Question 1

Which of the following is NOT one of Modigliani and Miller's set of conditions referred to as perfect capital markets?

Accepted Answer

A)  All investors hold the efficient portfolio of assets. 
B)  There are no taxes, transaction costs, or issuance costs associated with security trading. 
C)  A firm's financing decisions do not change the cash flows generated by its investments, nor do they reveal new information about them. 
D)  Investors and firms can trade the same set of securities at competitive market prices equal to the present value of their future cash flows. 
A)  All investors hold the efficient portfolio of assets. 
B)  There are no taxes, transaction costs, or issuance costs associated with security trading. 
C)  A firm's financing decisions do not change the cash flows generated by its investments, nor do they reveal new information about them. 
D)  Investors and firms can trade the same set of securities at competitive market prices equal to the present value of their future cash flows. A

Question 2

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 D

Question 3

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 Without. 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 in With and Without are shown below:
   To achieve the same payout as Without you would need to invest $1000 in With Bond's paying 5% interest and purchase a 10% stake in With's equity paying $50 or $150 in dividends.
So your payoff when the firm's FCF is 1000 = 50 (interest) + 50 (dividends) = $100 (same as Without's dividends)
Payoff when firm's FCF is 2000 = 50 (interest) + 150 (dividends) = $200 (same as Without's dividends)

Question 4

Suppose you are a shareholder in d'Anconia Copper holding 300 shares, and you disagree with the decision to lever the firm. You can undo the effect of this decision by

Accepted Answer

A)  borrowing $2,000 and buying 100 shares of stock. 
B)  selling 100 shares of stock and lending $2,000. 
C)  borrowing $1,200 and buying 60 shares of stock. 
D)  selling 60 shares of stock and lending $1,200. 
A)  borrowing $2,000 and buying 100 shares of stock. 
B)  selling 100 shares of stock and lending $2,000. 
C)  borrowing $1,200 and buying 60 shares of stock. 
D)  selling 60 shares of stock and lending $1,200.

Question 5

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 you borrow $30,000 in financing the project. According to MM proposition II, the firm's equity cost of capital will be closest to:

Accepted Answer

A)  21% 
B)  15% 
C)  20% 
D)  25% 
A)  21% 
B)  15% 
C)  20% 
D)  25%

Question 6

Use the information for the question(s) below.
Assume that Rose Corporation's (RC) EBIT is not expected to grow in the future and that all earnings are paid out as dividends. RC is currently an all equity firm. It expects to generate earnings before interest and taxes (EBIT) of $6 million over the next year. Currently RC has 5 million shares outstanding and its stock is trading for a price of $12.00 per share. RC is considering borrowing $12 million at a rate of 6% and using the proceeds to repurchase shares at the current price of $12.00.
-Prior to any borrowing and share repurchase, the equity cost of capital for RC is closest to:

Accepted Answer

A)  11% 
B)  10% 
C)  12% 
D)  9% 
A)  11% 
B)  10% 
C)  12% 
D)  9%

Question 7

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 you borrow $60,000 in financing the project. According to MM proposition II, the firm's equity cost of capital will be closest to:

Accepted Answer

A)  45% 
B)  30% 
C)  25% 
D)  35% 
A)  45% 
B)  30% 
C)  25% 
D)  35%

Question 8

Which of the following statements is FALSE?

Accepted Answer

A)  The levered equity return equals the unlevered return, plus an extra "kick" due to leverage. 
B)  By holding a portfolio of the firm's equity and its debt, we can replicate the cash flows from holding its levered equity. 
C)  The cost of capital of levered equity is equal to the cost of capital of unlevered equity plus a premium that is proportional to the market value debt-equity ratio. 
D)  If a firm is unlevered, all of the free cash flows generated by its assets are available to be paid out to its equity holders. 
A)  The levered equity return equals the unlevered return, plus an extra "kick" due to leverage. 
B)  By holding a portfolio of the firm's equity and its debt, we can replicate the cash flows from holding its levered equity. 
C)  The cost of capital of levered equity is equal to the cost of capital of unlevered equity plus a premium that is proportional to the market value debt-equity ratio. 
D)  If a firm is unlevered, all of the free cash flows generated by its assets are available to be paid out to its equity holders.

Question 9

Which of the following statements is FALSE?

Accepted Answer

A)  The Law of One Price implies that leverage will affect the total value of the firm under perfect capital market conditions. 
B)  In the absence of taxes or other transaction costs, the total cash flow paid out to all of a firm's security holders is equal to the total cash flow generated by the firm's assets. 
C)  With perfect capital markets, leverage merely changes the allocation of cash flows between debt and equity, without altering the total cash flows of the firm. 
D)  In a perfect capital market, the total value of a firm is equal to the market value of the total cash flows generated by its assets and is not affected by its choice of capital structure. 
A)  The Law of One Price implies that leverage will affect the total value of the firm under perfect capital market conditions. 
B)  In the absence of taxes or other transaction costs, the total cash flow paid out to all of a firm's security holders is equal to the total cash flow generated by the firm's assets. 
C)  With perfect capital markets, leverage merely changes the allocation of cash flows between debt and equity, without altering the total cash flows of the firm. 
D)  In a perfect capital market, the total value of a firm is equal to the market value of the total cash flows generated by its assets and is not affected by its choice of capital structure.

Question 10

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 11

Two separate firms are considering investing in this project. Firm unlevered plans to fund the entire $80,000 investment using equity, while firm levered plans to borrow $45,000 at the risk-free rate and use equity to finance the remainder of the initial investment. Calculate the risk premiums for both the levered and unlevered firm.

Accepted Answer

@#IMG-DLM&_TB2720_00 PV(equity cash flows) = @#IMG-DLM&_TB27

Question 12

Which of the following statements is FALSE?

Accepted Answer

A)  With no debt, the WACC is equal to the unlevered equity cost of capital. 
B)  With perfect capital markets, a firm's WACC is dependent of its capital structure and is equal to its equity cost of capital only the firm it is unlevered. 
C)  As the firm borrows at the low cost of capital for debt, its equity cost of capital rises, but the net effect is that the firm's WACC is unchanged. 
D)  Although debt has a lower cost of capital than equity, leverage does not lower a firm's WACC. 
A)  With no debt, the WACC is equal to the unlevered equity cost of capital. 
B)  With perfect capital markets, a firm's WACC is dependent of its capital structure and is equal to its equity cost of capital only the firm it is unlevered. 
C)  As the firm borrows at the low cost of capital for debt, its equity cost of capital rises, but the net effect is that the firm's WACC is unchanged. 
D)  Although debt has a lower cost of capital than equity, leverage does not lower a firm's WACC.

Question 13

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

Question 14

Equity in a firm with no debt is called:

Accepted Answer

A)  levered equity. 
B)  unlevered equity. 
C)  riskless equity. 
D)  risky equity. 
A)  levered equity. 
B)  unlevered equity. 
C)  riskless equity. 
D)  risky equity.

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.
Assume that Rose Corporation's (RC) EBIT is not expected to grow in the future and that all earnings are paid out as dividends. RC is currently an all equity firm. It expects to generate earnings before interest and taxes (EBIT) of $6 million over the next year. Currently RC has 5 million shares outstanding and its stock is trading for a price of $12.00 per share. RC is considering borrowing $12 million at a rate of 6% and using the proceeds to repurchase shares at the current price of $12.00.
-Following the borrowing of $12 and subsequent share repurchase, the number of shares that RC will have outstanding is closest to:

Accepted Answer

A)  4.0 million 
B)  6.0 million 
C)  4.9 million 
D)  4.5 million 
A)  4.0 million 
B)  6.0 million 
C)  4.9 million 
D)  4.5 million

Question 17

Use the following information to answer the question(s) below.
Galt Industries has 50 million shares outstanding and a market capitalization of $1.25 billion. It also has $750 million in debt outstanding. Galt Industries has decided to delever the firm by issuing new equity and completely repaying all the outstanding debt. Assume perfect capital markets.
-Suppose you are a shareholder in Galt industries holding 100 shares, and you disagree with this decision to delever the firm. You can undo the effect of this decision by

Accepted Answer

A)  borrowing $1500 and buying 60 shares of stock. 
B)  selling 32 shares of stock and lending $800. 
C)  borrowing $1000 and buying 40 shares of stock. 
D)  selling 40 shares of stock and lending $1000. 
A)  borrowing $1500 and buying 60 shares of stock. 
B)  selling 32 shares of stock and lending $800. 
C)  borrowing $1000 and buying 40 shares of stock. 
D)  selling 40 shares of stock and lending $1000.

Question 18

Which of the following statements is FALSE?

Accepted Answer

A)  Modigliani and Miller's conclusion verified the common view, which stated that even with perfect capital markets, leverage would affect a firm's value. 
B)  We can evaluate the relationship between risk and return more formally by computing the sensitivity of each security's return to the systematic risk of the economy. 
C)  Investors in levered equity require a higher expected return to compensate for its increased risk. 
D)  Leverage increases the risk of equity even when there is no risk that the firm will default. 
A)  Modigliani and Miller's conclusion verified the common view, which stated that even with perfect capital markets, leverage would affect a firm's value. 
B)  We can evaluate the relationship between risk and return more formally by computing the sensitivity of each security's return to the systematic risk of the economy. 
C)  Investors in levered equity require a higher expected return to compensate for its increased risk. 
D)  Leverage increases the risk of equity even when there is no risk that the firm will default.

Question 19

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.
-What is a market value balance sheet and how does it differ from a book value balance sheet?

Accepted Answer

One application of MM Proposition I is t

Question 20

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 you borrow only $45,000 in financing the project. According to MM proposition II, calculate the firm's equity cost of capital.

Accepted Answer

PV(equity cash flows - unlever

Which of the following is NOT one of Modigliani and Miller's set of conditions referred to as perfect capital markets?

Suppose you are a shareholder in d'Anconia Copper holding 300 shares, and you disagree with the decision to lever the firm. You can undo the effect of this decision by

Which of the following statements is FALSE?

Which of the following statements is FALSE?

Which of the following statements is FALSE?

Equity in a firm with no debt is called:

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

Which of the following statements is FALSE?

The Corporation

Introduction to Financial Statement Analysis

Financial Decision Making and the Law of One Price

The Time Value of Money

Interest Rates

Valuing Bonds

Investment Decision Rules

Fundamentals of Capital Budgeting

Valuing Stocks

Capital Markets and the Pricing of Risk

Optimal Portfolio Choice and the Capital Asset Pricing Model

Estimating the Cost of Capital

Investor Behavior 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

Raising Equity Capital

Debt Financing

Leasing

Working Capital Management

Short-Term Financial Planning

Mergers and Acquisitions

Corporate Governance

Risk Management

International Corporate Finance

Filters

Exam 14: Capital Structure in a Perfect Market

Which of the following is NOT one of Modigliani and Miller's set of conditions referred to as perfect capital markets?

Suppose you are a shareholder in d'Anconia Copper holding 300 shares, and you disagree with the decision to lever the firm. You can undo the effect of this decision by

Which of the following statements is FALSE?

Which of the following statements is FALSE?

Which of the following statements is FALSE?

Equity in a firm with no debt is called:

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

Which of the following statements is FALSE?

The Corporation

Introduction to Financial Statement Analysis

Financial Decision Making and the Law of One Price

The Time Value of Money

Interest Rates

Valuing Bonds

Investment Decision Rules

Fundamentals of Capital Budgeting

Valuing Stocks

Capital Markets and the Pricing of Risk

Optimal Portfolio Choice and the Capital Asset Pricing Model

Estimating the Cost of Capital

Investor Behavior 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

Raising Equity Capital

Debt Financing

Leasing

Working Capital Management

Short-Term Financial Planning

Mergers and Acquisitions

Corporate Governance

Risk Management

International Corporate Finance

Filters