) 100(.07)(.35) 50(.07)(.35) + + = $6.286 (1.07) 1 (1.07) 2 (1.07) 3 Diff: 2 Skill: Analytical 9) 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 Aardvarkʹs new project. D D r + r Answer: rU = 1 - D + E E D + E D 400 400 rU = 1 - + .07 = 10.0% 400 + 600 .12 400 + 600 V U = 100 (1.010)1 + 80 (1.010)2 + 60 (1.010)3 = $202.10 PV (interest tax shield) = D1 rDτc D2 rDτc D0 rDτc + + (1 + rD)1 (1 + rD)2 (1 + rD)3 PV (interest tax shield) = 150(.07)(.35) 100(.07)(.35) 50(.07)(.35) + + = $6.286 (1.07) 1 (1.07) 2 (1.07) 3 V L = V U + PV (interest tax shield) = $202.10 + $6.29 = $208.39 Diff: 3 Skill: Analytical 18.7 Other Effects of Financing 1) 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 projectʹs 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. Answer: B Diff: 1 Skill: Conceptual Chapter 18 Capital Budgeting and Valuation with Leverage 531 2) 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 inthe 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. Answer: A Diff: 2 Skill: Conceptual 3) Luther Industries is considering borrowing $500 million to fund a new product line. Given investorsʹ uncertainty regarding its prospects, Luther will pay a 7% interest rate on this loan. The firmʹs 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 Lutherʹs 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 Answer: D Explanation: D) Luther Industries is paying (7% - 5% = 2%) more for the loan than the risk demands. However, part of this 2% premium in the interest rate is being offset by the interest tax shield. Therefore the true cost in any year is the amount of debt × (2%) × (1 - τc). Cost per year = $500M(.02)(.65) = $6.5M, we need to discount this amount each year by the correct rD of 5%, this is amount is constant and occurs each year for four years we have an annuity, solving: PMT = 6.5 I = 5% FV = 0 N = 4 Compute PV = $23.04 million Diff: 2 Skill: Analytical 532 Berk/DeMarzo · Corporate Finance 18.8 Advanced Topics in Capital Budgeting 1) Consider the following equation for the Project WACC with a fixed debt schedule: rwacc = rU - dτ c[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. Answer: C Diff: 1 Skill: Analytical 2) Consider the following equation for the Project WACC with a fixed debt schedule: rwacc = rU - dτ c[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. Answer: B Diff: 2 Skill: Analytical ...
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This note was uploaded on 02/02/2012 for the course BUS 438 taught by Professor Dutt during the Winter '12 term at Cal Poly.

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