Deck 18: Capital Budgeting and Valuation With Leverage

Question 1

Use the information for the question(s)below.
Omicron Industries' Market Value Balance Sheet ($ Millions)
and Cost of Capital
Omicron Industries New Project Free Cash Flows
Assume that this new project is of average risk for Omicron and that the firm wants to hold constant its debt to equity ratio.
The Debt Capacity for Omicron's new project in year 1 is closest to:

A)$38.75
B)$48.25
C)$50.25
D)$58.00

Answer 1

$38.75

Question 2

Which of the following methods are used in capital budgeting decisions?

A)WACC method
B)APV method
C)FTE method
D)All of the above are used in capital budgeting decisions.

Answer 2

All of the above are used in capital budgeting decisions.

Question 3

Consider the following equation: D^{t = d ×}

the term D^t in this equation is:

A)the firms target debt to value ratio.
B)the firms target debt to equity ratio.
C)the investment's debt capacity.
D)the dollar amount of debt outstanding at time t.

Answer 3

the investment's debt capacity.

Question 4

Use the table for the question(s)below.
Consider the information for the following four firms:

The weighted average cost of capital for "Eenie" is closest to:

A)6.0%
B)6.5%
C)7.5%
D)5.5%

Question 5

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

A)$23.75
B)$27.50
C)$28.75
D)$25.75

Question 6

Consider the following equation: r_wacc = r_E + r_D(1 - τ_c)
The term r_E 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.

Question 7

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.

Question 8

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:

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

Question 9

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 firm's weighted average cost of capital (WACC).
D)A project's cost of capital depends on its risk.

Question 10

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

A)7.10%
B)7.50%
C)9.60%
D)8.75%

Question 11

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.

Question 12

Consider the following equation: r_wacc = r_E + r_D(1 - τ_c)
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.

Question 13

Use the information for the question(s)below.
Omicron Industries' Market Value Balance Sheet ($ Millions)
and Cost of Capital
Omicron Industries New Project Free Cash Flows
Assume that this new project is of average risk for Omicron and that the firm wants to hold constant its debt to equity ratio.
The Debt Capacity for Omicron's new project in year 0 is closest to:

A)$38.75
B)$75.50
C)$50.25
D)$10.25

Question 14

Use the information for the question(s)below.
Omicron Industries' Market Value Balance Sheet ($ Millions)
and Cost of Capital
Omicron Industries New Project Free Cash Flows
Assume that this new project is of average risk for Omicron and that the firm wants to hold constant its debt to equity ratio.
The Debt Capacity for Omicron's new project in year 2 is closest to:

A)$55.25
B)$38.75
C)$22.00
D)$33.00

Question 15

Use the table for the question(s)below.
Consider the information for the following four firms:

The weighted average cost of capital for "Meenie" is closest to:

A)10.5%
B)7.4%
C)10.0%
D)8.8%

Question 16

Consider the following equation: r_wacc = r_E + r_D(1 - τ_c)
The term r_D(1 - τ_c)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.

Question 17

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 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.

Question 18

Consider the following equation: r_wacc = r_E + r_D(1 - τ_c)
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.

Question 19

Consider the following equation: D^{t = d ×}

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 investment's debt capacity.

Question 20

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:

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

Question 21

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

A)8.75%
B)7.10%
C)9.60%
D)7.50%

Question 22

Use the table for the question(s)below.
Consider the information for the following four firms:

The unlevered cost of capital for "Eenie" is closest to:

A)6.0%
B)5.5%
C)7.5%
D)6.5%

Question 23

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 there after. Rose currently maintains a debt to equity ratio of 1, its marginal tax rate is 40%, its cost of debt r_D is 6%, and its cost of equity r_E is 10%. Rose Industries will maintain a constant debt-equity ratio for the acquisition.
The unlevered value of Rose's acquisition is closest to:

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

Question 24

Use the information for the question(s)below.
Omicron Industries' Market Value Balance Sheet ($ Millions)
and Cost of Capital
Omicron Industries New Project Free Cash Flows
Assume that this new project is of average risk for Omicron and that the firm wants to hold constant its debt to equity ratio.
Which of the following statements is FALSE?

A)To determine the project's 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.

Question 25

Use the information for the question(s)below.
Omicron Industries' Market Value Balance Sheet ($ Millions)
and Cost of Capital
Omicron Industries New Project Free Cash Flows
Assume that this new project is of average risk for Omicron and that the firm wants to hold constant its debt to equity ratio.
Calculate the debt capacity of Omicron's new project for years 0, 1, and 2.

Question 26

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.
The Debt Capacity for Iota's new project in year 0 is closest to:

A)$263.25
B)87.75
C)$50.25
D)$118.00

Question 27

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

Question 28

Use the information for the question(s)below.
Omicron Industries' Market Value Balance Sheet ($ Millions)
and Cost of Capital
Omicron Industries New Project Free Cash Flows
Assume that this new project is of average risk for Omicron and that the firm wants to hold constant its debt to equity ratio.
The interest tax shield provided by Omicron's new project in year 1 is closest to:

A)$3.00
B)$1.05
C)$50.25
D)$17.60

Question 29

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

Question 30

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

A)$96
B)$124
C)$126
D)$25

Question 31

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:

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

Question 32

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 there after. Rose currently maintains a debt to equity ratio of 1, its marginal tax rate is 40%, its cost of debt r_D is 6%, and its cost of equity r_E is 10%. Rose Industries will maintain a constant debt-equity ratio for the acquisition.
Rose's unlevered cost of capital is closest to:

A)8.0%
B)7.5%
C)7.0%
D)9.0%

Question 33

Use the table for the question(s)below.
Consider the information for the following four firms:

The unlevered cost of capital for "Moe" is closest to:

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

Question 34

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

Question 35

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.

Question 36

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.
The NPV for Iota's new project is closest to:

A)$25.25
B)$13.25
C)$9.00
D)$18.50

Question 37

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.
The unlevered value of Luther's Product Line is closest to:

A)$25 million
B)$60 million
C)$45 million
D)$40 million

Question 38

Use the information for the question(s)below.
Omicron Industries' Market Value Balance Sheet ($ Millions)
and Cost of Capital
Omicron Industries New Project Free Cash Flows
Assume that this new project is of average risk for Omicron and that the firm wants to hold constant its debt to equity ratio.
Which of the following statements is FALSE?

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, r_d, rather than its after-tax cost, r_d (1 - τ_c ).
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 39

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 there after. Rose currently maintains a debt to equity ratio of 1, its marginal tax rate is 40%, its cost of debt r_D is 6%, and its cost of equity r_E 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 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

Question 40

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:

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

Question 41

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 there after. Rose currently maintains a debt to equity ratio of 1, its marginal tax rate is 40%, its cost of debt r_D is 6%, and its cost of equity r_E is 10%. Rose Industries will maintain a constant debt-equity ratio for the acquisition.
Which of the following is NOT a step in valuation using the flow to equity method?

A)Determine the equity cost of capital, r_E.
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, r_U.

Question 42

Nielson's share price is closest to:

A)$20.80
B)$24.40
C)$27.50
D)$31.20

Question 43

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 there after. Rose currently maintains a debt to equity ratio of 1, its marginal tax rate is 40%, its cost of debt r_D is 6%, and its cost of equity r_E 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 equal to?

Question 44

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 there after. Rose currently maintains a debt to equity ratio of 1, its marginal tax rate is 40%, its cost of debt r_D is 6%, and its cost of equity r_E is 10%. Rose Industries will maintain a constant debt-equity ratio for the acquisition.
Which of the following statements is FALSE?

A)The project's 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 firm's FCF by their before-tax cost.

Question 45

Use the information for the question(s)below.
Omicron Industries' Market Value Balance Sheet ($ Millions)
and Cost of Capital
Omicron Industries New Project Free Cash Flows
Assume that this new project is of average risk for Omicron and that the firm wants to hold constant its debt to equity ratio.
Calculate the present value of the interest tax shield provided by Omicron's new project.

Question 46

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 there after. Rose currently maintains a debt to equity ratio of 1, its marginal tax rate is 40%, its cost of debt r_D is 6%, and its cost of equity r_E is 10%. Rose Industries will maintain a constant debt-equity ratio for the acquisition.
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

Question 47

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 there after. Rose currently maintains a debt to equity ratio of 1, its marginal tax rate is 40%, its cost of debt r_D is 6%, and its cost of equity r_E is 10%. Rose Industries will maintain a constant debt-equity ratio for the acquisition.
Describe the key steps in the flow to equity method for valuing a levered investment.

Question 48

Consider the following equation: r_wacc = r_U - τ_cdr_D
The term r_U in this equation is:

A)the firm's unlevered cost of debt.
B)the firm's cost of debt.
C)the project's unlevered cost of capital.
D)the project's debt to value ratio.

Question 49

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 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 50

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 r_U for a new project by looking at single-division firms that have similar business risks.
C)The project's equity cost of capital depends on its unlevered cost of capital, r_U, 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.

Question 51

Use the following information to answer the question(s)below.
Nielson Motors (NM)is a newly public firm with 25 million shares outstanding. You are doing a valuation analysis of Nielson and you estimate its free cash flow in the coming year to be $40 million. You expect the firm's free cash flows to grow by 4% per year in subsequent years. Because the firm has only been listed on the stock exchange for a short time, you do not have an accurate assessment of Nielson's equity beta. However, you do have the following data for another firm in the same industry:
Nielson has a much lower debt-equity ratio of .5, which is expected to remain stable, and Nielson's debt is risk free. Nielson's corporate tax rate is 40%, the risk-free rate is 5%, and the expected return on the market portfolio is 10%.
Nielson's estimated equity beta is closest to:

A)0.95
B)1.00
C)1.25
D)1.45

Question 52

Use the following information to answer the question(s)below.
Nielson Motors (NM)is a newly public firm with 25 million shares outstanding. You are doing a valuation analysis of Nielson and you estimate its free cash flow in the coming year to be $40 million. You expect the firm's free cash flows to grow by 4% per year in subsequent years. Because the firm has only been listed on the stock exchange for a short time, you do not have an accurate assessment of Nielson's equity beta. However, you do have the following data for another firm in the same industry:
Nielson has a much lower debt-equity ratio of .5, which is expected to remain stable, and Nielson's debt is risk free. Nielson's corporate tax rate is 40%, the risk-free rate is 5%, and the expected return on the market portfolio is 10%.
Nielson's equity cost of capital is closest to:

A)11.3%
B)12.2%
C)14.0%
D)14.4%

Question 53

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:

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

Question 54

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 there after. Rose currently maintains a debt to equity ratio of 1, its marginal tax rate is 40%, its cost of debt r_D is 6%, and its cost of equity r_E is 10%. Rose Industries will maintain a constant debt-equity ratio for the acquisition.
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 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 55

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 there after. Rose currently maintains a debt to equity ratio of 1, its marginal tax rate is 40%, its cost of debt r_D is 6%, and its cost of equity r_E is 10%. Rose Industries will maintain a constant debt-equity ratio for the acquisition.
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

Question 56

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 there after. Rose currently maintains a debt to equity ratio of 1, its marginal tax rate is 40%, its cost of debt r_D is 6%, and its cost of equity r_E is 10%. Rose Industries will maintain a constant debt-equity ratio for the acquisition.
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).

Question 57

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 Armadillo Industries is closest to:

A)10.3%
B)10.0%
C)9.5%
D)9.9%

Question 58

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 there after. Rose currently maintains a debt to equity ratio of 1, its marginal tax rate is 40%, its cost of debt r_D is 6%, and its cost of equity r_E 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:

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

Question 59

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 Anteater Enterprises is closest to:

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

Question 60

Consider the following equation: r_wacc = r_U - τ_cdr_D
The term d in this equation is:

A)the project's unlevered cost of capital.
B)the project's dollar amount of debt.
C)the firm's unlevered cost of debt.
D)the project's debt to value ratio.

Question 61

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:

The unlevered value of Aardvark's new project is closest to:

A)$205
B)$100
C)$164
D)$202

Question 62

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:

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 Aardvark's interest tax shield is closest to:

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

Question 63

Use the following information to answer the question(s)below.
Taggart Transcontinental is considering a $250 million investment to launch a new rail line. The project is expected to generate a free cash flow of $32 million per year, and its unlevered cost of capital is 8%. Taggart's marginal corporate tax rate is 35%.
Assume that to fund the investment Taggart will take on $150 million in permanent debt with the remainder of the investment funded by a cut in dividends. Assuming Taggart will incur a 2% (after-tax)underwriting fee on the new debt issue, the NPV of Taggart's new rail line is closest to:

A)$195 million
B)$200 million
C)$235 million
D)$240 million

Question 64

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:

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 Aardvark's new project is closest to:

A)$210.15
B)$207.35
C)$207.00
D)$210.50

Question 65

Use the following information to answer the question(s)below.
Rearden Metal is evaluating a project that requires an investment of $150 million today and provides a single cash flow of $180 million for sure one year from now. Rearden decides to use 100% debt financing for this investment. The risk-free rate is 5% and Rearden's corporate tax rate is 40%. Assume that the investment is fully depreciated at the end of the year.
The NPV of this project using the WACC method is closest to:

A)$10 million
B)$13 million
C)$42 million
D)$71 million

Question 66

Use the following information to answer the question(s)below.
Taggart Transcontinental is considering a $250 million investment to launch a new rail line. The project is expected to generate a free cash flow of $32 million per year, and its unlevered cost of capital is 8%. Taggart's marginal corporate tax rate is 35%.
Assuming that to fund the investment Taggart will take on $250 million in permanent debt and ignoring issuance costs, the NPV of Taggart's new rail line is closest to:

A)$195 million
B)$200 million
C)$235 million
D)$240 million

Question 67

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:

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 Aardvark's new project.

Question 68

Use the following information to answer the question(s)below.
Taggart Transcontinental is considering a $250 million investment to launch a new rail line. The project is expected to generate a free cash flow of $32 million per year, and its unlevered cost of capital is 8%. Taggart's marginal corporate tax rate is 35%.
Assuming that to fund the investment Taggart will take on $250 million in permanent debt and assuming Taggart will incur a 2% (after-tax)underwriting fee on the new debt issue, the NPV of Taggart's new rail line is closest to:

A)$195 million
B)$200 million
C)$235 million
D)$240 million

Question 69

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. KT's 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.
If KT expects to maintain a debt to equity ratio for this project of .6 then KT's project based WACC, r_wacc, for this project is closest to:

A)10.5%
B)11.1%
C)9.6%
D)10.8%

Question 70

Use the following information to answer the question(s)below.
Rearden Metal is evaluating a project that requires an investment of $150 million today and provides a single cash flow of $180 million for sure one year from now. Rearden decides to use 100% debt financing for this investment. The risk-free rate is 5% and Rearden's corporate tax rate is 40%. Assume that the investment is fully depreciated at the end of the year.
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.

Question 71

Use the following information to answer the question(s)below.
Rearden Metal is evaluating a project that requires an investment of $150 million today and provides a single cash flow of $180 million for sure one year from now. Rearden decides to use 100% debt financing for this investment. The risk-free rate is 5% and Rearden's corporate tax rate is 40%. Assume that the investment is fully depreciated at the end of the year.
The WACC for this project is closest to:

A)3.0%
B)5.0%
C)7.0%
D)8.2%

Question 72

Use the following information to answer the question(s)below.
Rearden Metal is evaluating a project that requires an investment of $150 million today and provides a single cash flow of $180 million for sure one year from now. Rearden decides to use 100% debt financing for this investment. The risk-free rate is 5% and Rearden's corporate tax rate is 40%. Assume that the investment is fully depreciated at the end of the year.
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.

Question 73

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. KT's 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.
If KT expects to maintain a debt to equity ratio for this project of 1 then KT's project based WACC, r_wacc, for this project is closest to:

A)11.1%
B)10.8%
C)9.6%
D)10.5%

Question 74

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:

Based upon the three comparable firms, calculate that most appropriate unlevered cost of capital for Aardvark to use on this new product.

Question 75

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:

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 Aardvark's interest tax shield.

Question 76

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:

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

Question 77

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. KT's 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.
If KT expects to maintain a debt to equity ratio for this project of 1, then KT's equity cost of capital, r_E, for this project is closest to:

A)17.0%
B)5.0%
C)15.0%
D)12%

Question 78

Use the following information to answer the question(s)below.
Rearden Metal is evaluating a project that requires an investment of $150 million today and provides a single cash flow of $180 million for sure one year from now. Rearden decides to use 100% debt financing for this investment. The risk-free rate is 5% and Rearden's corporate tax rate is 40%. Assume that the investment is fully depreciated at the end of the year.
The NPV of this project using the APV method is closest to:

A)$10 million
B)$13 million
C)$42 million
D)$71 million

Question 79

Use the following information to answer the question(s)below.
Rearden Metal is evaluating a project that requires an investment of $150 million today and provides a single cash flow of $180 million for sure one year from now. Rearden decides to use 100% debt financing for this investment. The risk-free rate is 5% and Rearden's corporate tax rate is 40%. Assume that the investment is fully depreciated at the end of the year.
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, r_D.
C)With a constant interest coverage policy, the value of the interest tax shield is proportional to the project's 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.

Question 80

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. KT's 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.
If KT expects to maintain a debt to equity ratio for this project of .6 then KT's equity cost of capital, r_E, for this project is closest to:

A)5.0%
B)12%
C)15.0%
D)17.0%