Chapter 18

Chapter 18 - Chapter 18 Capital Budgeting and Valuation...

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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 firms debt-equity ratio is constant. Answer: A Explanation: A) D) Diff: 1 Topic: 18.1 Overview Skill: Conceptual 18.2 The Weight 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 firm's 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 firm's before-tax cost of capital for debt. C) When the market risk of the project is similar to the average market risk of the firm's investments, then its cost of capital is equivalent to the cost of capital for a portfolio of all of the firm's securities; that is, the project's cost of capital is equal to the firms weighted average cost of capital (WACC). D) A project's cost of capital depends on its risk. Answer: B Explanation: A) D) Diff: 1 Topic: 18.2 The Weighted Average Cost of Capital Method Skill: Conceptual 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 firms debt-equity ratio. B) A disadvantage of the WACC method is that you need to know how the firm's leverage policy is implemented to make the capital budgeting decision. C) The intuition for the WACC method is that the firm's 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 firm's weighted average cost of capital. Answer: B Explanation: A) D) Diff: 1 Topic: 18.2 The Weighted Average Cost of Capital Method 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 firm's current debt/equity ratio. Answer: D Explanation: A) D)...
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Chapter 18 - Chapter 18 Capital Budgeting and Valuation...

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