Deck 14: Capital Structure in a Perfect Market

Question 1

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:

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

Answer 1

$10,000

Question 2

Use the following information to answer the question(s)below.
Nielson Motors (NM)has no debt. Its assets will be worth $600 million in one year if the economy is strong, but only $300 million if the economy is weak. Both events are equally likely. The market value today of Nielson's assets is $400 million.
Equity in a firm with debt is called:

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

Answer 2

levered equity.

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 $40,000 at the risk free rate and issues new equity to cover the remainder. In this situation, the cash flow that equity holders will receive in one year in a weak economy is closest to:

A)$90,000
B)$0
C)$50,000
D)$48,000

Answer 3

$48,000

Question 4

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 $40,000 at the risk free rate and issues new equity to cover the remainder. In this situation, the value of the firm's levered equity from the project is closest to:

A)$0
B)$50,000
C)$90,000
D)$40,000

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 to raise the funds for the initial investment the firm borrows $80,000 at the risk free rate, then the cash flow that equity holders will receive in one year in a strong economy is closest to:

A)$0
B)$6,000
C)$33,000
D)$10,000

Question 6

Use the following information to answer the question(s)below.
Nielson Motors (NM)has no debt. Its assets will be worth $600 million in one year if the economy is strong, but only $300 million if the economy is weak. Both events are equally likely. The market value today of Nielson's assets is $400 million.
Which of the following statements is FALSE?

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 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 to raise the funds for the initial investment, the project is sold to investors as an all-equity firm. The equity holders will receive the cash flows of the project in one year. The market value of the unlevered equity for this project is closest to:

A)$94,100
B)$90,000
C)$86,250
D)$98,600

Question 8

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 $40,000 at the risk free rate and issues new equity to cover the remainder. In this situation, the cost of capital for the firm's levered equity is closest to:

A)23%
B)25%
C)15%
D)18%

Question 9

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 cash flow that equity holders will receive in one year in a weak economy is closest to:

A)$6,000
B)$10,000
C)$0
D)$33,000

Question 10

Use the following information to answer the question(s)below.
Nielson Motors (NM)has no debt. Its assets will be worth $600 million in one year if the economy is strong, but only $300 million if the economy is weak. Both events are equally likely. The market value today of Nielson's assets is $400 million.
Suppose the risk-free interest rate is 4%. If Nielson borrows $150 million today at this rate and uses the proceeds to pay an immediate cash dividend, then according to MM, the expected return of Nielson's stock just after the dividend is paid would be closest to:

A)-17.5%
B)-12.5%
C)12.5%
D)17.5%

Question 11

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 cost of capital for the firm's levered equity is closest to:

A)45%
B)25%
C)15%
D)95%

Question 12

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%.
The NPV for this project is closest to:

A)$6,250
B)$14,100
C)$10,000
D)$18,600

Question 13

Use the following information to answer the question(s)below.
Nielson Motors (NM)has no debt. Its assets will be worth $600 million in one year if the economy is strong, but only $300 million if the economy is weak. Both events are equally likely. The market value today of Nielson's assets is $400 million.
Suppose the risk-free interest rate is 4%. If Nielson borrows $150 million today at this rate and uses the proceeds to pay an immediate cash dividend, then according to MM, the market value of its equity just after the dividend is paid would be closest to:

A)$0 million
B)$150 million
C)$250 million
D)$400 million

Question 14

Use the following information to answer the question(s)below.
Nielson Motors (NM)has no debt. Its assets will be worth $600 million in one year if the economy is strong, but only $300 million if the economy is weak. Both events are equally likely. The market value today of Nielson's assets is $400 million.
The expected return for Nielson Motors stock without leverage is closest to:

A)-25.0%
B)-17.5%
C)-12.5%
D)12.5%

Question 15

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 $40,000 at the risk free rate and issues new equity to cover the remainder. In this situation, the cash flow that equity holders will receive in one year in a strong economy is closest to:

A)$117,000
B)$75,000
C)$50,000
D)$0

Question 16

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. Construct a table detailing the percentage returns to the equity holders of both the levered and unlevered firms for both the weak and strong economy.

Question 17

Use the following information to answer the question(s)below.
Nielson Motors (NM)has no debt. Its assets will be worth $600 million in one year if the economy is strong, but only $300 million if the economy is weak. Both events are equally likely. The market value today of Nielson's assets is $400 million.
Which of the following statements is FALSE?

A)Leverage decreases the risk of the equity of a firm.
B)Because the cash flows of the debt and equity sum to the cash flows of the project, by the Law of One Price the combined values of debt and equity must be equal to the cash flows of the project.
C)Franco Modigliani and Merton Miller argued that with perfect capital markets, the total value of a firm should not depend on its capital structure.
D)It is inappropriate to discount the cash flows of levered equity at the same discount rate that we use for unlevered equity.

Question 18

Use the following information to answer the question(s)below.
Nielson Motors (NM)has no debt. Its assets will be worth $600 million in one year if the economy is strong, but only $300 million if the economy is weak. Both events are equally likely. The market value today of Nielson's assets is $400 million.
Equity in a firm with no debt is called:

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

Question 19

Suppose that to raise the funds for the initial investment the firm borrows $45,000 at the risk free rate and issues new equity to cover the remainder. In this situation, calculate the value of the firm's levered equity from the project. What is the cost of capital for the firm's levered equity?

Question 20

Use the following information to answer the question(s)below.
Nielson Motors (NM)has no debt. Its assets will be worth $600 million in one year if the economy is strong, but only $300 million if the economy is weak. Both events are equally likely. The market value today of Nielson's assets is $400 million.
Which of the following statements is FALSE?

A)The relative proportions of debt, equity, and other securities that a firm has outstanding constitute its capital structure.
B)The most common choices are financing through equity alone and financing through a combination of debt and equity.
C)The project's NPV represents the value to the new investors of the firm created by the project.
D)When corporations raise funds from outside investors, they must choose which type of security to issue.

Question 21

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

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.

Question 22

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

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 23

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?

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

Question 24

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%.
According to MM Proposition 1, the stock price for With is closest to:

A)$8.00
B)$24.00
C)$6.00
D)$12.00

Question 25

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.
The number of shares that Galt must issue is closest to:

A)15 million
B)25 million
C)30 million
D)40 million

Question 26

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 600 shares, and you disagree with this decision to delever the firm. You can undo the effect of this decision by:

A)Borrow $6,000 and buy 240 shares of stock
B)Sell 240 shares of stock and lend $6,000
C)Borrow $9,000 and buy 360 shares of stock
D)Sell 360 shares of stock and lend $9,000

Question 27

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

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 28

Which of the following statements is FALSE?

A)As long as investors can borrow or lend at the same interest rate as the firm, homemade leverage is a perfect substitute for the use of leverage by the firm.
B)When investors use leverage in their own portfolios to adjust the leverage choice made by the firm, we say that they are using homemade leverage.
C)The value of the firm is determined by the present value of the cash flows from its current and future investments.
D)The investor can re-create the payoffs of unlevered equity by borrowing and using the proceeds to purchase the equity of the firm.

Question 29

Which of the following statements is FALSE?

A)Investors can alter the leverage choice of the firm to suit their personal tastes either by borrowing and reducing leverage or by holding bonds and adding more leverage.
B)On the market value balance sheet the total value of all securities issued by the firm must equal the total value of the firm's assets.
C)The market value balance sheet captures the idea that value is created by a firm's choice of assets and investments.
D)One application of MM Proposition I is the useful device known as the market value balance sheet of the firm.

Question 30

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.

Question 31

Use the following information to answer the question(s)below.
d'Anconia Copper is an all-equity firm with 60 million shares outstanding, which are currently trading at $20 per share. Last month, d'Anconia announced that it will change its capital structure by issuing $300 million in debt. The $200 million raised by this issue, plus another $200 million in cash that d'Anconia already has, will be used to repurchase existing shares of stock. Assume that capital markets are perfect.
At the conclusion of this transaction, the number of shares that d'Anconia Copper will repurchase is closest to:

A)5 million
B)15 million
C)20 million
D)40 million

Question 32

Use the following information to answer the question(s)below.
d'Anconia Copper is an all-equity firm with 60 million shares outstanding, which are currently trading at $20 per share. Last month, d'Anconia announced that it will change its capital structure by issuing $300 million in debt. The $200 million raised by this issue, plus another $200 million in cash that d'Anconia already has, will be used to repurchase existing shares of stock. Assume that capital markets are perfect.
The market capitalization of d'Anconia Copper after this transaction takes place is closest to:

A)$800 million
B)$900 million
C)$1,100 million
D)$1,200 million

Question 33

Which of the following statements is FALSE?

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 34

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 expected returns for both the levered and unlevered firm.

Question 35

Use the following information to answer the question(s)below.
d'Anconia Copper is an all-equity firm with 60 million shares outstanding, which are currently trading at $20 per share. Last month, d'Anconia announced that it will change its capital structure by issuing $300 million in debt. The $200 million raised by this issue, plus another $200 million in cash that d'Anconia already has, will be used to repurchase existing shares of stock. Assume that capital markets are perfect.
At the conclusion of this transaction, the value of a share of d'Anconia Copper will be closest to:

A)$18.33
B)$20.00
C)$25.00
D)$27.50

Question 36

Use the following information to answer the question(s)below.
d'Anconia Copper is an all-equity firm with 60 million shares outstanding, which are currently trading at $20 per share. Last month, d'Anconia announced that it will change its capital structure by issuing $300 million in debt. The $200 million raised by this issue, plus another $200 million in cash that d'Anconia already has, will be used to repurchase existing shares of stock. Assume that capital markets are perfect.
The market capitalization of d'Anconia Copper before this transaction takes place is closest to:

A)$800 million
B)$900 million
C)$1,100 million
D)$1,200 million

Question 37

Which of the following statements is FALSE?

A)As long as the firm's choice of securities does not change the cash flows generated by its assets, the capital structure decision will not change the total value of the firm or the amount of capital it can raise.
B)If securities are fairly priced, then buying or selling securities has an NPV of zero and, therefore, should not change the value of a firm.
C)The future repayments that the firm must make on its debt are equal in value to the amount of the loan it receives up front.
D)An investor who would like more leverage than the firm has chosen can lend and add leverage to his or her own portfolio.

Question 38

Which of the following statements is FALSE?

A)When a firm issues new shares that account for a significant percentage of its outstanding shares, the transaction is called a leveraged recapitalization.
B)MM Proposition I applies to capital structure decisions made at any time during the life of the firm.
C)By choosing positive-NPV projects that are worth more than their initial investment, the firm can enhance its value.
D)Holding fixed the cash flows generated by the firm's assets, however, the choice of capital structure does not change the value of the firm.

Question 39

Suppose you are a shareholder in d'Anconia Copper holding 500 shares, and you disagree with the decision to lever the firm. You can undo the effect of this decision by:

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 40

Use the following information to answer the question(s)below.
d'Anconia Copper is an all-equity firm with 60 million shares outstanding, which are currently trading at $20 per share. Last month, d'Anconia announced that it will change its capital structure by issuing $300 million in debt. The $200 million raised by this issue, plus another $200 million in cash that d'Anconia already has, will be used to repurchase existing shares of stock. Assume that capital markets are perfect.
At the conclusion of this transaction, the number of shares that d'Anconia Copper will have outstanding is closest to:

A)5 million
B)15 million
C)20 million
D)40 million

Question 41

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. After the repurchase how many shares will Luther have outstanding?

A)1.0 billion
B)1.2 billion
C)0.75 billion
D)1.1 billion

Question 42

Use the following information to answer the question(s)below.
Galt Industries has no debt, total equity capitalization of $600 million, and an equity beta of 1.2. Included in Galt's assets is $90 million in cash and risk-free securities. Assume the risk-free rate is 4% and the market risk premium is 6%.
Galt's asset beta (ie the beta of its operating assets)is closest to:

A)1.1
B)1.2
C)1.3
D)1.4

Question 43

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:

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

Question 44

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 you borrow enough 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. The number of shares of Without stock you purchased is closest to:

A)425
B)1650
C)2000
D)825

Question 45

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 that Taggart Transcontinental currently has no debt and has an equity cost of capital of 10%. Taggart is considering borrowing funds at a cost of 6% and using these funds to repurchase existing shares of stock. Assume perfect capital markets. If Taggart borrows until they achieved a debt -to-value ratio of 20%, then Taggart's levered cost of equity would be closest to:

A)8.0%
B)9.2%
C)10.0%
D)11.0%

Question 46

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 that Rearden Metal currently has no debt and has an equity cost of capital of 12%. Rearden is considering borrowing funds at a cost of 6% and using these funds to repurchase existing shares of stock. Assume perfect capital markets. If Taggart borrows until they achieved a debt -to-equity ratio of 50%, then Rearden's levered cost of equity would be closest to:

A)10.0%
B)12.0%
C)15.0%
D)16.0%

Question 47

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 With stock. Using homemade (un)leverage you invest enough at the risk-free rate so that the payoff of your account will be the same as a $5000 investment in Without stock? The number of shares of With stock you purchased is closest to:

A)100
B)425
C)1650
D)825

Question 48

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.
The market value of Luther's non-cash assets is closest to:

A)$20 billion
B)$19 billion
C)$25 billion
D)$24 billion

Question 49

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?

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

Question 50

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?

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

Question 51

Use the following information to answer the question(s)below.
Galt Industries has no debt, total equity capitalization of $600 million, and an equity beta of 1.2. Included in Galt's assets is $90 million in cash and risk-free securities. Assume the risk-free rate is 4% and the market risk premium is 6%.
Galt's WACC is closest to:

A)10.6%
B)11.2%
C)11.8%
D)12.5%

Question 52

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 With stock. Using homemade (un)leverage, how much do you need to invest at the risk-free rate so that the payoff of your account will be the same as a $5000 investment in Without stock?

A)$5000
B)$0
C)$2,500
D)$4,000

Question 53

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.
After the repurchase how many shares will Luther have outstanding?

A)0.75 billion
B)1.0 billion
C)1.1 billion
D)1.2 billion

Question 54

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?

Question 55

Use the following information to answer the question(s)below.
Galt Industries has no debt, total equity capitalization of $600 million, and an equity beta of 1.2. Included in Galt's assets is $90 million in cash and risk-free securities. Assume the risk-free rate is 4% and the market risk premium is 6%.
Consider the following equation: E + D = U = A
The E in this equation represents:

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

Question 56

Use the following information to answer the question(s)below.
Galt Industries has no debt, total equity capitalization of $600 million, and an equity beta of 1.2. Included in Galt's assets is $90 million in cash and risk-free securities. Assume the risk-free rate is 4% and the market risk premium is 6%.
Galt's enterprise value is closest to:

A)$90 million
B)$510 million
C)$600 million
D)$690 million

Question 57

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?

Question 58

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?

Question 59

Use the following information to answer the question(s)below.
Galt Industries has no debt, total equity capitalization of $600 million, and an equity beta of 1.2. Included in Galt's assets is $90 million in cash and risk-free securities. Assume the risk-free rate is 4% and the market risk premium is 6%.
Consider the following equation: E + D = U = A
The U in this equation represents:

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 60

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.
Fill in the table below showing the payments debt and equity holders of each firm will receive given each of the two possible levels of free cash flows:

Question 61

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 Lincoln is closest to:

A)0.95
B)1.00
C)1.05
D)0.90

Question 62

The following equation: X = r_E + r_D
Can be used to calculate all of the following EXCEPT:

A)the cost of capital for the firm's assets.
B)the levered cost of equity.
C)the unlevered cost of equity.
D)the weighted average cost of capital.

Question 63

Use the following information to answer the question(s)below.
Galt Industries has no debt, total equity capitalization of $600 million, and an equity beta of 1.2. Included in Galt's assets is $90 million in cash and risk-free securities. Assume the risk-free rate is 4% and the market risk premium is 6%.
Which of the following statements is FALSE?

A)Holding cash has the opposite effect of leverage on risk and return.
B)We use the market value of the firm's net debt when computing its WACC and unlevered beta to measure the cost of capital and market risk of the firm's business assets.
C)Since the WACC does not change with the use of leverage, the value of the firm's free cash flow evaluated using the WACC does not change, and so the enterprise value of the firm does not depend on its financing choices.
D)Even if the firm's capital structure is more complex, the WACC is calculated by computing the weighted average cost of only the firm's debt and equity.

Question 64

Use the following information to answer the question(s)below.
Galt Industries has no debt, total equity capitalization of $600 million, and an equity beta of 1.2. Included in Galt's assets is $90 million in cash and risk-free securities. Assume the risk-free rate is 4% and the market risk premium is 6%.
Which of the following statements is FALSE?

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 65

Use the following information to answer the question(s)below.
Galt Industries has no debt, total equity capitalization of $600 million, and an equity beta of 1.2. Included in Galt's assets is $90 million in cash and risk-free securities. Assume the risk-free rate is 4% and the market risk premium is 6%.
Which of the following statements is FALSE?

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 66

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:

Based upon the three comparable firms, what asset beta would you recommend using for your firm's new project?

Question 67

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:

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

Question 68

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

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 69

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:

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

Question 70

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?

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

Question 71

Use the following information to answer the question(s)below.
Galt Industries has no debt, total equity capitalization of $600 million, and an equity beta of 1.2. Included in Galt's assets is $90 million in cash and risk-free securities. Assume the risk-free rate is 4% and the market risk premium is 6%.
Consider the following equation: E + D = U = A
The A in this equation represents:

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

Question 72

Use the following information to answer the question(s)below.
Galt Industries has no debt, total equity capitalization of $600 million, and an equity beta of 1.2. Included in Galt's assets is $90 million in cash and risk-free securities. Assume the risk-free rate is 4% and the market risk premium is 6%.
Which of the following statements is FALSE?

A)While debt itself may be cheap, it increases the risk and therefore the cost of capital of the firm's equity.
B)Although debt does not have a lower cost of capital than equity, we can consider this cost in isolation.
C)We can use Modigliani and Miller's first proposition to derive an explicit relationship between leverage and the equity cost of capital.
D)The total market value of the firm's securities is equal to the market value of its assets, whether the firm is unlevered or levered.

Question 73

Use the following information to answer the question(s)below.
Galt Industries has no debt, total equity capitalization of $600 million, and an equity beta of 1.2. Included in Galt's assets is $90 million in cash and risk-free securities. Assume the risk-free rate is 4% and the market risk premium is 6%.
Which of the following statements is FALSE?

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 74

Use the following information to answer the question(s)below.
Galt Industries has no debt, total equity capitalization of $600 million, and an equity beta of 1.2. Included in Galt's assets is $90 million in cash and risk-free securities. Assume the risk-free rate is 4% and the market risk premium is 6%.
Which of the following statements is FALSE?

A)If we can identify a comparison firm whose assets have the same risk as the project being evaluated, and if the comparison firm is levered, then we can use its equity cost of capital as the cost of capital for the project.
B)We can calculate the cost of capital of the firm's assets by computing the weighted average of the firm's equity and debt cost of capital, which we refer to as the firm's weighted average cost of capital (WACC).
C)The portfolio of a firm's equity and debt replicates the returns we would earn if the firm were unlevered.
D)When evaluating any potential investment project, we must use a discount rate that is appropriate given the risk of the project's free cash flow.

Question 75

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

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 76

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

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

Question 77

Which of the following equations would NOT be appropriate to use in a firm with risky debt?

A)β_E = β_U + (β_U - β_D)
B)β_U = β_E+ (β_U - β_D)
C)β_E = β_U + β_U
D)β_U = β_E +
β_D

Question 78

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 Blinkin is closest to:

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

Question 79

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:

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

Question 80

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:

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