Question 1

Show mathematically that the stock price of RC won't change following the debt issuance and share repurchase.

Accepted Answer

EPS = (EBIT)/ Shares outstanding = ($6M)/ 5M shares = $1.20 EPS (unlevered)
V =

$12.00 =

so r_U = .10
r_E = r_U +

(r_U - r_D)
r_E = .10 +

(.10 - .06)= .11 or 11%
EPS = (EBIT - Interest)/ Shares outstanding = ($6M - .06 × $12)/ 4M shares = $1.32 EPS
V =

= $12.00 which equals the original stock.

Question 2

In a perfect capital market,the total value of a firm is ________ the market value of the total cash flows generated by its assets and is not affected by its choice of capital structure.

Accepted Answer

A)  greater than 
B)  smaller than 
C)  equal to 
D)  not related to 
A)  greater than 
B)  smaller than 
C)  equal to 
D)  not related to C

Question 3

Use the information for the question(s) below.
Consider a project with free cash flows in one year of $90,000 in a weak economy or $117,000 in a strong economy, with each outcome being equally likely. The initial investment required for the project is $80,000, and the project's cost of capital is 15%. The risk-free interest rate is 5%.
-Suppose that to raise the funds for the initial investment the firm borrows $80,000 at the risk free rate,then the value of the firm's levered equity from the project is closest to:

Accepted Answer

A)  $0 
B)  $10,000 
C)  $6,000 
D)  $8,600 
A)  $0 
B)  $10,000 
C)  $6,000 
D)  $8,600 B

Question 4

Use the information for the question(s) below.
Luther is a successful logistical services firm that currently has $5 billion in cash. Luther has decided to use this cash to repurchase shares from its investors, and has already announced the stock repurchase plan. Currently Luther is an all equity firm with 1.25 billion shares outstanding. Luther's shares are currently trading at $20 per share.
-With perfect capital markets,what is the market value of Luther's equity after the share repurchase?

Accepted Answer

A)  $15 billion 
B)  $10 billion 
C)  $25 billion 
D)  $20 billion 
A)  $15 billion 
B)  $10 billion 
C)  $25 billion 
D)  $20 billion

Question 5

When investors use leverage in their own portfolios to adjust the leverage choice made by the firm,we say that they are using ________.

Accepted Answer

A)  homemade leverage 
B)  operating leverage 
C)  financial leverage 
D)  total leverage 
A)  homemade leverage 
B)  operating leverage 
C)  financial leverage 
D)  total leverage

Question 6

Which of the following statements is false?

Accepted Answer

A)  The unlevered beta measures the market risk of the firm's business activities, ignoring any additional risk due to leverage. 
B)  If a firm holds $1 in cash and has $1 of risk-free debt, then the interest earned on the cash will equal the interest paid on the debt. The cash flows from each source cancel each other, just as if the firm held no cash and no debt. 
C)  The unlevered beta measures the market risk of the firm without leverage, which is equivalent to the beta of the firm's assets. 
D)  When a firm changes its capital structure without changing its investments, its levered beta will remain unaltered, however, its asset beta will change to reflect the effect of the capital structure change on its risk. 
A)  The unlevered beta measures the market risk of the firm's business activities, ignoring any additional risk due to leverage. 
B)  If a firm holds $1 in cash and has $1 of risk-free debt, then the interest earned on the cash will equal the interest paid on the debt. The cash flows from each source cancel each other, just as if the firm held no cash and no debt. 
C)  The unlevered beta measures the market risk of the firm without leverage, which is equivalent to the beta of the firm's assets. 
D)  When a firm changes its capital structure without changing its investments, its levered beta will remain unaltered, however, its asset beta will change to reflect the effect of the capital structure change on its risk.

Question 7

Use the information for the question(s) below.
Consider two firms, With and Without, that have identical assets that generate identical cash flows. Without is an all-equity firm, with 1 million shares outstanding that trade for a price of $24 per share. With has 2 million shares outstanding and $12 million dollars in debt at an interest rate of 5%.
-Assume that MM's perfect capital markets conditions are met and that you can borrow and lend at the same 5% rate as With.You have $5000 of your own money to invest and you plan on buying Without stock.Using homemade leverage,how much do you need to borrow in your margin account so that the payoff of your margined purchase of Without stock will be the same as a $5000 investment in With stock?

Accepted Answer

A)  $10,000 
B)  $5000 
C)  $2,500 
D)  $0 
A)  $10,000 
B)  $5000 
C)  $2,500 
D)  $0

Question 8

Use the information for the question(s) below.
Consider two firms: firm Without has no debt, and firm With has debt of $10,000 on which it pays interest of 5% per year. Both companies have identical projects that generate free cash flows of $1000 or $2000 each year. Suppose that there are no taxes, and after paying any interest on debt, both companies use all remaining cash free cash flows to pay dividends each year.
-Suppose you own 10% of the equity of With.What is another portfolio you could hold that would provide you with the same exact cash flows?

Accepted Answer

The cash flows for a 10% ownership stake

Question 9

Which of the following statements is false?

Accepted Answer

A)  Since the publication of their original paper, Modigliani and Miller's ideas have greatly influenced finance research and practice. 
B)  Proposition I was one of the first arguments to show that the Law of One Price could have strong implications for security prices and firm values in a competitive market; it marks the beginning of the modern theory of corporate finance. 
C)  The conservation of value principle extends far beyond questions of debt versus equity or even capital structure. 
D)  The conservation of value principle for financial markets states that with perfect capital markets, financial transactions neither add nor destroy value, but instead represent a repackaging of risk (and therefore return). 
A)  Since the publication of their original paper, Modigliani and Miller's ideas have greatly influenced finance research and practice. 
B)  Proposition I was one of the first arguments to show that the Law of One Price could have strong implications for security prices and firm values in a competitive market; it marks the beginning of the modern theory of corporate finance. 
C)  The conservation of value principle extends far beyond questions of debt versus equity or even capital structure. 
D)  The conservation of value principle for financial markets states that with perfect capital markets, financial transactions neither add nor destroy value, but instead represent a repackaging of risk (and therefore return).

Question 10

Consider the following equation: βU =   βE +   βD
The term βU in the equation is?

Accepted Answer

A)  the same as the beta of the firm's assets. 
B)  the required return on the firm's equity. 
C)  the proportion of the firm financed with equity. 
D)  equal to zero if the firm's debt is riskless. 
A)  the same as the beta of the firm's assets. 
B)  the required return on the firm's equity. 
C)  the proportion of the firm financed with equity. 
D)  equal to zero if the firm's debt is riskless.

Question 11

Which of the following statements is false?

Accepted Answer

A)  The money taken in by the firm as a result of the share issue exactly offsets the dilution of the shares. 
B)  Most analysts prefer to use performance measures and valuation multiples that are based on the firm's earnings before interest has been deducted. 
C)  The fact that the firm's earnings per share and price-earnings ratio are affected by leverage implies that we can always reliably compare these measures across firms with different capital structures. 
D)  In general, as long as the firm sells the new shares of equity at a fair price, there will be no gain or loss to shareholders associated with the equity issue itself. 
A)  The money taken in by the firm as a result of the share issue exactly offsets the dilution of the shares. 
B)  Most analysts prefer to use performance measures and valuation multiples that are based on the firm's earnings before interest has been deducted. 
C)  The fact that the firm's earnings per share and price-earnings ratio are affected by leverage implies that we can always reliably compare these measures across firms with different capital structures. 
D)  In general, as long as the firm sells the new shares of equity at a fair price, there will be no gain or loss to shareholders associated with the equity issue itself.

Question 12

Use the information for the question(s) below.
Luther Industries has no debt, a total equity capitalization of $20 billion, and a beta of 1.8. Included in Luther's assets are $4 billion in cash and risk-free securities.
-What is Luther's enterprise value?

Accepted Answer

A)  $16 billion 
B)  $10.5 billion 
C)  $24 billion 
D)  $20 billion 
A)  $16 billion 
B)  $10.5 billion 
C)  $24 billion 
D)  $20 billion

Question 13

When corporations raise funds from outside investors,they must choose which type of security to issue.The most common choices are financing through

Accepted Answer

A)  equity alone. 
B)  debt alone. 
C)  a combination of debt and equity. 
D)  A and C 
A)  equity alone. 
B)  debt alone. 
C)  a combination of debt and equity. 
D)  A and C

Question 14

Use the information for the question(s) below.
You are evaluating a new project and need an estimate for your project's beta. You have identified the following information about three firms with comparable projects:  
-The unlevered beta for Nod is closest to:

Accepted Answer

A)  1.00 
B)  0.90 
C)  0.95 
D)  1.10 
A)  1.00 
B)  0.90 
C)  0.95 
D)  1.10

Question 15

Consider the following equation: E + D = U = A
The U in this equation represents

Accepted Answer

A)  the value of the firm's equity. 
B)  the market value of the firm's assets. 
C)  the value of the firm's unlevered equity. 
D)  the value of the firm's debt. 
A)  the value of the firm's equity. 
B)  the market value of the firm's assets. 
C)  the value of the firm's unlevered equity. 
D)  the value of the firm's debt.

Question 16

Use the information for the question(s) below.
Luther is a successful logistical services firm that currently has $5 billion in cash. Luther has decided to use this cash to repurchase shares from its investors, and has already announced the stock repurchase plan. Currently Luther is an all equity firm with 1.25 billion shares outstanding. Luther's shares are currently trading at $20 per share.
-Assume that in addition to 1.25 billion common shares outstanding,Luther has stock options given to employees valued at $2 billion.The market value of Luther's non-cash assets is closest to:

Accepted Answer

A)  $22 billion 
B)  $20 billion 
C)  $25 billion 
D)  $18 billion 
A)  $22 billion 
B)  $20 billion 
C)  $25 billion 
D)  $18 billion

Question 17

Consider the following equation: βU =   βE +   βD
The term βD in the equation is

Accepted Answer

A)  the same as the beta of the firm's assets. 
B)  the required return on the firm's equity. 
C)  the proportion of the firm financed with equity. 
D)  equal to zero if the firm's debt is riskless. 
A)  the same as the beta of the firm's assets. 
B)  the required return on the firm's equity. 
C)  the proportion of the firm financed with equity. 
D)  equal to zero if the firm's debt is riskless.

Question 18

Use the information for the question(s) below.
Rockwood Enterprises is currently an all equity firm and has just announced plans to expand their current business. In order to fund this expansion, Rockwood will need to raise $100 million in new capital. After the expansion, Rockwood is expected to produce earnings before interest and taxes of $50 million per year in perpetuity. Rockwood has already announced the planned expansion, but has not yet determined how best to fund the expansion. Rockwood currently has 16 million shares outstanding and following the expansion announcement these shares are trading at $25 per share. Rockwood has the ability to borrow at a rate of 5% or to issue new equity at $25 per share.
-If Rockwood finances their expansion by issuing $100 million in debt at 5%,what will Rockwood's cost of equity capital be?

Accepted Answer

A)  11.25% 
B)  10.70% 
C)  12.50% 
D)  12.00% 
A)  11.25% 
B)  10.70% 
C)  12.50% 
D)  12.00%

Question 19

Use the information for the question(s) below.
Luther is a successful logistical services firm that currently has $5 billion in cash. Luther has decided to use this cash to repurchase shares from its investors, and has already announced the stock repurchase plan. Currently Luther is an all equity firm with 1.25 billion shares outstanding. Luther's shares are currently trading at $20 per share.
-With perfect capital markets,what is the market price per share of Luther's stock after the share repurchase?

Accepted Answer

A)  $25 
B)  $24 
C)  $15 
D)  $20 
A)  $25 
B)  $24 
C)  $15 
D)  $20

Question 20

Use the information for the question(s) below.
Luther Industries has no debt, a total equity capitalization of $20 billion, and a beta of 1.8. Included in Luther's assets are $4 billion in cash and risk-free securities.
-Considering the fact that Luther's cash is risk-free,Luther's unlevered beta is closest to:

Accepted Answer

A)  1.90 
B)  2.25 
C)  1.50 
D)  1.45 
A)  1.90 
B)  2.25 
C)  1.50 
D)  1.45

Exam 14: Capital Structure in a Perfect Market

Show mathematically that the stock price of RC won't change following the debt issuance and share repurchase.

In a perfect capital market,the total value of a firm is ________ the market value of the total cash flows generated by its assets and is not affected by its choice of capital structure.

When investors use leverage in their own portfolios to adjust the leverage choice made by the firm,we say that they are using ________.

Which of the following statements is false?

Which of the following statements is false?

Consider the following equation: βU = βE + βD The term βU in the equation is?

Which of the following statements is false?

Use the information for the question(s) below. Luther Industries has no debt, a total equity capitalization of $20 billion, and a beta of 1.8. Included in Luther's assets are $4 billion in cash and risk-free securities. -What is Luther's enterprise value?

When corporations raise funds from outside investors,they must choose which type of security to issue.The most common choices are financing through

Use the information for the question(s) below. You are evaluating a new project and need an estimate for your project's beta. You have identified the following information about three firms with comparable projects: -The unlevered beta for Nod is closest to:

Consider the following equation: E + D = U = A The U in this equation represents

Consider the following equation: βU = βE + βD The term βD in the equation is

The Corporation

Introduction to Financial Statement Analysis

Arbitrage and Financial Decision Making

The Time Value of Money

Interest Rates

Investment Decision Rules

Fundamentals of Capital Budgeting

Valuing Bonds

Valuing Stocks

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

Debt and Taxes

Financial Distress, managerial Incentives, and Information

Payout Policy

Capital Budgeting and Valuation With Leverage

Valuation and Financial Modeling: a Case Study

Financial Options

Option Valuation

Real Options

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

Consider the following equation: β_U = β_E + β_D The term β_U in the equation is?

Consider the following equation: β_U = β_E + β_D The term β_D in the equation is