Question 1

Which of the following statements is false?

Accepted Answer

A)  The firm's unlevered cost of capital is equal to its pre-tax weighted average cost of capital - that is, using the pre-tax cost of debt, rd , rather than its after-tax cost, rd (1 - τc ). 
B)  A firm's 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 project's cash flows, so they should be discounted at the project's unlevered cost of capital. 
D)  The first step in the APV method is to calculate the value of free cash flows using the project's cost of capital if it were financed without leverage. 
A)  The firm's unlevered cost of capital is equal to its pre-tax weighted average cost of capital - that is, using the pre-tax cost of debt, rd , rather than its after-tax cost, rd (1 - τc ). 
B)  A firm's 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 project's cash flows, so they should be discounted at the project's unlevered cost of capital. 
D)  The first step in the APV method is to calculate the value of free cash flows using the project's cost of capital if it were financed without leverage.

Question 2

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 Rose's free cash flow by $5 million the first year, and this contribution is expected to grow at a rate of 3% every year thereafter. Rose currently maintains a debt-to-equity ratio of 1, its marginal tax rate is 40%, its cost of debt rS1U1B1DS1U1B0 is 6%, and its cost of equity rS1U1B1ES1U1B0 is 10%. Rose Industries will maintain a constant debt-equity ratio for the acquisition.
-The unlevered value of Rose's acquisition is closest to:

Accepted Answer

A)  $63 million 
B)  $50 million 
C)  $167 million 
D)  $100 million 
A)  $63 million 
B)  $50 million 
C)  $167 million 
D)  $100 million

Question 3

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.
-Luther's unlevered cost of capital is closest to:

Accepted Answer

A)  8.0% 
B)  8.5% 
C)  9.0% 
D)  6.4% 
A)  8.0% 
B)  8.5% 
C)  9.0% 
D)  6.4%

Question 4

Luther Industries is considering borrowing $500 million to fund a new product line.Given investors' uncertainty regarding its prospects,Luther will pay a 7% interest rate on this loan.The firm's 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 Luther's marginal corporate tax rate is 35%,then the net effect of the loan on the value of the new product line is closest to:

Accepted Answer

A)  $22 million 
B)  $34 million 
C)  $35 million 
D)  $24 million 
A)  $22 million 
B)  $34 million 
C)  $35 million 
D)  $24 million

Question 5

Use the information for the question(s) below.
Iota Industries' Market Value Balance Sheet ($ millions) and Cost of Capital
   Iota Industries' New Project Free Cash Flows
   Assume that this new project is of average risk for Iota and that the firm wants to hold constant its debt-to-equity ratio.
-Iota's weighted average cost of capital is closest to:

Accepted Answer

A)  8.40% 
B)  9.75% 
C)  10.85% 
D)  11.70% 
A)  8.40% 
B)  9.75% 
C)  10.85% 
D)  11.70%

Question 6

In many Canadian firms,the corporate ________ is commonly responsible for calculating the firm's WACC.

Accepted Answer

A)  controller 
B)  treasurer 
C)  chief financial officer 
D)  chief executive officer 
A)  controller 
B)  treasurer 
C)  chief financial officer 
D)  chief executive officer

Question 7

Use the information for the question(s) below.
Iota Industries' Market Value Balance Sheet ($ millions) and Cost of Capital
   Iota Industries' New Project Free Cash Flows
   Assume that this new project is of average risk for Iota and that the firm wants to hold constant its debt-to-equity ratio.
-Calculate the NPV for Iota's new project.

Accepted Answer

r_wacc = @#IMG-DLM& r_E + @#IMG-DLM& r_D(1 - τ_c),where D = n

Question 8

In the flow-to-equity (FTE)valuation method,the cash flows to ________ are then discounted using the ________ cost of capital.

Accepted Answer

A)  debt holders; equity 
B)  equity holders; weighted average 
C)  equity holders; equity 
D)  debt holders; weighted average 
A)  debt holders; equity 
B)  equity holders; weighted average 
C)  equity holders; equity 
D)  debt holders; weighted average

Question 9

Which of the following statements is false?

Accepted Answer

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 don't need to compute the project's debt capacity to determine interest and net borrowing before we can make the capital budgeting decision. 
D)  The WACC and APV methods compute the firm's 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. 
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 don't need to compute the project's debt capacity to determine interest and net borrowing before we can make the capital budgeting decision. 
D)  The WACC and APV methods compute the firm's 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.

Question 10

Which of the following is NOT a step in the adjusted present value method?

Accepted Answer

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 
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

Question 11

Which of the following statements is false?

Accepted Answer

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 project's 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. 
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 project's 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.

Question 12

Use the table for the question(s) below.
Consider the information for the following four firms:
  
-The weighted average cost of capital for "Minie" is closest to:

Accepted Answer

A)  9.50% 
B)  8.75% 
C)  6.75% 
D)  8.25% 
A)  9.50% 
B)  8.75% 
C)  6.75% 
D)  8.25%

Question 13

Which of the following statements is false?

Accepted Answer

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 firm's 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. 
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 firm's 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.

Question 14

Use the information for the question(s) below.
Aardvark Industries is considering a project that will generate the following free cash flows:
   You are also provided with the following market value balance sheet and information regarding Aardvark's cost of capital:
  
-Aardvark's unlevered cost of equity is closest to:

Accepted Answer

A)  10.0% 
B)  10.4% 
C)  9.5% 
D)  9.0% 
A)  10.0% 
B)  10.4% 
C)  9.5% 
D)  9.0%

Question 15

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:
  
-The unlevered cost of capital for Antelope Incorporated is closest to:

Accepted Answer

A)  10.3% 
B)  9.9% 
C)  10.1% 
D)  9.5% 
A)  10.3% 
B)  9.9% 
C)  10.1% 
D)  9.5%

Question 16

Suppose that to fund this new project,Aardvark borrows $120 million with the principal to be paid in three equal installments at the end each year.The present value of Aardvark's interest tax shield is closest to:

Accepted Answer

A)  $5.15 
B)  $5.00 
C)  $5.90 
D)  $5.25 
A)  $5.15 
B)  $5.00 
C)  $5.90 
D)  $5.25

Question 17

Describe the key steps in the flow-to-equity method for valuing a levered investment.

Accepted Answer

The key steps in the flow-to-equity meth

Question 18

Use the table for the question(s) below.
Consider the information for the following four firms:
  
-The weighted average cost of capital for "Moe" is closest to:

Accepted Answer

A)  10.00% 
B)  7.75% 
C)  8.25% 
D)  8.50% 
A)  10.00% 
B)  7.75% 
C)  8.25% 
D)  8.50%

Question 19

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 Rose's free cash flow by $5 million the first year, and this contribution is expected to grow at a rate of 3% every year thereafter. Rose currently maintains a debt-to-equity ratio of 1, its marginal tax rate is 40%, its cost of debt rS1U1B1DS1U1B0 is 6%, and its cost of equity rS1U1B1ES1U1B0 is 10%. Rose Industries will maintain a constant debt-equity ratio for the acquisition.
-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:

Accepted Answer

A)  $100 million 
B)  $120 million 
C)  $124 million 
D)  $115 million 
A)  $100 million 
B)  $120 million 
C)  $124 million 
D)  $115 million

Question 20

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 ________ on an after-tax basis.

Accepted Answer

A)  creditors 
B)  shareholders 
C)  debtors 
D)  investors 
A)  creditors 
B)  shareholders 
C)  debtors 
D)  investors

Exam 21: Capital Budgeting and Valuation With Leverage

Which of the following statements is false?

In many Canadian firms,the corporate ________ is commonly responsible for calculating the firm's WACC.

In the flow-to-equity (FTE)valuation method,the cash flows to ________ are then discounted using the ________ cost of capital.

Which of the following statements is false?

Which of the following is NOT a step in the adjusted present value method?

Which of the following statements is false?

Use the table for the question(s) below. Consider the information for the following four firms: -The weighted average cost of capital for "Minie" is closest to:

Which of the following statements is false?

Suppose that to fund this new project,Aardvark borrows $120 million with the principal to be paid in three equal installments at the end each year.The present value of Aardvark's interest tax shield is closest to:

Describe the key steps in the flow-to-equity method for valuing a levered investment.

Use the table for the question(s) below. Consider the information for the following four firms: -The weighted average cost of capital for "Moe" is closest to:

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 ________ on an after-tax basis.

The Corporation

Introduction to Financial Statement Analysis

Arbitrage and Financial Decision Making

The Time Value of Money

Interest Rates

Valuing Bonds

Valuing Stocks

Investment Decision Rules

Fundamentals of Capital Budgeting

Capital Markets and the Pricing of Risk

Optimal Portfolio Choice and the Capital Asset Pricing Model

Estimating the Cost of Capital

Investor Behaviour and Capital Market Efficiency

Financial Options

Option Valuation

Real Options

Capital Structure in a Perfect Market

Debt and Taxes

Financial Distress, managerial Incentives, and Information

Payout Policy

Valuation and Financial Modelling: a Case Study

The Mechanics of Raising Equity Capital

Debt Financing

Leasing

Working Capital Management

Short-Term Financial Planning

Mergers and Acquisitions

Corporate Governance

Risk Management

International Corporate Finance

Filters

In the flow-to-equity (FTE)valuation method,the cash flows to are then discounted using the cost of capital.