Deck 21: Dynamic Capital Structures and Corporate Valuation

Question 1

Which of the following statements concerning the compressed adjusted present value (APV) model is NOT CORRECT?

A) The value of a growing tax shield is greater than the value of a constant tax shield.
B) For a given D/S, the levered cost of equity using the compressed APV model is greater than the levered cost of equity under MM's original (with tax) assumptions.
C) For a given D/S, the WACC in the compressed APV model is less than the WACC under MM's original (with tax) assumptions.
D) The total value of the firm increases with the amount of debt.
E) The tax shields should be discounted at the unlevered cost of equity.

Answer 1

C

Question 2

Which of the following statements concerning the compressed adjusted present value (APV) model is NOT CORRECT?

A) The value of a growing tax shield is greater than the value of a constant tax shield.
B) For a given D/S, the levered cost of equity in the compressed APV model is greater than the levered cost of equity under MM's original (with tax) assumptions.
C) For a given D/S, the WACC in the compressed APV model is greater than the WACC under MM's original (with tax) assumptions.
D) The total value of the firm is independent of the amount of debt it uses.
E) The tax shields should be discounted at the unlevered cost of equity.

Answer 2

D

Question 3

In the compressed adjusted present value model, the appropriate discount rate for the tax shield is the after-tax cost of debt.

Answer 3

False

Question 4

Glassmaker Corporation Data
Glassmaker Corporation has a currentcapital structure consisting of $100 million (market value) of 9% bonds and $300 million (market value) of common stock.Glassmaker's beta is 1.5.Glassmaker faces a 25% tax rate.Glassmaker plans on making big changes in operation and capital structure during the next several years.(Its tax rate will remain unchanged.) Under these plans, the free cash flows for Glassmaker are estimated to be $29 million for each of the next 4 years; the horizon value of the free cash flows (discounted at the rate assumed by the compressed adjusted present value (CAPV) approach) is $487 million at Year 4.Glass maker will increase its debt to $140 million in the recapitalization.This will cause the estimatedtax savings due to interest expenses areestimatedto be$3.2 million for each of the next 4 years; the horizon value of the tax shields (discounted at the rate assumed by the CAPV approach) is estimated to be $53 million at Year 4.Glassmaker has no nonoperating assets.Currently, the risk-free rate is 6.0% and the market risk premium is 4.0%.
​
Refer to data for Glassmaker Corporation.What is Glassmaker's current levered cost of equity based on its current capital structure?

A) 11.00%
B) 11.50%
C) 12.00%
D) 12.50%
E) 13.00%

Question 5

Glassmaker Corporation Data
Glassmaker Corporation has a currentcapital structure consisting of $100 million (market value) of 9% bonds and $300 million (market value) of common stock.Glassmaker's beta is 1.5.Glassmaker faces a 25% tax rate.Glassmaker plans on making big changes in operation and capital structure during the next several years.(Its tax rate will remain unchanged.) Under these plans, the free cash flows for Glassmaker are estimated to be $29 million for each of the next 4 years; the horizon value of the free cash flows (discounted at the rate assumed by the compressed adjusted present value (CAPV) approach) is $487 million at Year 4.Glass maker will increase its debt to $140 million in the recapitalization.This will cause the estimatedtax savings due to interest expenses areestimatedto be$3.2 million for each of the next 4 years; the horizon value of the tax shields (discounted at the rate assumed by the CAPV approach) is estimated to be $53 million at Year 4.Glassmaker has no nonoperating assets.Currently, the risk-free rate is 6.0% and the market risk premium is 4.0%.
​
Refer to data for Glassmaker Corporation.According to the compressed adjusted present value model, what discount rate should you use to discount Glassmaker's free cash flows and interest tax savings?

A) 10.00%
B) 11.00%
C) 11.25%
D) 12.03%
E) 13.11%

Question 6

Kitto Electronics Data
Kitto Electronics expects an EBIT of $200,000 for Year-1.EBIT is expected to grow at 6% thereafter.The tax rate is 25%.In order to support growth, Kitto must reinvest 20% of its EBIT in net operating assets.Kitto has $300,000 in 8% debt outstanding, and a similar company with no debt has a cost of equity of 11%.
Refer to data for Kitto Electronics.According to the compressed adjusted present value model, what is Kitto's unlevered value?

A) $1,782,000
B) $1,980,000
C) $2,200,000
D) $2,420,000
E) $2,662,000

Question 7

Which of the following statements about valuing a firm using the compressed adjusted present value (CAPV) approach is most CORRECT?

A) The horizon value is calculated by discounting the free cash flows beyond the horizon date and any tax savings at the cost of debt.
B) The horizon value is calculated by discounting the expected earnings at the WACC.
C) The horizon value is calculated by discounting the free cash flows beyond the horizon date and any tax savings at the WACC.
D) The horizon value must always be more than 20 years in the future.
E) The horizon value is calculated by discounting the free cash flows beyond the horizon date and any tax savings at the levered cost of equity.

Question 8

MM showed that in a world with taxes, a firm's optimal capital structure would be almost 100% debt.

Question 9

Sallie's Sandwiches
Sallie's Sandwiches is financed using 20% debt at a cost of 8%.Sallie projects combined free cash flows and interest tax savings of $2 million in Year 1, $4 million in Year 2, $5 million in Year 3, and $117 million in Year 4.(The Year 4 value includes the combined horizon values of FCF and tax shields.) All cash flows are expected to grow at a 3% constant rate after Year 4.Sallie's beta is 2.0, and its tax rate is 25%.The risk-free rate is 6%, and the market risk premium is 5%.
Using the data for Sallie's Sandwiches and the compressed adjusted present value model, what is the total value (in millions)?

A) $72.37
B) $73.99
C) $74.49
D) $75.81
E) $76.45

Question 10

In the compressed adjusted present value model, the appropriate discount rate for the tax shield is the unlevered cost of equity.

Question 11

Which of the following statements concerning the compressed adjusted present value (APV) model is NOT CORRECT?

A) The value of a growing tax shield is greater than the value of a constant tax shield.
B) For a given D/S, the levered cost of equity is greater in the compressed APV model than the levered cost of equity under MM's original (with tax) assumptions.
C) For a given D/S, the WACC is greater in the compressed APV model than the WACC under MM's original (with tax) assumptions.
D) The total value of the firm increases with the amount of debt.
E) The tax shields should be discounted at the cost of debt.

Question 12

MM showed that in a world without taxes, a firm's value is not affected by its capital structure.

Question 13

According to MM, in a world without taxes the optimal capital structure for a firm is approximately 100% debt financing.

Question 14

In the compressed adjusted present value model, the appropriate discount rate for the tax shield is the WACC.

Question 15

Which of the following statements about valuing a firm using the compressed adjusted present value (CAPV) approach is most CORRECT?

A) The value of equity is calculated by discounting the horizon value, the tax shields, and the free cash flows at the cost of equity.
B) The value of operations is calculated by discounting the horizon value, the tax shields, and the free cash flows before the horizon date at the unlevered cost of equity.
C) The value of equity is calculated by discounting the horizon value and the free cash flows at the cost of equity.
D) The CAPV approach stands for the accounting pre-valuation approach.
E) The value of operations is calculated by discounting the horizon value, the tax shields, and the free cash flows at the cost of equity.

Question 16

If the capital structure is stable, and free cash flows are expected to be growing at a constant rate at the horizon date, then the compressed adjusted present value model calculates the horizon value by discounting the post-horizon free cash flows and post-horizon expected future tax shields at the weighted average cost of capital.

Question 17

Glassmaker Corporation Data
Glassmaker Corporation has a currentcapital structure consisting of $100 million (market value) of 9% bonds and $300 million (market value) of common stock.Glassmaker's beta is 1.5.Glassmaker faces a 25% tax rate.Glassmaker plans on making big changes in operation and capital structure during the next several years.(Its tax rate will remain unchanged.) Under these plans, the free cash flows for Glassmaker are estimated to be $29 million for each of the next 4 years; the horizon value of the free cash flows (discounted at the rate assumed by the compressed adjusted present value (CAPV) approach) is $487 million at Year 4.Glass maker will increase its debt to $140 million in the recapitalization.This will cause the estimatedtax savings due to interest expenses areestimatedto be$3.2 million for each of the next 4 years; the horizon value of the tax shields (discounted at the rate assumed by the CAPV approach) is estimated to be $53 million at Year 4.Glassmaker has no nonoperating assets.Currently, the risk-free rate is 6.0% and the market risk premium is 4.0%.
​
Refer to data for Glassmaker Corporation.Using the compressed adjusted present value model, how much will Glassmaker's equity be worth after completing the recapitalization? (Round your answer to the closest thousand dollars.)

A) $316
B) $340
C) $348
D) $366
E) $380

Question 18

Sallie's Sandwiches
Sallie's Sandwiches is financed using 20% debt at a cost of 8%.Sallie projects combined free cash flows and interest tax savings of $2 million in Year 1, $4 million in Year 2, $5 million in Year 3, and $117 million in Year 4.(The Year 4 value includes the combined horizon values of FCF and tax shields.) All cash flows are expected to grow at a 3% constant rate after Year 4.Sallie's beta is 2.0, and its tax rate is 25%.The risk-free rate is 6%, and the market risk premium is 5%.
Using the data for Sallie's Sandwiches and the compressed adjusted present value model, what is the appropriate rate for use in discounting the free cash flows and the interest tax savings?

A) 12.0%
B) 13.9%
C) 14.4%
D) 16.0%
E) 16.9%

Question 19

In a world with no taxes, MM show that a firm's capital structure does not affect the firm's value.However, when taxes are considered, MM show a positive relationship between debt and value, i.e., its value rises as its debt is increased.

Question 20

The present value of the free cash flows discounted at the unlevered cost of equity is the value of the firm's operations if it had no debt.

Question 21

Zeta Technologies has the following projections.It has no non-operating assets.Calculate Zeta's intrinsic value of equity using the FCFE model. $\begin{array}{cccc}&\text { Current }\\&{\text { year }} & \text { Year 1 } & \text { Year 1 } & \text { Year 3 } \\\text { FCF }&\mathrm{NA} & \$ 1,000 & \$ 1,200 & \$ 1,248 \\\text { Total debt }&\$ 3,000 & \$ 3,900 & \$ 4,290 & \$ 4,462\\\text { Interest rate on debt } & 6 \% & 6 \% & 6 \% & 6 \% \\\text { Tax rate } & 25 \% & 25 \% & 25 \% & 25 \%\\\text { Long-term growth rate } & 4 \% \\\text { Required return on } & \\\text { equity } & 9 \%\end{array}$

A) $21,165
B) $23,282
C) $25,610
D) $28,171
E) $30,988

Question 22

Alpha Manufacturing has the following financial information for the current year and projected for next year.Calculate its projected free cash flow to equity. $$\begin{array} { l r r } &\text { Current } \\& { \text { year } } & \text { Projected } \\\text { EBIT } & \$ 1,500 & \$ 1,800 \\\text { Operating assets } & \$ 3,000 & \$ 3,400 \\\text { Operating liabilities } & \$ 200 & \$ 220 \\\text { Total debt } & \$ 1,500 & \$ 1,800 \\\text { Interest rate on debt } & 6 \% & 6 \% \\\text { Tax rate } & 25 \% & 25 \%\end{array}$$

A) $893
B) $983
C) $1,081
D) $1,189
E) $1,308

Question 23

Gators Incorporated has the following information for the current year and projected for next year.Calculate its projected free cash flow to equity.(Assume new debt is added at the beginning of the year.) $\begin{array}{lr}&\text {Current}&\\&\text {year}&\text {Projected}\\ \text { FCF } & \text { NA } &\$1,000\\\text { Total debt } & \$ 400&\$600 \\\text { Interest rate on debt } & 6 \% & 6 \% \\\text { Tax rate } & 25 \%& 25 \%\end{array}$

A) $1,066
B) $1,173
C) $1,290
D) $1,419
E) $1,561

Question 24

Epsilon Consultants has the following projected free cash flows to equity and other information.It has no non-operating assets.Calculate Epsilon's intrinsic value of equity using the FCFE model. $$\begin{array} { l c c r } & \text { Year 1 } & \text { Year 2 } & \text { Year 3 } \\\text { FCFE } & \$ 1,000 & \$ 1,200 & \$ 1,260 \\\text { Long-term FCFE growth } & 5 \% & & \\\text { Required return on } \\\text { equity }& 9 \% & &\end{array}$$ ? ?

A) $28,440
B) $31,284
C) $34,413
D) $37,854
E) $41,640

Question 25

The rate used to discount projected merger cash flows should be the cost of capital of the new consolidated firm because it incorporates the actual capital structure of the new firm.

Question 26

The market value of DeLoach Photography's debt is $200,000 and its yield is 8%.The firm's equity has a market value of $800,000, its free cash flows are growing at a 4% rate, and its tax rate is 25%.A similar firm with no debt has a cost of equity of 12%.Using the compressed adjusted present value (CAPV) model, what would its total value be if it had no debt?

A) $878,750
B) $925,000
C) $950,000
D) $997,500
E) $1,050,000

Question 27

Kitto Electronics Data
Kitto Electronics expects an EBIT of $200,000 for Year-1.EBIT is expected to grow at 6% thereafter.The tax rate is 25%.In order to support growth, Kitto must reinvest 20% of its EBIT in net operating assets.Kitto has $300,000 in 8% debt outstanding, and a similar company with no debt has a cost of equity of 11%.
Refer to data for Kitto Electronics.Using the compressed adjusted present value model, what is Kitto's value of equity?

A) $2,020,000
B) $2,070,500
C) $2,122,263
D) $2,175,319
E) $2,229,702

Question 28

Gamma Pharmaceuticals has the following financial information for the current year and projected for next year.Calculate Gamma's projected free cash flow to equity. $$\begin{array} { l r r } & { \text { Current } } \\& \text { year } & \text { Projected } \\\text { NOPAT } & { \text { NA } } & \$ 1,000 \\\text { Total operating capital } & \$ 2,000 & \$ 2,200 \\\text { Total debt } & \$ 900 & \$ 800 \\\text { Interest rate on debt } & 6 \% & 6 \% \\\text { Tax rate } & 25 \% & 25 \%\end{array}$$

A) $549
B) $604
C) $664
D) $730
E) $803

Question 29

Angelou Corporation has debt worth $150,000, with a yield of 8%, and equity worth $350,000.It is growing at a 5% rate, and its tax rate is 25%.A similar firm with no debt has a cost of equity of 13%.Using the compressed adjusted present value model, what is the value of the firm's tax shield, i.e., how much value does the use of debt add?

A) $33,750
B) $37,500
C) $41,250
D) $45,375
E) $49,913

Question 30

Volunteer Enterprises has the following information for the current year.Calculate its free cash flow to equity. $$\begin{array} { l r } \text { FCF } & \$ 1,000 \\\text { Interest expense } & \$ 40 \\\text { Frincipal payments } & \$ 200 \\\text { New debt } & \$ 300 \\\text { Tax rate } & 25 \%\end{array}$$ ?

A) $1,070
B) $1,177
C) $1,295
D) $1,424
E) $1,567

Question 31

Holland Auto Parts is considering a merger with Workman Car Parts.Workman's market-determined beta is 0.9, and the firm currently is financed with 20% debt, at an interest rate of 8%, and its tax rate is 25%.If Holland acquires Workman, it will increase the debt to 60%, at an interest rate of 9%, and the tax rate will increase to 35%.The risk-free rate is 6% and the market risk premium is 4%.Using the Compressed APV Model, what will Workman's required rate of return on equity be after it is acquired?

A) 7.4%
B) 8.9%
C) 9.3%
D) 9.6%
E) 9.7%

Question 32

Theta Therapeutics has the following information and projections.Use the FCFE model to calculate the intrinsic value of Theta's equity. $$\begin{array} { l r r r r } &{ \text { Current } } & & \\ & \text { year } & \text { Year 1 } & \text { Year 2 } & \text { Year 3 } \\\text { EBIT (operating profit) } & \text { NA } & \$ 1,000 & \$ 1,100 & \$ 1,200 \\\text { Operating assets } & \$ 1,200 & \$ 1,300 & \$ 1,500 & \$ 1,600 \\\text { Operating liabilities }& \$ 300 & \$ 300 & \$ 400 & \$ 500 \\\text { Total Debt } & \$ 1,000 & \$ 900 & \$ 1,100 & \$ 1,200 \\\text { Tax rate } & \mathrm { NA } & 25 \% & 25 \% & 25 \% \\\text { Interest rate on debt } & \mathrm { NA } & 6 \% & 6 \% & 6 \% \\\text { long-term growth rate } & 4 \% & & &\\\text { Required return on equity }&9\%\end{array}$$

A) $14,156
B) $15,572
C) $17,129
D) $18,842
E) $20,726

Question 33

Kitto Electronics Data
Kitto Electronics expects an EBIT of $200,000 for Year-1.EBIT is expected to grow at 6% thereafter.The tax rate is 25%.In order to support growth, Kitto must reinvest 20% of its EBIT in net operating assets.Kitto has $300,000 in 8% debt outstanding, and a similar company with no debt has a cost of equity of 11%.
Refer to data for Kitto Electronics.Using the compressed adjusted present value model, what is the value of Kitto's tax shield?

A) $97,741
B) $102,885
C) $108,300
D) $114,000
E) $120,000

Question 34

The market value of Rudyard Incorporated's debt is $200,000 and its yield is 9%.The firm's equity has a market value of $300,000, its earnings are growing at a rate of 5%, and its tax rate is 25%.A similar firm with no debt has a cost of equity of 12%.Using the compressed adjusted present value model, what is Rudyard's cost of equity?

A) 11.4%
B) 12.0%
C) 12.6%
D) 13.3%
E) 14.0%

Question 35

Eta Edibles had free cash flow to equity, required return, and long-term growth rate as indicated below.Eta has no non-operating assets.Calculate Eta's intrinsic value of equity using the FCFE model. $$\begin{array} { l r } \text { Most recent FCFE } & \$ 1000 \\\text { Required return on } & \\\text { equity } & 9 \% \\\text { Long-term growth rate } & 4 \%\end{array}$$

A) $18,909
B) $20,800
C) $22,880
D) $25,168
E) $27,685